Is It Possible To Defend's Sky High Valuation?

| About:, Inc. (AMZN)
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Here on Seeking Alpha, certain stocks are more discussed and more controversial than others. And (AMZN) stands out as one of the most debated. Those bullish on the stock contend that it is changing the retailing industry, and that with Jeff Bezos at the helm, the company will thrive. And bears argue that the company is spreading itself thin, profitability is spotty, and the valuation is outrageous. So who is right? We believe that it is better to be bullish on Amazon than bearish, but this article should not be seen as a call to buy Amazon. We are simply looking at aspects of the bearish thesis and addressing why we believe that they are not an ironclad reason to be short the stock. As a matter of disclosure, we have no position in Amazon. We will explore several elements of the Amazon story, including its valuation and its financials.

Valuation: Duping Someone, Duping Everyone, or Duping No One?

Here on Seeking Alpha, we have noticed that it is difficult to defend stocks with high valuations. Detractors of companies like Amazon, LinkedIn (LNKD), or (CRM) all point to their outrageous valuations as reasons not to invest. But is it? For newly public technology companies, valuations are often seen as too high. Apple (AAPL) went public at 102 times earnings in 1980. And Google (GOOG) was valued at 218 times earnings when it became public. On a simple valuation standpoint, both companies would have likely been deemed to poor investments. Yet anyone who ignored valuations and simply bought shares at that time made one of the best investments that the markets have ever seen. And at around 140 times earnings (depending on whose figures are used) Amazon is in between Apple and Google.

And yet, there is a dilemma here. Apple and Google both grew into their share prices. Both grew so rapidly that they were able to increase their share price and lower the valuation. Not Amazon. The company grew and grew, and the valuation did as well. Amazon has been an "expensive" stock since it began trading in May 1997. Yet that has not stopped the shares from advancing over 11,000% since then. Simply ignoring Amazon's valuation has historically been a good way to make money.

Amazon's continued high valuation presents a set of questions. How has the company been able to sustain such a multiple (and occasionally no multiple due to losses) for nearly 15 years? Most richly valued companies have only a short grace period in which to justify their valuation, or face a plunge in stock price. Not Amazon. CEO Jeff Bezos and the company have largely ignored investors, all while delivering outstanding returns to them. From what we have read here on Seeking Alpha, critics of this company believe that no one should own the stock given its valuation. Yet 69% of the company is owned by institutional investors & mutual fund companies (Jeff Bezos owns about 19.33% of Amazon). How is it that these "professionals" (Bezos aside) are able to brings themselves to invest in a company that is supposedly uninvestable? Do they know something that we do not?

With high-priced stocks, their critics almost always charge that they are part of a pump and dump scheme, in which analysts promote (pump) the stock to naive retail investors, all while asset managers dump their shares on those innocent, unsuspecting retail investors. We however, think that this is not the case. Amazon's largest owners, aside from Jeff Bezos, are mutual fund companies such as Fidelity and T-Rowe Price. And 2 of the largest funds that own Amazon stock, Fidelity's Contrafund, and T-Rowe Price's Growth stock fund, have held Amazon stock for years. Fidelity's Contrafund has held Amazon since June 30, 2007, and T-Rowe Price's Growth stock fund has been holding Amazon since June 30, 2006. These are not hedge funds or investment banks unloading their shares on unsuspecting retail investors. Clearly these mutual funds, arguably run by "professional" investors know how to invest. So how is it that they have brought themselves to invest in this company, when the valuation should mean that no one should ever buy it? Are they being duped as well? We think not. In the last 15 years, the only investors who have been duped are those who refused to believe in the company. But, all this brings us back to the question of just how Amazon is able to sustain its premium valuation. And the answer, as with many things, lies in psychology, and can be illustrated by the dichotomy between Amazon and Microsoft (MSFT).

The Ballmer Discount, the Bezos Premium

Research & development is the lifeblood of the technology industry. For Microsoft, it means researching new ways of computing, new versions of its products, and new technologies that we may not have even thought of yet. For Amazon, it means something else. It is about changing the way people shop, changing how fulfillment centers work, and changing the way that media is consumed. The lines between traditional business investment and research & development are blurred at Amazon.

We are suing Microsoft here to illustrate the differences that investor psychology plays in determining a company's valuation. Microsoft spends billions on research & development each year, but in most years precious little to show for it other than incremental upgrades to its products. Occasionally, it sees success with things like Kinect. Microsoft bulls argue that the research & development Microsoft does, which many observers see as a huge waste of money, must be seen in a long-term context of at least 5-10 years out. But few people do, and Microsoft trades at valuations that many see as absurd as a result and we call this the Ballmer discount (this is not meant to be an article about the virtues or lack thereof of an investment in Microsoft).

Amazon, by contrast, is able to sustain its valuation from what we call the Bezos premium. Since founding the company, Jeff Bezos has run Amazon his way, always investing in the future, be it with the Kindle, his expanding warehouses, or most recently, Kiva Systems, which Amazon is buying for $775 million, thus allowing it to control the company's robotic machines (and presumably keep them out of competitor's hands). By ignoring the market, Amazon has been able to deliver huge profits to investors, all while sustaining its outsized valuation. This is the Bezos premium at work. Investors in Amazon believe, to this day, that Jeff Bezos can continue to grow the company and not only maintain its e-commerce leadership, but expand it. Too many investors forget that the markets are the sum of their participants. Psychology plays an enormous role in investing, and so long as people believe in Jeff Bezos, the premium valuation will remain. And investors who are short Amazon would be wise to remember it.

The Financials: Quality is in the Eye of the Beholder

Amazon has never been a company concerned with meeting its quarterly earnings estimates. And it has delivered outstanding returns to shareholders by doing so. If the quarter beats analyst estimates, wonderful. And if not, then so be it.

Amazon is in what seems like a perpetual investment mode, and that is a key aspect of the bearish argument. And the company's financials lay bare this fact. We provide an overview of Amazon's financials for the past several years below. Financials, 2007-2011

2011 2010 2009 2008 2007
Revenue $48.077 Billion $34.204 Billion $24.509 Billion $19.166 Billion $14.835 Billion
Expenses $47.215 Billion $32.798 Billion $23.38 Billion $18.324 Billion $14.18 Billion
Operating Income $862 Million $1.406 Billion $1.129 Billion $842 Million $655 Million
Operating Margin 1.79% 4.11% 4.61% 4.39% 4.42%
Operating Cash Flow $3.903 Billion $3.495 Billion $3.293 Billion $1.697 Billion $1.405 Billion
GAAP EPS $1.37 $2.53 $2.04 $1.49 $1.12
Cash & Cash Equivalents $9.576 Billion $8.762 Billion $6.366 Billion $3.727 Billion $3.112 Billion
Long-Term Debt & Liabilities $2.625 Billion $1.561 Billion $1.192 Billion $896 Million $1.574 Billion

Amazon's aggressive investments in its various businesses have allowed it to grow revenue dramatically, but margins are suffering as a result. And there is no escaping this fact. Amazon's financial statements do not lie. To be bullish on Amazon at this point in time requires a belief that margins will expand in the years to come. Yet for at least the first quarter of 2012, that looks unlikely. Amazon has guided for operating income (loss) of between ($200 million) and $100 million, as it ramps up its investments in retail, content, and the Kindle line. But should this be of concern to investors? Yes and no. The valuation will become even richer in the months to come, should Amazon continue on this path. Yet since this is simply more investing in the future, we believe that most of Amazon's investors will not be concerned by this. And in downgrading Amazon to neutral, Merrill Lynch echoed these sentiments. Its downgrade was predicated not on overvaluation, but on continued spending that will weigh on Amazon's margins. Merrill Lynch believes that margins will rebound in the future, but that it may take more time than many investors realize. The firm has a $235 price target for Amazon.

Amazon a Buy?

Here, the critics may pounce once again, charging that we are promoting a stock with a rich valuation, something that often seems blasphemous on Seeking Alpha, as if no stocks with high P/E ratios can be invested in. But, that is not the intent of this article. And we are not planning on buying Amazon stock. Why?

We are avoiding Amazon shares not because of its valuation, which we do not think of as a valid reason to avoid the stock or short it. Investor psychology shows that Amazon has been able to maintain a premium valuation for 15 years, and we see no signs of that trend ending anytime soon. And its margins, on their own are not a long-term issue. At some point, they will stabilize. Rather, we do not plan on investing in Amazon because we believe that it is suffering from an identity crisis.

Amazon started out as a bookseller, and gradually transitioned to being the largest e-commerce company in the world. But now, Amazon is expanding into many new markets. Cloud services. Digital media. Tablets. Payment services. Amazon is trying to compete in a myriad of different markets. And we do not think that is the best strategy, primarily because it is spreading the company thin. Companies like Google and Apple are able to compete in many markets because they are much stronger financially than Amazon. Google's reach seems to be in every technology market, yet that expansion, for the most part, is not coming at the expense of profitability. And at Amazon, it is. Before we would be willing to have a direct investment in Amazon, we want the company to have more focus. Amazon is trying to compete against companies like Apple and Google, and expand into new markets, but without the financial resources of those 2 companies.


We do not see issues with Amazon's valuation, for the company's investor base has tolerated its valuations since it went public. So long as Jeff Bezos continues to lead Amazon, we believe that the company will be able to maintain its valuation, much to the detriment of those who are short the stock. And the company's margins, while under pressure in 2011, and likely 2012, will recover to normalized levels in time. These factors, in our opinion, are not the real issue with Amazon. Rather, it is the company's identity crisis. But until can truly figure out what kind of company it is, we think that it is best to remain on the sidelines.

Disclosure: I am long AAPL, MSFT, CRM, GOOG.

Additional disclosure: We are long shares of MSFT via the SPDR Dow Jones Industrial Average ETF. We are long shares of CRM and GOOG via a mutual fund that gives them a weighting of 3.4% and 2.24% respectively.