Since the start of the year, Amazon (AMZN) has made a good run, returning about 45%+. However, with a P/E ratio of 300, Amazon looks expensive. Is Amazon a good investment or is it over-valued? Amazon's value is driven by two key variables: its profit margin and its expected sales growth rate. Let's look at both in more detail.
Net Profit Margin
People have been concerned lately about Amazon's net profit margin, which has declined in recent periods. See chart below. A closer look will reveal that this is not a significant concern over the long term as the net profit margin will likely rebound in coming years.
Amazon added about 17.9 million square feet of fulfillment center space in 2011 which was 68% more than the previous year's square footage that already existed. 2010 itself saw a 49% increase in square footage from 2009. You need to build the business before you get sales especially when you are adding sales into the billions. The amount of square footage that Amazon added last year works out to 463 football fields (386 when you count end zones) worth of space.
Per the chart above, you can see that fulfillment costs contributed the most to a declining net margin. There are costs associated with this new space many of which are fixed, such as the lease payments, utilities, etc. If fixed costs increase faster than sales, then its percentage of sales will also increase which is what is currently happening. Adding this new space has directly affected profitability.
There is light at the end of this profitability tunnel though. Amazon is building out for the future. Last year's capacity may have grown faster to meet anticipated sales in the future, but sales will grow faster in coming years, better absorbing the newly built capacity. You can't grow if you don't have capacity; Amazon made sure it had the capacity first. So in the next few years, I expect fulfillment costs, many of which are fixed, to be better absorbed by rising sales which lead to a better percentage of sales. The gain will flow to the bottom line as improved profitability.
One of the numbers to watch to determine how Amazon is utilizing its capacity is the sales per square foot, which has declined recently as Amazon has added this new square footage. This number will rise again as space is used more efficiently. See below.
Over the long term, I expect Amazon's net margin to be anywhere from 3%-5%. This adjustment would put the P/E ratio into the 75-180 range instead of the current P/E of 305. This ratio is still very high because investors expect large increases in sales over time.
The Amazon today isn't the same Amazon from ten years ago. As you can see in the breakdown below, Amazon derives a large amount of its revenue from the Electronics and Other General Merchandise category and not primarily books.
In analyzing sales growth potential, there are three trends to consider: the growth of total retail, the growth of e-retailing as a share of total retail, and the growth of Amazon's share of e-retailing. Amazon is growing its share of e-retailing, e-retailing is growing its share of total retail, and total retail generally grows as fast as the overall economy. See below for a chart of the last ten years.
So what type of world do you see in the future? Is it one that George Jetson or Marty McFly would recognize where people make purchases on their smart phones and tablets instead of at stores? Or will brick and mortar continue to dominate as it has for thousands of years. This makes a big difference because it will directly affect Amazon's sales growth rates. The more people utilize technology to purchase merchandise, the more likely Amazon's sales growth rate will be higher.
This valuation is based on the two variables discussed above: net margin and the sales growth rate. Capex is expected to be about the same as depreciation over time. I also expect the continuation of no dividends and any profits are reinvested back into the business to support growing sales. I use a 10% discount rate and a twenty year time frame which is typically much longer than I would normally use but Amazon is expected to grow sales for a long time.
At the end of the twenty years, I calculate a market cap based on a P/E ratio times projected earnings. The P/E that I use is 13.67 (Gordon Growth using a 2.5% growth rate and 10% discount rate). Then, I discount that calculated market cap back to the present. Remember, I am not discounting any profits in between because all profits will be plowed back into the business to support growth and will not be available for owners. This proxy market cap in the future is about where the company will be traded after most of the growth is completed. What determines this future value is the rate of growth in the earnings which is directly related to Amazon's margins and sales growth rate during that time period.
Below is a value matrix based on these two variables. Amazon's current market cap is $113B. The gray line shows the combination where the market price is neither over- or under-valued. Per the table at a 4% margin, I calculate that the market is pricing an average sales growth rate of 17.5% per year for twenty years.
So what is the appropriate sales growth rate? That depends on how you see e-retailing becoming a more integral part of everyday consumer life. Amazon will be the primary beneficiary of more people using the Internet to make their retail purchases online. There is a lot of uncertainty here.
But consider this. I think Amazon is capable of about a 4% margin in the long term; at that margin, the market price is telling me that I need a sales growth rate of 17.5% to be fairly valued as noted above. With Amazon currently at about 0.4% of the world's total retail market share per above (Walmart has 3.4% of the world's retail), it would grow to 3.0% of that share in twenty years at a 17.5% growth rate (I assume world total retail grows at 6% per estimates by the IMF). The question is: is Amazon at a 3.0% of total world retail market share reasonable?
If Amazon makes up, at most, 20% of e-retailing (currently makes up 12.0% of e-retailing), then e-retailing as a whole would make up 15% of the world's total retail at that level. E-retailing today makes up about 3.2% of the world's total retail. Will the world buy 15% of its merchandise online in 20 years?
If you say no, then you think the stock is overvalued. I happen to think that a 17.5% growth rate for that amount of time into the future is not sustainable. There will always be a need to see and feel the product before you purchase it in addition to getting customer service from a live person. For example, you can buy the iPhone online but there is a reason why Apple stores exist that goes beyond the simple utility of online convenience. There are just not as many things that compete enough on price that you would buy simply by looking at a little picture of it online. Secondly, even if e-retailing did rise to those levels, then competition will heat up in that space. There are plenty of sites now that specialize and do just fine. Amazon's ability to navigate such an environment could be perilous.
So based on this valuation and analysis, my opinion is that Amazon is over-valued.
Any gain that could be had is likely already built into the price of the stock. Even if Amazon achieved these wild expectations that are baked into the price, the best return you can earn would not be far from the discount rate; the valuation is already very rich. So the risk profile is much wider on the down side for the stock price and investors could really lose money when expectations start to fall short.
In my opinion, Amazon is a great company but not a great stock at this time. It might be wise to steer clear for now.