Amazon (AMZN, Financial) stock has had quite a run. Investors have bid up the stock tremendously, focusing on strong revenue growth and significant market share gains. In this article, I seek to show why enthusiasm for the stock is completely unfounded and why Amazon may present a good short opportunity.
As one of the largest, most successful Internet retailers, Amazon generates revenue from many products and services. Merchandise and content is purchased for resale from vendors and third-party sellers. In addition, Amazon manufactures and sells the Kindle e-reader.
One side note before I project Amazon's future revenues: The firm's financial health is extremely solid. Amazon's pristine balance sheet carries a tangible book value of $5.856 billion as of June 30, 2011, very little debt, and cash and marketable securities totaling $6.355 billion. Off-balance sheet operating and capital commitments are negligible, amounting to under $900 million per year, an extremely small percentage of Amazon's costs. The firm is equipped to handle a difficult economic environment due to its strong financial position.
Amazon divides revenue into two segments, North America and International, and further into three sub-segments: media, electronics and other general merchandise, and "other." The "other" segment represents insignificant non-retail activity plus Amazon Web Services (AWS).
The majority of revenue is derived from the media and electronics segments. The media segment consists primarily of book sales, but also other items such as music and DVDs. The electronics segment consists of many items such as computers, tablets and televisions, as well as non-electronics items. Amazon's future revenue will be determined primarily by their share of the global books and electronics markets. I will first project media segment revenues by examining the U.S. market for book sales.
As data from the U.S. Census Bureau shows, this is a slow-growth market:
Since this is a mature market, future growth within Amazon's domestic media segment must come from gaining market share. Below shows Amazon's strong revenue and market share gains since 2006:
While still impressive, the growth rate within Amazon's domestic media segment has slowed because there is only so much revenue that can be generated from a mature market once a certain level of penetration is achieved. Amazon has shown the ability to increase market share 5-6% per year, to the point where they may control 75% of the market by 2016. Assuming a 1% growth rate in U.S. book sales the next five years, I project Amazon's domestic media segment revenues through 2016 below:
Amazon's international media segment has also grown revenues significantly as shown below:
I project Amazon's international media revenues to grow slightly more than its domestic segment, due to significant opportunity within emerging markets:
The U.S. electronics market is also a slow-growth market. However, it has grown faster than the market for book sales as shown below:
If Amazon's electronics sales are added, the CAGR increases to nearly 3%. In an article dated July 5, 2011 by Steven Smith and Alan Wolf, it is estimated Amazon had $7.9 billion of electronics sales in 2010 within the U.S., representing approximately 72% of segment revenue in "electronics and other general merchandise."
Link: http://www.twice.com/article/470500Amazon_s_Gain_Is_Brick_and_Mortar_s_Pain_In_CE_Share_Shift.php
Below U.S. electronics sales are shown including sales from Amazon:
Amazon has begun to take significant market share within electronics since 2005 as shown below:
According to a recent NPD study (link below):
http://www.neowin.net/news/study-many-consumers-still-dont-buy-electronics-online
From the article:
"For example, only 19 percent of people surveyed by NPD said they would be 'extremely' or 'very likely' to buy a new television online, even though 56 percent of them research which TV they want to buy online.
Other products that people are reluctant to buy on a web site include a Blu-Ray player (21 percent), a camcorder (also 21 percent) and oddly enough a mobile phone or smartphone (23 percent). The products with the highest percentage of people willing to pay for them online include computers and computer software (both 34 percent), an eReader (32 percent) and a digital camera (30 percent)."
Although Amazon has grown revenues significantly, it may be difficult to capture more than 20% market share due to the reluctance of many consumers to purchase expensive durables online. For many people there is comfort in testing an item at a store, walking out with their purchase, as well as the value and convenience of customer service when buying and returning.
I project Amazon's market share to slow when it reaches 20% as shown below:
Due to potential from emerging markets and the slow growth of the U.S. electronics market, I project Amazon's international segment to grow revenues faster than the domestic segment. Amazon's international segment's electronics revenues since 2006 and my future projections are below:
My projections:
My total projected revenues for Amazon are as follows, which include "other" segment revenues reaching nearly $5 billion domestically within 5 years, due to growth of Amazon Web Services (AWS):
Amazon not only faces the challenge of a mature domestic market within its core products but also a challenge improving margins. Amazon's past gross margins are below:
While many companies such as Google (GOOG) and Intel (INTC) have had success increasing gross margins as revenues have grown, Amazon has had trouble doing so. Their gross margin year after year has been remarkably similar. Why? Google and Intel offer products and services which are vitally important and hard to replicate, while Amazon sells commodities and competes mostly on price. Below are gross margins from competitors:
Competitors have remarkably similar gross margins. From Amazon's past execution and the performance of its competitors, it seems unlikely Amazon will be able to improve gross margins much above 25%. Investors are making a mistake by treating Amazon as a unique internet firm. Although Amazon's top line growth needs to be recognized, investors will soon realize Amazon is just another retailer unable to improve gross margins because it is in the business of selling commodities and competing on price.
Below I will examine Amazon's other costs and show why they will also have difficulty increasing their operating margins, which not only has to do with the difficulty of improving gross margins, but also increasing fulfillment, shipping, and technology costs.
A description of fulfillment costs from the most recent 10k:
"Fulfillment costs represent those costs incurred by operating and staffing our fulfillment and customer service centers, including costs attributable to buying, receiving, inspecting, and warehousing inventories; picking, packaging, and preparing customer orders for shipment; payment processing and related transaction costs, including costs associated with our guarantee for certain seller transactions; and responding to inquiries from customers. Fulfillment costs also include amounts paid to third parties that assist us in fulfillment and customer service operations."
Fulfillment costs ranged from 8.4%-8.7% of sales from 2006-10. However, in 2011 they have increased to 9.1% of sales. It appears it is costing Amazon more to prepare and process orders. This may not seem like a big deal, as these costs for the first six months of 2011 have only increased 90 basis points compared to the first six months of 2010. But when your operating margins are below 5%, 90 basis points is a big deal.
Net shipping costs are part of "costs of sales." From 2006-09 net shipping costs as a % of revenue ranged from 3%-3.5%. In 2010 they increased to 4.1% of revenue. In 2011, they are up to 4.8% of revenue, an increase of one full percentage point over the first six months of 2010. As Amazon enters the more expensive electronics market and is forced to compete on price, it appears they have no choice but to eat more shipping costs.
A description of Technology and Content expenses from the 10-k:
"Technology and content expenses consists primarily of payroll and related expenses for employees involved in application development, category expansion, editorial content, buying, merchandising selection, and systems support, as well as costs associated with the compute, storage, and telecommunications infrastructure used internally and supporting AWS."
Since 2007, technology and content costs ranged between 5.1% and 5.5% of sales. They have increased to 6.5% of sales the first six months of 2011, a 90 basis point increase from the first six months of 2010. Again, a big deal when operating margins are below 5%. There is no sign of these costs decreasing as a % of revenues, as Amazon states in the latest 10Q, "We expect these trends to continue over time."
The factors above explain why Amazon's operating margin the first six months of 2011 was almost chopped in half compared with the first six months of 2010.
Now that we have an idea of Amazon's future revenue growth and costs, we need to determine the best way to value Amazon.
An EV/EBITDA valuation will not work because Amazon's closest competitors are much slower growth retailers. Currently, Amazon carries a ridiculous EV/EBITDA multiple over 40, nearly 4x e-Bay's multiple.
Free cash flow will also not work because Amazon has been spending aggressively on capital expenditures the past 18 months as they expand rapidly. Shown below:
Amazon has some work to do if they seek to achieve their ultimate goal stated in the 10k as follows:
"Our financial focus is on long-term, sustainable growth in free cash flow per share."
Both of the above measures would underestimate the value of Amazon. I believe a discounted earnings model is more appropriate, which measures the future earnings power of the underlying business. Below is my discounted earnings model on Amazon. The assumptions are derived from my explanations above. I assume slightly lower tax rates each year due to a greater % of revenue from abroad generated in lower-tax jurisdictions, as well as a slight dilution of share count consistent with the trend due to Amazon's stock compensation. There is no sign of share buybacks in the future. Although Amazon purchased a small amount of shares in 2008, there have been no share repurchases since:
To justify a value of the most recent high near $250 per share, Amazon would have to gain control of 100% of the US books AND electronics markets by 2016! This assumes the same strong revenue growth I projected abroad, and gives you an idea of how challenging it will be for Amazon if they do not begin to focus on cost control. If Amazon is able to increase gross margins to 26% from 23%, a fair value of $250 per share can be justified. While it seems fulfillment, shipping, and technology costs will be higher in the future, as all are geared to remaining competitive and providing better customer service, if Amazon is unable to improve gross margins, the stock price will eventually suffer. With Wal-Mart's gross margin barely above 25%, a firm with perhaps the best ability in terms of "bargaining power with suppliers," it appears unlikely Amazon will be able to improve gross margins to 26%. Given Amazon's long-term performance, gross margins in the 23% range seem more likely.
Now I will turn my attention to Best Buy.
Why on earth would a slow growth, bricks and mortar electronics retailer be appealing as an investment?
While Best Buy is not as liquid as Amazon, the firm remains in solid financial condition. As of the end of May 2011, tangible book value stood at $3.5 billion, cash and equity investments totaled over $2.5 billion, and the firm had virtually no net debt. Like Amazon, Best Buy's financial condition gives the firm the ability to handle a prolonged slow growth economy.
Best Buy's electronics sales and total revenues are not as bad as the recent stock price is reflecting. When domestic electronics sales are examined and broken down in further detail, it is evident larger items such as televisions are suffering much more than smaller items such as tablets.
Below are bricks and mortar electronics and appliance store sales in the US since they peaked in 2007:
Total sales are 9.4% below their peak reached in 2007. A piece of these sales relates to computer and software stores. Although, total electronics and appliance sales are down significantly since they peaked, sales at computer and software stores are 8% above the level reached in 2007. After a trough in 2001 after the technology crash, computer and software sales have grown solidly, were the least sensitive to the Great Recession, and produced the strongest recovery of the electronics/appliance store group. If we strip out computer and software sales and focus solely on appliances and other electronics, we see a market still suffering:
If Amazon's sales are added to total electronics and appliance sales, the decline from the peak level reached in 2007 is only 4%, not 9.4%. If Amazon's sales are added and the computer and software store sales are stripped out, electronics and appliance sales are still down 7% from the peak achieved in 2007. This tells me only some of Best Buy's struggle with electronics may have to do with losing market share to Amazon, much of it relates to weak sales of larger durable items such as television and appliances in general. The same can be said for car sales, which remain well below 2007 levels in the United States.
If we examine Best Buy's share of the bricks and mortar market and total market share including Amazon sales, the numbers are not as bad as the stock price is reflecting. Keep in mind that Best Buy's fiscal year ends in late February/early March, so Best Buy's fiscal 2006 revenue in compared with market data from 2005 and so forth:
We see that Best Buy still retains significantly more market share of the total US electronics markets than they had in 2007. Sales of consumer electronics items specifically are relatively similar to where they were in 2007, while the overall market including Amazon is still down significantly if computer and software store sales are stripped out. Computer and software are reported in Best Buy's home office segment, while consumer electronics consists of items such as televisions. The decline in consumer electronics sales since 2010 is not as bad as it looks. Keep in mind Circuit City virtually shut down in 2009 after they declared bankruptcy. Best Buy was able to take advantage of one of their largest competitors going out of business and gained significant market share in 2010. However, that extra share proved to be unsustainable as newer entrants such as Amazon began to increase their presence after Circuit City's demise.
While Best Buy may not reach market share levels enjoyed in 2010, market share is also not in free fall. Instead of dealing with competitors such as Circuit City, Best Buy must deal with a different competitor in Amazon. There are enough consumers who find comfort in purchasing a large durable such as a television at a store, and when overall sales pick up, Best Buy should benefit.
Based on my projections for the total electronics and appliance market to grow 3% annually the next five years and Amazon to have 26% of the market by the end of 2016, my Best Buy sales projections are below, which assume they retain 37% of the bricks and mortar market:
While areas such as consumer electronics and the entertainment segment have been struggling, Best Buy's home office division has been a bright spot, sparked by sales of tablets and mobile devices, not only domestically but also abroad through the partnership with Carphone Warehouse in Europe. In addition, Best Buy is growing appliance sales abroad by taking advantage of China's emerging middle class. The home office division both domestically and abroad has grown same store sales strongly the past 3 years, as the tablet and mobile markets continue to grow. Same stores sales grew 10.4%, 12.8%, and 3.6% respectively in the domestic home office division in 2009, 2010, and 2011, while sales grew abroad 5% in the home office division in fiscal 2011. Due to Best Buy's focus in China, same store appliance sales grew abroad in fiscal 2010 and 2011, 7.3%, and 15.2% respectively.
Despite meager top line growth, Best Buy is making every effort to add shareholder value. Instead of opening many big box Best Buy stores, which increase capital expenditures substantially, Best Buy is focusing its efforts on growing areas by opening Best Buy mobile locations to take advantage of mobile and tablet demand in the US, as well as expansion of Five Star Stores in China to take advantage of appliance demand in a growing emerging market.
In fiscal 2012, Best Buy plans to open 150 small-format mobile stores within the United States and only 6-8 big Best Buy stores. In years past they opened as many as 100 big Best Buy stores domestically. To take advantage of the Chinese appliance market, Best Buy plans to open 40 to 50 Five Star stores. Substantially fewer openings of big Best Buy stores will reduce capital expenditures remarkably and help free cash flow. Capital expenditures were as much as $1.3 billion in fiscal 2009 but were only $744 million in fiscal 2011 and are on pace to be only $800 million in fiscal 2012. Lower capital expenditures help free up cash to add shareholder value through buybacks and dividends.
Earlier this year, Best Buy authorized a $5 billion share buyback program, which is fairly significant considering their current market cap is only $9 billion. So far this year, Best Buy has reduced share count by 7%. This has potential to substantially increase earnings per share over time. Best Buy also announced a 7% increase of the dividend. At its current price, Best Buy has a 2.64% yield, which is now remarkably more than the current yield of the 10 year Treasury.
In my opinion, Best Buy is making good use of its capital. Share buybacks, dividends, expansion in growing areas, contraction in slower areas, and a focus on controlling costs, have the potential to stop the recent slide in the stock price and provide much better future returns.
Below I will value Best Buy using the same discounted earnings model I used for Amazon. I choose to use discounted earnings instead of free cash flow because I feel a free cash flow model does not capture the effect of future share repurchases.
Because the mobile phone and tablet markets are growing abroad as is appliance demand in China, I project Best Buy's foreign revenue to grow 3% annually. Gartner estimates 1.6 billion mobile phones were sold in 2010 worldwide and sales are on pace to exceed 1.7 billion in 2011. Gartner also estimates global tablet sales will be 63.3 million in 2011 up from 17.6 million in 2010. They estimate sales of over 300 million globally by 2015.
Below is the link to an article showing strong home appliance demand in China, helped by the country's subsidy program:
http://en.21cbh.com/HTML/2011-6-7/yNMjUwXzIxMDMyNw.html
Quote from the article:
"During the first 5 months of the year, a total of 45.23 million units of home appliances worth RMB 109.5 billion under the subsidy program were sold, up 71% and 103% from the same period last year, respectively, according to data released by the Ministry of Commerce on Saturday."
My projections for Best Buy's International Revenues are below:
Below is my discounted earnings model on Best Buy. I assume a 5% reduction in share count per year.
Based on thorough analysis, I feel Best Buy provides significant upside potential and a margin of safety at its current price, while Amazon's growth is already priced in. Only time will tell if I am correct, but I am willing to give this investment thesis 3-5 years to play out.
As one of the largest, most successful Internet retailers, Amazon generates revenue from many products and services. Merchandise and content is purchased for resale from vendors and third-party sellers. In addition, Amazon manufactures and sells the Kindle e-reader.
One side note before I project Amazon's future revenues: The firm's financial health is extremely solid. Amazon's pristine balance sheet carries a tangible book value of $5.856 billion as of June 30, 2011, very little debt, and cash and marketable securities totaling $6.355 billion. Off-balance sheet operating and capital commitments are negligible, amounting to under $900 million per year, an extremely small percentage of Amazon's costs. The firm is equipped to handle a difficult economic environment due to its strong financial position.
Amazon divides revenue into two segments, North America and International, and further into three sub-segments: media, electronics and other general merchandise, and "other." The "other" segment represents insignificant non-retail activity plus Amazon Web Services (AWS).
The majority of revenue is derived from the media and electronics segments. The media segment consists primarily of book sales, but also other items such as music and DVDs. The electronics segment consists of many items such as computers, tablets and televisions, as well as non-electronics items. Amazon's future revenue will be determined primarily by their share of the global books and electronics markets. I will first project media segment revenues by examining the U.S. market for book sales.
As data from the U.S. Census Bureau shows, this is a slow-growth market:
Book Sales from the US Census Bureau: | ||||||||||
(In Millions of $ per year) | ||||||||||
2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | CAGR | |
Book Sales | 15450 | 16236 | 16877 | 16889 | 16983 | 17184 | 16870 | 16051 | 15662 | 0.17% |
Growth Rate | 5.1% | 3.9% | 0.1% | 0.6% | 1.2% | -1.8% | -4.9% | -2.4% |
Since this is a mature market, future growth within Amazon's domestic media segment must come from gaining market share. Below shows Amazon's strong revenue and market share gains since 2006:
North America Media Segment | |||||
2006 | 2007 | 2008 | 2009 | 2010 | |
Net Sales | 3582 | 4630 | 5350 | 5964 | 6881 |
Growth Rate | 29.3% | 15.6% | 11.5% | 15.4% | |
% Market Share | 21.1% | 26.9% | 31.7% | 37.2% | 43.9% |
US Books Sales (In Millions of $ per year) | 16983 | 17184 | 16870 | 16051 | 15662 |
While still impressive, the growth rate within Amazon's domestic media segment has slowed because there is only so much revenue that can be generated from a mature market once a certain level of penetration is achieved. Amazon has shown the ability to increase market share 5-6% per year, to the point where they may control 75% of the market by 2016. Assuming a 1% growth rate in U.S. book sales the next five years, I project Amazon's domestic media segment revenues through 2016 below:
2011 | 2012 | 2013 | 2014 | 2015 | 2016 | |
Revenue | 7910 | 8787 | 9682 | 10594 | 11523 | 12469 |
Growth Rate | 11.1% | 10.2% | 9.4% | 8.8% | 8.2% | |
% Market Share | 50% | 55% | 60% | 65% | 70% | 75% |
Projected US Books Market | 15819 | 15977 | 16137 | 16298 | 16461 | 16626 |
Growth Rate | 1.00% | 1.00% | 1.00% | 1.00% | 1.00% | 1.00% |
Amazon's international media segment has also grown revenues significantly as shown below:
2006 | 2007 | 2008 | 2009 | 2010 | |
International Media revenues | 3485 | 4612 | 5734 | 6810 | 8007 |
Growth Rate | 32.3% | 24.3% | 18.8% | 17.6% |
I project Amazon's international media revenues to grow slightly more than its domestic segment, due to significant opportunity within emerging markets:
2011 | 2012 | 2013 | 2014 | 2015 | 2016 | |
Int. Media Revenue | 9849 | 11819 | 13592 | 15630 | 17193 | 18913 |
Growth Rate | 23% | 20% | 15% | 15% | 10% | 10% |
The U.S. electronics market is also a slow-growth market. However, it has grown faster than the market for book sales as shown below:
U.S. electronics and appliance store sales 2001-2010 bricks and mortar (in millions of $ per year) Source: Department of Commerce | ||||||||||||
2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 10 yr CAGR | |
Revenue | 82363 | 80395 | 83897 | 86796 | 94524 | 101449 | 107826 | 110849 | 108869 | 98384 | 100471 | 2% |
Growth Rate | -2.39% | 4.36% | 3.46% | 8.90% | 7.33% | 6.29% | 2.80% | -1.79% | -9.63% | 2.12% |
If Amazon's electronics sales are added, the CAGR increases to nearly 3%. In an article dated July 5, 2011 by Steven Smith and Alan Wolf, it is estimated Amazon had $7.9 billion of electronics sales in 2010 within the U.S., representing approximately 72% of segment revenue in "electronics and other general merchandise."
Link: http://www.twice.com/article/470500Amazon_s_Gain_Is_Brick_and_Mortar_s_Pain_In_CE_Share_Shift.php
Below U.S. electronics sales are shown including sales from Amazon:
2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 10 yr CAGR | |
Total market with Amazon | 82363 | 80810 | 84386 | 87427 | 95334 | 102486 | 109280 | 113104 | 112051 | 102919 | 108371 | 2.78% |
Amazon has begun to take significant market share within electronics since 2005 as shown below:
2005 | 2006 | 2007 | 2008 | 2009 | 2010 | |
Amazon US Electronics Revenue | 1037 | 1454 | 2255 | 3182 | 4535 | 7900 |
Market Share | 1.0% | 1.3% | 2.0% | 2.8% | 4.4% | 7.3% |
According to a recent NPD study (link below):
http://www.neowin.net/news/study-many-consumers-still-dont-buy-electronics-online
From the article:
"For example, only 19 percent of people surveyed by NPD said they would be 'extremely' or 'very likely' to buy a new television online, even though 56 percent of them research which TV they want to buy online.
Other products that people are reluctant to buy on a web site include a Blu-Ray player (21 percent), a camcorder (also 21 percent) and oddly enough a mobile phone or smartphone (23 percent). The products with the highest percentage of people willing to pay for them online include computers and computer software (both 34 percent), an eReader (32 percent) and a digital camera (30 percent)."
Although Amazon has grown revenues significantly, it may be difficult to capture more than 20% market share due to the reluctance of many consumers to purchase expensive durables online. For many people there is comfort in testing an item at a store, walking out with their purchase, as well as the value and convenience of customer service when buying and returning.
I project Amazon's market share to slow when it reaches 20% as shown below:
In Millions of $ per year | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 |
Amazon US Electronics Segment Projected Revenues | 18604 | 25549 | 32894 | 37269 | 41877 | 46728 |
% of revenue from electronics sales | 72% | 72% | 72% | 72% | 72% | 72% |
Amazon Electronics Sales | 13395 | 18395 | 23684 | 26834 | 30152 | 33644 |
Total US Electronics Market | 111622 | 114971 | 118420 | 121973 | 125632 | 129401 |
US Electronics Market Growth Rate | 3% | 3% | 3% | 3% | 3% | 3% |
Amazon Market Share | 12% | 16% | 20% | 22% | 24% | 26% |
Due to potential from emerging markets and the slow growth of the U.S. electronics market, I project Amazon's international segment to grow revenues faster than the domestic segment. Amazon's international segment's electronics revenues since 2006 and my future projections are below:
Amazon International Electronics and other general merchandise segment | |||||
2006 | 2007 | 2008 | 2009 | 2010 | |
Revenues in Millions of $ per year | 1337 | 2071 | 3110 | 4768 | 7365 |
Growth Rate | 54.9% | 50.2% | 53.3% | 54.5% |
My projections:
2011 | 2012 | 2013 | 2014 | 2015 | 2016 | |
Revenues | 11931 | 17897 | 26845 | 37584 | 48859 | 58630 |
Growth Rate | 62% | 50% | 50% | 40% | 30% | 20% |
My total projected revenues for Amazon are as follows, which include "other" segment revenues reaching nearly $5 billion domestically within 5 years, due to growth of Amazon Web Services (AWS):
2011 | 2012 | 2013 | 2014 | 2015 | 2016 | |
Amazon Projected Revenues | 49944 | 66497 | 86305 | 105052 | 124072 | 141908 |
Growth Rate | 46.0% | 24.9% | 23.0% | 17.8% | 15.3% | 12.6% |
Amazon not only faces the challenge of a mature domestic market within its core products but also a challenge improving margins. Amazon's past gross margins are below:
2006 | 2007 | 2008 | 2009 | 2010 | |
Amazon Net Sales | 10711 | 14835 | 19166 | 24509 | 34204 |
Growth Rate | 38.5% | 29.2% | 27.9% | 39.6% | |
Cost of Sales | 8255 | 11482 | 14896 | 18978 | 26561 |
% of Revenue | 77.1% | 77.4% | 77.7% | 77.4% | 77.7% |
Gross Margin | 2456 | 3353 | 4270 | 5531 | 7643 |
Gross Margin % | 22.9% | 22.6% | 22.3% | 22.6% | 22.3% |
While many companies such as Google (GOOG) and Intel (INTC) have had success increasing gross margins as revenues have grown, Amazon has had trouble doing so. Their gross margin year after year has been remarkably similar. Why? Google and Intel offer products and services which are vitally important and hard to replicate, while Amazon sells commodities and competes mostly on price. Below are gross margins from competitors:
Gross Margin TTM | |
Best Buy | 25.0% |
Wal-Mart | 25.2% |
Barnes and Noble | 26.1% |
Competitors have remarkably similar gross margins. From Amazon's past execution and the performance of its competitors, it seems unlikely Amazon will be able to improve gross margins much above 25%. Investors are making a mistake by treating Amazon as a unique internet firm. Although Amazon's top line growth needs to be recognized, investors will soon realize Amazon is just another retailer unable to improve gross margins because it is in the business of selling commodities and competing on price.
Below I will examine Amazon's other costs and show why they will also have difficulty increasing their operating margins, which not only has to do with the difficulty of improving gross margins, but also increasing fulfillment, shipping, and technology costs.
A description of fulfillment costs from the most recent 10k:
"Fulfillment costs represent those costs incurred by operating and staffing our fulfillment and customer service centers, including costs attributable to buying, receiving, inspecting, and warehousing inventories; picking, packaging, and preparing customer orders for shipment; payment processing and related transaction costs, including costs associated with our guarantee for certain seller transactions; and responding to inquiries from customers. Fulfillment costs also include amounts paid to third parties that assist us in fulfillment and customer service operations."
Fulfillment costs ranged from 8.4%-8.7% of sales from 2006-10. However, in 2011 they have increased to 9.1% of sales. It appears it is costing Amazon more to prepare and process orders. This may not seem like a big deal, as these costs for the first six months of 2011 have only increased 90 basis points compared to the first six months of 2010. But when your operating margins are below 5%, 90 basis points is a big deal.
Net shipping costs are part of "costs of sales." From 2006-09 net shipping costs as a % of revenue ranged from 3%-3.5%. In 2010 they increased to 4.1% of revenue. In 2011, they are up to 4.8% of revenue, an increase of one full percentage point over the first six months of 2010. As Amazon enters the more expensive electronics market and is forced to compete on price, it appears they have no choice but to eat more shipping costs.
A description of Technology and Content expenses from the 10-k:
"Technology and content expenses consists primarily of payroll and related expenses for employees involved in application development, category expansion, editorial content, buying, merchandising selection, and systems support, as well as costs associated with the compute, storage, and telecommunications infrastructure used internally and supporting AWS."
Since 2007, technology and content costs ranged between 5.1% and 5.5% of sales. They have increased to 6.5% of sales the first six months of 2011, a 90 basis point increase from the first six months of 2010. Again, a big deal when operating margins are below 5%. There is no sign of these costs decreasing as a % of revenues, as Amazon states in the latest 10Q, "We expect these trends to continue over time."
The factors above explain why Amazon's operating margin the first six months of 2011 was almost chopped in half compared with the first six months of 2010.
Now that we have an idea of Amazon's future revenue growth and costs, we need to determine the best way to value Amazon.
An EV/EBITDA valuation will not work because Amazon's closest competitors are much slower growth retailers. Currently, Amazon carries a ridiculous EV/EBITDA multiple over 40, nearly 4x e-Bay's multiple.
Free cash flow will also not work because Amazon has been spending aggressively on capital expenditures the past 18 months as they expand rapidly. Shown below:
2010 | Q1 and Q2 2011 | |
Net Income | 1152 | 391 |
Depreciation and Amortization | 568 | 446 |
Stock-Based Comp | 424 | 254 |
Excess Tax Benefits from Stock-Based Comp | -259 | -61 |
Capital Expenditures | -979 | -731 |
Free Cash Flow | 906 | 299 |
Amazon has some work to do if they seek to achieve their ultimate goal stated in the 10k as follows:
"Our financial focus is on long-term, sustainable growth in free cash flow per share."
Both of the above measures would underestimate the value of Amazon. I believe a discounted earnings model is more appropriate, which measures the future earnings power of the underlying business. Below is my discounted earnings model on Amazon. The assumptions are derived from my explanations above. I assume slightly lower tax rates each year due to a greater % of revenue from abroad generated in lower-tax jurisdictions, as well as a slight dilution of share count consistent with the trend due to Amazon's stock compensation. There is no sign of share buybacks in the future. Although Amazon purchased a small amount of shares in 2008, there have been no share repurchases since:
Amazon Discounted Earnings Model | ||||||
2011 | 2012 | 2013 | 2014 | 2015 | 2016 | |
Amazon Projected Net Sales | 49944 | 66497 | 86305 | 105052 | 124072 | 141908 |
Growth Rate | 46.0% | 24.9% | 23.0% | 17.8% | 15.3% | 12.6% |
Cost of Sales | 38457 | 51203 | 66455 | 80890 | 95536 | 109270 |
% of Revenue | 77% | 77% | 77% | 77% | 77% | 77% |
Gross Margin | 11487 | 15294 | 19850 | 24162 | 28537 | 32639 |
% of Revenue | 23% | 23% | 23% | 23% | 23% | 23% |
Fulfillment Costs | 4495 | 5652 | 7336 | 8929 | 10546 | 12062 |
% of Revenue | 9% | 8.5% | 8.5% | 8.5% | 8.5% | 8.5% |
Marketing Costs | 1498 | 1995 | 2589 | 3152 | 3722 | 4257 |
% of Revenue | 3% | 3% | 3% | 3% | 3% | 3% |
Technology and Content Costs | 3246 | 3990 | 5178 | 6303 | 7444 | 8515 |
% of Revenue | 6.5% | 6% | 6% | 6% | 6% | 6% |
General and Administrative Costs | 749 | 997 | 1295 | 1576 | 1861 | 2129 |
% of Revenue | 1.50% | 1.50% | 1.50% | 1.50% | 1.50% | 1.50% |
Other Costs | 200 | 266 | 345 | 420 | 496 | 568 |
% of Revenue | 0.40% | 0.40% | 0.40% | 0.40% | 0.40% | 0.40% |
Operating Margin | 1299 | 2394 | 3107 | 3782 | 4467 | 5109 |
% of Revenue | 2.6% | 3.6% | 3.6% | 3.6% | 3.6% | 3.6% |
Other Income | 25 | 120 | 155 | 189 | 223 | 255 |
Earnings before Taxes | 1324 | 2514 | 3262 | 3971 | 4690 | 5364 |
Taxes | 25% | 24% | 23% | 22% | 21% | 20% |
Net Income | 993 | 1910 | 2512 | 3097 | 3705 | 4291 |
Diluted Shares Outstanding | 460 | 469.2 | 478.6 | 488.2 | 497.9 | 507.9 |
Earnings per Share | 2.16 | 4.07 | 5.25 | 6.34 | 7.44 | 8.45 |
Discounted Earnings per Share | 0.53 | 3.61 | 4.24 | 4.65 | 4.96 | 5.12 |
Cost of Capital used | 10% | |||||
Terminal Growth Rate | 5% | |||||
Sum of Discounted Earnings | 23.12 | |||||
Discounted Terminal Value | 107.58 | |||||
Amazon Fair Value per Share (after net cash per share adjustment) | 139.88 |
To justify a value of the most recent high near $250 per share, Amazon would have to gain control of 100% of the US books AND electronics markets by 2016! This assumes the same strong revenue growth I projected abroad, and gives you an idea of how challenging it will be for Amazon if they do not begin to focus on cost control. If Amazon is able to increase gross margins to 26% from 23%, a fair value of $250 per share can be justified. While it seems fulfillment, shipping, and technology costs will be higher in the future, as all are geared to remaining competitive and providing better customer service, if Amazon is unable to improve gross margins, the stock price will eventually suffer. With Wal-Mart's gross margin barely above 25%, a firm with perhaps the best ability in terms of "bargaining power with suppliers," it appears unlikely Amazon will be able to improve gross margins to 26%. Given Amazon's long-term performance, gross margins in the 23% range seem more likely.
Now I will turn my attention to Best Buy.
Why on earth would a slow growth, bricks and mortar electronics retailer be appealing as an investment?
While Best Buy is not as liquid as Amazon, the firm remains in solid financial condition. As of the end of May 2011, tangible book value stood at $3.5 billion, cash and equity investments totaled over $2.5 billion, and the firm had virtually no net debt. Like Amazon, Best Buy's financial condition gives the firm the ability to handle a prolonged slow growth economy.
Best Buy's electronics sales and total revenues are not as bad as the recent stock price is reflecting. When domestic electronics sales are examined and broken down in further detail, it is evident larger items such as televisions are suffering much more than smaller items such as tablets.
Below are bricks and mortar electronics and appliance store sales in the US since they peaked in 2007:
US Electronics and Appliance Store Sales (Bricks and Mortar) Source: Department of Commerce | ||||||
2006 | 2007 | 2008 | 2009 | 2010 | % below peak level | |
Total Sales | 107826 | 110849 | 108869 | 98384 | 100471 | 9.4% |
Total sales are 9.4% below their peak reached in 2007. A piece of these sales relates to computer and software stores. Although, total electronics and appliance sales are down significantly since they peaked, sales at computer and software stores are 8% above the level reached in 2007. After a trough in 2001 after the technology crash, computer and software sales have grown solidly, were the least sensitive to the Great Recession, and produced the strongest recovery of the electronics/appliance store group. If we strip out computer and software sales and focus solely on appliances and other electronics, we see a market still suffering:
US Electronics and Appliance Store Sales (Bricks and Mortar) ex computer and software | ||||||
2006 | 2007 | 2008 | 2009 | 2010 | % below peak level | |
Total Sales | 88049 | 90303 | 88335 | 78766 | 78320 | 13.3% |
If Amazon's sales are added to total electronics and appliance sales, the decline from the peak level reached in 2007 is only 4%, not 9.4%. If Amazon's sales are added and the computer and software store sales are stripped out, electronics and appliance sales are still down 7% from the peak achieved in 2007. This tells me only some of Best Buy's struggle with electronics may have to do with losing market share to Amazon, much of it relates to weak sales of larger durable items such as television and appliances in general. The same can be said for car sales, which remain well below 2007 levels in the United States.
If we examine Best Buy's share of the bricks and mortar market and total market share including Amazon sales, the numbers are not as bad as the stock price is reflecting. Keep in mind that Best Buy's fiscal year ends in late February/early March, so Best Buy's fiscal 2006 revenue in compared with market data from 2005 and so forth:
Best Buy Fiscal Year | 2006 | 2007 | 2008 | 2009 | 2010 | 2011 |
Best Buy Total Domestic Sales | 27380 | 31031 | 33328 | 35070 | 37314 | 37186 |
Market Share % of Bricks and Mortar | 26.99% | 28.78% | 30.07% | 32.21% | 37.93% | 37.01% |
Market Share % including Amazon | 26.72% | 28.40% | 29.47% | 31.30% | 36.26% | 34.31% |
2007 | 2008 | 2009 | 2010 | 2011 | % Below Peak | |
Best Buy Domestic Consumer Electronics Sales | 13964 | 13664 | 13677 | 14552 | 13759 | 5.5% |
We see that Best Buy still retains significantly more market share of the total US electronics markets than they had in 2007. Sales of consumer electronics items specifically are relatively similar to where they were in 2007, while the overall market including Amazon is still down significantly if computer and software store sales are stripped out. Computer and software are reported in Best Buy's home office segment, while consumer electronics consists of items such as televisions. The decline in consumer electronics sales since 2010 is not as bad as it looks. Keep in mind Circuit City virtually shut down in 2009 after they declared bankruptcy. Best Buy was able to take advantage of one of their largest competitors going out of business and gained significant market share in 2010. However, that extra share proved to be unsustainable as newer entrants such as Amazon began to increase their presence after Circuit City's demise.
While Best Buy may not reach market share levels enjoyed in 2010, market share is also not in free fall. Instead of dealing with competitors such as Circuit City, Best Buy must deal with a different competitor in Amazon. There are enough consumers who find comfort in purchasing a large durable such as a television at a store, and when overall sales pick up, Best Buy should benefit.
Based on my projections for the total electronics and appliance market to grow 3% annually the next five years and Amazon to have 26% of the market by the end of 2016, my Best Buy sales projections are below, which assume they retain 37% of the bricks and mortar market:
Best Buy Projected Domestic Revenue | ||||||
2012 | 2013 | 2014 | 2015 | 2016 | 2017 | |
Projected Domestic Revenue | 36344 | 35733 | 35052 | 35201 | 35328 | 35430 |
% Share of Bricks and Mortar | 37.0% | 37.0% | 37.0% | 37.0% | 37.0% | 37.0% |
% Share of Total Market including Amazon | 32.56% | 31.08% | 29.60% | 28.86% | 28.12% | 27.38% |
Projected Bricks and Mortar Market Sales | 98227 | 96575 | 94736 | 95139 | 95480 | 95756 |
Projected Electronics/Appliance Market Sales | 111622 | 114971 | 118420 | 121973 | 125632 | 129401 |
While areas such as consumer electronics and the entertainment segment have been struggling, Best Buy's home office division has been a bright spot, sparked by sales of tablets and mobile devices, not only domestically but also abroad through the partnership with Carphone Warehouse in Europe. In addition, Best Buy is growing appliance sales abroad by taking advantage of China's emerging middle class. The home office division both domestically and abroad has grown same store sales strongly the past 3 years, as the tablet and mobile markets continue to grow. Same stores sales grew 10.4%, 12.8%, and 3.6% respectively in the domestic home office division in 2009, 2010, and 2011, while sales grew abroad 5% in the home office division in fiscal 2011. Due to Best Buy's focus in China, same store appliance sales grew abroad in fiscal 2010 and 2011, 7.3%, and 15.2% respectively.
Despite meager top line growth, Best Buy is making every effort to add shareholder value. Instead of opening many big box Best Buy stores, which increase capital expenditures substantially, Best Buy is focusing its efforts on growing areas by opening Best Buy mobile locations to take advantage of mobile and tablet demand in the US, as well as expansion of Five Star Stores in China to take advantage of appliance demand in a growing emerging market.
In fiscal 2012, Best Buy plans to open 150 small-format mobile stores within the United States and only 6-8 big Best Buy stores. In years past they opened as many as 100 big Best Buy stores domestically. To take advantage of the Chinese appliance market, Best Buy plans to open 40 to 50 Five Star stores. Substantially fewer openings of big Best Buy stores will reduce capital expenditures remarkably and help free cash flow. Capital expenditures were as much as $1.3 billion in fiscal 2009 but were only $744 million in fiscal 2011 and are on pace to be only $800 million in fiscal 2012. Lower capital expenditures help free up cash to add shareholder value through buybacks and dividends.
Earlier this year, Best Buy authorized a $5 billion share buyback program, which is fairly significant considering their current market cap is only $9 billion. So far this year, Best Buy has reduced share count by 7%. This has potential to substantially increase earnings per share over time. Best Buy also announced a 7% increase of the dividend. At its current price, Best Buy has a 2.64% yield, which is now remarkably more than the current yield of the 10 year Treasury.
In my opinion, Best Buy is making good use of its capital. Share buybacks, dividends, expansion in growing areas, contraction in slower areas, and a focus on controlling costs, have the potential to stop the recent slide in the stock price and provide much better future returns.
Below I will value Best Buy using the same discounted earnings model I used for Amazon. I choose to use discounted earnings instead of free cash flow because I feel a free cash flow model does not capture the effect of future share repurchases.
Because the mobile phone and tablet markets are growing abroad as is appliance demand in China, I project Best Buy's foreign revenue to grow 3% annually. Gartner estimates 1.6 billion mobile phones were sold in 2010 worldwide and sales are on pace to exceed 1.7 billion in 2011. Gartner also estimates global tablet sales will be 63.3 million in 2011 up from 17.6 million in 2010. They estimate sales of over 300 million globally by 2015.
Below is the link to an article showing strong home appliance demand in China, helped by the country's subsidy program:
http://en.21cbh.com/HTML/2011-6-7/yNMjUwXzIxMDMyNw.html
Quote from the article:
"During the first 5 months of the year, a total of 45.23 million units of home appliances worth RMB 109.5 billion under the subsidy program were sold, up 71% and 103% from the same period last year, respectively, according to data released by the Ministry of Commerce on Saturday."
My projections for Best Buy's International Revenues are below:
2012 | 2013 | 2014 | 2015 | 2016 | 2017 | |
Best Buy Projected Foreign Revenues | 13479 | 13883 | 14299 | 14728 | 15170 | 15625 |
Growth Rate | 3% | 3% | 3% | 3% | 3% | 3% |
Below is my discounted earnings model on Best Buy. I assume a 5% reduction in share count per year.
2012 | 2013 | 2014 | 2015 | 2016 | 2017 | |
Best Buy Projected Total Revenues | 49823 | 49616 | 49352 | 49930 | 50498 | 51055 |
Growth Rate | -0.42% | -0.53% | 1.17% | 1.14% | 1.10% | |
Cost of Goods Sold | 37317 | 37162 | 36964 | 37397 | 37823 | 38240 |
% of Sales | 74.9% | 74.9% | 74.9% | 74.9% | 74.9% | 74.9% |
S G & A Domestic | 7378 | 7254 | 7116 | 7146 | 7172 | 7192 |
S G & A Foreign | 3181 | 3276 | 3375 | 3476 | 3580 | 3688 |
Total S G & A % of Sales | 21.2% | 21.2% | 21.3% | 21.3% | 21.3% | 21.3% |
Operating Income | 1947 | 1923 | 1897 | 1911 | 1923 | 1935 |
Interest Expense | 100 | 100 | 100 | 100 | 100 | 100 |
Earnings Before Tax | 1847 | 1823 | 1797 | 1811 | 1823 | 1835 |
Taxes | 674 | 666 | 656 | 661 | 665 | 670 |
Tax Rate | 36.5% | 36.5% | 36.5% | 36.5% | 36.5% | 36.5% |
Net Income | 1173 | 1158 | 1141 | 1150 | 1158 | 1165 |
Minority Interest | 50 | 53 | 55 | 58 | 61 | 64 |
Net Income Attributable to Best Buy Shareholders | 1123 | 1105 | 1086 | 1092 | 1097 | 1101 |
Diluted Shares Outstanding | 381.40 | 362.33 | 344.21 | 327.00 | 310.65 | 295.12 |
Earnings Per Share | 2.94 | 3.05 | 3.15 | 3.34 | 3.53 | 3.73 |
Discounted Earnings | 1.18 | 2.70 | 2.56 | 2.49 | 2.41 | 2.34 |
Cost of Capital used | 9% | |||||
Terminal Growth Rate | 1% | |||||
Discounted Earnings | 13.69 | |||||
Discounted Terminal Value | 29.54 | |||||
Best Buy Fair Value per Share(after adjustment for cash and securities/debt/minority interest) | 42.30 |
Based on thorough analysis, I feel Best Buy provides significant upside potential and a margin of safety at its current price, while Amazon's growth is already priced in. Only time will tell if I am correct, but I am willing to give this investment thesis 3-5 years to play out.
