Amazon is the Dominant Internet Retailer, but Too Expensive
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As I mentioned, Internet-Related is the largest and fastest growing sector for venture capital over the last six months. My previous two reports looked at Google and Yahoo, the premier search companies. This report looks at Amazon, and I will follow up with analyses of Ebay and Priceline in the days to come.
Amazon Surged After Last Year’s Q1 was Reported
Amazon’s stock doubled during 2007, following three years of mediocre performance. What happened last year?
The gap up on April 26th, 2007 coincided with Amazon reporting their March quarter. Strong growth and expanding margins drove revenues and earnings above street consensus estimates and management guidance. Revenues of $3.015 billion in Q1 2007 were above management’s range of $2.85 to $3.00 billion, and operating earnings of $145 million were well above management’s guidance of $82 to $122 million.
A short squeeze might have added fuel to the fire last year, as Amazon is one of the Nasdaq’s most heavily shorted large companies. Yet it is unlikely that short sellers actually drove the gap up. Short interest went from 48.5 mm shares on April 15, 2007 to 53.9 mm shares on May 15, 2007. In other words, the short sellers actually added to their positions in the face of the gap up. The short interest then backed off to 30.9 mm shares by the end of 2007, but it is valuable to note how disciplined these large short sellers were in the face of Amazon’s breakout quarter. In my opinion, the proverbial “short squeeze” is more rare than commentators in the investment press would have us believe.
The Fundamentals Behind Last Year’s Stock Move
Here’s what happened at Amazon last year: revenue growth accelerated, spending growth on technology infrastructure and retail inventory buildout moderated, and as a result, earnings grew rapidly.
First, revenue growth accelerated. The bar chart to the right shows incremental quarterly revenues year-over-year at Amazon for the last four years. Growth in revenues was a stable $400 million per quarter for three years, up until the December 2006 quarter. Amazon showed tremendous growth in that quarter, increasing revenues by $1 billion rather than the $400 million run-rate of the previous three years.
The most important growth segment was “Electronics and other general merchandise”, which was up 55% worldwide in the December 2006 quarter. Amazon saw reasonably good growth in their segment labeled “Media” (ie Books), which was up 25% in the quarter, and in their segment labeled “Other” (ie Cloud Computing), which was up 13%, but non-book merchandise sales were the key driver to the strong revenue growth in that outstanding December quarter.
The strength in the “Electronics and other general merchandise” segment has continued — delivering 50%+ growth every quarter since December 2006, including an increase of 56% in this most recent March 2008 quarter. The success in “Electronics and other general merchandise” was fortuitous, but it was not accidental. Amazon had been spending heavily throughout the previous three years on their infrastructure. This spending provided the backdrop necessary for the accelerated revenue growth Amazon has enjoyed over the last six quarters.
Secondly, accelerating revenues were accompanied throughout 2007 by slowing spending growth.
Technology and Content is one of Amazon’s operating expense categories. As you can see to the right, Technology and Content expense as a percentage of revenues had been trending up for three years, until the breakout quarter in March 2007. Amazon management said repeatedly during that three year period of rising expenses that they were investing in new businesses for the future — the Amazon Elastic Compute Cloud (EC2) and Simple Storage Service (S3), new fulfillment centers in Europe, and expanding their inventories across their store segments.
Well, Amazon seems to have gotten it precisely right. After three years of investing in new businesses, revenues accelerated. Since their breakout quarter in March of 2007, the trend in expenditures on Technology and Content as a % of revenues has reversed. This has driven an expansion in operating margins, and over the last year, Amazon’s cash flow and cash on the balance sheet has doubled.
The trend in operating margins is one of the oldest and most useful indicators for stock performance. I’ve been running this as a quantitative screen for over 20 years. Basically, you measure the quarterly change in operating margins on a year-over-year basis. If you get a situation where a company’s operating margins have been dropping for over five quarters (Amazon’s operating margins trended down for three years), a positive change in operating margins can be a powerful and long lasting buy signal.
That was certainly the case with Amazon. The operating margin in the March 2007 quarter was 4.81%, up 0.16% from the 4.65% operating margin in the March 2006 quarter. Amazon then saw operating margins continue to improve in the subsequent June and September 2007 quarters, and the stock moved up.
On a less positive note, operating margins have been merely stable during the most recent December 2007 and March 2008 quarters. This is a concern. I note that analyst estimates for 2009 look for continued margin improvement, and Amazon may not be in a position to deliver.
Valuing Amazon at $93 Long Term, $55 Currently
View the spreadsheet used for this valuation analysis.
I think Amazon’s management — most visibly CEO Jeff Bezos and CFO Tom Szkutak — pulled off a spectacular coup in the last several years. They spent three years investing in the infrastructure and new businesses necessary to position Amazon for accelerated global growth. They had a superb vision, they executed on a very difficult plan, and they were rewarded in 2007 with a double in cash flow, a double in cash on the balance sheet, and a double in the Amazon stock price.
I certainly do not want to bet against Amazon’s management. Using some very aggressive assumptions for revenue growth over the next five years, however, I think Amazon is fully valued at the current price of $80. My 5.5 year target for Amazon is $93, and discounting that long term price back at 10% per year gives me a current buy price of $55.
I’ve made several assumptions in developing this five year target value of $93.
- I have projected revenues rising 21% per year from 2007 to 2013, increasing from $14.8 billion in 2007 to $45.6 billion in 2013
- I have followed consensus analysts and projected operating margins improving in 2008 and 2009. Specifically, I have annual operating margins going from 4.42% in 2007 to 4.62% in 2008 and then 5.22% in 2009.
- I have projected stable operating margins of 5.22% from 2010 to 2013
- I have projected no growth in shares outstanding from 2007 through 2013. I see Amazon as continuing to be cash flow positive in the years ahead, and I note that shares outstanding were flat in 2006 and 2007.
- I place a 20 multiple on 2013 projected earnings per share and a 1.0 multiple on 2013 estimated sales.
- I discounted the $93 long term target price back at 10% per year to arrive at a current value of $55.
There are two near-term risks to my projections, one on the downside and one on the upside. First, on the downside, operating margins may very well not expand in 2008 and 2009. In fact, I think this likely. If operating margins do not expand, Amazon could disappoint on the earnings front. The risk to the upside is in Amazon’s hot new products — the electronic reader called the Kindle and their cloud computing initiatives. These new products could spur better than expected revenue growth.
I certainly understand why an investor would want to buy and hold Amazon. Management has been superb, the company has several successful new products, and their revenues could triple over the next five years. This has all the hallmarks of a one-decision stock.
Reasonable valuations on those 2013 projections, however, leave little room for upside. Most retail stocks trade at 15 times projected earnings and 0.5 times sales. I am using 20 times 2013 projected earnings and 1.0 times 2013 sales to arrive at a $93 long term target price. Adjusting for a 10% annuallized internal rate of return, Amazon looks overpriced to me at these levels. I would look for an entry point of $55.
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