Can Investors Build a Cheaper Amazon?

Amazon (AMZN, Financial) has always posed a unique conundrum for value investors.

The company itself is extremely appealing. It has dominant positions in online retail and cloud services with the potential to disrupt other industries as well. The problem has always been that the stock looks expensive using traditional valuation metrics. Amazon trades at a price-earnings (P/E) ratio of 165.7 and a forward P/E of around 45 (although given Amazon’s propensity to reinvest most of its profits into future growth analysts' profit estimates should be taken with a grain of salt). Throughout most of its modern history as a publicly traded company the stock has looked expensive, but the company has continued to meet and exceed investors’ expectations.

What is a value investor to do?

Well, we wondered if it would be possible to assemble sort of a cheaper Amazonlike company out of existing publicly traded stocks. We would need a large cloud services provider and an online retailer. We thought Amazon most closely resembles some combination of Microsoft (MSFT, Financial), Walmart (WMT, Financial), and eBay (EBAY, Financial).

No combination of businesses will be a perfect match but we think those three might be the closest. Microsoft is the No. 2 cloud services provider behind Amazon, Walmart is the No. 2 online retailer, and eBay is another dominant online retailer that covers the auction portion of Amazon’s business. Other options could include Adobe Systems (ADBE, Financial) or Google, a subsidiary of Alphabet (GOOG, Financial)(GOOGL, Financial), for the cloud business and perhaps excluding Walmart in favor of just eBay or the online retailing portion. You can let us know what you think might be a good combination in the comments.

Here’s how our poor man’s Amazon stacks up when compared to the real thing.

*via Morningstar.com

Probably the most important point is that there is a huge difference in growth rates, which should be expected given the companies' P/Es. Amazon grew revenue 22% last quarter. EBay, working off a much smaller revenue base, only managed a 3% revenue increase. Walmart barely grew at all. Microsoft is the lone bright spot with 29% quarter-over-quarter growth in its service business (overall GAAP revenue growth is lower due to the transition to subscription-based cloud services).

There is a good reason Amazon trades where it does –Â growth. Our bargain Amazon collection of stocks is cheaper but also growing much slower. Which is a better deal?

Well, it depends on where market share gains and losses come from. If online sales continue to eat away at traditional mall-based retailers, it should provide enough growth to make stocks like eBay and Walmart attractive. Yes, Walmart has had some troubles as of late with online growth, but it is the No. 2 player and the company best positioned from a logistical standpoint to become a strong competitor to Amazon.

(Graphic source)

As of the second quarter in 2016 online sales made up 16% of all retail sales. As you can tell by the diverging fortunes of mall-based retailers and Amazon, it appears that there is still a substantial runway for online sales to grow. As long as Walmart and eBay can capture some of that growth they should be able to justify their below-market multiples.

The picture for cloud services is much better for our budget Amazon. At this point it’s pretty clear already that Microsoft’s cloud transition has been a success so there shouldn’t be any worries there.

Is our budget Amazon a better deal than the real thing? Well, as you’ll see in the disclosure below we own Microsoft but not Walmart, eBay or Amazon. Our final answer is we don’t know. So far we’ve been content to invest in the shift to online retail at the margins (via payment companies such as Visa [V] and PayPal [PYPL]) and simply watch the transformation of retail from afar. What are your thoughts?

Disclosure: Long Microsoft, Visa, PayPal.

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