Seeking Alpha
Value, special situations, research analyst, registered investment advisor
Profile| Send Message|
( followers)  

I don't think you'll find any bears in the Amazon River region of South America, but on Seeking Alpha, there is a habitat. So as soon as I saw the Amazon.com (NASDAQ:AMZN) announcement of its new Kindle line, I knew I was going to have to come here to see what the growly ones were saying. Actually, I knew in advance what they'd say: I just wanted to confirm that they'd stay true to form. I wasn't disappointed. Some among them can recite a script better than Kenneth Branagh reciting Hamlet's "To be or not to be" monologue (an admittedly low hurdle; I thought Branagh was awful in the role). Since the bears have come out of hibernation to commemorate the new Kindle announcement, I figure it would be worthwhile to others to do a more comprehensive review the key issues. So here goes:

AMZN Has High Valuation Metrics

Yes, it certainly does, that being the world's worst-kept secret. In fact, I'm not even sure the word "high" suffices when the forward P/E is 109. Stratospheric, incredible, breathtaking, or some new superlative, would seem preferable. I will tell you right here that as much as I admire the company and would really love to own its shares, valuation is the reason I do not presently have a long position. But it's not the triple-digit metric per se that concerns me.

Given that everybody who can count knows AMZN is so spectacularly valued, it behooves us to consider the possible reasons: (1) there's something about the numbers that makes the effective valuation less high than it seems; (2) investors are stupid; or (3) investors believe AMZN can grow into its valuation.

There is a bit to be said, in this case, for option #1. The second-worst-kept secret (behind the P/E) is the fact that AMZN's EPS are now below-trend due to the company's decision to step-up spending in connection with its hardware efforts. But we can't rest on that. Even if we were to assume Amazon had not moved beyond simple e-ink Kindles, we'd still likely be looking at a P/E in the range of, say, 50-80 depending on how much growth you think the company might have posted since 2010, the last more-or-less normal year.

As to option #2, the stupidity theory, I'd have settled comfortably on that one back when I was in my early twenties and still inclined to laugh at Mr. Market as I relished the conceit of being the only one who actually knew how to look up a P/E. But I'm a grown-up now and I know better. Mr. Market may not always be right, but he has reasons for doing what he does and if you are going to disagree, you really should take the trouble to understand where the differences of opinion lie and double-check your position.

Today, when valuation metrics stay as persistently and spectacularly high as they have with AMZN, the most prudent course of action, assuming option #1 (unusual numbers) has been taken off the table, is to pursue option #3, the potential for the company to grow into its valuation (actually, we'd like to see the company grow beyond its valuation, that being the difference, I suppose, between a Hold and a Buy). So that's the approach I'm going to take.

How Much Growth Would a Shareholder Need to See?

In a September 28, 2011 article, I presented a different sort of framework for evaluating a stock's price. Instead of passing judgment on the here-and-now P/E, etc., I try to back out the 3- to 5-year EPS growth rate the company would have to achieve in order to justify the current price and then determine whether I think this embedded growth expectation is reasonable. Details of the approach are set forth in the prior article. In sum, I (1) decide how much of an annual return I'd want to get if I were to buy AMZN today; (2) calculate what the price AMZN shares would have to reach in the future in order to give me that return, (3) divide the price by an assumed more-normal P/E to determine the level of EPS the company would have to achieve in order to make the investment work, and (4) calculate the growth rate it would take for EPS to reach that level.

Often, this process is quite simple. But when things are happening that make here-and-now EPS un-representative of the company's normal earning power, we have to be more thoughtful. I decided to refrain from using current EPS as a starting point. As noted, the number is being depressed by high spending in order to get the Kindle line established, which included the first version of Fire, new e-ink models, and now it's still newer offerings.

Let me stop here. A huge issue with many Amazon bears have is that the company is pursuing such a strategy. They apparently believe corporate management should never sacrifice the present to invest for the future and must always maximize the immediate period.

Amazon CEO Jeff Bezos, however, has shown himself to reject this sort of approach. He has been well known from day one to believe in subordinating short-term results to achieve long-term prosperity. And so far, he's done a decent job of it. The company broke into the black in 2003 and has seen profits grow consistently through 2010, the year its current hardware strategy started to seriously dent current results. Return on Equity is the primary method for evaluating the reasonableness of the profit earned by a firm. That's often been hard to evaluate for Amazon given that prior losses depressed equity, thus pushing the return-on-equity ratio to unsustainably high levels. What I can say is that by 2010, with equity having risen to more reasonable levels, Amazon's return on equity was 19.0%, which is pretty good in today's extreme low-interest rate environment. (Market interest rates are a starting point for determining cost of capital and acceptable levels of returns on capital). So at least through 2010, it's beyond dispute that Bezos was right and his critics were wrong. I'll discuss future prospects later, but for now, I'm saying all this to suggest that 2010, the last "normal" year of AMZN profitability, is a reasonable starting point for the analysis I want to do.

Back to the stock: I'll start with an assumed current price of $260 and that I want an annual return of at least 15% from the stock. That would put my five-year target price at $523. I'll assume next that the P/E will move down from above 100 to 30. That means I'll need EPS to reach $17.40. The company reported $2.53 a share in 2010. If the company hits $17.40-a-share in EPS five years hence, that means it will have posted a seven-year EPS growth rate of 31.7%.

Obviously, it wouldn't work if Amazon was to grow 31.7% per year starting now. As the world knows full well, and as many on Seeking Alpha loudly proclaim, current results are below-trend. So we'd need to see at least one year of growth that comes in well above 31.7% in order to pull it off. Nobody can know for sure what will happen, but I suspect we may get another dud in 2013 and see the super-normal compensating growth in 2014, or perhaps spread between 2014, 2015, or maybe even spread all the way through 2017. It's also possible Amazon may further stretch the timetable with more Kindle development (some even talk about phones), but for now, assuming the company sticks with what it has (including not just Kindle but its cloud efforts, Amazon Prime, etc.) the question is whether it's plausible to assume an AVERAGE growth rate of 31.7% for EPS between 2010 and 2017. It's not a slam dunk, but it's a lot more palatable than the here-and-now triple-digit P/E (based, as it is, on off-trend earnings).

If you want to change any of my assumptions and come up with your own threshold, look at the Appendix to my prior article. You'll see an illustration of an excel spreadsheet, with formulas spelled out, that can help you.

Can Amazon Deliver The Required EPS Growth?

Let's start by looking at some history. Figure 1 shows various year-over-year growth rates from 2003 through 2010.

Figure 1

(click to enlarge)

Revenue growth in 2011, which was not depressed by hardware spending, rose 40.6%, helped more than likely, by the presence of lots of new Kindles and Kindle apps (for pc, for mac, for iPad and iPhone, and for Droid phones and tablets).

Anecdotally, I'm an avid reader and have lately been getting into local book clubs and noticed two interesting and perhaps relevant phenomenon.

Contrary to stereotype, reading may not be quite as old-people oriented as some assume. Don't underestimate the twenty-somethings and thirty-somethings! Consider, too, the role of social media in helping face-to-face book clubs organize and for general on-line interaction (see, e.g. goodreads.com) in helping this emerge from the shadows. And the success of things like the Harry Potter series, the Game of Thrones series, the Hunger Games trilogy, all of which became huge in book form, suggest might not be so crazy for me to make inferences based on the small sample I observe.

The other book-club observation is that e-readers have barely begun to scratch the surface. Even among those I've met in their twenties and thirties, only a minority (less than a quarter I'd say) are showing up with e-readers, the rest still toting hard-copy books. Again, I'm working with a small sample, but it does appear that the e-reader trend (as well as the tablet and smartphone trends) still has a lot of growth ahead. And every new device has the potential to boost sales of books, magazine subscriptions, videos, etc.

Considering what Amazon has accomplished before the post-2010 hardware push (the basic Kindles were out earlier, but I'm talking mainly about the big Fire-driven push), I don't think it's crazy to assume Amazon can meet the 31.7% 2010-17 EPS growth target.

What about the future P/E?

I assumed a future P/E of 30. That, I think, is the much tougher issue. Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) are in the mid-teens. The issues for the company differ, but we do have to assume that at some point Mr. Market will cut Amazon's P/E and won't necessarily wait for the company to cease to be amazing.

If we cut the Amazon P/E assumption to 25, the required seven-year EPS growth rate would be 35.2%. With an assumed future P/E of 20, the required growth rate rises to 39.6%. And with an assumed future P/E of 15, the required EPS growth rate becomes 45.5%.

This essentially is what's keeping me from being long the stock right now. Even the 45.5% target growth rate is arguable, but I'm not ready to commit on that basis.

Competition - It's Not Apple, Google (hardware), Samsung, etc.

Yes, Amzon has hardware that competes, sort of, with Apple and Google, Samsung, etc. I say sort of because Amazon is not really a hardware company. It makes its money as a retailer, with books, videos and music being its most traditional product categories and a whole of other things having been added over the years. If Amazon could also profit from sales of devices, that would certainly be nice. But it's no more necessary that this occur than it is that Gillette make a profit selling razor-blade handles. Once you have the handle, you'll buy blades and that's where Gillette feathers its nest. Once you have an Amazon device (or app - more in a moment), you're likely to buy a lot of content from Amazon. That's the goal.

Apple and Samsung are clearly hardware companies. Google seems to be morphing from a search company into something. I'm not sure what that is. Judging by the way Google puts things out there and then lets them sit around (Google+, Google Office, etc.), I'm not even sure those who work there can say what the company will be five to ten years hence. Ultimately, I don't see Google as a serious hardware competitor to Amazon, because Amazon can happily make money when consumers use apps on Google devices. As far as retail goes, I'll discuss that below.

Suppose some or all of the big-name hardware companies introduce products that make even the new Fire look like smoldering embers, or suppose they cut production costs and prices to a level that would prevent anybody outside the Amazon family (those who get it for free or possibly with employee discounts) to want to own one. Might that doom Amazon? I've seen at least one Seeking Alpha bear suggest this would be the case. Actually, though, the notion is ridiculous.

The worst case competitive scenario for Amazon hardware is that Amazon gets blown out of the business. That means Amazon won't get to continue losing money on sales of devices - oops, the inability to continue to lose money is not a bad thing. Take two: That means Amazon won't get to sell books or videos to those who use electronic devices - Cut! There are Kindle apps for iPad, iPhone and Droid and darn good ones and they all synch magnificently; I have apps for my iPad, my Samsung phone and PC and as soon as I close a book on one device, all the others pick up the page numbers as well as any bookmarks, notes or highlights I added, meaning I can go seamlessly back and forth. It's good for Amazon if a book is bought for use on a Kindle. It's good for Amazon if a book is bought for use on an iPad or iPhone. It's good for Amazon if a book is bought for use on a Droid phone or tablet. It's good for Amazon if a book is bought for use on a PC or mac. It would be spectacularly good for Amazon if device pricing could fall further and thereby put more devices into the hands of more consumers.

It would of course be better for Amazon if it could have a monopoly on devices, but that's not happening because monopolies can be illegal and because Amazon wouldn't have the hardware prowess to pull it off. But the "lesser" scenarios, wherein Amazon content is used on apps in addition to or in lieu of Amazon hardware, are fine. To suggest it could jeopardize the company's survival is beyond absurd.

Competition - Barnes & Noble

I feel sorry for Barnes & Noble (NYSE:BKS). I really do. I love going into the stores and have been a frequent and heavy buyer for years. I'm not even bothered by the company being a national chain. They don't get nearly as much credit as they should for the latitude they give to store managers to tailor inventory to the tastes of the locality in which they operate, which adds massive appeal to the stores. I want them to survive. Actually, I want them to flourish - really. I'd feel a major loss if the chain were to vanish or become badly diminished.

Unfortunately, I do not like anything about what I'm seeing from this once-powerful book merchant.

First off, I have no idea what they were thinking when they decided at the outset that the in-store discounts available to membership cardholders would not apply to purchases of e-books. That's a good way to fight for share of a newly emerging market - Not! Even yesterday, I was at a Barnes & Noble near the Nook service desk and overheard a mother and young daughter being told by the representative that they couldn't use a Barnes & Noble gift card to download a book to the Nook Tablet the girl was holding; that it was good for in-store purchase only. I didn't follow the details of the explanation, but who cares. One might have thought that its considerable and impressive portfolio of brick-and-mortar stores would give Barnes & Noble a way to offer customers something Amazon can't match. I cannot imagine what sort of internal organizational structure or priorities could be allowed to trump that.

Worse, however, much worse, was and still is the Barnes & Noble tendency to see the rivalry between Kindle and Nook as a hardware competition that could be won by price-cutting and/or feature creep. Nobody should be surprised by how Amazon matched or exceeded every hardware development since Nook came out (color, tablet functionality, e-ink glow-light). That's the history of consumer electronics. Innovate and be imitated. What made Barnes & Noble think they could be an exception?

Oddly, though, Barnes & Noble completely neglected the area with a critical need for enhancement: its book-buying ecosystem. They did nothing to improve their web site since the debut of the first Nook.

Here's an anecdote illustrating how bad it is. Not long ago, my wife wanted me to pick up a particular kind of trade book at Barnes & Noble, but I couldn't figure out how it was classified for shelving purposes nor could I find a sales person to help me. So I went to the display area where all the sample Nooks are placed, picked one up and tried to do a search figuring that would give me clues as to Barnes & Noble's thoughts regarding classification. After several tries with me not being able to pull up a single relevant title, I took out my phone, opened the Kindle app, found many titles on my first search (repeating one that came up empty on Nook). I was then able to search Nook, but only after I had gone to Amazon to get the names and authors of specific titles.

This was not by any means an isolated occurrence. Back in the day, Barnes & Noble actually beat Amazon in getting an e-reader app onto phones, and after having tried it, I assumed I'd get a Nook when it debuted. But as my frustration with the ecosystem and sub-standard search protocols mounted, and as I found myself having to search Amazon, study reviews there, etc. before going back to the Barnes & Noble app to buy, I figured that the process made no sense. So I bought a Kindle instead, and never looked back.

I'm flabbergasted that Barnes & Noble spent as heavily as it did pursuing an ultimately-elusive hardware advantage, while it does not appear that they spent a penny where it really counted - on the eco-system behind the hardware. Nor, from on-line comments posted often by Nook users, does Barnes & Noble seem to have put much, if anything, into customer service. (As I was reminded yesterday having overheard the mother and daughter having cheerful humans who can interact with customers in stores means nothing if they are not empowered to satisfy the customer.)

I know I've spoken anecdotally, but what we see in the marketplace is consistent (with Nook still lagging Kindle by a wide margin), suggesting many feel the way I do. And the situation is especially pathetic considering Barnes & Noble has such an amazing brick-and-mortar presence, which seems to be nothing more than a wasted competitive advantage.

Assuming, as is the case, that competition is a fact of life, Amazon probably couldn't invent a better patsy against which to compete than Barnes & Noble. It has the feel of the barnstorming Harlem Globetrotters playing against the Washington Generals, a team created solely to be beaten by them.

All that said, we can't yet completely shut our eyes to Barnes & Noble considering that they are looking to work closely with Microsoft (NASDAQ:MSFT), which has big hopes for its own tablet. Presumably, the Nook app will be pre-installed. But unless Microsoft does something uncharacteristically stupid, which I doubt, Kindle apps will also be available, if not from day one then quickly thereafter. Microsoft wants to sell its tablet and excluding Amazon is not likely to be the route to prosperity, which will be hard enough since Microsoft's success in the post PC world remains limited. I see no reason to assume those who purchase the Microsoft tablet will be so enamored with even a pre-installed a Nook app that they won't spend thirty seconds downloading and installing the Kindle app. And that would bring us back to square one: a competition based not on hardware but on ecosystem, the battle regarding which Barnes & Noble has shown itself to be badly armed.

Competition - The Other Merchants and Possibly Tax Collectors

Amazon has been avoiding collection of sales tax and this has been giving it a price advantage over brick and mortar merchants, even those who are efficient. (I'm referring not just to books but general merchandise.) Bears suggest this won't last forever. On this issue, I agree with them. I can't imagine Amazon will be able to dodge this bullet indefinitely.

Bears also suggest this will eliminate Amazon's competitive advantage and badly damage the company. This is a much more interesting issue.

On the one hand, there is something to be said for immediate gratification, which favors the experience of going to a brick-and-mortar merchant and getting purchased merchandise into your hands right away. Amazon deliveries are pretty speedy, but it's not the same as immediate. And there's much to be said for physically seeing the merchandise before buying. The absence or diminution of an on-line price advantage may make them less inclined to go that route.

On the other hand, you can't see merchandise at a brick-and-mortar retailer or take immediate delivery unless they have it in stock, and often they don't and this is often not a random occurrence. With consumer spending likely to stay more subdued in this post-2008 world and with too many stores and too many malls (regional or strip) trying to lure those consumers, there's more pressure than ever for brick-and-mortar retailers to stay lean with inventory, not just quantity but variety. Most of my Amazon purchases have been motivated a lot more by availability than price. Brick-and-mortars could, of course, beef up their inventories, but that increased inventory investment could go a long way toward pushing their prices upward and putting Amazon back in the driver's seat, even without any sales-tax differential. Remember: operational scale and efficiency matter a lot when it comes to Amazon pricing. It's not just sales tax.

And even where stores have merchandise, consumers need to find time to get there. Some purchases I made at Amazon were done so because Amazon was able to deliver more quickly then I'd be able to get to the store, especially as the peak holiday season approaches and my aversion to traffic jams and filled-up parking lots mounts.

I don't know how to balance potential loss of the no-sales-tax factor versus the other aspects of Amazon's appeal. I'm not sure anyone else does. I think we'll all have to watch how this plays out and is one reason why I'm uncertain as to a future P/E assumption.

Another consideration is the apparent efforts on the part of Google to develop some sort of on-line shopping destination. This doesn't involve an e-commerce venue anything like what we see on amazon.com. Instead, they are hoping retailers who are visible in Google search results can be persuaded to pay to have specific products appear. If this works as Google hopes, a consumer looking for a particular product would, as an alternative to Amazon's e-commerce super-site, be able to search Google, find various retailers offering it and buy from one of them via their own commerce sites.

Google's efforts shouldn't necessarily terrify an Amazon shareholder. There's a lot that has to happen to make this a serious threat. First and foremost, retailers will have to be willing to ante up for the kinds of detailed search-result listings that would be needed. And there would have to be enough to enable Google to be seen, in the eyes of on-line shoppers, as a bona-fide eco-system that can offer the sort of variety and informational support they have come to expect on Amazon. Based on seat-of-the-pants (all we can go on at this point) thought, I'm putting the odds of this becoming a serious threat at below 50%. But Google being Google, it has to be well above zero.

Long-Term Fundamentals

I went into a lot of detail in this regard in an October 28, 2011 Seeking Alpha article. Obviously, these are not the most up-to-date figures. But the period that followed has so far been one that is not normal given Amazon's unusual spending on hardware launch. To get a sense of where Amazon was on a normal basis, you can check that article.

Summary

I'm not telling you to buy Amazon. As noted, I don't presently own the shares.

I am, however, hoping to help you recognize nonsensical rhetoric for what it is and call your attention to the relevant issues; (1) Good companies can and do at times sacrifice short-term results for long-term benefits and to date, Jeff Bezos has shown himself quite adept at making such sacrifices and garnering handsome benefits for Amazon; (2) Fundamentally speaking, Amazon is fine; even in its self-induced off period, it's still profitable; (3) Kindle Fire success would certainly be good for Amazon, but the company's future doesn't hinge on it; (4) Increased sales of devices, whoever makes them, benefits Amazon whose main hardware goal is to expand the range of its distribution and usage platforms; (5) It takes more than third-grade arithmetic to value a stock, so you can't just calculate a P/E and consider the job finished, whether said P/E is very high or very low; (6) the growth assumptions it would take to justify owning Amazon at current share-price levels are plausible, but not yet sufficiently high-probability to make we want in.

Source: Bear Hunting Along The Amazon