Amazon: A Wonderful Business At A Terrible Price

| About:, Inc. (AMZN)

Few companies in American history have had the destructive impact on such well-financed and high-quality operators as Inc. (NASDAQ:AMZN) has had on its primary competitors. Drastic technological changes, a visionary management team, and favorable capital markets have enabled Amazon to build one of the widest moats in American business. While there is little doubt that Amazon will continue to enhance its strong competitive position, the relative attractiveness of the equity is marginal at best. For institutional investors that are willing to go short, selling calls to take advantage of the high implied volatility and to enable a better entry price into the short position would make a lot of sense. For retail long-term investors, Amazon offers absolutely no margin of safety whatsoever and should likely be avoided.

The only American retailer that Amazon really resembles in any way in terms of impact is the Wal-Mart Stores, Inc. (NYSE:WMT) of yesteryear. Both companies did everything they could to focus on the customer. This means offering the lowest prices and creating a culture where the customer is number one. While many retailers make the claim of putting the customer first, few companies have been willing to take the painful, yet necessary steps to accomplish the task. In Wal-Mart's high-growth phase under founder Sam Walton's leadership, the company did everything that it could to keep costs at an absolute minimum. This meant acquiring low-cost leases in small towns, and emphasizing a disciplined and unique culture, in which other benefits of the working environment were implemented to somewhat offset lower wages. In addition, Wal-Mart brought in talented executives from other retailers to implement a best-in-class logistics and distribution system. Of course, rapid economic and population expansion certainly aided Wal-Mart's cause like the shift towards Internet consumption has helped Amazon. Still, other competitors have had the same benefits but less success.

Wal-Mart's consistently low prices ensured significant volume and inventory turnover, while the logistics and distribution system kept stores supplied much more efficiently than its competition. Under Walton's leadership, Wal-Mart grew its store base at an absolutely astounding rate, with an efficiency and profitability that is truly unique in the history of retail. Walton realized that to differentiate itself from the other prominent retail operators, it was necessary for the company to have significantly lower mark-ups than its competition. Few retailers were willing to charge 20% more than they paid for an item, compared to the 40-50% mark-up that was the status quo. At that point in time, discount stores were fairly unique, and Wal-Mart out-executed and undercut the competition through the leadership of one of the greatest retailers and businessman of the last 100 years.

Amazon's development has been just about as extraordinary under the leadership of Jeff Bezos. From humble beginnings as a seller of books, the company has become one of the world's largest retail operations and technology concerns. Revenues have grown from a relatively meager $3.9 billion in 2002 to over $54 billion in the last 12 months. Amazon possesses considerable cost advantages over just about any retailer due to its lack of a physical retail presence, and the expenses that are associated with operating retail real estate. In addition, Amazon generates extremely high turnover, and it usually collects cash from the customer prior to paying for the inventory, allowing for extremely high returns on capital. Amazon has spent aggressively on various fulfillment locations and on technology to build out and eventually enhance its scale advantages in the online retail category.

These efforts wouldn't have been possible without accommodative capital markets. Amazon has used low interest rates to fund long-term debt required for capital expenditures, and the extremely high valuation of the stock has allowed the company to compensate employees without draining too much cash, and to acquire some of its competition, such as Zappos, etc. The share count is up about 20% in the last decade, and will likely continue to grow resulting in substantial dilution for current shareholders.

Amazon has been far less effective in generating the consistently high profitability that Wal-Mart was able to generate, even in the early years. Pre-tax margins of 6-8% on high volumes were considerably more attractive than Amazon's inconsistent margins, which generally have hovered around 4%. Wal-Mart's regional approach and exceptional operators make it a difficult comparison for anyone to measure up to -- even in today's extremely difficult retail environment, Wal-Mart has consistently posted operating margins around 5.8-6%. Amazon's market capitalization of close to $120 billion is rather extraordinary, considering the company has only generated about $4.8 billion in net income between 2002 and 2011. Amazon has also benefited from more favorable tax treatment through online sales, which is very uncertain moving into the future, reducing but not eliminating the company's cost benefits.

The bull argument is based on Amazon's wide moat (I don't think you could significantly dent its leadership with $5-10 billion), its explosive revenue growth, and the belief that its Enterprise and consumer technology businesses will lead to margin expansion. This argument makes a ton of sense to me, as I couldn't be more bullish on the business itself, but the stock price reflects far too much optimism.

Amazon is a category killer of gigantic proportions in online retail. Companies such as Best Buy Co. (NYSE:BBY), Circuit City, Borders, and Barnes & Noble Inc. (NYSE:BKS) have discovered that the modern consumer is both price and convenience sensitive. Through being the undisputed leader in both areas, Amazon has virtually assured that the companies that still exist are likely to struggle to earn returns significantly greater than their cost of capital.

Amazon's Enterprise business, where it allows virtually any type of business access to its technology infrastructure, is very attractive, and will likely grow at an even more robust rate than the online retail business. I'm less excited about the consumer technology side of the business, where Amazon's only competitive advantage is its digital distribution system. While the Kindle product line has been quite impressive and competitive, I'm less positive that Amazon's capital wouldn't be better spent improving and expanding its online retail business, than competing with the likes of Apple Inc. (NASDAQ:AAPL) and Google Inc. (NASDAQ:GOOG) in consumer technology.

(click images to enlarge)

As you can see, per-share earnings growth has not been very impressive for Amazon relative to the valuation. At its recent high of $259.99, the company is trading at 313 times trailing twelve months earnings. Analysts' mean earnings estimate for 2013 is $2.97, representing a forward P/E ratio of 87.5. Earnings are likely artificially low due to the high capital spending program that has been essential in creating the company's rapid global growth, but it is difficult to assess the sustainability of any decrease in capital spending, as the company has really never been run for maximizing profitability.

On the other hand, Wal-Mart has posted extremely strong profitability and earnings growth, as seen below. In addition, the more mature company has consistently been reducing its share count and paying solid dividends to shareholders.

Despite Wal-Mart's 50-year track record of success and drastically larger profits, the company only trades at about two times the market capitalization of Amazon. Imagine what an extraordinary amount of expectations are priced into Amazon for it to trade at such lofty levels, particularly considering Wal-Mart's stock is close to its 52-week high as well.

The table below shows what Amazon's 10-year earnings would be assuming 7%, 10%, and 20% EPS growth from 2013's questionable $2.97 analysts' mean estimates.

Even assuming 20% EPS growth, the company would be trading at greater than 10 times 2023 earnings. This doesn't make sense, and I see no reason why Amazon's stock won't perform as badly as Microsoft Corp.'s (NASDAQ:MSFT), Cisco Systems Inc.'s (NASDAQ:CSCO), or Dell Inc.'s (NASDAQ:DELL) did when they were trading at such ridiculous levels, despite what I expect to be exceptional business performance similar to what those companies experienced.

Selling the January 2014 $350 calls for $14.65 won't make you rich, but it should stack the odds in your favor for a market-hedge, or to initiate a long-term short position. For retail investors, it might be prudent just to put Amazon in the "too hard" pile. Short-term stock performance for a momentum stock such as Amazon is impossible to forecast, but I'd be very surprised not to see significant pain at some point for buyers of the stock at current levels.

Disclosure: I am long MSFT, DELL, GOOG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.