Amazon is Overvalued and on the Wane

Larry is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Trees don't grow to the sky, and neither will Amazon. When a stock is priced for a stratospheric rise, it invites skepticism.

Sure, we order from Amazon (NASDAQ: AMZN), too. Who doesn't? Right now, that ubiquitous consumer use may make it seem invulnerable.

The online retailer’s first-quarter earnings and revenue beat analysts’ expectations after Amazon had issued guidance to analysts that there would be a loss. However, quarterly income fell over 40% from the previous year. The company managed fresh lows in operating margins of 1.5%, and guided to a quarterly range whose midpoint is an expected loss. It won a recent victory when the Justice Department sued five major book publishers and Apple of colluding to keep book prices higher than Amazon sells them.

The shares are up almost 30% this year. Amazon trades at a lofty 185 times trailing earnings. But before you buy the stock, consider:


Comfort Myths about Amazon


Amazon is like Coke.


The analogy is that Amazon is an indispensable franchise in its infancy, like Coca-Cola, and that like Coke, it is building out a global distribution system that will enable everyone in the world to want and use Amazon.


The biggest flaw in this comparison is that Amazon is a retailer, not a manufacturer. Coke has always had a distinctive product that you can only get from Coke, and a five-fold increase in the world population over its first 100 years didn't hurt either. In time, Coke leveraged its beverage distribution into a global marketing and distribution platform for a broad spectrum of products. Just like Amazon, right?


Anything Amazon sells, you can get from somewhere else. Its distribution system is a mix of its website, third-party shippers and warehouses of other people's stuff. Amazon's database has value too, maybe more than all the rest. But its only physical product  – apart from a catchy ordering phrase – is its electronic reader, which by most accounts is break-even or a small loss-leader.

Amazon is like Gillette.

Gillette is renowned for selling its unique razors at cheap prices so that you can buy the more expensive blades. Hewlett-Packard has the same model with printers. The pitch is that, even though Amazon gives away the Kindle at cost or less, it makes it up with better margins on its e-books.

We have no doubt that Amazon has higher margins on e-books, what with essentially no inventory or shipping overhead (although there are associated info-tech costs). However, e-books aren't unique to Amazon, and neither are books. Gillette's blades are only available from Gillette, and like Coke, are distinct enough to command a loyal following. 

In the longer term, besides other e-reader devices, Amazon is going to have an iPad problem. At the moment, the two devices don't compete any more than a Ford Focus competes with a Porsche: The gaps in technology and price points are too wide. However, if Apple follows its usual strategy, by the end of next year we should see iPads begin to encroach on the $199 segment as what is now the iPad 2 works its way through rounds of price cuts.

Amazon Web Services is the buried treasure.

This is the worst-kept secret on Wall Street. Say the secret word, "AWS," and all the Amazon bulls in the room jump up and do the secret fist pump. Although Amazon doesn't break out all the details, the prevailing belief is that AWS, its cloud-computing platform, is the company’s most profitable business. We don't doubt it. What's more, the legend goes, they're going to spin it out at some point so you're getting it now for – well, not for cheap, but it's "not even in the stock."

Oh, but it is. There isn't an institutional holder in the U.S. who doesn't know the AWS treasure story. And while we don't want to say "never," we do say, "fat chance." Do you really think Amazon wants to disclose how less profitable the rest of its business is? Five or 10 years from now, when Amazon is trading at 15 times earnings, the 80-something year-old Carl Icahn may buy up 10% of the stock and demand a spin-off, but Amazon is only going to do it when they have to. In the meantime, everybody with a server farm is trying to crash this business. That doesn't mean they can, but it does mean pricing is only going to become more competitive.

Someday, Amazon will cut back on capital expenditures.

Sure they will. And Wal-Mart will hand brooms to its customers and offer them a coupon if they sweep the store while they shop.

We will get to the numbers below, but while Amazon does spend a bit more in some years and a bit less in some others, here's the reality: No growth in cap-ex means no growth in revenue. Consider that carefully. It doesn't mean that if Amazon cut its cap-ex budget by 25% next year, revenue growth would stop. What it does mean is that Amazon has to keep spending on cap-ex to keep up with its competition, or its revenue growth will decline quickly, just like a retailer that stops spending money on its stores. (Can you say, "Sears?").

Later, we're going to model a 30% growth rate for Amazon for the next five years. That would be an impressive achievement. If the company does manage to pull this off, it's going to mean a lot more fulfillment centers and technology. When its growth rate slows, then it will slow spending on cap-ex. Not before.

Truths about Amazon

Amazon is a retailer.

It is not a cool product company like Apple (or even Gillette), and it is not a cloud stock, AWS notwithstanding. It is a retailer of general merchandise, the biggest general store out there. A more accurate comparison is Wal-Mart Stores (NYSE: WMT), the behemoth retailer whose sales are still 10 times Amazon's. Wal-Mart annihilated the regional and local department store model, taking a lot of local general merchandise business with it in the process. Like Amazon, it used economy of scale, friendly service and significant price advantage to become dominant.

But the Wal-Mart tree didn't grow to the sky. Instead, the stock price peaked at the end of 1999 and has been dead money ever since (though with the dividend, you did get some return). The law of large numbers caught up with the company: It doubled sales from 1995 to 1999, but the last doubling took almost 10 years. Once it owned the general merchandise business, it became stuck with rates of growth tied to the growth in the gross domestic product. Specialty retailers – like Apple, Lululemon and most of the luxury category – don't and won't distribute their products through Amazon or Wal-Mart.

Amazon's margins will always be supermarket margins.

If there is one issue that can start a fight in the Amazon tavern, it's the question of profits. Using Generally Accepted Accounting Principals? Non-GAAP? “Adjusted” (which used to be known as "EBBS," or "Earnings Before Bad Stuff")?

Let's cut to the metal and look at what we consider two very important metrics, ones that are much harder to fool with over time. The first is shareholder equity. Now, this number isn't impervious to accounting tricks, and we could have a lively discussion about Amazon's goodwill, but we don't need to at this moment. 

Consider the annual growth rate in Amazon’s shareholder equity (SE) since 2006:

        2011      2010      2009      2008      2007        2006

<table> <tbody> <tr> <td> <p><strong>SE</strong></p> </td> <td> <p>7,757</p> </td> <td> <p>6,864</p> </td> <td> <p>5,257</p> </td> <td> <p>2,672</p> </td> <td> <p>1,197</p> </td> <td> <p>431</p> </td> </tr> <tr> <td> <p>chg</p> </td> <td> <p>13.01%</p> </td> <td> <p>30.57%</p> </td> <td> <p>96.74%</p> </td> <td> <p>123.22%</p> </td> <td> <p>177.73%</p> </td> <td> <p>75.20%</p> </td> </tr> </tbody> </table>

Note how it has steadily fallen off, to a rather pedestrian 13% in 2011.

We're going to combine this with our own measure of cash return on the business: cash from operations, excluding changes in working capital, and after capital expenditures. In other words, how much are you really earning from your business operations? I use it as my "real" operating margin.

Using this measure, Amazon's average annual operating margin going back to 2003 (we excluded the recession year of 2002, so as to have a reasonable base) is 3.6%. It peaked in 2003 at 5.5%, and bottomed last year at 1.3%, but we don't necessarily take last year as the final indicator. The measure fluctuates, yet suggests that the median rate over the same time period is 3.4%. In the first quarter of 2012, the rate was 3.6%.

This is a supermarket margin. Not the bottom of the pack, certainly, at 1% or 2%, but a supermarket number all the same. And 3.6% is a no growth tech number, or even much of a tech number at all: our 2011 estimates for this measure in three other companies that we follow, cloud-computing software maker VMWare, Web-based sales aid provider and chip maker RF Micro Devices, range from 15% to 25%. Amazon earned $1.36 per share in cash after cap-ex for 2011, giving it a pricey multiple of 135 times to 150 times, based on the recent trading range (VMWare and are both in the 60-times range).

Now let's make some reasonable, even generous assumptions. The first assumption is that Amazon can grow revenue at 30% per year for the next five years. Its annualized rate for the last eight years is 31.85%, the company projects 30% for 2012, and as it gets larger, 30% will become more difficult to manage. But we'll take the sunny view. That would put 2017 sales at $232 billion.


The second assumption is that Amazon is still earning its 3.6% long-term average margin. That would put real operating earnings at $16.71 in 2017.


The third assumption is that return on equity will improve to 20% (compared to last year's 13%) and be the annualized average over the same time period. That gives Amazon $23,162 billion in equity at the end of 2017.


The final assumption is that Amazon's growth in share count is moderate, to only 500 million shares from 461 million at the end of 2011 (this is very nearly the same growth rate in share count as the last five years, 2006 to 2011). That would give Amazon a book value of $46.32 per share.


Now let's look at some possible valuations. In our hypothetical 2017, Amazon is a company with about $235 billion in sales. At that stage in its history, Wal-Mart sold for a bit more than four times book value. At five times book value, Amazon would be worth about $230 billion; at six times, $275 billion. For argument's sake, we'll take $190 as a reasonable average price for Amazon in 2012. The implied rate of return is then between 3.9% and 7.7%. You can get that in the bond market, without a 150 multiple.


But suppose that the company will sell for 10 times book value in 2017, which would be a gigantic first for a 22-year old retailer with 3.6% margins. That works out to a 19.6% return, which is pretty good. It will also trade at about 30 times cash earnings, also remarkable. Is it possible?


Retailers generally do not have moats around their business, especially ones who do not have their own product line. Their glory days come during the period of rapid store expansion; at some point, geographic saturation sets in. Amazon, of course, doesn't have physical stores, but does have branding power and it does have one moat – almost no sales tax. 

Two of these will probably fall over the next five years. Amazon is going to end up paying sales tax. We liked its no-tax situation in the early days of the Internet, but the infancy period is over. Governments need money, and the burgeoning practice of "showrooming," or going to a physical store and then ordering it from Amazon, is a point-of-sale distinction that no longer holds up. Taxes are an emotionally charged issue, yet this one is going to go. Local governments are keenly aware of the job, tax and revenue losses from stores disappearing under the Amazon juggernaut. Wal-Mart shrunk the nation’s store base, but Amazon kills it.


Which brings us to showrooming again. It wasn't long ago that Circuit City went out of business, leaving the field clear to Best Buy (NYSE: BBY). That party was short-lived. Best Buy is on the ropes now, being showroomed to death. If  Best Buy should vanish, where will you go to look at your television before ordering it from Amazon? Wal-Mart or Costco, perhaps, but your selections are going to be limited.


The answer is that Amazon may very well be obliged to start opening its own showrooms. Shocking, but think about it – what else are they going to do if you can't check out the merchandise first, particularly in electronics and durables? It won't be any Apple-like story, either, as that company has exclusivity around the magic of its products. It'll mean more cap-ex, and while the novelty might increase sales for a time, margins won’t get a lift.


Amazon's stock price got a recent run-up on the news that it bought Kiva Systems, a robot maker. The obvious bull-broker thesis is that Amazon will drive costs down by stocking its fulfillment centers with robots (and we suspect the move was partly driven by the spate of publicity about challenging work conditions at fulfillment centers).


We think it can happen, but it will take time to make it work successfully, and longer to make it accretive to earnings. But consider also how that is going to change Amazon's situation with local governments – it’s going to build a fulfillment center, and hire 10 people? That's not going to replace all the lost little stores, is it?


One possibility in the next five years is an online supplemental sales tax, where Web purchases trigger a higher sales tax than physical stores. The argument: Such a move protects local business and tax revenue.


Amazon's myths mislead investors. It is not a good long-term investment. But before you run out and short Amazon stock, be careful. In the growth-starved world in which we live, Amazon still has revenue growth, and it can put up big numbers by selling stuff at or below cost. Its latest earnings beat started another frenzy, though how long the stock lasts at these levels is another issue.


Growth managers are willing to pay up for growth when times get tough, because there are fewer candidates. Perhaps the biggest irony of Amazon's stock price is that if we were living in a world of strong growth, the company would have a much lower multiple by now with its recent string of poor bottom-line results. But with alternatives scarce, fund managers are reluctant to sell its stock. They were afraid to sell Digital Equipment and Research in Motion, too – until everybody else did.


For every growth story, new myths come along to replace the broken ones. We would not be surprised to see within the next year, some manager on TV talking up how Amazon is going to own the online robot business.  All that said, we guess that five years from now, Amazon is the new Wal-Mart – and the stock turns out to have been dead money.


M. Kevin Flynn, CFA, is the president of Avalon Asset Management Company in Lexington, Mass.


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