Amazon Is Taking Over the World… But Is the Valuation Reasonable?
Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As discussed in detail in the nine previous articles in this series, the growth potential of Amazon.com (NASDAQ: AMZN) is truly remarkable. A continuation of top line growth puts Amazon in a position to catch Wal-Mart (NYSE: WMT) as the largest retailer worldwide by sales in around 10 years. While this top line growth is fantastic, the big question for Amazon investors is (and has been for years) the stock's valuation. Here is a quick look at how Amazon stacks up against some of its closest rivals in a collection of standard valuation metrics:
If an investor looks at these numbers and nothing else, there is the potential to reach the conclusion that Amazon is wildly overpriced and is due for a significant correction. Before jumping to that conclusion, it is important to consider a number of additional factors. For starters, Amazon's TTM earnings includes a one-time impairment charge relating to the company's investment in LivingSocial that should be excluded in an evaluation of normalized earnings. More significantly, there are a number of reasons that Amazon can't be accurately compared to this peer group as discussed below.
Do not forget about growth!
The previous nine blog posts detailing Amazon's less-known growth opportunities were intended to drive home a point about Amazon's growth. To depict it more simply, here is a comparison of analysts' expected growth rates for each of the companies noted above over the next five years:
With this comparison in mind, the expectation that Amazon's growth will remain stellar is certainly worthy of a premium over these large cap peers. Considering that Amazon's revenue is growing over five times faster than the average of this peer group, a price to sales ratio that is four times greater than the peer group seems a bit more reasonable. However, just layering expected growth on P/E and P/S ratios alone still does not quite validate the huge premium placed on Amazon shares.
There's more to the story
It is important to remember that Amazon's business is nowhere near as simple as the peer group mentioned above (or any of the companies mentioned in this series). For example, Macy's (NYSE: M) is a pure-play department store; while Amazon has built comparable e-commerce offerings for everything from apparel to cosmetics, this is just a fraction of what Amazon does. For example, Amazon is a leader in the rapidly growing cloud computing industry; aside from being a completely different business than Macy's, peers in this industry such as Rackspace Holdings and VMware command huge valuation premiums with current price to earnings ratios of 106 and 54, respectively. This is just one example of how Amazon's high growth initiatives aren't comparable on an apples-to-apples basis with a brick and mortar discount retailer like Target (NYSE: TGT).
Amazon is investing in the future in many ways
Layering growth factors on the valuation metrics discussed above still doesn't create a compelling argument for the current price to earnings and free cash flow yield valuations placed on the company. The reason for this is the myriad of investments Amazon is making to secure its long term place as the world's largest retailer. Some of these investments are obvious, while others are less so:
- When thinking about "investments," an obvious area of focus is capital expenditures. Over the past 12 months, Amazon has invested $2.3 billion in capex relating to both capacity upgrades for future growth and expansion of services. This is particularly significant given that the long-term competitive advantage of Amazon's e-commerce business model is that it is less capital intensive than the brick and mortar competition that needs to invest heavily in stores in every shopping center in town. Once this tremendous growth begins to slow, Amazon will be able to scale capex back to levels significantly lower than both its recent history and its peer group.
- A less frequently considered drag on free cash flow is the investment in inventory to support growth. While brick-and-mortar retailers have constant pressure to curb increases to inventory, Amazon's growth initiatives have required a net cash investment of $1.3 billion over the past 12 months and $1.8 billion during 2011.
To provide a sense of scale, adjusting Amazon's free cash flow for 50% of TTM capex and eliminating the TTM net cash investment in inventory to derive an overly simplistic measure of a "slower growing" Amazon results in a free cash flow yield of 2.9%; 2.9% is by no means a screaming buy, but this more apples-to-apples comparison is very close to the 3.2% free cash flow yield of Costco Wholesale (NASDAQ: COST) at today's prices and is more reflective of the current business environment for each of these lower-growth peers.
- Another common investing activity is acquisitions. While Costco, Wal-Mart and Target have largely expanded organically, these companies haven't grown into adjacent business lines via acquisition. Meanwhile, Amazon has a long track record of successful acquisitions ranging from e-commerce portals such as Zappos.com and Woot.com to warehouse robotic system maker Kiva; during the past 12 months, Amazon has spent $759 million on acquisitions that will help fuel future growth. These acquisitions have routinely used a significant portion of Amazon's free cash flow, which the company feels is a more productive use of excess cash at this time than dividend payments to shareholders.
- On the earnings front, it is important to note that these investments manifest themselves in earnings today. On the face of the income statement, $1.9 billion of depreciation over the past 12 months includes sizable depreciation charges for assets placed into service to support future growth even though the assets are not currently generating revenue at full capacity. Additionally, these investments in data centers and fulfillment centers across the globe require minimum levels of operating expense to staff and run the facilities even if revenue is just starting to ramp up. While it may sound like bad business to have new fulfillment centers that are only half full, Amazon has a plan to fully utilize these investments in the near future. The extent of these costs are impossible to quantify, but given the rapid expansion of facilities, this can easily create a material difference in earnings when Amazon is deliberately operating its business at low margins.
Amazon's biggest investment of all
Amazon's biggest investment since CEO Jeff Bezos' first letter to shareholders in 1997 has been and continues to be its customers. Among the powerful quotes in the 1997 letter, a particularly relevant summary of Amazon's long-term vision is summarized below:
"The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.
Our decisions have consistently reflected this focus. We first measure ourselves in terms of the metrics most indicative of our market leadership: customer and revenue growth, the degree to which our customers continue to purchase from us on a repeat basis, and the strength of our brand. We have invested and will continue to invest aggressively to expand and leverage our customer base, brand, and infrastructure as we move to establish an enduring franchise.
Because of our emphasis on the long term, we may make decisions and weigh tradeoffs differently than some companies. Accordingly, we want to share with you our fundamental management and decision-making approach so that you, our shareholders, may confirm that it is consistent with your investment philosophy:
We will continue to focus relentlessly on our customers..."
Amazon has stayed true to this vision 15 years later, focusing on customer acquisition, retention, and satisfaction. Amazon has achieved this through a wide array of initiatives. Examples include the development of the Kindle, Amazon Prime, and rapid shipping that is continuously improving towards the ultimate goal of offering same day delivery by leveraging the new fulfillment centers opening across the country. None of these initiatives are cheap and frequently lose money upfront, but rather than charge customers more Amazon would rather attract new customers and generate near-fanatic loyalty by also providing remarkably low pricing and convenience. The result is powerful; millions of customers purchasing Kindles and subscribing to Prime are coming back to Amazon repeatedly as the go-to source of everything from e-books to televisions. This is exactly what Bezos set out to do in 1997 before the Kindle was even contemplated.
This disruptive mentality will continue to drive growth until Amazon is satisfied with its customer base and has reached the point of being an "enduring franchise." Between now and then, Amazon has the power to start making subtle changes to its pricing structure. A 1% price increase may not sound like much, but when considering that Amazon is currently content to operate at less than a 1% operating margin as it invests in the future, such an increase would double earnings.
Is Amazon a buy today?
This blog series in its entirety comes down to this seemingly simple question. Given Amazon's growth story and the illustrative examples above demonstrating how price to sales and free cash flow are really not out of whack with the competition when factoring in the impact of investments and growth, the stock is not wildly overpriced like so many in the market believe.
While it is a supportable conclusion that Amazon will trade at higher prices in the future than it does today, it is virtually impossible to model a realistic scenario where Amazon can be a 10-bagger from today's prices. Instead, it is realistic to expect more modest returns in the future as further growth is offset by P/E and P/S compression based upon the hefty growth expectations already priced into the stock; these returns will likely track more closely to the overall market than Amazon's tremendous market out-performance in the past. In the event that Amazon's growth stumbles, investors can expect to see a sharp correction. While there are no indications at this time that Amazon will struggle to grow in the future, there is sufficient risk based on Amazon's current valuation that supports a conclusion that the shares are somewhere between fairly valued and slightly over-valued today. Investors should weigh this risk/reward profile carefully and ensure that any investment in Amazon is part of a balanced and diversified portfolio.
BrewCrewFool owns shares of Amazon.com and Costco Wholesale. The Motley Fool recommends Amazon.com and Costco Wholesale. The Motley Fool owns shares of Amazon.com and Costco Wholesale. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!