Amazon And Irrational Exuberance: Sell For The Long Term

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About: Amazon.com, Inc. (AMZN)
by: D. H. Taylor

Summary

Amazon's valuation exceeds a rational market capitalization even after the market sold off.

AWS may very well perform going forward. However, the market has priced in way too much value into this portion of the company.

Retail remains a negative and will eventually weigh on the stock as revenue stagnates.

Prime adds to top and bottom line. However, there is not enough value to maintain market capitalization.

With the latest earnings release, Amazon (AMZN) has disappointed the market, and the stock sold off sharply. Even despite the selloff, I wanted to break out the potential of the three "pillars" to demonstrate that Amazon's valuation is still out of sync with its future potential; Amazon's stock price remains irrationally exuberant. The three pillars of Amazon: AWS, Prime, and retail marketplace, are still growing. Despite their respective current growth rates, however, future revenue and earnings do not merit the current stock price. When you look at each segment by themselves and then add them together, the valuations are too rich for even the most generous analysis. Eventually, the stock price will fall.

Here is a look at Amazon's stock chart:

Amazon Stock Chart

The latest earnings release

I wanted to first look at the latest earnings release, not so much to go over the minutia, but to show that the smallest miss led to a large price move.

As stated, Amazon beat earnings, and they did that by a large number. Q3 GAAP EPS of $5.75 beat by $2.66. However, revenues were lower by a small amount; less than 1%. Revenue was $56.57B (+29.3% Y/Y) but missed by $540M.

Along with future guidance, the revenue miss is what most are saying was the catalyst for the Amazon stock sell-off; the stock dropped from the close on Thursday of $1,748.00 to a low the next day of $1,440.00, a move of some 17% lower.

Here are some visuals on the revenue and the earnings to give a perspective of how the company is performing, where you can see where all the "trouble" comes from. Although there is increasing earnings, the rate is lower than the previous quarter's on a year-over-year basis.

Amazon Revenue Growth

Amazon earnings and revenue

The less than 1% miss on revenue dropped Amazon's stock by 17%. I believe that Amazon will miss more earnings releases in the future, and I also believe that future guidance will edge lower and lower with earnings. That could spell a lot of trouble for the giant. And, there is a lot of room for trouble.

The pillars and their potential

There are three so-called pillars within Amazon that Bezos and Co. look towards when they view the company. They are: Prime, AWS, and the retail marketplace segment of the company. There is also a potential fourth pillar, that being Alexa. However, that division has a substantial way to go.

Amazon Web Services (AWS) has been the key driver of the stock lately. The division started in 2006. Now, it is growing rapidly in a segment that is a big part of the company's earnings. The segment is supposed to grow 38% to end the year at ~$130 billion. Amazon now controls some 41% of that. This segment is supposed to reach ~$225 billion by the end of 2021.

Assuming that even in a pure perfect competition world, Amazon retains all of its customers and grows to 41% of that ~$225 billion, then Amazon's revenue from this segment would be $92.25 billion. Profits from that, using a generous 15% of revenue, would be $13.5 billion. The average market capitalization is about 20-times earnings. If AWS were standalone, given these factors, this portion of Amazon would be worth approximately $270 billion. A value investor would look at this company and expect to pay that amount for all of its company shares.

Then, there is Prime. Amazon kept the number of subscribers under a tight lid until just recently; Bezos revealed that the company had just surpassed 100 million Prime subscribers worldwide. Nice. The revenue on that is approximately $10 billion but, this will increase to about $18 billion by 2020 as subscribers and rates increase.

Given the same above calculations, at $18 billion, with 15% earnings rate and another 20 times future earnings, the value of Prime, standalone, is $54 billion.

Then, there is the final "pillar", the retail marketplace. This division is the largest, however, least profitable within the company. Before I look at the numbers, let me prime you with a question: How much would you pay for the privilege to lose money?

We need to estimate how much the retail segment of the business earns in order to get to the nuts and bolts of the business. The Street did an excellent job of this, and I will paraphrase their findings. If you separate out AWS and then the membership value of Prime subscriptions (via a decent approximation), you are left with revenue that is about 60% of total revenue. This is derived from both ads and retail marketplace. If you also separate out AWS and Prime earnings from total earnings, you get a decent approximation of earnings contribution from ads and retail marketplace business. Despite the fact that the referenced article was from a previous quarter, the retail segment - after separating out the AWS and Prime numbers - is fairly similar. The loss was ~$2 billion.

Ahhh... but wait, there is more. There are two factors that are going to start weighing on Amazon even more: Interest rate increases and tariffs will weigh on revenue and earnings for Amazon. Both of these, interest rate increases and tariffs, act as a tax on the consumer thereby decreasing their ability to spend on other things, such as merchandise on sale at Amazon.com. Interest rate increases have not seemed to have hit the consumer just yet, but, eventually, that will happen. And, tariffs will eventually hit all retailers; they will have to raise their prices. That will slow the purchases of consumers as well.

So, how much do you pay for a company that loses money? The AWS calculation came to about $270 billion. The Prime calculation was another $54 billion, bringing the total to $324 billion. Amazon's current market capitalization is $805 billion. By my calculations, in order to lose some $2 billion a quarter - $8 billion annually - you would need to pay $481 billion.

Either there is something way off with my math, which even rounding figures do not make these numbers jive, or Amazon's stock is irrationally exuberant. The numbers do not add up. The stock needs to come back down.

Revenue guidance

I mentioned earlier that I felt Amazon's revenue and earnings would be coming in lower in the future. The future is now. Barron's had this to say about the future guidance and how versus what the market is looking for:

In its earnings press release, Amazon said it now expects fourth-quarter sales to be between $66.5 billion and $72.5 billion. The midpoint of that range, $69.5 billion, is well short of the $73.8 billion that Wall Street has been expecting. Amazon's fourth-quarter forecast for operating income of $2.1 billion to $3.6 billion (with a midpoint of $2.85 billion) was also well short of the $3.86 billion estimate.

I think the closer we get to the next earnings release, things will get interesting for Amazon.

The takeaway and a disclaimer

Over the long haul, as more and more earnings numbers come in, the truth that Amazon does not produce a profit in its retail marketplace and the fact that AWS and Prime are not going to float the company and maintain the market capitalization will weigh on the stock.

I had not spoken kindly of Amazon's valuation just a few weeks ago. I felt it was irrationally exuberant. I had shorted Amazon when the stock was above $2,000.0.00 and rode that down to the dip at $1,750.00. I used options on the trade and did fairly well with it. I then put on a delta-neutral trade going into the earnings release, but I coincided the trade with Microsoft's (NASDAQ:MSFT) earnings release; I went long a debt-neutral trade on both Amazon and Microsoft simultaneously on Tuesday, just before. I had exited both of those trades on Thursday, prior to the earnings release for Amazon. However, I still had a long put on and just left it. That actually worked out well; the subsequent price drop put the put into the money. But the amount was small. So, I have been an active trader the past few weeks on Amazon.

Now that we know more information, I am looking for ways to short Amazon stock again. I am looking for a solid, long-term move lower. I will be looking over the short term to enter a structured, likely a delta-neutral, short position. I believe that Amazon's stock is way overpriced. And, I also believe the stock will move lower.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.