Amazon: A Study in Herd Behavior

By mark cabaniss - July 26, 2012 | Tickers: AMZN, AAPL, GOOG, WMT | 0 Comments

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Back in the late 90s, the World's Greatest Investor/old fuddy duddy Warren Buffett was puzzled by the high-flying, profitless internet stocks.  If he were a business school professor, he remarked, he'd have one question on his final -- how do you place a valuation on these internet stocks?  Anyone who submitted an answer would get an "F."  His point was simple -- it is mathematically impossible to place a value on a company without earnings.  A fraction with a denominator of zero is not a legal fraction; it has no meaning; it's value is undefined.  A company without earnings doesn't have a PE.  It has nothing at all, except for a hope, of making money, someday.

Amazon.com (NASDAQ: AMZN) is, for all practical purposes, a company barely in the black.The Zack's analyst Consensus Estimate for earnings when they report after the bell today is one cent.  This number has been taken down an earlier analyst consensus estimate of 20 cents 90 days ago.  Taking the estimate down from 20 cents to one cent sets the stage for another manufactured "earnings beat;" if, say, actual earnings were to come in at three cents or four cents or ten cents a share, analysts could say (and would say, with straight faces,) that the company "crushed estimates" with a "huge beat."

To be sure, Amazon is a great company -- I shop there quite often myself, and always have a fine shopping experience.  But it is, I submit, a terrible stock for exactly one reason -- overvaluation.  The current consensus earnings estimate for Amazon is $1.21 for 2012.  That means that the current PE ratio is 179.  Its most direct competitors, meanwhile, are Apple (NASDAQ: AAPL), Google (NASDAQ: GOOG), and Walmart (NYSE: WMT).  They have PEs of 14, 18, and 15, respectively.  That makes Amazon's PE multiple roughly ten times greater than those of Apple, Google, and Walmart.  Is Amazon a better company than Apple, Google, or Walmart? If so, is it ten times better?

Amazon has their fingers in many pies, but they are, for now, predominately a retailer, one with very thin margins.  In fact, their margins are so thin that they are zero or even negative on their own product, the Kindle.  It reminds me of the old joke about the tailor:  "So, how're you doin' on the new suits?" asks his friend.  "Terrible," comes the reply, "they cost me $200 each to make, and I can only sell them for $100.  But, I'm making it up on volume."

Suppose Amazon "crushes estimates" with an "earnings beat" today of two cents a share and then announces plans to begin making and sellling smartphones at a loss.  If the past is any guide, the majority of the analysts will cheer.  Why?  well, the idea is that by selling their products at a loss, Amazon will gain a large market share, and then, and then, someday, they will start selling their products at a profit, and, since they will have a sizeable market share, it will be a sizeable profit.  Savvy?  But for me,  it is a mystery why the Amazon bulls are so excited to see Amazon getting into another profitless venture, such as smartphones.  I don't know what to make of it, except euphoria:  I get the impression that if Amazon were to announce they were going into the hamburger business against McDonald's, all the analysts would cheer:  "Hooray!  Hamburgers are a great business opportunity!  The market is huge!  Just China alone presents enough opportunity to keep growth exploding for the foreseeable future!"  The very, very recent past is littered with the corpses of companies that once had sizeable market shares in the phone market -- Motorola, Nokia, Ericcson, Reasearch in Motion -- remember them?  I'll bet Warren Buffet does.  

But today's Amazon cheerleaders do not.  They do not because they choose not to.  This is a variant of confirmation bias.  We tend to seek out answers that support what we already believe to be the truth, thus giving ourselves a little pat on the back, because the evidence shows we're right.  Regarding Amazon, there are an awful lot of investors sitting on great piles of paper profits; for many, no doubt, Amazon has been the single greatest success of their investing lives.  As investors, we are often admonished to hang on to our winners.  Cut your losers, but let your winners run.  Indeed, even the great Buffet describes his ideal holding period as "forever."

But your winners can't run forever, if they are in rapidly churning, trendy markets.  Indeed, experience shows just the opposite -- consumers are anything but loyal to their electronic gizmos such as phones.  They can't wait to dump their current phone, and it's has-been maker, for tomorrows hot new trending must-have gotta-get-it cool new product.  This is herding behavior.  The herd loves conformity, which means keeping up on all the current trends.  Even mighty Apple could be nothing five years from now, if Samsung or someone else were to invent some cool new phone that everyone on the planet just had to have.

A price war, selling your products at a loss, is a war of attrition.  You go into it with the idea that you can keep it up longer than the other guy, and that you will be the last man standing.  But if the other guy is wildly profitable, like Apple, and you are not, like Amazon, why would you think you will be able to hold out longer than the other guy?  Wouldn't you go broke first, since he is making money, and you are not?  This would seem to be elementary, Buffet 101, but Amazon investors seem to be overlooking it. The only explanation I can think of for this oversight is that Amazon investors think that somehow a more profitable part of the company is subsidising the less profitable parts of the company, and will continue to do so for as long as it takes.  The problem with this view is that there are no more profitable parts of Amazon.  None.  Every one of their competitors has greater profit margins.  All of them -- Walmart, Apple, Google, eBay -- all of them.  This April Amazon decided to go into selling industrial products and services against WW Grainger.  Result? Grainger's gross profit margins have improved for five straight months, and now stand at 43.5%.  When eBay reported strong earnings last week, Amazon went up in sympathy.  But why?  If your competitor is getting stronger, doesn't that necessarily mean that you are getting weaker, in a relative sense?  And if you don't have any profit margins because you don't make any profit, can you really afford to get any weaker?

But Amazon is the future of retailing, say the bulls.  Online retailing is inexorably displacing traditional brick-and mortar retailing.  Interestingly, people seem to believe that Amazon's model of online retailing directly to the consumer is somehow new.  But 100 years ago Sears Roebuck and Montgomery Ward had essentially the same model of retailing with their mail order catalogs.  Show the customer your goods in your inexpensive, virtual showroom or catalog, then deliver the goods via the mail, direct from the warehouse, eliminating the need for actual physical stores and all those expenses and employees.  But somehow Walmart came along and put them both put of business.  And Walmart makes a profit today while Amazon does not.

I have seen Amazon supporters arguing in print that "valuation doesn't matter."  I confess I haven't bothered to read and try to understand this argument.  That is because it makes no sense, as is easily demonstrated.  Suppose someone were to argue to me that "valuations don't matter."  "Fine," I say, "then you won't mind buying my hundred shares of Amazon for, say, ten thousand dollars a share.  That would be one million dollars.  Just put it over there."  "Aaaah," they would say, "but why would I buy it from you for ten thousand dollars a share when I can buy it in the market for $217.00 a share?"  Which proves my point -- valuations do matter, even to those who say they don't.  So if a PE of 10,000 is meaningful as perhaps an overly rich valuation, then perhaps a P/E of 179 is also meaningful?

Animal behaviorists say that there is a critical number in any given herd or flock:  If 5% of the animals or birds change direction, then the rest of the herd will follow them.  Experts in crowd control know this.  They station a certain number of people near exits.  If enough people begin walking decisively toward the exits, then the rest of the crowd will instinctively fall in behind them.  You don't need a bunch of people in uniforms yelling on bull horns; all you need is for the crowd to see that it is time to go, because, there are a bunch of people going right now.

There are an awful lot of people sitting on large paper profits in Amazon.  If 5% of them were to decide to book their profits and get out now, the whole herd could change direction.  If Amazon were to revert to a PE on a par with it's competitors, say 17, then the stock price would fall to $20.40.  That means there is a lot of downside.  As for upside?  Well, Amazon could announce they are going to start building cars, and compete with Toyota, or selling jeans and hot coffee at retail Amazon stores, and compete with Gap and Starbucks, or whatever.  As long as there are people who can convince themselves that "valuations don't matter," there will be jobs for cheerleader "analysts" to proclaim that beating a number that has just recently been reduced 95% is a "huge earnings beat."  I'm sticking with Buffet.  Companies that don't have earnings don't have values, period.

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