In his recent article, Seeking Alpha contributor Arne Alsin makes the argument that Amazon's (AMZN) accounting for third party sales as net revenue actually understates the growth rate Amazon has been achieving. This, together with Arne expecting that Amazon will someday, somehow, achieve 4-5% operating margins on the gross merchandise volume which it sells, leads him to be positive on Amazon, and indeed, name it as his top pick.
Arne estimates that Amazon would report $97 billion in sales for 2012, instead of the $64 billion it will otherwise report, following GAAP rules.
I have several problems with this line of thinking. Here they go.
Gross Merchandise Volume Is Irrelevant
First of all, gross merchandise volume is irrelevant. What matters is the margins the companies are able to extract from this volume. Amazon reporting net or gross revenues is just the same -- it doesn't change cash flow and it doesn't change earnings. The only thing it changes is the reported revenues, and as Arne said, the implied growth rate on those revenues. But even there, the growth rate doesn't change much. Using Arne's numbers, Amazon grew its GAAP revenues from 2006 to 2012 at a 34.8% compounded rate. Had Amazon reported its gross merchandise value during those years, the growth rate would have been 38.9%.
If we look at merchandise volume, then other stocks would be more attractive.
While Arne is singing the praises of Amazon's $97 billion in gross merchandise volume, Alibaba is targeting 1 trillion renminbi, or $157 billion, for 2012. That's a full 61.8% more than Amazon, and as we've seen, Alibaba is growing faster as well.
Yet Yahoo sold 20% of Alibaba for $7.1 billion. That valued the entire outfit at $35.5 billion, or roughly one-third of Amazon's market capitalization -- for a company that, using this "gross merchandise volume" criteria, is 61.8% larger than Amazon and growing faster. That about sums it up.
If someone is so keen on buying a stock based on the gross merchandise volume it controls, or the speed at which it grows, one wouldn't buy Amazon. One would try to buy Alibaba or Yahoo because of the 20% stake it still holds (which, if valued the way Amazon is valued in the market today, would be worth more than what the whole of Yahoo trades for).
It Doesn't Stop At The Gross Merchandise Volume…
Arne repeats something that the market is taking for granted now: That Amazon has 100% gross margins on the third party sales, and also on the AWS services (though here, Arne indicates 75%).
This is simply not true. First, Amazon doesn't really report gross margins. In its SEC filings, Amazon includes a line for "cost of sales," and analysts have taken to the practice of removing this line from revenues and calling what they get afterwards "gross margins." However, these aren't really gross margins, because there are many direct, variable costs of selling that Amazon doesn't include in "cost of sales." For instance, payment processing charges are not deducted there. They show up a bit below, in "fulfillment costs." Commissions paid to affiliates are also not deducted there -- they show up a little lower in "marketing costs." These are clearly variable costs of doing business, which hit third party sales as much as they hit Amazon's own sales, so the gross margin on those third party sales is far from being 100%.
Regarding AWS, the same thing happens. Analysts sometimes talk about it contributing 100% to gross margins, but that's because Amazon only accounts for its business costs in the "technology cost" line. Indeed, Equinix (EQIX) is in a business comparable to AWS'. Does it report 100% -- or 75% for that matter -- in gross margins? No, it doesn't. It carries 50% gross margins, and AWS is certainly not much different.
My conclusion here is simple. No, taking into account gross merchandise value doesn't change much regarding Amazon's valuation and prospects. It's still incredibly overvalued, and its earnings and estimates are still heading the wrong way.
One can try justifying its market value by dreaming of a huge amount of revenues (which Amazon might attain) and then pegging a huge operating margin to those revenues -- but then the question remains: How is Amazon going to get those margins? Amazon is selling into a very competitive market, and as far as we can see in its financials, Amazon is not necessarily competitive on cost. Competing on price while not leading on cost is not a sustainable strategy.
Disclosure: I am short AMZN.