Amazon Is Overvalued and On the Wane: Part I
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 (NASDAQ: AMZN). When a stock is priced for a stratospheric rise, it invites skepticism.
Yet the online retailer’s recent first-quarter earnings of $0.28 per share, combined with revenue growth of 34% over the first quarter of 2011, easily beat analysts’ expectations after Amazon had issued guidance to analysts for a probable loss. The stock soared on the surprise, and the shares are up almost 30% this year. Amazon won a recent victory when the Justice Department sued five major book publishers and Apple (NASDAQ: AAPL), accusing those companies of colluding to keep book prices higher than Amazon sells them. We use Amazon ourselves – who doesn't? Right now, that ubiquitous consumer use may make it seem invulnerable.
Then again, Amazon trades at a lofty 185 times trailing earnings. The last earnings report was indeed a positive surprise, yet quarterly income fell over 40% from the previous year. The company also managed fresh lows in operating margins of 1.5%, and guided to a second-quarter range for earnings whose midpoint is an expected loss.
So before you buy the stock, you might want to consider of the myths that have sprung up around Amazon, along with some of the truths that tend to get lost in the excitement. In Part One of this two-part essay on the company, we'll begin with some of the myths.
Comfort Myths about Amazon
Amazon is like Coke.
The analogy is that Amazon is an indispensable franchise in its infancy, like Coca-Cola (NYSE: KO), 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 that beverage maker, 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 will 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 competition from 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. But 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. There are already rumors of a $299 iPad arriving this year.
Amazon Web Services (AWS) 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" to a spinout. 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 spinoff, 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 in Part II, 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?”).
In the next piece, where we crunch some numbers, we're going to model a 30% growth rate for Amazon for the next five years, which would be an impressive achievement. If the company does manage to pull this off, though, it's going to need more buildings and more technology, not less. When its growth rate slows, then it will slow spending on cap-ex. Not before.
M. Kevin Flynn, CFA, is the president of Avalon Asset Management Company in Lexington, Mass.
This post was written by M. Kevin Flynn and edited by Larry Light, editor-in-chief of Advice IQ. Niether owns shares of any of the companies mentioned. The Motley Fool owns shares of Apple, Amazon.com, and The Coca-Cola Company. Motley Fool newsletter services recommend Amazon.com, Apple, and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
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