Stocks are often evaluated by how the underlying business might perform in the future rather than how things are going right now. Therefore, companies whose main markets or products are under threat tend to have their stock price depressed. On the other hand, companies in new markets with huge growth potential trade at multiples well beyond what’s recommended in any classic investment book. There is nothing wrong with companies being evaluated based on their underlying business outlook; the real problem relies on the fact that sometimes analysts tend to be wrong about the outlook they attribute to stocks. Clearly, Amazon.com belongs to the group of companies trading at generous multiples due to the optimistic outlook surrounding the company. Let us see what substantiates this optimistic stance:
Innovation process in services and products
Just by looking at common media reports about Amazon (NASDAQ:AMZN) you can conclude that the company is always launching and developing new products and services. The innovation within the company has some interesting characteristics.
(Photo credits: Sindy)
Just like Google (GOOGL), there is a decentralized approach to the pursuit of innovations. The company incentivizes the pursuit of small scale experiments. This way, the company sets a natural selection in the initial stage of the development of new business ideas. Often, we see Amazon developing some of these small scale ideas. Lately, we have seen several products being developed by Amazon especially in the media content (Kindle). Since in this area differentiation is high, the company has been able to get a positive impact in Gross Margin:
Table 1 – Gross Margin evolution (2013, 2012, 2011) Lean company
Since the ’80s, the US recognized the Japanese superiority in industrial production, and many US companies have pursued the best Japanese practices in efficiency improvement. Presently, many start-ups incorporate lean principles from the very start. Therefore, Amazon’s management soon recognized that the company’s customers wouldn’t be willing to pay for an inefficient retail system. Waste prevention became one of the top priorities.
One example of defect elimination is the implementation of the andon-cord principle. The company allows customer-service agents to cut a line of products once there is evidence of repeated problems. The product is taken from the website until the issue is solved. This allows the elimination of numerous defects.
On the innovation side, the company adopted autonomation, i.e. humans use the help of machines for automating low-value repetitive tasks, while human workers focus on high-value complex tasks. This results in fewer defects and more successfully shipped items.
Additionally, the company leverages its ability to have fast turnover times for inventories, which means the company generates negative working capital.
In the end it’s all about valuation
I have just described a great company, so should you buy it? Not so fast. In the end it’s all about how much you pay for the great company you have just analyzed. A great business paired with an awful price will most likely end up a poor investment. As we have seen, Amazon is pursuing all those wonderful opportunities that make growth investors salivate endlessly. This creates a problem when trying to identify a figure for normalized profits. It is really hard to grasp where Amazon would be right now in terms of profits if it were more focused on generating earnings. The main problem relies on the fact that the company claims to be so focused on investing in growth that it is impossible to have an accurate idea about the company’s real profit potential. Therefore, I suggest a simple benchmark exercise in order to deal with this problem. The next table might help us in our quest:
Table 2: Amazon sales mix for 2013, 2012 and 2011 (Source: Amazon 10K – 2013)
Now, let us make some simple assumptions. Imagine that the Media segment is like DirectTV (NASDAQ:DTV), EGM segment is like Best Buy (NYSE:BBY) and the Other segment (includes the third party sellers marketplace) is like Wal-Mart (NYSE:WMT), in terms of profit margins. If this was the case, we would notice a clear trend towards a Best Buy like profit margin. Additionally, we would have approximately the following margins (I have used the 2014Q4 revenue mix and benchmark adjusted margins):
Table 3: Weighted profit margin for AMZN based on benchmark companies for segments
So, our simplistic exercise lead us to a 4.37% profit margin for Amazon. Using a 10% Revenue growth rate for 2015, we will have around USD 97.887 Billion in sales in the current year. Using the 4.37% profit margin, theoretically, Amazon should have around USD 4.28 Billion in profits.
As you must be noticing, this figure means a PER around 40 times our theoretical earnings (current price: USD 374.28). For a company already valued at USD 172 Billion, projecting a growth interval between 6% and 16% in 2015Q1, it is hard to find a 40 times earnings multiple realistic.
I started this article by showing evidence about how good Amazon’s business organization is. My goal is to provide assurance that the company is solid in terms of business and is not going anywhere. Answering the question in the article title, long-time shareholders can sleep well knowing they own a great business organization.
However, the results of our analysis revealed a very high earnings multiple. The exercise about valuation is a simple rationale made to provide a tangible view of the potential margin profit if Amazon tried to milk its profits. Some might have used other companies as a benchmark, I welcome other ideas and views about it in the commenting section. However, this rough measure should not be that far from reality which, in my opinion, should lead the prospective investor to think twice before buying this stock at the current price level.
I like Amazon’s business organization, but this won’t be enough for me to feel compelled to buy the stock at the current levels. I will, however, maintain some attention to this stock waiting for a steep dip in the stock price. If that day comes and Amazon is still well managed then I will most likely invest in the company.