This article does not entail a recommendation on whether one should long or short Amazon (NASDAQ:AMZN). I would simply like to share a few rather interesting realizations I had regarding Amazon. I remember reading through Margin of Safety and coming across the passage where Klarman mentions that capital markets typically do not affect the underlying value of well capitalized firms. I immediately started thinking about Amazon, which may be a rare exception to the rule.
Amazon is an incredible success story that has had rapid growth and delivers substantial value to its customers. The equity markets have rewarded Amazon very well in the past decade. I have attached a few 7-year historic metrics, starting with P/E.
Next we have 12 month revenue growth rates.
And of course, we have operating margin as well.
So we have had a long term P/E multiple expansion, which is probably best explained by strong historic growth and optimistic outlooks. And shareholders couldn't care less about profitability in the near future, which is suggested by the operating margin data. As a result, Bezos doesn't care either.
I propose the following thought experiment. If everyone suddenly became cold-hearted value investors who offered to pay no more than a generous 20x FCF for Amazon, how would Bezos react? Such a posse of investors would threaten much of Bezos' equity wealth. Incentives would realign and growth would give way to cash generation. Failure to do so will likely result in a management shakeup. The point is that growth, without regards to margins or earnings, is the policy of Amazon as long shareholders pay for growth. Whether this adds or detracts value is a difficult question that bulls and bears grapple with.
The implications of the growth at all cost policy are rather profound. Amazon is a retailer that doesn't care about profits, a huge competitive advantage. According to McKinsey's 2012 report, Amazon prices goods 5-13% lower than its competitors, including shipping and taxes. On the other hand, Amazon's competitors are valued on their profitability and cash flow generation. Imagine if Macy's or Wal-mart suddenly priced goods so that their operating margins were ~1%. I don't think Mr. Market would respond well. Any corporation that doesn't care about profits is guaranteed to be a disruptive and potent competitor.
If shareholders stop buying growth and start paying 20x FCF, Amazon will likely raise its prices substantially to boost margins and profits. If operating margins are pressured up to ~5%, Amazon will have lost a substantial portion of its price advantage. It will cease to compete on price in the event of a changing shareholder base. Convenience will be its key sell point.
A Zero Coupon Bond
If we consider the operations of Amazon, we can intuitively understand that it is investing into its systems to expand, passing on savings to grow user base, and focusing on the long term. Chances are, we won't see a whole lot of FCF for a long time because of the growth focus. Most of the cash flow is then many years down the road, resulting in a payoff schedule similar to that of a zero coupon bond.
To figure out the valuation of a growth company like Amazon, we have to discount the future cash flow. We assume that current shareholders of Amazon are valuing it in this manner because the alternative is pure speculation. The present value of the security is very sensitive to the discount rate given the distance of the cash flows from the present (similar to a zero). Small changes in outlook and perceived discount rate lead to large changes. This is evident by the large price swings and P/E multiple changes we have seen lately.
It also means that Amazon is likely mispriced more times than not, as market participants wager on the correct discount rate daily with their dollars. Tiny mistakes in estimating the discount rate or future cash flow timings lead to large mispricings. There is a correct discount rate. We just don't know what it is.
Again, this article does not contain any recommendations for buying or selling Amazon. I just wanted to highlight that it is very difficult for other retailers to compete against Amazon since they face margin and profit pressures from shareholders. In addition, Amazon, like most growth stocks without substantial earnings, has payoff characteristics resembling that of a zero coupon bond with large cash flows at maturity. As a result, small mistakes in estimating a WACC can be brutal. I just figured the above insights are probably worth sharing. Feel free to share thoughts in the comments section and I welcome all feedback.
Disclosure: I am short AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.