Amazon: If you build it, he will come!
I have a long standing fascination with Amazon from its inception as a dot-com poster child in the late 1990s to its current standing as online retailer to the world today. I have always liked the company's willingness to challenge established retailing rules on how business should be done and admired Jeff Bezos for being to willing to leap into places where others only tip toe. As an investor, though, I have found the company to be cheap at times in the last 15 years and expensive at others, and the most recent earnings report led me to revisit the company, primarily to examine whether the market's negative reaction to the most recent earnings report was appropriate or an over reaction.
A short history of Amazon
For those younger than 25, it is hard to imagine a world without online retailing, in general, and Amazon, in specific. It was just over 20 years ago, on July 5, 1994, that Amazon was founded in Seattle, Washington, by Jeff Bezos, in his garage, continuing the long tradition of garage-founded companies in the United States. The company caught the dot-com wave of the late 1990s and was listed on the NASDAQ in 1997. While its revenues grew during the early years, the company remained small in operating numbers, relative to other retail giants, and generated just about $1.6 billion in revenues in 1999, while reporting an operating loss of -$598 million. Its market capitalization, though, rocketed up (with the rest of the sector), hitting almost $ 35 billion in early 2000. In fact, it was one of the companies that I used as a prop for a book I had on valuing young, technology companies, and at the risk of gravely embarrassing myself, this was my valuation of Amazon in January 2000, close to its peak:
It is never flattering to the ego to compare actual to expected numbers, especially for young growth companies, but I compare my forecasted revenues & operating income for Amazon (from my January 2000 valuation) to the actual revenues & operating income for the company (from 2000 to 2011) in the table below.
I must confess that I did not have the foresight to predict the behemoth that Amazon would become in retailing and the tentacles that it put into other businesses (including media and cloud data) but my forecasted revenues were higher than the actual numbers every year through 2010; since 2010, though, the company has blown the lid of my forecasts. I did overestimate the profitability of the company, assuming that margins would converge on the industry average (of 10%) in early 2000. After mounting a steady improvement in margins in the first half of the last decade, the company seems to have relapsed in the last few years.
A Field of Dreams company
A couple of years ago, James Stewart wrote an article in the New York Times, using Amazon as an illustration of how short term markets don't pay heed to the long term judgments that Amazon's managers (and Jeff Bezos in particular). The discussion about whether markets are short term and if so, why, is one well worth having, but I took issue with Mr. Stewart on his use of Amazon as an example of market short termism. In fact, I would argue that markets have been extraordinarily forgiving of Amazon's long loss-making history and have given Mr. Bezos breaks that very few companies have received through history.
The movie that comes to mind whenever Amazon reports yet another earnings report, with strong revenue growth and increasing losses, is the Field of Dreams, with this scene, in particular, playing out. As I see it, Jeff Bezos has built the ultimate field of dreams company (and I don't mean that in a dismissive way), where he has sold investors on the notion that if he builds revenues up, the profits will come. The losses at Amazon are not an accident but reflect the way the company approaches business, selling products and services below cost and with lots of hype, with the intent of inserting themselves in peoples' lives so completely that they will be unable to extricate themselves in the future. To provide a simple illustration of this process, consider one of Amazon's most successful services, Amazon Prime, to which I am a subscriber. At $99/year, it is a bargain for me, since the shipping costs I save vastly exceed the cost of the service. While that may reflect my family's profligate spending habits, there is some evidence in Amazon's own financials that the cost of providing this shipping service vastly exceeds the revenues that they collect:
If this were an aberration, you could argue that the benefits received elsewhere may exceed the net costs, but it is not. In fact, you can take many of Amazon's recent innovations (including the Kindle) and put them to the profitability test and will find them falling short.
At this stage, the value of Amazon rests on how much you trust the vision that Jeff Bezos for Amazon and believe in his capacity to fulfill that vision. In fact, the value of Amazon will be largely determined by your assumptions about how you see its revenue growing in the future and its operating margins evolving. To provide perspective, if you assume that Amazon will continue its steep revenue growth into the future (and is able to grow revenues to about $250 billion by 2024) and that its operating margin will converge on the average operating margin for the retail sector (5.53% for US retailers), the value of equity that you obtain is about $54.5 billion (or $118/share). You can download the spreadsheet that contains the Amazon valuation.
If you are bullish on Amazon, at its current stock price, you either have to be expecting even higher revenues (than $250 billion) in 2024 than or much higher steady state margins (than 5.53%), with the best-case scenario being one where Amazon continues growing revenues significantly, driving its competitors to distraction or into bankruptcy, and then uses its market power to charge higher prices and generate high profit margins. Thus, assuming a 10% operating margin (instead of 5.53%), in conjunction with the revenues forecast in the base case, would yield a value per share of $253/share, closer to the current stock price of $282.
Rather than play scenario games, I chose to vary revenue growth and operating margins to see the combinations that deliver values (shaded in yellow) that exceed the current stock price ($292) in the table below:
Amazon: Value per Share
I draw three lessons from this table. The first is that there are pathways that Amazon can follow that deliver values greater than $292 but they are narrow and require a combination of high revenue growth and high operating margins to sustain, some of which may expose the company to anti-trust action down the road. The second is that the variable that makes the bigger difference is the operating margin, not revenue growth. In fact, if the margin stays at 2.5%, higher revenue growth causes value to decline as the cost of increasing revenues (acquisitions and reinvestment) exceed the benefits. The breakeven operating margin at which growth even starts to create value is about 4%. It is presumptous of me to give advice to a legendary CEO, but it seems to me as an investor that it is time for Amazon to reorient itself towards improving profitability, even if it means giving up revenue growth. The third is that the potential for explosive returns seems low. While there are combinations of revenue/margin that deliver values well above $292, they seem improbable, requiring Amazon to have revenues like Walmart and margins like Lululemon.
Amazon is a fascinating company and Jeff Bezos deserves the plaudits that he gets for building the company. In a market where most CEOs seem incapable of original thought or imagination, his success in getting markets to go along, even in the absence of profitability, is a testimonial to the importance of CEO vision, charisma and single mindedness. That does not mean, however, that CEOs like Bezos and Elon Musk are incapable of missteps, and I think that it may be time for reset at Amazon, where profitability has to enter into decison making much more explicitly. Then again, Amazon has found ways to surprise is in the past and may have another rabbit in the hat that it can pull out in the near future.