A Reality Check For Amazon's Haters

Oct.28.11 | About: Amazon.com, Inc. (AMZN)

It seems that Amazon.com (NASDAQ:AMZN) has been attracting some negative attention on Seeking Alpha. Consider, for example, some of the recent articles on this site: "Amazon's Earnings And Strategy Should Scare Investors, Attract Shorts"; "Amazon: The Perfect Storm"; "Amazon's A Great Buy If It Can Fall To $45"; "Why Sometimes I Hate Being Right: Amazon Will Go Lower"; "Amazon's Stock Should Trade Well Below $100," etc.

Hating Amazon is by no means a new phenomenon. Nowadays, they seem deeply bothered by AMZN’s decision to push its new Kindle products out the door for minimal profits or, as I assume, losses, and there does seem to be some consternation over the company’s margins, spending on other things such as data capacity, fulfillment centers, etc. Indeed, if you read enough, it would be easy to conclude that Jeff Bezos knows nothing at all about retailing. Consider the following, from a sell-side research report regarding AMZN’s offering of free shipping to some customers:

While (this) can potentially lead to better fulfillment economics, we believe the results of our study indicate that multiple item orders can also be more difficult for the company to fulfill efficiently, especially given Amazon’s breadth of product selection. Thus, we believe Amazon’s fulfillment operations could actually be stressed by this promotion (which we believe has been successful) and dramatically increase the costs of fulfilling these orders, thereby making it more difficult for the company to achieve its Q4 fulfillment efficiency targets. This struggle is at the core of our concerns over Amazon’s current broadlines business strategy. That is, we fear Amazon’s growth strategy is in direct opposition to its fulfillment efficiency goals.

While acknowledging that AMZN might rally into the holiday season, the three analysts who signed off on the report expressed concern about “a drought of positive catalysts following Amazon’s Q4 earnings release.”

The day before that 11/20/00 report was published, AMZN closed at $27.44. The first trading day following the company’s 10/25/11 earnings “disappointment” and reflecting they typical selloff that follows such an event, AMZN closed at $198.40, making for a 19%-plus annual rate of appreciation in the 11 years following the report. Yes, there were some awful times in between, not just for AMZN but for many stocks (for one thing, the bursting of the dot-com bubble getting underway). But ultimately, don’t the analysts’ concerns, which seemed so well-reasoned at the time (this was a 23-page report presenting a detailed and rather impressive research effort) seem so trivial now, when we can look back and see the big picture.

My purpose, here, isn’t to point a finger at the analysts who wrote that report. We all miss out on things. It is part of the nature of what we do when we evaluate stocks. I do, however, suggest that you think about what was really going on in that report, why these particular analysts went wrong at that particular time. They were dismissing the possibility that Jeff Bezos and his staff might actually know a bit more about running what is, essentially, a mail-order (albeit a modern cyber version of “mail”) retailing business than they did. And they, actually, may have been better qualified than most AMZN critics; the lead analyst on that team worked three years at Gymboree and Crate & Barrel before taking a job on the sell side, although the bio published by her firm doesn’t specify what she actually did for those companies (Mail order fulfillment? Cashier? We don’t know.).

But aren’t we supposed to be evaluating management? Gurus and writers are always telling us to do this.

That is, actually, one of the hardest questions to answer. It’s tempting, and fun, to directly second guess, as those analysts did, but unless we are truly qualifications to make professional judgments relevant to the actual running of the business, it’s incredibly easy for armchair quarterbacks to go wrong. Unless we’re truly expert in the company’s business (we’re all expert in something, so sooner or later we’ll all get chances to strut our stuff, but more often than not, we won’t have the necessary expertise), the best we can do is combine broad common sense (Is what management is doing at least arguably reasonable in light of what we see other businesses do and the results of those actions?) with a more thoughtful assessment of the results of what management has actually accomplished (the fundamental track record). This, by the way, is one of the reasons why I look at the profiles of Seeking Alpha authors and commenters, especially when the opinions are most virulent: As the flow of ideas becomes more democratized, the burden on the listener-reader to assess the capabilities of the speakers grows.

Not having experience in retailing of any variety, I’m going to be quite restrained in my assessment of Jeff Bezos and his team. I can bring some common sense to bear as an Amazon customer and from what I have seen over the years from other kinds of retailers and to some extent, even from the experiences of other emerging growth businesses. But I’ll focus mainly on the numbers, the telltale signs that help us assess whether the folks there know what they’re doing. When it comes to the details of how AMZN chooses to manage its business, I’m not going to second guess. If it seems rational in light of what successful businesses typically do, and if the AMZN numbers look good, then I’ll assume management is doing well.

Before going further, I just want to note that company analysis and stock analysis are two separate tasks. It is possible to encounter a great company whose shares make for a terrible investment (often because of over-valuation). It is also possible to encounter a terrible company whose shares are irresistible (i.e. the cigar-butt value approach). And, of course, we find countless of in-between combinations. I addressed the stock (i.e. valuation) on September 28. Today, I’ll confine myself to the company itself.

So let’s look at those supposedly horrible margins we hear so much about, and by implication the price cutting and spending levels. Tables 1 and 2 show AMZN’s five-year average operating margin and pretax margin as well as averages for the various categories of retailing (by the way, the Thomson Reuters fundamentals database, the one used in StockScreen123, puts AMZN in the Catalog and Mail Order group).

So where’s the margin problem? AMZN is in line with its industry averages and within retailing, its group seems middle of the road; nothing special on the good side, and nothing special on the bad side.

I do vaguely recall one Seeking Alpha commenter blasting AMZN for having margins well below those of other tech companies he/she follows. That’s an odd comparison. AMZN is not a technology company; it’s a retailer -- and Kindle does not change that (more on this below). Some might point out that AMZN’s gross margins are below average. So what? The difference between gross margin and operating margin often comes to a matter of whether a company chooses to classify certain kinds of expenses as cost of goods sold, or as selling general & administrative. Sometimes, the distinction is clear-cut. Other times it’s not. I’d get into more of a debate if I were an accountant, but I’m not. As an investment analyst, I’m content to focus on operating margin, which factors in both kinds of costs regardless of how different companies label them.

Moreover, margins in isolation are not important. High margin is usually associated with lower volume (turnover), and vice versa. Neither strategy is inherently good or bad. Some high-margin-low-turnover companies succeed; others don’t. Some low-margin-high-turnover companies succeed, others don’t. The most effective way to make comparisons is to use return on capital, which balances the margin-turnover tradeoffs all retailers continually make. The table below shows how AMZN fare in terms of return on equity:

That, actually, is pretty good, enough so to cast serious doubt on arguments taking issue with AMZN’s business model. It may still be possible to attack AMZN’s approach. There is more to life than numbers (more on this below). But at the very least, the burden of proof shifts to the AMZN critics, and with numbers like these, it’s going to be a pretty heavy burden.

By the way, ROE is not necessarily the most conservative measure of returns. It can be inflated by use of debt. But as Table 4 shows, the return-on-equity comparison is almost rigged against AMZN since it has spent years reducing debt and has now paid it all down, a situation that is in stark contrast with retailing in general, where ROE-boosting use of debt is quite common (although less so in AMZN’s sub-category).

When a still-young, growing company uses cash flow to pay down debt as aggressively as AMZN has, one has a right to wonder if it’s hampering its ability to prosper in the future. But the table below, which shows the five-year average annual rates of capital spending growth for AMZN and the various retail groups, should alleviate such concerns.

Finally, there’s growth. It’s not the most Graham & Dodd-esque metric around, but for better or worse, investors want it, and they want it badly. So we really do have to pay attention to it, and do so with the following 2 tables.

This is not an exhaustive study of all of AMZN’s numbers. But I think we have come far enough to see that Jeff Bezos may not be the dumbest person in retailing, and that maybe he actually knows a bit more about his business than at least some of his many cyber-critics. More importantly, the numbers we see suggest that we ought to give Bezos at least some measure of respect as we turn to what for us is necessarily the much more challenging task, an assessment of the qualitative aspects of this story? We can’t know for sure he’s still getting it right, but I think we can at this point confer upon Bezos a presumption of innocence. (Some may be jolted by such a suggestion coming so close on the heels of the Netflix disaster. I never really looked closely at the Netflix story but I’ve evaluated enough businesses over enough years to comfortably assume that when a company doubles prices in the face of a lackluster economy and increasing competition, any presumption of innocence its management might previously have had would vanish. There’s a fine line between common sense and second guessing and you have a better chance of staying on the right side if you are consciously thoughtful about the differences.)

So this brings us to the topic the haters have probably been waiting for, the rotten third-quarter results and potentially worse numbers we may get in the fourth quarter. If we can’t find a satisfactory explanation, then the presumption of innocence would have to vanish here as well.

First, let’s address the issue of whether it’s even proper for us to try to explain away the third quarter and the near-term guidance. The numbers speak for themselves, right? Well, maybe not. Numbers are important. As one who specializes in quantitative screening and ranking, I generally live and die by them. But then, if that’s all there was, anybody who reads a for-dummies book could quickly become a stock-market gazillionaire.

Actually, all of us, even numbers geeks like me, have to be aware of qualitative considerations and no, I’m not just making this up because I like to buy stuff from AMZN. It comes from no less a source than Graham-Dodd:

Presenting economic reality is impossible, through accounting or any other process. Economics is not an exact science; rather it is a social science in which judgments play a major role. It would be wonderful if accounting were one of the exact science that observes all variables, measures them with whatever degree of accuracy is needed and presents a final number that all would agree was “economic reality.” Unfortunately, it is not even possible for two persons to agree on what economic reality is. Economic activity manifests itself in many ways that are not subject to scientific observation and measurement. (Source: Graham and Dodd’s Security Analysis; Cottle, Murray, Block; page 137.)

This is why analysts often re-cast the financials in ways they deem more suitable for discerning the factors most likely to help them formulate reasonable assumptions about the future, a task to which G-D devotes considerable attention. In that spirit, let’s see if we can add some analytic perspective to Kindle and other kinds of spending AMZN is now doing even to the point of busting the here-and-now numbers.

Without getting into details you can read in many other places, suffice it to say AMZN is spending a lot of money today to produce what it hopes will bring in a lot more money tomorrow. It’s willing to pretty much give away or even subsidize a portion of the price of Kindles with an expectation it will make more money down the road as people buy e-content for use directly on Kindle or perhaps even other kinds of content if Kindle Fire habituates them further to shopping at Amazon as opposed to other venues.

Is this a slam dunk? Of course not. Is it a reasonable idea? Again, I’m not qualified to second-guess Jeff Bezos, but the initial introduction of Kindle seems, as far as anyone can see, to have brought in a heck of a lot of content sales, some of which AMZN might have gotten anyway, and some of which it might otherwise have lost. And by the way, prices on Kindle content are pretty much at full levels nowadays, but there are no costs associated with storing and moving physical objects. So it would appear AMZN and its content partners (who, under today’s agency model, tend to be the ones who set the prices) have some leeway to balance margin (pocket the cost savings) and turnover (which would likely be spurred if prices were to come down).

But what about other costs -- for data handling, regular-merchandise fulfillment capability, etc. Nobody likes seeing costs go up. Realistically, though, if you want to grow a business, you have to spend to cope with larger capacity. If you have a distribution facility capable of handling 1,000 widgets per month, and you want to grow to 2,000, you’re going to have to find a way to double your capacity, whether by building a new facility, expanding the one you’ve got, re-engineering the one you’ve got, or leasing from someone else. And the expenditures are going to have to be made before you get any new revenues. Good luck if you expect to tell those who supply labor and materials for a new distribution facility that you’ll pay them later, after you get money from sales of widgets 1,001 through 2,000.

While I’m not qualified to step into Bezos’ job, it does seem that basic business common sense supports the reasonableness of what he’s looking to do, and his track record to date (e.g., lowball pricing early on to attract customers who bought enough and paid enough later on to give AMZN above-average ROE) does seem to support a presumption of innocence regarding whether he’ll actually be able to find buyers for widgets 1,001 through 2000 and get them to pay enough to allow AMZN to continue to earn a reasonable ROE.

But still, AMZN stunk up the joint in the third quarter and, horror of horrors, may lose money in the fourth quarter. This is hardly a unique situation. Successful companies get that way by investing in their businesses. Sometimes, these outlays are classified as capital spending and don’t hit the income statement all at once (the expenditures are allocated over the expected life of the venture with the amount attributable to each year becoming a depreciation expense), and sometimes, they take the form of regular income-statement items, wherein all the impact is felt up front. AMZN is likely dealing with both kinds of expenditures. The expenditures that get recognized as depreciation are old hat; conventional accounting rules are well accustomed to handling them. That’s not so, however, for others.

If AMZN chooses to spend $210 for a Kindle Fire and sell it for $199, accounting rules cause the transaction to be tallied as an $11 here-and-now loss. But is that a complete picture of economic reality? Can we not assume that particular Kindle Fire will lead to more than $11 worth of profit for AMZN? Presumably Bezos believes this. He may be wrong, but then, amateur merchants who thought they had knew more about AMZN’s business than he does have not fared well historically. And it’s not exactly as if Bezos’ current strategy is leaning against the forces of common sense. We already know that people who buy e-readers really do use them to look at content they purchased. We’ve seen it with e-books and e-periodicals. We haven’t seen it with e-videos yet (although iTunes has some experience there), but the notion does not sound so crazy as to eliminate Bezos’ presumption of innocence.

Bottom line: Analysis of the stock can be dicey, but as noted, I’m not going to address that here because I already did so in my prior article. As to the company, however, I think it’s more clear that AMZN is pretty good and that haters are badly off base.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.