“Our heavy investments in Prime, AWS, Kindle, digital media, and customer experience in general strike some as too generous, shareholder indifferent, or even at odds with being a for-profit company. 'Amazon, as far as I can tell, is a charitable organization being run by elements of the investment community for the benefit of consumers,' writes one outside observer. But I don’t think so. To me, trying to dole out improvements in a just- in-time fashion would be too clever by half. It would be risky in a world as fast-moving as the one we all live in. More fundamentally, I think long-term thinking squares the circle. Proactively delighting customers earns trust, which earns more business from those customers, even in new business arenas. Take a long-term view, and the interests of customers and shareholders align.
As I write this, our recent stock performance has been positive, but we constantly remind ourselves of an important point – as I frequently quote famed investor Benjamin Graham in our employee all-hands meetings – “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” We don’t celebrate a 10% increase in the stock price like we celebrate excellent customer experience. We aren’t 10% smarter when that happens and conversely aren’t 10% dumber when the stock goes the other way. We want to be weighed, and we’re always working to build a heavier company.”
- Jeff Bezos’ 2012 letter to Amazon shareholders
Recently I have read a few articles on Amazon’s hefty stock price. With a trailing P/E ratio of over 600 and a forward P/E ratio just shy of 100, Amazon’s stock has been categorized by some as a bubble stock along with some other high flyers such as Tesla, LinkedIn and Twitter. Included below are two articles for the reader’s amusement:
I think anyone who claims Amazon’s stock is a bubble based solely on the P/E ratio may need to rethink his or her investment process. A claim based on any superficial numbers is extremely inadequate.
Let me clarify that I don’t think Amazon’s stock is cheap. Heck, I think there is a very good chance that it is overvalued at the current price. However, valuation is not the focus of this article. As a huge admirer of Jeff Bezos, I want to share with the readers some analysis and thoughts on Amazon’s moat and true earnings power.
According to Amazon’s 10-K, Amazon opened its doors on the World Wide Web in July 1995 and offers Earth’s Biggest Selection. Amazon seeks to be Earth’s most customer-centric company for its customer set. Since Amazon’s inception, Jeff Bezos has been relentless focusing on building and widening Amazon’s moat. Until now, a majority of his efforts may have adversely impacted Amazon’s short term and intermediate term margins, but at the same time, widened Amazon’s long term sustainable moat.
With Bezos’ leadership, Amazon became the most disruptive force in retail in recent history. Spending heavily on fulfillment centers, technology and human capital, Amazon has built up a very wide moat with its low-cost operations and network effect.
If you spend some time going through Amazon’s annual report for the last eight to 10 years, you will find out that Amazon has increased its spending as a percentage of sales on fulfillment centers. In 2005, fulfillment cost was 8.8% of sales and during the most recent year (2013), it is 11.5% of sales, which by itself has nonupled since 2005. But Bezos’ vision and efforts paid off: Amazon now enjoys massive scale and cost advantage. The best part is, Amazon can price below its brick-and-mortar competitors and still generate excess returns because it doesn’t have to have physical stores, saving an enormous amount of money. This cost advantage in turn generates stronger cash flow than its retail competitors and enables Amazon to offer a wide selection, convenience, and superior customer service — a rare combination among retailers.
More importantly, Amazon’s investment has also built up a massive network effect. According to Morningstar, Amazon’s low prices, a wider selection of products, expedited and affordable shipping and user-friendly interface “attract millions of customers, which in return attract merchants of all kinds to Amazon.com, including third-party sellers on Amazon's Marketplace platform and wholesalers/manufacturers selling directly to Amazon. Additionally, customer reviews, product recommendations and wish lists increase in relevance as more consumers and products are added to the Amazon platform, enhancing its network effect.”
Today when we think about Amazon, we think about all the good things we can buy from it at a cheaper price than we can from brick-and-mortar retailers. We think about Kindle, and we think about Amazon Prime’s free two-day shipping and video streaming services. Not everyone reads on Kindle and certainly not everyone uses Amazon Prime. But for so many of us, Kindle and Amazon Prime have become an essential part of life. Barnes & Noble tried to compete against Kindle with Nook but everyday when commuting on the subway in New York City, I see a lot of people reading on a Kindle device, but rarely do I see anyone using a Nook. At work, we talk about how great Amazon Prime membership is and how frustrating it would be for us if suddenly Amazon takes it away. Again, not everyone loves the Prime membership but for a significant amount of Americans and foreigners, it is hard to go back to the days without the Prime membership.
And let’s not forget about the less-talked-about Amazon web services. Amazon spent heavy in technology and content, which was only 5.3% of sales in 2005. Now it’s 8.8% of sales. According to Morningstar’s research analysts, as a result of this investment, “Amazon’s public cloud computing offerings now possess more than 4 times the computing capacity in use than the next 14 largest providers combined, providing the company with scale advantages and often making it the preferred name for corporations looking to reduce information technology expenditures. AWS generated approximately $3 billion in revenue during 2013, and (Morningstar) forecasts average annual revenue growth of more than 30% over the next five years. With recent investments for additional capacity, (Morningstar) also expects AWS to become an increasingly positive margin contributor because of its highly leverageable nature."
All of the above competitive advantages have been widening, at the cost of short-term to intermediate-term margin contraction. This brings us to the topic of Amazon’s true earnings power. While Amazon’s gross margin has expanded to 27% from the low 22%, its reported net margin has actually shrunk. In fact, a common non-believer’s argument rests upon Amazon’s almost non-existent profit margin, which has been less than 1%, or even negative during the past couple of years. It seems like a perfectly fine argument. After all, a common characteristic of a bubble stock company is the lack of real profitability. While it is true for many bubble stocks, Amazon’s real earnings power is hidden and probably will be hidden until some years later in the future. Furthermore, as stated in Amazon’s annual report many times, Bezos’ preferred metric is free cash flow, which has been growing consistently. Earnings lag free cash flow largely because of huge depreciation and amortization expenses.
One of the stories renowned value investor Tom Russo (Trades, Portfolio) used in last year’s Omaha Value Investing Conference was the story of Starbucks. I took some notes but found this post better. Here is a summary from the post:
"Several years ago, a young analyst kept asking Howard Schultz when they were going to show profits in China. Howard Schultz asked him how big did you want Starbucks to be. He then told the analyst and his investors if you want us to dominate China, then let us not show profits for a long time. And if you permit that, we will end up with a dominant position in an important market with moat-like characteristics. If you try to establish, as so many American companies did, a base in China and do it without impacting earnings, you'll do it with a very small business that won't have a competitive franchise.
And that trade off is just as clear an expression of this notion of the capacity to suffer. Now Schultz isn't going to lose Starbucks because he has enough stock to keep it on the course that he chooses. But there are many companies that don't have that control. Most don't. And so they favor short-term results versus the long term. "
Similar to Starbucks’ investment in China, Amazon may not show profit for a while. But if you want short-term results at the expense of long-term prosperity, which is often what Wall Street wants, you can immediately stop investing in things that will make your moat wider and even start destroying it. In the case of Amazon, Bezos can cut fulfillment cost and technology and content cost each by half. This will immediately improve Amazon’s margin to around 10%, as opposed to less than 1%. EPS will be something like $16 per share, as opposed to $0.59 per share. This all can be done, easily.
Can Amazon do this? Possibly in the future, but not today. Amazon has been reaping the benefits of its huge investment in the past and it will continue to reap the benefit of past and current investment in the future. I think Amazon is pretty close to the end of the investment cycle. How close? Nobody knows, but when that day comes, Amazon’s true earnings power will be admirable. I think Amazon will very likely to be able to produce at least a 5% to 6% net margin on a consistent basis. At today’s revenue level, this implies a true earnings power of between $9 to $10 per share. Now compare that to the reported $0.59 per share.
A company’s intrinsic value calculation is not as easy as applying a multiple to a reported earnings number. The numerator price is known and quoted everyday, but estimating a business’ true earning power is not merely finding the reported EPS number on the form 10-K. Very often we have to applaud to a management for its capacity to suffer over the short term and very often we have to stay rational in an environment that encourages short-term thinking. Amazon is a prime example of the concept of capacity to suffer. Amazon is built to last and it has gone from good to great, and argubly greater.
What is Amazon’s future? No one knows for sure. But I will be waiting patiently for an opportunity to be a partial owner of this great company.
“We want to be weighed, and we’re always working to build a heavier company.” (Last sentence from the opening quote.)
- Jeff Bezos