The largest river in the world; a tall, powerful, aggressive woman; an ecommerce company that produces e-readers and sells cloud-computing services; a technology stock with a greater market value than Cisco Systems (CSCO) and Qualcomm (QCOM); a risky investment. Amazon (AMZN).
Given its abbreviation on the NASDAQ, this company might remind investors of the amazing run it has had over the years (though it might remind Carlos Slim of people eating lunch). Amazon survived the dot-com bubble to go on to become one of the world's most valuable companies, with a market capitalization that puts it among the top twenty-five most valuable publicly traded companies in the United States. Yet the value of technology companies seems more fickle than that of, say, the offspring of Standard Oil. Investors beware.
Last week, a single share of Amazon would cost $234 to buy and give an investor an ownership stake of about 2.2 Billionths of the company.
Thus, if Amazon earns two billion dollars in a year, an investor holding a single share of Amazon might reasonably feel they have a claim to four dollars and forty cents that year; and if Amazon claimed to have ten billion dollars worth of equity on their balance sheet, an investor might roughly estimate that they would receive twenty-two dollars for their share if Amazon decided it couldn't earn money and thus liquidated.
If the above figures seem modest, you might be surprised to find that they are actually quite generous. Amazon reported earnings of one penny per diluted share last quarter. They have reported less than forty cents in earnings per share for the each of last four quarters. In the last five years, they have only reported earnings greater than fifty cents in a quarter five times and they have never reported per share earnings of greater than a dollar in a single quarter. Amazon doesn't just report low earnings, they also report declining earnings. Earnings have declined in all but one quarter since the start of 2011.
Amazon also claims to have less equity than I used in my example. Currently, they show seven and a half billion dollars worth on their books, or only $16.60 per share. Few would use this as a primary determinant of Amazon's value, but the divergence between shareholder's equity and the price of shares seems extreme relative to other tech companies that carry over 100 billion dollar valuations. For instance, a share of Google (GOOG) would cost $642 and entitle its owner to $198 dollars worth of reported equity.
On the other hand, Amazon's rising market value dares us to deny the company's robustness. Shares continue to become more expensive to buy despite the anemic fundamentals. What can possibly account for Amazon's buoyancy? A salesperson hoping to sell you Amazon would cite qualitative aspects of the company's business. When pressed for numbers, they might present you with revenue figures.
The above chart shows five years worth of Amazon's self-reported quarterly sales. Taken alone, the growth looks impressive; but should investors look at growth alone?
To answer that, we need to make certain assumptions about investors. First, we will assume an audience of investors who are concerned primarily with earning a capital return on their capital investment. For instance, these investors would rather earn money on their investment than engage in charity or feel like they were "part of history". Second, we will assume that these investors see buying shares of a company as purchasing part of that company's business rather than buying chips whose value are decoupled from that of the underlying business. For instance, these investors would not buy shares of a stock based on a belief in a greater fool or chartist omens.
This subset of investors would seek to identify the value of what they put into the business and compare that with the value that they can take out of the business. To take out of the business, earnings must first be generated and retained, id est through the operations of the business or the sale of its assets.
What Revenue Figures Don't Tell Us
A company's revenue, taken alone, does not tell us about the earnings that company will generate. To understand earnings, investors must look at revenue in the context of the costs of that revenue and the expenses associated with keeping the business viable.
To use an analogy: If I measured the amount of energy in a tank of gasoline and equated that with the amount of kinetic energy I could give my Acura, I might expect to be able to accelerate my car to fantastic speeds. It will look exciting on paper, but a real-life attempt to achieve those speeds will prove anti-climactic, since reality accounts for things like the friction in my engine and the billions of tiny collisions between my car and the air molecules it drives through. In the same way, charting a company's revenues might be a great way to impress an audience at a shareholder meeting, but those shareholders might find themselves with thinner wallets a year later if they fail to understand those revenues in the context of the world in which the business operates.
To avoid losses, investors must thus seek to vigorously establish the relationship between revenues and earnings. Increasing revenues can be seen as positive, necessary, or neither positive nor necessary - in which case they should be seen as negative. We can view increasing revenues as positive when we can thoughtfully articulate a method by which we can generate greater returns on our investment in a higher revenue environment than we could in a lower revenue environment. We can view increasing revenues as necessary in instances when larger revenues are needed to protect the viability of the business, for instance in situations where a business must place large orders or have the capacity to sell large volumes due to the needs of its partners or customers.
We should view revenue increases with intense skepticism when neither of the above conditions are present. Since I suspect this sounds intuitively absurd, I will attempt to illustrate it with a short story.
A Short Story About Revenue
In a small village live a 10-year-old boy and a 100-year-old man who both deliver papers. They can earn one dollar every hour when they work. One day, the man tells the boy that if he brings him one dollar, he will give the boy two dollars in exchange for it, thus letting the boy make a free dollar. Excited, the boy delivers papers for an hour, obtains a dollar, and brings it to the man. The man gives the boy two dollars in exchange, which the boy then spends.
The next day, the man talks to the boy again and tells him that he will allow him to make another free dollar. This time, the boy must bring him two dollars and in exchange the man will give him three. The boy goes out, delivers papers for two hours, makes two dollars, and returns. The man gives takes the boy's two dollars and gives him three, which the boy then spends.
On the third day, the man offers the boy five dollars in exchange for four; on the fourth day, he offers him nine in exchange for eight; and so on. By the tenth offer, the man offers the boy $513 in exchange for $512, and the boy then works 64 consecutive eight hour work shifts before returning to the man to make his one free dollar. Exhausted, the boy says to the man:
"Let's pretend tomorrow is the eighteenth time you have doubled the cost of obtaining my free dollar. Working eight hours per day and 365 days per year, I will the same age as you by the time I make my next free dollar; and you will be dead."
"If only I had figured that out when I was at your age," says the man, "Say, you're a smart kid, do you have any advice for an old man?"
"Sure," replies the boy, "If you figure out how to get that final dollar, don't invest it in Amazon."
When all else is equal, a deal that allows you to turn one dollar into two dollars is better than a deal that allows you to turn $1,000,000 into $1,000,001. Yet the first (better) deal is the low revenue deal, and the second (worse) deal is the high revenue deal. Despite this, many investors seem keen to accept revenue growth as a substitute for presents and future tangible returns on their investment, when in fact they never should.
The Consequence Of Chasing Revenue
Those lusting after revenue growth often find themselves paying indulgences to a wrathful market. To find examples of such retribution, take a look at Fortune's 2011 list of "Fastest Growing Companies". The list ranks companies by their revenue growth. Amazon stood at 43rd place, with a three-year revenue growth rate of 31%. For many companies, membership on the lists seems to have been more of a curse than a blessing. Infamous names include First Solar (FSLR), Green Mountain Coffee Roasters (GMCR), and Netflix (NFLX). First Solar and Green Mountain Coffee Roasters ranked even higher than Amazon, at 8th and 9th place, respectively.
Investors enamored with First Solar's 64% three-year revenue growth statistic may be less impressed with the 73% decline in the value of its shares in 2011, and the further 65% decline in what remained by June of this year. What about the next fastest grower on the list? Appetite for shares of Green Mountain Coffee Roasters reached a fever pitch in 2011, rallying to $112 on September 19th; yet a three-year revenue growth of 63% would not save investors from the ensuing sell-off. Shares of the company would lose 60% of their peak value by the end of the year and another 50% by June of this year.
More modestly growing super-stars also fall. Take Netflix, for example. Fortune listed their three-year revenue growth at 23%, or eight percentage points lower than Amazon's growth. Netflix was successfully leveraging technology to disrupt brick and mortar movie rental businesses much like Amazon uses technology to disrupt brick and mortar retail operations. Like Amazon, shares of Netflix appreciated in a steep, linear fashion - then they pulled through the clouds, inverted, and gave investors the bird as they did a 4g negative dive. Shares that traded for just under $300 dollars in 2011 now trade for under $60 (an 80% decline).
How do these companies become so overvalued in the first place? Foundationless analyst enthusiasm deserves much of the blame. Analyst ratings often provide a false sense of security for investors. I'll use Piper Jaffray's (PJC) analysis of the above examples to demonstrate this point, since they reiterated an Overweight rating on Amazon last week with a $260 price target. Here are the last ratings and price targets that Piper Jaffrey had on First Solar, Green Mountain Coffee Roasters, and Netflix before those stocks suffered brutal declines.
First Solar: Piper Jaffray had an Overweight rating and a $200 price target on First Solar before the stock began declining. First Solar never reached that price. It fell to below $90 per share before Piper Jaffray issued a new price target of $150 per share and reiterated its Overweight rating on September 5, 2011. They didn't downgrade the stock to Neutral until it had fallen to under $33 per share on December 14, 2011.
Green Mountain Coffee Roasters: Piper Jaffray had an Overweight rating and a $117 price target on Green Mountain Coffee Roasters before the stock began declining. Green Mountain Coffee Roasters never reached that price. Shares fell to under $46 before Piper Jaffray issued a new price target of $52 per share and reiterated their Overweight rating on December 20, 2011. They did not downgrade the shares to Neutral until they had fallen to under $26 on May 5, 2012.
Netflix: Piper Jaffray increased their price target to $330 and reiterated an Overweight rating on Netflix on July 13, 2011, three days after the shares peaked. Netflix never reached that price target nor had it ever reached the previous price target. Shares had fallen to $156 before Piper Jaffray reverted back to their $305 price target and reiterated their Overweight rating on September 15, 2011. They did not downgrade the shares to Neutral until July 15, 2012, at which point they were trading for under $85.
Perhaps Goldman Sachs (GS) could make us a custom product that would enable us to short the reputation of analysts.
Misbehaving Fund Managers
Analyst rhetoric emboldens the worst kinds of fund managers in their search for returns. An ethical manager might see a rising stock like Amazon but avoid it if he thought the shares looked risky. A less ethical manager might see the same stock and buy it anyway if she knew she had the backing of the analysts. If the stock continues to rise, she gains face, but if the stock falls, she can shift her loss of face onto others. She can use the fact that experts were bullish on the company as "evidence" that the declines were unforeseeable, even if they weren't. This sort of ad populum fallacy works because it takes advantage of one of the greatest holes in the average person's intuition. If someone ever tells you that you must be wrong because everyone else in the room disagrees with you, don't even bother reminding them that all of the world's people once thought it was flat.
The fund managers and the analysts get paid in this scenario, while Granda Millie that bought the fund or listened to the analyst loses out. We can identify another loser though: The Company. The very fact that the price of the stock has coupled itself to the company's revenue growth and decoupled itself from all else poisons management.
Misbehaving Company Managers
Ideally, incentives align management with the health of the company and the returns of its investors, but the opposite occurs in a company like Amazon. In these companies, shareholders tighten their grip on their shares and even buy more shares when revenues rise. The stock goes up, they feel good about their holdings, and they reward management. In the case of Amazon, the effect is double, since Jeff Bezos undoubtedly enjoys the hot, whiffy edema of his own portfolio.
When everyone has married their happiness to revenue growth, management starts behaving badly in order to keep revenue growth high. It's easy, after all: slash prices a bit, advertise more. Suddenly they are slapping ads all over their website in an attempt to sell heaps of Amazon Kindles for less than they spend on the parts they need to build them. It sounds like a bad deal, but shareholders cheer when Jeff tells them that Amazon's own device is the best selling product on Amazon.com.
The result? See for your self.
Behold the effect of subsidizing sales and sacrificing profit for revenue. A nascent Amazon may have been able to ignore their margins as it established itself. It could skate on thin ice and not worry if it fell in the water, since it was small and could get back up. Today, Amazon is Jabba The Hut on ice skates, gliding across a massive, thawing lake. It isn't a matter of if, but rather a matter of when, Amazon will break the ice and take a very cold bath - and it could be next quarter.
Investors don't seem to notice, though. The share price simply clings to the sales data that Amazon releases.
Yet the shares don't tumble when earnings slide from low to negligible.
I was temped to elevate the orange line about a foot above the blue line to remind us that this stock trades at nearly 300 times earnings now.
High Price, Low Cash, Rising Share Count, Falling Earnings
Do we see the handwriting on the wall at Amazon? Shares have become enormously expensive, but shareholder returns have evaporated. Revenue continues to grow, but whatever weak connection it once had to earnings has been all but completely lost. This means that investors have allocated massive amounts of capital into a company by mistake, and now they have little left to do but wait to be smitten. Perhaps they dream that analyst salesmanship will attract a greater fool to bail them out. As they wait, they must buy more shares to support the stock and thus stall the market's wrath.
Recently, investors have had the help of company buybacks, but Amazon will not be able to support the shares with buybacks for long. Share count has been rising overall and will continue to rise.
Think about it this way: over the last five years, thirty-seven million new shares of Amazon have come onto the market. Just to neutralize one million new shares would cost Amazon over $230 million, since shares now trade for over $230 apiece. It is thus likely that Amazon will not be able to lend meaningful support to the price of its stock in the future since it will not be able to earn enough money to buy back the shares that are entering the market. Shareholders will thus have to continue to use their own money to support the stock. This wasn't so bad when shares were trading for $80, but at over $230 apiece this Sysiphean task will require a Herculean effort.
In order to maintain the share price, the large holders of Amazon must cooperate by holding onto their shares and absorbing new shares that become available. Eventually, the cost of supporting the shares will become too great for one of the players. In anticipation of this, that player will likely defect and begin to sell out of their position. Shares will rapidly reach a point of no return if no buyer steps in. I personally doubt any fund would step in and buy a large stake in Amazon at this point if shares were falling. Like little credit default swaps for equities, the premiums on the put options indicate that the market already knows this stock is risky.
Amazon could try to further support its stock if investors fled, but it lacks both the earnings and the cash it would need to do so. Amazon hasn't been able to build up a large cash hoard the way other large tech companies like Apple (AAPL), Microsoft (MSFT), Cisco, and Google have. They have an investment grade credit rating but it's rather meaningless since they have so few assets on their balance sheet to borrow against. Amazon bulls brag about the company's "lack of debt" but they ignore the company's dearth of assets. It's easy to have low debt when you lease and amortize nearly everything you use rather than buying it.
Just for perspective, Amazon reports seven and a half billion dollars in equity versus a market capitalization of over $105 billion. So even if shareholders lost $30 billion in market value, Amazon would still have an amount of equity equal to only 10% of their market capitalization. Shares would thus have to fall a lot further before Amazon could support them in any meaningful way.
How Low Can You Go?
Shares would also need to fall dramatically to come in line with earnings. Amazon's best year for earnings was 2010, when they earned $2.53 per share. Granted, their share count is rising, so achieving past levels of EPS will always an uphill battle for Amazon. We'll be generous and ignore that, though. We will also generously ignore all of Amazon's new employees, leases, and reality in general when coming up with an earnings-based value for Amazon. After all, this company needs all the help it can get.
Let's triple Amazon's best year's earnings per share to $7.59. From there, if we gave Amazon a price to earnings ratio of 15, which is slightly better than Apple's PE ratio (a true technology growth company with significant earnings), then we would come up with a value for Amazon shares of $113.85. Had we used last year's actual EPS, we would have estimated the value of Amazon shares to be $20.55.
No Stock, No Talent
Amazon's business will suffer when its stock corrects because Amazon needs its stock to fund its operations. I discovered this about a year ago after befriending a former Amazon executive that offered to get me a job at the company. After we talked, I began researching what it was like to work for Amazon. I interviewed someone I knew that had worked there, I scoured the internet for blogs, and I read what seemed to be most of the entries about the company on websites like glassdoor.com.
Afterwards, I felt like I had a good idea of what it was like to work at Amazon and why people chose to work at Amazon. To the former point, my research led me to believe that working for Amazon was generally an unpleasant experience, and I'm putting that mildly for the sake of politeness. I found out that employees nicknamed the Seattle headquarters "the meat-grinder" and many felt they were treated like lemons: brought on board when they were young and full of vitality, squeezed for all the juice they had, and tossed to the side once all that remained was their useless pulp.
Despite horrible conditions, people still apply to work at Amazon. From what I gathered, they tend to cite two reasons. First, compensation is decent, and given the performance of the company stock, people expect it to get much better if they hang around long enough to become an executive. Second, people think employment at Amazon looks good on a resume.
What can we infer about the first point? Well, if the prospect of lucrative stock-based compensation brings talent to Amazon, then removing the prospect of lucrative stock-based compensation will reduce Amazon's ability to attract and maintain talent. Thus, a decline in the price of Amazon shares will materially damage the health of the business. This company holds "frugality" as one of its core values. If the shares slide, don't be surprised if you see posters on Wall Street with this printed on them:
Uncle Jeff Wants YOU
To Help Pay His Employees
Nearest recruiting station
This is what makes Amazon such a risky investment. Not only does it have some of the most overvalued shares on the market, but it also needs those overvalued shares. When they decline, the business itself will suffer, and so they will decline more.
(Note: I gathered my data on Amazon's sales, earnings, margins, equity, cash, investments, and shares outstanding from their own reports. You can find those reports here.)
Disclosure: I am short AMZN.