Many of you may recall the age of investing enlightenment know as the late 1990s. I am referring to the time when many "insightful" investors believed that the business models of successful retail businesses would become forever changed. Specifically, the successful retail businesses of the future would rely largely upon the internet for their sales and profits as opposed to the "sales on-site" model of traditional brick and mortar businesses.
The theory seemed to make perfect sense; internet sales would greatly reduce the capital expenditures of many retail businesses. In turn, such businesses would experience greater returns on equity which could be reinvested into their expansion thus their cost of growth would decline precipitously when compared to traditional brick and mortar dinosaurs.
In retrospect, the new age model of Internet sales and marketing has had an extremely disruptive effect on the sales of many traditional businesses. Traditional book stores, travel agencies, movie rental outlets and electronic stores have suffered greatly as a result of internet competition. For instance, most book stores have become tantamount to free-reading libraries that sell coffee and pastries. Few readers are willing to pay extra for the right to purchase a book in a brick and mortar store when they could buy it online at a more favorable cost; however they have no objection to sampling the wares so long as the practice does not dent their pocket book. Furthermore, the selection of available books is virtually limitless when purchased through the likes of Amazon (NASDAQ:AMZN) and the product can be shipped in a timely manner.
Clearly, the advent of low-cost Internet buying has been beneficial to the consumer and detrimental to a number of brick and mortar businesses but the question remains, Is the business model superior in terms of profitability and efficiency? That is the subject of today's discussion which uses Amazon as a proxy for the "new-age" business model and Wal-Mart as a proxy for the traditional brick and mortar business model.
Analyzing the Efficiency of Amazon's Business Model vs. Wal-Mart's Model
Ladies and gentlemen, in this corner stands the Baron of Brick and Mortar, the Benevolent Beast of Bentonville, the long-standing champion of retail which was born from the omniscient business vision of its founder Sam Walton, Wal-Mart (NYSE:WMT) the Wonderful.
In the opposing corner stands the challenger, the Sultan of Cyberspace, the Imperator of the Information Highway who swings the wreaking ball of destruction upon its cowering competition, Amazon (NASDAQ:AMZN) the Amazing.
Now that we have introduced the contestants, let's proceed directly to the "tale of the tape"; more specifically, their trailing 10-year income statement summaries which reveal insights into their underlying operating efficiencies.
INCOME STATEMENT: 10-YEAR SUMMARY (NASDAQ:AMZN)
INCOME STATEMENT: 10-YEAR SUMMARY (NYSE:WMT)
In evaluating the two businesses, I am going to focus upon to two different ratios. The ratios are: earnings before interest and taxes (EBIT) as a percentage of sales (EBIT/Sales) which will be defined as operating margin and depreciation as a percentage of sales (Depreciation Expense/Sales).
The reasoning behind the evaluation lies in the assumption that superior business models should produce higher returns on capital expenditures than ordinary businesses. For our purposes depreciation serves as a pro-rated estimate of the annual cost of capital expenditures. Further, our evaluation is not only interested in uncovering the effectiveness of generating future sales by the increases in capital expenditures but also monitoring the profitability which the increase in sales generates. Therefore, monitoring the operating margin of both businesses is also essential in evaluating the effectiveness of the divergent business models.
Depreciation as a percentage of sales is being used to estimate the effectiveness of capital expenditures in creating new sales. In other words, a company which maintains a low depreciation to sales ratio is effectively redeploying its capital so long as it is maintaining its historical operating margins. If its operating margins are consistently declining while its revenues are increasing then the company's business model is probably suspect. After all, what good is it to invest in growth capital expenditures if the sales do not result in a favorable rate of profitability?
The following tables depict the operating margin (OM) and depreciation as a percentage of sales (DPS) for Amazon and Wal-Mart:
A review of the aforementioned data quickly reveals several facts. First of all, Wal-Mart has been extremely consistent in maintaining an operating margin of around 5.5 percent; however the cost of its growth has risen slightly in the form of an increase in the cost of its depreciation as a percentage of sales from about 1.5% to about 1.8% in the past nine years.
A review of the Amazon data provides us with some puzzling results. Fiscal years 2004 and 2005 were quite comparable to Wal-Mart in terms of operating margin and clearly superior in terms of depreciation as a percentage of sales. It seems at that point in time their Internet-based sales model was outperforming the traditional brick-and-mortar business model employed by Wal-Mart.
Fiscal year 2003, although it is not included in the table above, was even more impressive for Amazon in terms of profitability; its operating margin was 7.4% although its DPS was significantly higher at 1.4%.
Starting in fiscal 2006 to 2010 both the OM and the DPS took a decisive turn for the worse at Amazon. During that period the OM for Wal-Mart became significantly higher than the OM of Amazon. Additionally, the DPS of Amazon also moved in an unfavorable direction.
The huge change came in fiscal 2011 and 2012 when the operating margin for Amazon fell off a cliff. The eroding profitability has been accompanied by drastic increases in depreciation costs culminating in a bloated DPS of 3% as of the latest fiscal report.
Surprisingly, the severe declines in profitability and increasing depreciation costs of Amazon have not deterred the stock from reaching all-time highs.
The Risk vs. Reward of Owning Amazon
It would seem that the current valuation of Amazon stock does not reflect a realistic view of its past business model or its past or present profitability. Rather, the current bloated valuation appears to be either entirely momentum-based or more likely a result of a distorted perception of the company’s future profitability.
Proponents of Amazon would argue that its dramatic increase in depreciation costs are merely a necessary prerequisite designed to pave the way for future profitability. To quote Jim Cramer: "Amazon has virtually no competitors, which means when they want to, they can start showing all the earnings they want. They just have to stop spending to invest in new business."
To that I reply, balderdash! If Amazon has no competition then why has it shown such paltry operating margins in the past decade? It may be the biggest fish in the world of e-commerce but it has plenty of competition in virtually every line that it sells and that will always cap its pricing power. The whole business model of the Internet ensures that fact.
Simply stated, Internet businesses have relatively few barriers to entry and limited capital requirements which are exactly the reasons that they show such high returns on equity. More specifically, they have low requirements for capital investment hence they have low start up costs. Thus, when a certain line of business becomes attractively profitable then competition enters and the profit margins of Amazon are quickly capped and its profit margins begin to erode.
Amazon may have a decided advantage due to their logistics and economies of scale but its gross margins will always be capped just like any other retailer that deals in commodity-based items.
It could be argued that Wal-Mart has a far greater competitive advantage in terms of its purchasing power and distribution network. Yet it is only able to achieve maximum gross margins of slightly less than 25% and operating margins of approximately 6% in its best years.
Let’s assume that Amazon can do slightly better when it completes its build out — a big assumption indeed. The current market cap of Amazon is almost $120 billion. Let’s further assume that it merits a price to earnings ratio of 30 times its future earnings (that is double the current PE ratio of Wal-Mart). To achieve that lofty multiple, Amazon must nearly quadruple its record earnings of $1.15 billion that it achieved in 2010. In other words, it has to record about $4 billion in net earnings in the not-to-distant future to justify a bloated forward P/E of 30. Good luck in achieving that pipe dream.
The current valuation risk for investing in Amazon is highly tilted toward the risk side of the equation and contains no margin of safety. That may be the softest thing that one can say about going long the stock and is likely the understatement of the year.
Disclosure: no position in WMT or AMZN