Look, I love Amazon (AMZN). You name it, and I've probably bought it from Amazon. Just off the top of my head, in the past twelve months, I've bought headphones, a computer, camping equipment, guitar strings, apparel, music, movies, books... the list goes on and on and on. Whenever I want to buy something, Amazon's my first destination.
But just because I'm a devoted Amazon customer doesn't mean I'm a believer in their stock -- in fact, I'm staying well away from it. Here's why.
Amazon and Pricing
Amazon's share price has exploded over the past few years, along with revenue. In fact, TTM revenues trace out a fairly good model of the stock price.
click to enlarge images
But here's the problem. Earnings haven't kept up with revenues. As a result, the P/E ratio has skyrocketed to 186.
As a value investor, I tend to be very wary of stocks with sky-high P/E ratios. Why? Super-high P/Es are essentially bets on future growth. And if that growth doesn't show up, the stock doesn't just underperform -- it tanks.
Amazon's run-up looks eerily similar to another one I stayed out of: Netflix (NFLX). This time last summer, Netflix was being called a "Wall Street darling" stock... and then a few months later came the crash, which was essentially a gigantic P/E compression.
NFLX PE Ratio data by YCharts
Like Amazon, Netflix too had strongly accelerating revenues.
NFLX Revenues data by YCharts
And Amazon's EPS looks a little like Netflix's. Worse, actually.
NFLX Earnings Per Share TTM data by YCharts
Analyzing Amazon's Earnings
The reason Amazon's earnings haven't kept up with revenue is well-known: Amazon's strategy is to prioritize long-term growth over short term profits:
Throughout its 15-year history as a public company, Amazon has at times caused fits among analysts with its willingness to invest heavily in initiatives that erode the company's profits, with the promise that those seeds will eventually turn into a bounty the company can harvest in the years to come. That cycle, though, has repeated itself often enough that Amazon's skeptics believe it is a permanent state of affairs, indefinitely depressing Amazon profit.
I'm totally fine with companies investing in their future -- for example, I love Intel's capex in preparation for mobile chipmaking.
But the problem is that with a P/E of 186 (and a PEG well over 5), Amazon's stock is priced so highly that all of their initiatives had better succeed. They're walking a tightrope: one wrong move, and their stock could collapse like Netflix.
This problem faces Amazon especially in plans outside their traditional area of expertise -- for example, their planned foray into smartphones. (For a thorough analysis, see Helix Investment Management's article.) For example, it's well known that Amazon loses money on selling the Kindle Fire but more than makes it up in sales. In the last quarter, Amazon's share of the tablet market fell from over 16% to 4% -- and now Google has introduced the new Nexus 7, which is touted as a Kindle Fire Killer. This puts Amazon in somewhat of a bind: either they have to continue spending money to try and outdo Google, or they have to deal with dwindling Kindle Fire sales (which means the "future profits" they promised will never materialize).
So don't get me wrong -- I'm not saying that Amazon doesn't have a good future. Their back-end supply chain/logistics investments are likely to pay off for them in the long run, and their revenues should continue to increase strongly. Their cloud computing platform looks pretty good, recent power outages aside.
Calculations
As I mentioned above, the fundamental issue with Amazon is that they're priced for absolute success -- anything less, and they'll experience rapid P/E compression (aka, a crash). In fact, even if they do achieve great success, it's unrealistic to predict that their stock will continue appreciating in the long-term as it has now. Look at the example of Microsoft (MSFT), whose stock languished for a decade as it underwent P/E compression. Even though Microsoft's EPS almost tripled from 2001 to 2008 ($0.68 to $1.93), the share price went just about nowhere. Why? Well, a share price of $25 represents a rather pricy P/E of >36 for $0.68 EPS. The same share price of $25 represents a very reasonable P/E of 13 for an EPS of $1.93. So essentially, MSFT earnings tripled, but due to P/E compression, the stock performance was mediocre at best.
Many "new tech" companies like Facebook (FB), Zynga (ZNGA), LinkedIn (LNKD), and others have been caught up in this "new tech bubble" of unrealistic valuations. While these companies may continue to grow earnings, you can't expect them to maintain a P/E of 100+ forever. Amazon is in this boat.
What do you think a reasonable P/E is for Amazon, 10 years down the road? 35, perhaps? At today's stock prices, a 35 P/E for Amazon would represent roughly $6.40 in earnings. For Amazon to have a $225 stock price in 10 years, at a P/E of 35, it would need to grow earnings at 18% annually. For Amazon to have a stock price of $225 at a P/E of 30 in 10 years, it would need 20% annual EPS growth -- JUST TO KEEP THE CURRENT STOCK PRICE. One more scenario: the stock appreciates 7% per year (historical equity average) over the next ten years. This makes it worth $442 at the end of ten years. Just to have a P/E of 50 at this point, Amazon would need to log 22% annual EPS growth for 10 years. That's a hard task. And I'm betting you want more than 7% annual returns out of a "growth" investment like amazon.
The point of all these calculations: Amazon has a very high level of earnings growth priced into the stock already. While I have no doubt Amazon will continue to grow, the question is whether investors will get to cash in on any of that growth -- or if P/E compression will steal most of it away.
Conclusion
For what it's worth, I'm sticking with my "value" tech stocks like Intel. Such investments have far less downside (how much lower than P/E 11 can you reasonably go?) and far more upside, because even with a stable P/E, the stock price would grow at the rate of projected earnings growth. From a valuation standpoint, Amazon has too far to fall and little room to grow -- so I'm staying well away from it.
Disclaimer: I am an individual investor, not a licensed investment advisor or broker dealer. Investors are cautioned to perform their own due diligence. All information contained within this report is presented as-is and has been derived from public sources & management. Always contact a financial professional before making any major financial decisions. All investments have an inherent degree of risk. The future is uncertain, and actual results may be materially different from those expected. Past performance is no guarantee of future results. All views expressed herein are my own, and cannot be interpreted as the views of my employer(s) or any organizations I am affiliated with. Presentation of information does not necessarily constitute a recommendation to buy or sell. Never make any investment without conducting your own research and reading multiple points of view.
Disclosure: I am long INTC.
