Amazon (AMZN) is one of the greatest businesses in the U.S. today and Jeff Bezos is undeniably brilliant. Amazon will undoubtedly have much larger revenues and profits 5 years from now. Of course, the challenge with investing into great businesses is that they usually sell at high valuations so finding a good price to buy-in can be difficult. Investors who have held Microsoft (MSFT) since 1999 are very familiar with the fact that buying a fast-growing business at a lofty price can lead to terrible long-term results.
The best business Amazon has is letting 3rd parties sell through its site. Amazon takes almost a 20% commission and has very little operating costs for those sales. That is extremely profitable and makes up for the money it loses selling new release books at such heavy discounts with free shipping. All booksellers get their books from publishers at 50% off the suggested retailer price (unless it’s a wholesale or overstock book). When you see Amazon selling a new release at 48% off and free shipping, it is losing money on it. It also reportedly cost Amazon $200 to make the Kindle Fire that it is selling for $200. The “selling at cost” is a brilliant strategy though. It builds customer loyalty, a stronger competitive advantage, and brings more people to Amazon's site.
Valuing Amazon is a complicated subject because all valuations are based on future projections, which are hard to predict for slow growing companies and impossible for fast growing companies. A good starting point for valuing Amazon is predicting what its max revenues will be before it hits a plateau and grows slower.
It is unlikely Amazon will ever do $1 trillion in sales a year anytime soon. Even $500 billion seems like a stretch (Wal-Mart (WMT) does $400 billion worldwide; Apple (AAPL) does $160 billion; Microsoft $70 billion). There is a point when Amazon's sales will stop growing in double-digits; whether it is at $100 billion or $400 billion is the question.
In a normal operating environment, Amazon earns a 3%-4% after-tax profit margin. This is typical for brick-and-mortar retailers and Amazon's profit margins are similar because they discount very heavily, have other operating expenses, and constantly invest into new technology.
If you take 3%-4% of Amazon's maximum sales in the future, you get an idea of how much it can make. If you think sales will hit $200 billion before they start growing slow like Wal-Mart, then it will make $8 billion in profit. At that time Amazon will be a slow grower and deserves a p/e similar to a large cap that grows slow. At 12 times earnings, it would be worth $96 billion. Amazon today is selling at $80 billion. So if you hold it for 10 years and it grows from $35 billion in sales to $200 billion, the stock won't move much.
Of course, if you believe Amazon will grow to $400 billion before slowing down (the most optimistic scenario), it could be worth $192 billion in 10 years. Still, not that impressive. If you buy Amazon and it grows from $35 billion in sales to $400 billion in sales in 10 years, you will only slightly more than double your money. You can double your money in 10 years from preferred stocks yielding 7% if you reinvest dividends.
Amazon could earn better margins than 4% in theory, but it operates in a highly competitive market with huge discounts. Betting on higher margins in the future is taking a huge risk. It operates in a highly competitive industry and attracts customers by being a deep discounter. If it raises prices to increase margins they risk losing sales to competitors. For Amazon to improve margins it has to raise prices, sell more high margin items, reduce operating expenses, or grow 3rd party sales faster than other sales on its site.
Amazon and Microsoft Comparison
Amazon today is very similar to Microsoft in 1999. In 1999 everyone thought Microsoft would rule the world. Microsoft was growing rapidly, every PC needed it, and it virtually had a monopoly. It had Bill Gates---the richest man in the world and often regarded as a genius---running it and the face of the company. You couldn't invest in a better company at the time.
The stock hit $58 in 1999 (adjusting for splits) giving it a market cap of roughly $600 billion. It earned $7.8 billion that fiscal year, so it sold at over 76 times earnings. Amazon today sells at 145 times 2011 expected earnings.
Today Microsoft has a market cap of $220 billion and makes $25 billion. In other words, even though profits in 12 years have gone from $8 billion to $25 billion, the price of the company has fallen more than 60%. Microsoft the company has done well by tripling profits in 12 years. The stock, however, has done terrible.
In hindsight it is pretty clear you’d be better off buying Microsoft today at 9 times earnings and growing slow than you would have in 1999 at 76 times earnings and growing rapidly.
Below are Microsoft's numbers from their 1999 annual report. Instead of a 4% profit margin like Amazon, Microsoft had a remarkable 40% profit margin. Microsoft was growing rapidly and grew sales 30% in 1999. They grew net income 73%. Amazon doesn't grow that fast but sells at almost twice the p/e Microsoft did when it hit its peak share price.
|All numbers in millions, except Diluted EPS|
|Year Ended June 30||1995||1996||1997||1998||1999|
|Diluted earnings per share||0.29||0.43||0.66||0.84||1.42|
|Cash and short-term investments||4,750||6,940||8,966||13,927||17,236|
If I invest in Amazon, and I might one day, it will have to be at a much more attractive price. Amazon is a phenomenal company that sells at an overly-optimistic price.
Additional disclosure: Some of my clients own Microsoft