Amazon (AMZN), fresh off its latest quarterly miss saw its stock plummet 11% the day following their earnings report. Remarkably, this one day sell-off saw over $20 Billion wiped off Amazon's market cap. For the record, that $20 Billion is more than 10 times the cumulative profit that Amazon has earned in its entire public existence - since 1997. Amazon is now trading at a PE ratio (TTM) of 714 - which is only slightly less ridiculous than its PE ratio of 1,300 that it was trading at before the latest quarter's earnings.
For the record, I like Amazon as a company. It unquestionably provides a great deal of value to the consumer and there are opportunities to recover a larger share of that value for themselves and for shareholders down the road than what they are currently obtaining. However, it is, by any standard measure, wildly overvalued. Its main business is in selling goods over the Internet - which I thought was sufficiently proven to be a pretty lean business model by late 2000. So, it's no surprise that Amazon is seeking to diversify into, well, just about everything - because just about everything offers better margins than its main business. The problem for Amazon is that its other businesses aren't all that profitable either. Of course, digging into the details of all of these businesses is very difficult, as most of the information is grouped into "Other" in the financial statements. We know from public statements that Amazon Web Services is by far the largest contributor to the bottom line but details behind even that segment are sketchy.
Indeed, a very telling sign to me that I'm not the only one who is having a very difficult time making sense of this company is that the analyst estimates are all over the place. Amazon's 2014 analyst consensus estimate for net income is $2.06 per share (that would give Amazon a PE of 174 - Woohoo!). However, the low estimate is $0.62 per share and the high estimate is $5.18 per share; if that doesn't make you think that there is a lot of dart throwing in analyst offices these days, then I don't know what will! For comparison's sake, the range for Wal-Mart (WMT) is $5.60 to $5.80, the range for Microsoft (MSFT) is $2.60 to $2.81 and Apple (AAPL) is $40.20 to $47.04. I haven't checked all companies, but I would be shocked if there were a company of even remotely similar size that had a similar forecasted range.
Amazon Comparison to Main Industry Competitors
Amazon's core business is retail of consumer goods and electronics and, as previously mentioned, the margins there are terrible. In the most recent 10Q, Amazon states that its operating margin for its entire business was 1%, and net margins were approximately 0.3%. This was touted from company documents as a major improvement over the previous year (which it was). However, is it logical that a company that makes 0.3% margins should receive a PE multiple of 714? Remember, this isn't a start-up company, but rather a company that has been around since 1994 (public since 1997). This is also a company that has built enormous scale, has instant name recognition, has a great corporate image and had a built-in competitive advantage to the majority of its competition from the lack of online sales tax (an advantage that is now going away). Despite all of this, its net profit margin is still less than one half of one percent!
Consider further that its main retail competition comes from Wal-Mart, Target (TGT) and Costco (COST). The comparable net margins for each of those companies in 2013 were 3.6% for Wal-Mart, 3.3% for Target and 1.9% for Costco. The S&P 500 average net margin is around 9% - so Amazon has the weakest net margin among a very competitive industry - again, not sure why it justifies a PE of 714. Speaking of PE ratios, Wal-Mart has a PE of 14.5, Target is 17.7 and Costco is 24.1. Oh, and if you are into actually receiving cash from your investment all three offer dividends, with Wal-Mart returning a current 2.5% yield, Target 2.8% and Costco a 1.1% yield - at current valuations. These latter three companies also have a history of stock purchases, whereas Amazon has steadily increased the number of shares outstanding through the issuance of stock for employee compensation (which has more than compensated for share buybacks).
In short, there must be something incredibly compelling about Amazon to justify its sky-high valuation. So, what could that be? The main argument pointed to by supporters, and the company itself, is that Amazon is foregoing profits in the short run to invest for longer term growth. So, there are two questions then - the first is whether Amazon is actually investing a sizeable portion of its resources vis-à-vis its competitors and the second is whether those investments have a high likelihood of delivering sizable benefits in the future.
To answer the first question, Amazon has seen its capital expenditures decrease from $3.8 Billion in 2012 to $3.4 Billion in 2013. Had 2013 investments been at the 2012 level, then its 2013 earnings would have turned into a $160 Million loss. Next, comparing their investment level to that of some competitors, we see Wal-Mart invested approximately $13 Billion in their fiscal year 2013, Costco invested approximately $2.3 Billion in 2013 and Target invested $3.3 Billion in 2012. Adjusting for revenue, Amazon spends approximately 4.6% of its revenue on investments, which compares to Target's rate of 4.5%, Wal-Mart's rate of 2.8% and Costco at 2.2%. This may seem like a more fair way to compare the companies, but remember that Amazon's market capitalization is almost the size of Wal-Mart's (actually about 71% of Wal-Mart's) and almost five and four times (respectively) of Target and Costco. Apparently, the market is convinced that revenue doesn't need to be a limiting factor in comparing these companies capital expenditures'. In short, I don't believe there is significant evidence that Amazon is simply out-investing their competition.
So, what about the quality of investment? The majority of the investment appears to be normal corporate expansion. Among the areas of investment, there is improvement in internal information systems (which have been pretty widely acknowledged by employees as being mediocre at best) as well as improvements to the various external websites. Additionally, a large portion of the capital budget is allocated to constructing new fulfillment centers (typically leased but Amazon offers upfront capital to the developers). After the normal business expansion needs it doesn't appear that there is a great deal of additional capital that is left over, yet the mantra is that this company is worth the high valuation now because it is investing its capital for future profits. I find it difficult to believe that the market would be so confident in Amazon's IT improvements and real estate expansion to give it its current PE multiple. Thus, it seems logical that the market has bought into the fact that Amazon's relatively modest remaining capital dollars are being put to phenomenal use in business units in the "Other" category in the company's financial statements. Of that, I am skeptical.
The view into how much is being invested into other business units as well as exactly what is being developed is pretty hazy. From what has been made public, Amazon has created a host of business units that are all presumably receiving at least some business capital. Among these are Amazon Fresh, its reincarnation of Webvan (because one super low margin business was not enough!), digital content, digital products (Kindle) and computing services (Amazon Web Services).
As a thought exercise, are there any of the above-mentioned business units that are realistically likely to break out in a meaningful way? Dismissing out of hand Amazon Fresh as small potatoes with minimal upside, one highly visible business unit is their Kindle unit, which includes the digital content and the devices themselves. We have heard reports that the Kindle itself is losing money, but how could it not? Amazon is positioning itself as the low cost provider of high quality electronic readers and tablets - since when does high quality at a low price pay off when the business doesn't have a cost advantage? Then consider that hardware and content competition comes from Apple, Google (GOOG) and to a lesser degree, Microsoft; and on the hardware side, any other enterprise with a contact in China. With the environment thus situated, it seems highly unlikely that this unit will ever be profitable - let alone wildly so.
Amazon Web Services (AWS) is a slightly different story, however. Estimates for top line performance were slightly over $3 Billion in 2013, which constituted by far the largest share (around 80%) of total "Other" revenue. In this segment, Amazon is a market leader, and it seems likely that this is a business that has some legs and that could grow into a profitable unit. However, I don't believe that this unit has anywhere near the potential to justify the current Amazon stock price. Although profit and loss information has not been made public, consider that one of AWS main competitors in this industry is Computer Sciences Corporation (CSC). CSC recorded net income of $687 Million in the preceding twelve months and has a market capitalization of approximately $9 Billion. For the record, Amazon recorded net income of $239 Million and has a market capitalization of $171 Billion. So, if this business unit is what is driving Amazon's market value up - then why is a company like CSC, which is more profitable by a factor of three than Amazon - valued at only 5% of Amazon's value?
Other investments give the appearance of desperation. For example, much has been made in recent weeks of Amazon's plans to develop drones to deliver packages. The fact that these drones would need to be designed, permitted, built, fueled and piloted (likely at much higher wage rates than current delivery drivers) hasn't seemed to be a consideration. Recently, it has been announced that Amazon has been bulking up its content for the video services on Amazon Prime. Despite the fact that survey after survey reveal that almost everyone who becomes a Prime member does so to take advantage of the free shipping, Amazon still feels compelled to spend money building content. This is despite the fact that Netflix (NFLX) offers a far superior product and for Amazon to be competitive it would need to dramatically increase its budget for content as well as advertising. However, it is understandable why Amazon would want to compete directly with Netflix considering Netflix's previous year's profit margin was a whopping 1.73%!
Other Potential Trouble Spots
Another troubling consideration for those long Amazon is its reliance on an absurdly long window between accounts receivable and accounts payable. In recent years, total accounts-payable days has edged up from 72 in 2010 to 74 in 2011 and 76 in 2012. As explained very well by Jeffry Chmielewski, This works very well when sales are increasing rapidly but less well when sales aren't increasing - which may explain Amazon's seemingly insatiable need to continue to grow - in any business segment around.
Lastly, another concern that I have with Amazon is their reliance on stock as a form of employee compensation. In 2013, Amazon's stock-based compensation was over $1.1 Billion (a $300 Million increase from 2012). It is well known that Amazon works its employees hard, but it pays them well. However, a large percentage of that pay to their corporate and managerial talent is paid in stock - what happens if the value of that stock goes down? If Amazon can't rely on stock to entice and compensate talent, then it would either have to pay additional cash to its employees or risk losing them to competing companies. If the share price of the company were to decrease sharply, this impact on employees could ultimately lead the market to question further Amazon's business and to punish it with a lower PE multiple. You can almost see the stories to be published about rats leaving the sinking ship.
Since Amazon went public in 1997 its stock has seen two major bull runs - the first occurred during the tech boom of the late 1990's and into early 2000. We know how that ended up but Amazon survived that crash and has enjoyed a second major run-up in value since 2009. Below is a chart of its stock price since 1997:
The more recent bull run has also been very impressive. Below is a chart showing the value of $1 invested in Amazon since the beginning of 2009, versus $1 invested in the broader S&P 500 index:
Despite the strong appreciation of the last few years, I believe that Amazon has not and will not deliver the financial returns that justify its current valuation. I believe that there are substantial questions about the health of the main retail business as well as the value of the numerous "Other" business units. In the next six to twelve months I believe that it is highly likely that the major players who own Amazon stock look to discard significant portions of their positions and that the company will settle at a valuation closer to that of its retail competitors. Below is a chart showing what the value of Amazon would be, if valued at the same PE as that of some of its major competitors:
Although it seems harsh to predict a 97% - 98% decrease in price, I do not believe that Amazon has a compelling reason to be much higher. As usual with these types of trades, the market has a habit of staying irrational longer than anticipated - thus my recommended investment method would be to purchase put options with long expiration dates. Currently, the longest expiration available for purchase is January, 2016. Judging by the rapid rise and decline of Amazon stock in its limited history I do not believe that there would be a strong psychological barrier to the market participants that would prevent them from selling when the main institutional investors begin to sell. Thus, the fall of Amazon's stock price could be rapid and the best way to position for that potential sharp fall is through put options.