Will Nobody Defend Amazon’s Valuation?
Robby is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Let’s pretend you’re a potential Amazon.com investor. You begin your research by typing “Amazon stock” into your favorite web browser, interested to read analyst opinions. I guarantee you’ll find some. And more than likely, you’ll be flooded with articles taking a bearish perspective on the stock, pointing to the company’s high price-to-earnings ratio as a reason to short the stock. To summarize their analyses: “Amazon is grossly overvalued.” While it’s easy to conclude that a high price-to-earnings ratio equals an overvalued stock, proper valuation requires more investigation than a simple calculation of P/E. The bears need to consider reasons behind the multiple.
Limitations of Ratio Analysis
Taking a step back, let's ask ourselves: Why do analysts use valuation tools like price-to-earnings, price-to-book, and price-to-sales? With companies of various sizes and structures, these ratios are useful to compare one business with another in the same industry, regardless of market capitalization. But Amazon.com operates in several industries and its business model is unlike any other company. Ratio analysis isn't useful without context. Bearish commentators frequently compare Amazon’s P/E ratio with Apple’s, but these companies are not analogous! True, some of their tech businesses overlap and they compete in those areas, but these companies have different cost structures, different business activities, and different drivers of demand. Commentators shouldn’t be weighing Apple’s P/E against Amazon’s. (It’s like comparing apples to oranges?)
So how should Amazon.com (NASDAQ: AMZN) be classified? As an online retailer? As a tech company? Its operations differ greatly from a brick-and-mortar retailer like Wal-Mart, and its variety of income streams differentiates it from other online retailers. Overstock.com competes in that space, but the company’s lack of diversification precludes it from any effective comparison. Amazon’s business have expanded into consumer technology (competing with Apple and Google), entertainment (competing with Netflix (NASDAQ: NFLX), and web services (competing with Apple, Google, Microsoft, and many non-public companies).
Amazon’s multiple lines of business distort its valuation ratios.
Perhaps you’re a critic of Amazon’s low earnings. How can a $115 billion company be earning next to nothing? What gives, Jeffrey Preston Bezos?
Amazon has been sacrificing profits to spend heavily on its growth and operations. That means substantial investment in its distribution centers, customer service facilities, and network of warehouses. Amazon.com needs to ensure prompt delivery by getting geographically closer to customers. The company needs to maintain its stellar reputation as, hands-down, the best in its business, because brick-and-mortar companies aren’t far behind.
Last month, Urban Outfitters (NASDAQ: URBN) unveiled its new fulfillment center near Reno, NV – clearly intended to boost e-commerce sales. The retailer is revamping its operations to increase delivery speeds, offer customers more diversified shipping options, and locate inventory in one store that may be out-of-stock in another. Urban Outfitters, along with many other brick-and-mortar stores, is trying to exploit the tremendous growth of online sales. With juggernaut Amazon.com continuing to dominate with superior customer service, lower prices, top search engine results, and quick delivery, those stores will have a tough time gaining traction.
Amazon’s retail business is currently at the top, and the company must not fumble. Losing its dominance would be catastrophic to its broader goals of building a robust ecosystem, essential to its long-term profitability.
Strategic Placement of Acquisitions
As I wrote in my article Why Does This Company Sell Merchandise a Loss, I described the strategy of building an ecosystem. While Amazon is selling the Kindle Fire HD too low to profit, the company obviously isn’t trying to make money on the hardware. The aim is to increase the stickiness of the business, retain customers, and extend usage of peripheral services within in the same ecosystem.
Through its acquisitions, Amazon.com has been building an arsenal of brands that contribute to its long-term strategy. When Amazon announced on April 27, 1998 that it was acquiring Internet Movie Database Ltd., it explained it was doing so to “support its eventual entry into online video sales.” Now, Amazon’s Instant Video service is integrated with every Kindle Fire HD, which heavily employs IMDb.com as part of the experience. And movie-lovers browsing IMDb are directed to Instant Video to watch the content they're already looking for. When Diana Smith is reading IMDb's list of the top 250 movies, she comes across The Shawshank Redemption (1994), rated by users as the #1 film of all time. Along with all the informational goodies that IMDb has to offer, the movie’s page gives Diana several options: she can watch the film instantly via Amazon Instant Video, she can download the film in a digital format, or she can purchase the DVD through Amazon.com.
While Netflix’s unlimited instant streaming service costs $96 per year ($7.99 per month), Amazon Prime costs just $79. And for that price, Prime members receive unlimited streaming, free two-day shipping on purchases made on Amazon.com, and access to the Kindle Owners’ Lending Library. Even more, Amazon doesn’t require a subscription to stream its content. Diana Smith can watch Shawshank for $2.99 without signing up for Amazon Prime. Or she could download the film for $9.99. Netflix extends no such options for à la carte streaming, and no options for purchasing content. And since The Shawshank Redemption isn’t even available on Netflix for instant streaming, Diana Smith could only rent the film through Netflix's DVD-by-mail service - a privilege that would cost her an additional $7.99 per month.
Amazon's growth in this industry requires concentrated investment. Competing with a company like Netflix is incredibly expensive. Amazon.com is deferring short-term profits to strategically position the pieces in its very expansive puzzle.
The Bottom Line
In his 1998 letter to shareholders (PDF), Bezos emphasized the need to focus on the long-term, “to build something that we can all tell our grandchildren about.” Jeff Bezos made clear that Amazon’s business plan wouldn’t be held hostage by Wall Street’s short-term expectations. “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows,” he wrote. While a multitude of financial commentators point to a high P/E ratio as a reason to short the stock, I can’t presume that a traditional valuation model is helpful to assess this company’s share price.
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robbyinvest owns shares of Amazon.com. The Motley Fool owns shares of Amazon.com. Motley Fool newsletter services recommend Amazon.com. 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.