Amazon.com: Why Now Might Be the Time to Short

Amazon.com, Inc. (AMZN) is a compelling short at current levels. AMZN has shot up over 70% in the last two months, most recently on its "blowout q1" earnings report, a typically seasonally weak quarter in which AMZN reported EPS higher than their seasonally strong q4. Revenue growth has accelerated, and high hopes for new initiatives (digital distribution, web services, etc.) have fueled a speculative furor not seen in the name since the height of the boom. Analysts are excited by the prospect of amazon as a "media" company, rather than a online retailer of low margin products, trading at a over 100x earnings, with PEG multiples higher than Google (GOOG) and eBay (EBAY), both of which are more attractive, higher margin businesses.

For a variety of reasons, I believe these growth avenues are overblown, and that AMZN is more likely than not a leading online retailer with a strong online marketplace, low operating margins, and moderate but not spectacular growth going into the foreseeable future. I will argue that even if AMZN overnight became a leader in all areas they hope to grow into, the company would still be overvalued and likely to disappoint given current expectations. AMZN is overpriced on both an absolute basis, as well as relative to peers, and could see a upwards of a 30% drop based solely on a return to its prior lofty valuation levels, or upwards of a 50% drop if valuations were more in line with comps (which, arguably, are overvalued themselves), and potentially see further decreases as new ventures fail and their core retailing business receives continued pressure from offline and other online retailers, as well as the inevitable levy of an internet sales tax, which could wreak havoc on already tiny margins. Given the low PEG, as well as revenue and earnings growth going forward, I believe the risk of multiple expansion or multiples staying the same is relatively low, and that AMZN is an attractive low risk/high reward short.

Q1 "Blowout"
Amazon surprised analysts and everyone following the name. Though there were some legitimate business drivers for the gains (lower than expected margin compression, slightly better sales, etc.) the majority of the earnings surprise can be attributed to lowered R&D investment, a favorable tax situation, and foreign currency gains. These are not the kind of operational improvements that merit such an enormous increase in stock price, but instead served to artificially show earnings growth well above the real growth in the business.

Business Overview
AMZN is the largest pureplay internet retailer, with $10.7B in sales in 2006, and has grown its revenue at about 25-30% per year for the last few years. Though AMZN is primarily known to US investors for their domestic presence, the company has become an international force, deriving 55% of sales from the US vs. 45% internationally. The company continues to grow outside its core media products into other categories (electronics, etc.), but media--composed of books, dvd, and cds, still account for 66% of revenue.

AMZN is entering other popular spaces, including distribution of online music, dvd rentals, and its much hyped Amazon Web services. These businesses are all in their infancy, but are being relied upon to deliver growth coming forward, which I do not believe will come for several years, if at all.

Amazon's Non-Retail Businesses
Before delving to much into the economics of AMZN's core business, I think it is useful to discuss the prospects of Amazon's non-core operating businesses. I will argue that even if AMZN were to overnight become a leader in each of these new business, the total value of these business would not amount to more than $3B, or 1/10th AMZN's market cap.

Amazon Web Services
This business has received hype for sometime--despite being offered for the last couple years and not gaining much traction. The sales pitch here is that Amazon can sell its best in class technology and logistics solutions to other companies rather than those companies needing to worry about managing their own proprietary solutions. Outside their impressive e-commerce engine, which has been the bulk of the services hype, AMZN has a handful of other tools (a mediocre search product, selling excess storage an computer power, alexa, etc.) that have limited commercial value. Some analysts speculate that this opportunity could become larger than the entire business. I don't think any of these services--particularly the ecommerce service--will ever take off.

Reasons include:

1) Amazon is essentially trying to sell its technology to its main competitors (offline companies coming online). This is a lose/lose situation. Either it works and you make your competition stronger, or it doesn't and your business suffers.
2) Unsurprisingly, companies are not too keen on the prospect of outsourcing anything to a large competitor. If you are best buy, for example, how would you feel about licensing technology and trusting your infrastructure to your biggest online threat? It makes no sense to put the core infrastructure of your business into the hands of someone with a clear conflict of interest. Frankly, I can't see this business taking off as long as AMZN also acts as a retailer.
3) AMZN's e-commerce solution, in particular is not friendly with other solutions. If you are a offline retailer building an online presence, you want to be able to integrate your storefront with your webfront with your catalogue. It is very difficult to do this with amazon's solution, and this will never be something they are good at, given that they do not have a retail presence themselves. If you cut offline retailers out of the market, who are you left with, other than a few small niche online retailers who have themselves spent millions developing their own systems?
4) AMZN's other services (search, storage, cloud computing, etc.) are of questionable value, and are not related to their core competency (ecommerce). They might be able to make a few million from selling some extra memory and bandwith to startups (as they do now), but in my mind these don't representative particularly valuable near term or long-term business models.

For many of these reasons, Amazon has been eaten alive by GSIC in the e-commerce services space, which is the only area where I believe AMZN has a potentially valuable product. GSI, originally operator of small website Fogdog.com, has taken many of amazon's customers and won many contracts in head to head battles with e-commerce behemoth. GSIC reported $600M of revenue in the last fiscal year with its business here. Though AMZN does not break out this revenue, its other bucket for $263M for FY2006, so at the very least this business is half that of GSIC's and most likely more like a third or a quarter. Anyhow, for arguments sake, I will assume that this division is currently worth GSIC's EV ($1B), despite my belief that these businesses will continue to drain cash, and not be worth much of anything at all.

DVD rental
AMZN's foray into online dvd rentals is a much hyped, but largely irrelevant part of AMZN's future growth prospects. AMZN is a late entrant into the space, and it is unclear what additional value they bring compared with established competitors [Netflix (NFLX), Blockbuster Inc. (BBI), Wal-Mart (WMT), etc.], outside of arguably some benefit from their large customer list and distribution infrastructure. Despite speculation that they would launch in the US, they have only launched in the UK for the time being. I find it ironic that this business is attractive and an asset to a company like amazon, while the business on a stand-alone basis (with BBI and NFLX) is considered to be intensely competitive, unsustainable due to high churn, and at risk altogether from digital downloads. Forgetting all the concerns with the business model and the fact that AMZN is way behind the competition, I will assume that AMZN will become a leader in the space and that this opportunity is worth $1.2B currently, which is NFLX current EV.

Digital Distribution
Amazon is trying to eventually position itself to be a leader in digital content distribution. AMZN is late to the party, and has some formidable competition from the likes of Google, Yahoo (YHOO), Apple (AAPL), and a handful of small niche players (MovieLink, CinemaNow, etc.). To date, AMZN has focused on hyping its new digital music service. Lets forget for a moment that nearly all the big players have launched a similar service, or that apple is the undisputed leader in the space. After over a year of discussing ways of differentiating itself, including scrapped plans of releasing its own player, AMZN appears to have settled on a rather unspectacular solution--they will release DRM free music from EMI (for which APPL also has a contract), as well as 12,000 independent music companies. In other words, outside the 12k independent labels (who all likely have deal with APPL as well), there really isn't much differentiation, at least for the time being. Also, unlike other players, AMZN risks cannibalizing its own music sales.

Amazon also went ahead and released Unbox, a video download service that received some pretty awful reviews, particularly in comparison to Apple's storefront. This is another area where there are several established players, though no one has really been able to make the model work the same way it has worked for music. Even with broadband, movies can take a prohibitively long time to download, take up a large amount of server bandwidth, as well as a good deal of physical memory. Not to mention, unless you want to go through the hassle of hooking up your computer to your TV, you'll be confined to your computer screen for video watching. Like Unbox, AMZN's partnership with TiVo has generated little response, for similar reasons. Overall, I think this is another example of an expensive, early, and unattractive business. Despite all my reservations, I'll assume an EV of $800M for the digital opportunity, or about 8x the EV of Napster (NAPS).

Conclusion
Reviewing many of AMZN's most touted growth prospects reveals that, beneath the hype, AMZN faces significant competition in most areas, and even if we assume it becomes a market leader in each category, the total value of the opportunity is not particularly attractive currently.

Valuation
Netting out the $3B in non-core, immaterial businesses leaves us with a $27B market valuation on Amazon's e-commerce business. Using Amazon's upper end EBIT guidance for FY07 ($563M) gives us a forward valuation of 48x/EBIT. I use EBIT to net out the wild fluctuation in tax rate, which came in in the low 20%s vs. 40-50% historically for q1, and contributed to a large portion of the blowout q1. In addition to being an absurd multiple on its own right, this is well above EBAY (20-25x) and GOOG (25x-30x), both of whom I would argue have more sustainable competitive advantages, more attractive margins, and as good if not better growth prospects than AMZN. Even if we assume AMZN is worth the high end of GOOG's EBIT multiple, the stock would be worth about 40% less than it is now. If use consensus forward P/Es rather than EBIT, the numbers look even worse: 70x 2007 for AMZN, 33x for GOOG, and 23x for EBAY. Using GOOG again as the upper end of a market valuation would result in a drop of 0ver 50% from current levels. Using EBAY (arguably a more fitting comp) would result in 67% drop.

Another way to look at this is that the market was valuing AMZN at about $45/share before their earnings announcement, which it beat largely due to a lower than expected tax rate, a large decrease in R&D investment, and favorable foreign currency gains. I think it's difficult to argue that these factors should result in adding about $25/share increase, and that as a base case it would appear reasonable that AMZN should return to $50, where it was trading before its earning release, or a decrease of about 30% from current levels. Basically, any way you slice the analysis, AMZN is trading at an unjustifiable high valuation compared to comps, where it has traded historically, and on an absolute basis

Though I am usually hesitant to short high growth names, I believe the risk with AMZN is relatively low. Given memories of the internet bubble, and valuations significantly above other internet companies with superior growth profiles, I find it hard to believe that AMZN could achieve additional multiple expansion. Also, given my low expectations from growth initiatives, I don't believe we'll see AMZN as anything more than a 20% grower in a low margin retail business which, if correct, will be rewarded with a much lower valuation than experienced currently. Likely worst case scenario in my mind is that AMZN grows into its valuation over the next couple years and the stock moves nowhere. One option for the risk adverse would be to do a pair trade with GOOG and/or EBAY and profit from the multiple compression while hedging out some risk that the market continues its irrational pricing of some internet stocks.

Potential catalysts:

-Continued failure of new initiatives
-Internet sales tax is enacted or gains momentum
-Increased competition from niche players and offline companies building out an online presence.
-Rotation away from the internet names
-Unexpected tax rate fluctuations in upcoming quarters

Disclosure: Author is currently short AMZN.

AMZN 1-yr chart:

Comments

[Kris Tuttle]

A little screed-ish in presentation but a fairly thoughtful analysis of sentiment on AMZN.

I too am surprised how the company went from an also-ran to one of the Four Horseman that Jim Cramer is touting now.

Amazon is a great company, I admire them and appreciate them as a customer. As a business it is certainly solid and worth owning. But the move from 40 to over 60 forced me to cash out. I hadn't thought of shorting but in this market I'm adding to short positions so maybe some puts would make sense. Bull could still like the trendline if the stock fell from $70 to $50-55.

[ResearchIntensiveInvesting]

Thanks for the feedback--I should probably not try writing the bulk of a post like this at 3am again :).

I agree to that they have a great retail business and are doing some interesting things. This is one of those instances where I generally like the company, but think the stock is both a poor investment and has some near term catalysts that could drive the share price lower. I considered puts, but I don't feel comfortable trying to time this, and they are a bit expensive after the recent volatility. Also, I generally believe the upside at these levels is limited (I don't see this running much further, given that even many higher growth, lower market-cap runners like CROX, etc. are not trading for the same forward valuations that AMZN currently does.

[john_and_allen]

Shorting Amazon in my opinion, is the most suicidal advice you can provide your readers. Ironically, you are also telling them the great potentials Amazon has ahead.

Actually, we are experiencing a world of innovative technologies replacing old ones. Amazon is moving in synchronizations; although, some nascent technologies need time to be established, their trend is to takeover the roost. An example is Amazon Unbox on TiVo, in the future we could be able too see people in Australia downloading from Amazon on their TiVos that far. What do you think, a CD mail from Netflix is faster or more convenient? just think NOT R&D needed. So that, I don't agree with your statement: " Like Unbox, AMZN's partnership with TiVo has generated little response, for similar reasons. Overall, I think this is another example of an expensive, early, and unattractive business." All the contrary, if you look at the excitement this type of business is producing all over the net, you will be amazed. Just type: " Amazon Unbox on TiVo " in any Internet search engine and-watch results. So "unattractive&quo... is just another of your many: "I don't think."

In conclusion advising on shorting companies with innovative technologies such as: Amazon, Apple, TiVo, Google is really suicidal. Any of those companies stock-prices could climb hugely with just one accomplished home-run; for instances, if the Appeal Court rejects Echostar thievery appeal in favor of TiVo, Amazon starts selling its products directly on TV via TiVo. Apple start designing and selling UFTiVO. Google or Netflix offering free subscription on TiVo, etc. Amazon could start selling anything possible worldwide by globally syncronizing its technology with distributors of all sizes.

[ResearchIntensiveInvesting]

Thank you for the comments. I think a lot of the things you mention are far enough out that I am not worried about them having a large financial impact in the near term, as discussed in my write-up. Despite what some people may be saying about Unbox, it hasn't generated any revenue to speak of, and unless you see a big surge of sales in Apple TV or something else that allows the computer to better connect with the TV, I am not worried about digital downloads anytime soon.

There is a difference between investing in a stock based on valuation and expected financial performance, and investing it in because you like the company and think they are doing some neat things. This is exactly the kind of thing that helped fuel the internet boom, and will continue to allow for profitable opportunities to short companies like AMZN that get ahead of themselves. Though this is not something I plan to be short for 10 years plus, I do believe its jumping 70% on not much meaningful news is not a sustainable outcome, and that the risk/reward of a correction in the near future is a profitable opportunity.

[T Muller]

. A more realistic valuation in my opinion is $45/Share. I definitely believe the stock has gotten ahead of itself, and short covering has definitely helped push the stock higher as 8 million shares of short interest got squeezed out last month. I wouldn’t bet against this price momentum either; I wouldn’t short it unless the technicals completely collapsed. I wouldn’t buy it either unless it dropped into the low 40’s.
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