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Proceed to checkout, review your order, click, done. Buying stuff on Amazon is easy. It is a wonder, however, that investors ever find the nerve to hit the place-your-order button for Amazon stock. That is because the online retailer’s shares are expensive – basket-bustingly so. Yet buy investors do. So what are the justifications for owning Amazon at these levels? Can its valuation possibly make sense?
To see the reason for owning Amazon in 2012, start by thinking about Walmart in 1991. The big-box retailer sold $44bn worth of merchandise that year, and had already changed the way Americans shop, using its sheer size to take costs out of its supply chain and pass the savings along to customers. Over the prior 10 years, Walmart’s average annual sales growth had been 34 per cent.
Similarly, Amazon’s sales reached $48bn last year, topping off a decade in which sales growth averaged 31 per cent. It too has changed the way many people in America (and to a somewhat lesser extent Europe and Japan) shop for books (paper and digital), electronics, nappies, shoes – almost everything that can be delivered in a cardboard box or stream over an internet connection.
In 1991, as it turns out, Walmart was just getting started. Since then, the company’s annual sales have grown 10-fold to $450bn. It has increased its share of US retail from less than 4 per cent to more than 10 per cent, and built a $126bn international business from scratch. And like Amazon’s today, Walmart’s shares did not look like a bargain in 1991; at the end of that year they were fetching more than 40 times earnings. Yet it is hard to argue that buyers overpaid. They have enjoyed a 500 per cent return since.
The comparison is far from perfect, of course, and it pays to consider the places where it does not fit. One need not understand the operational differences between bricks and mortar and internet retail to see the contrast. Just look at the difference in growth and profitability.
The bottom line
In 1992, Walmart’s growth, while still high, was decelerating. Amazon’s growth was as high as ever last year. It takes an ever bigger slice of a pie – internet retail – that is itself expanding at a solidly double-digit pace in the US, and is expanding into other businesses. But whereas Walmart has delivered operating margins between 6 and 8 per cent for three decades, Amazon’s margins peaked at 6 per cent in 2004, dropped several points for the following five years, and then, in 2011, dropped to around 2 per cent.
Part of the decline stems from Amazon’s practice of subsidising delivery; shipping losses have been rising and now amount to more than 5 per cent of revenue. This company will cut profits to the bone to attract customers.
Amazon bulls will object that operating margin is not the right metric. Because Amazon pays its suppliers much more slowly than it is paid by its customers, in 2011 it averaged 90 days’ worth of sales in payables (money due to be paid out) versus 16 days in receivables (money due to come in). Good inventory management also frees up cash. Over the past five years, these benefits (known as negative working capital) have accounted for almost a third of Amazon’s free cash flow.
So operating profit does not reflect the company’s cash profitability. Fair enough. Bear in mind two things, though. Free cash flow has declined alongside Amazon’s operating profits in recent years. And this working capital benefit will decline when Amazon’s growth slows. Working capital will not be a significant source of cash flow for ever.
A prime valuation
Here the bulls will interrupt again. It could be that in the coming years Amazon will deliver much higher margins than it ever has, for four reasons. First, its electronic media businesses – from ebooks to online video – are intrinsically high margin, have no associated delivery costs, and are set to keep growing. Second, margins have room to improve as the company develops its services to third-parties. Amazon receives highly profitable commissions as other retailers use the company’s internet storefront and distribution centres to move their own goods. Third, the Amazon Web Services businesses, which supplies companies with computing power and cloud storage, could generate $2.2bn in revenue this year, Citigroup estimates. Its closest pure-play competitor, Rackspace, boasts 12 per cent operating margins.
Indeed, in the first quarter of 2012, service revenues (mostly made of third-party commissions and Amazon Web Services) rose by two-thirds from the year before, and represents 15 per cent of total revenue. These fast-growing and higher margin businesses should offset another trend that hurts profitability – the shift away from high-margin media to lower-margin electronics and general merchandise. During the first quarter, in fact, gross margins (the proportion of sales left after the cost of goods sold is deducted, but before overhead costs) expanded by 110 basis points year-over-year, Amazon’s biggest-ever expansion.
Finally, bulls insist, Amazon’s lack of profitability merely reflects that the company is in the middle of an investment phase. Spending on technology and content (rights to music and video as well as research and development), marketing (as it pushes Kindle devices) and capital expenditures (18m square feet of offices and distribution and data centres were added in 2011) has expanded much faster than sales this year.
The potential leverage from reduced investment is striking. For example, if capital expenditures over the past 12 months had stayed at the level relative to sales of two years ago, free cash flow would have been almost double the reported number.
There is, however, a big problem to solve before any of these bullish scenarios can be realised. One of Amazon’s crucial advantages – low prices – is coming under pressure.
Until recently, Amazon has enjoyed the advantage that most of its customers do not pay sales tax, even if they live in one of the 45 US states that charge it, at rates of between 4 to 9 per cent. This represents a discount for Amazon customers, but it is ending. Amazon is already collecting sales tax in six states; the rest are likely to follow. A shift in what customers pay may steer some of them back to traditional retailers, crimping growth.
That said, Amazon would reap one benefit from this change. Traditionally it has put distribution centres only in states without sales tax. Freed from this constraint, the company can add to its network and increase its lead how quickly it can deliver goods. As universal same-day or next-day delivery comes closer, the range of goods it would make sense to buy from Amazon increases. Toothpaste could be ordered the morning it runs out and appear that evening.
Low prices are also coming under increasing attack from Amazon’s suppliers. Book publishers may or may not have colluded, as the US justice department alleges, when they demanded that Amazon must not discount titles below levels they set. In many of Amazon’s key product lines, from digital media to electronics to fashion, suppliers see price and value as linked, and will threaten to stop shipments if they see Amazon’s bargains as tarnishing their brands. Already, Sony and Samsung have moved towards a “universal pricing policy”, insisting that all distributors respect certain minimum prices.
A pricey piece of the future
Trying to assess the value of a company that is as complex, innovative and fast-growing as Amazon is chancy. But there are two well-defined questions that potential buyers at the current share price must answer with a confident yes. Can the company shift its sales mix, and rein in spending, enough to sustainably expand margins? And can Amazon maintain sales growth in spite of upward pressure on its prices from an eroding tax advantage and dissenting suppliers?
On the first question, there is at least one good reason for hesitation. In its low-margin core retail business, Amazon competes with relatively fragmented traditional retailers that are generally struggling to form coherent online strategies. But in higher-margin web services and electronic media, it competes with aggressive and deep-pocketed companies that have staked their futures on media and cloud services: Apple, Google and Microsoft. Even if Amazon prevails, it will be an ugly fight.
On the price question, it is hard to gauge how the demands of price and convenience balance out for the average customer on the average Amazon item. The burden of proof is squarely on those who think that upward pressure on selling prices will not hamper top-line growth.
What is more, there is a third, much less defined question relating to valuation. In fast-changing industries such as internet retail, cloud services or digital media, how much faith should be put in the dominance of the early leader? In other words, investors know Amazon is spending heavily to protect its position; but is it spending enough? Valuations must include a thick margin for error to reflect the risk of a competitor landing a big blow.
This last point must – given Amazon’s heady share price – be decisive. Consider again the Walmart of two decades ago: its seemingly unlimited potential also came at a high valuation. That potential was fulfilled in spades, and investors did well. But returns were not nearly as extraordinary as the company’s operational performance. Yes, the intervening two decades have given Walmart investors a sixfold return; but so has the S&P consumer staples index. Even the plain old S&P 500 has returned 400 per cent.
It is impossible not to admire what Amazon has achieved so far or not to feel excited about what it could achieve in the next 20 years.
But investing is not about excitement. It is about balancing risk and reward and knowing what is predictable and what is not. Wait for a reduced valuation before clicking “buy”.
This interactive calculator is a basic two-step discounted cash flow model to help illustrate how variations in key assumptions can change Amazon’s potential market value and share price.
Enter your projections for Amazon’s sales growth, ebitda margin, and capex-to-sales ratio to see how these key assumptions affect the potential market value.
When you are satisfied with your model, you can share it by clicking the Twitter button above the charts.