Friday, April 23, 2010

The Amazon Tulip Bulb

Investors were underwhelmed by Amazon's (AMZN) earnings release, but the company continues to live a charmed life, sporting a $66 billion market value. For many this massive number proves Amazon is a great company. Bidding up the price of a company and then pointing at this as proof of enduring success is backwards.

Amazon investors have confused a great service with a great investment. At this price, Amazon is one, but cannot be the other. I hate to rain on the Amazon Bull Parade, but here are the company's profit numbers since 2000:

2000 : negative $417 million
2001: negative $161 million
2002: negative $2 million
2003: $168 million
2004: $349 million
2005: $338 million
2006: $190 million
2007: $476 million
2008: $600 million
2009: $902 million
2010: $299 million (Q1 only)

Aggregate profits for Amazon since 2003 (it's first profitable year) total $3.3 billion. To put this into (badly needed) perspective, CVS Caremark (CVS) earned $3.8 billion in 2009 alone. It's market value: $51 billion.

Drugstores don't capture the imagination like virtual retail.

That said, I love to shop on Amazon and I admire a snappy growth rate as much as the next guy, but $66 billion is absurd. Aggregate numbers matter.

If someone earned $5,000 in 2009 and their income jumped to $10,000 in 2010, they've experienced a 100% growth rate. But they're still broke. For those who will send flattering emails... I am not saying Amazon is broke. Just pointing out that growth rates are only part of the value equation.

No doubt, many companies would love to earn $299 million in a quarter. But it is a pathetic number for a company with a market value greater that Nike (NKE) and Costco (COST) combined.

Furthermore, Amazon's free cash flow for the first quarter was negative $1.2 billion. Not coincidentally, cash and equivalents dropped from $6.4 billion to $5 billion in just 3 months. With a drop in both inventory and accounts receivable (adding to cash)... it begs the question... what accounted for the loss of cash?

In my commentary on Amazon's year-end earnings release (Amazon's Rose-Colored Glasses), I discussed the huge increase in accounts payable at year-end. This allowed the company to tout free cash flow ($2.92 billion) that far exceeded its profit numbers ($902 million). Never mind that this number was temporary and misleading.

Needless to say, the first quarter saw the reversal of this short-term disparity. Accounts payable dropped $1.8 billion. Funny, management didn't mention this possibility in the last release.

No matter. If year-over-year growth continues, the company will have the same phenomenon at year-end 2010. Ultimately, however, cash flow will mirror profitability, not the other way around. Amazon can't push this wave in front of them forever. As growth slows (and it always does), the current pattern will be impossible to maintain.

Unfortunately, the current valuation (Did I mention Amazon is valued at $66 billion?) presupposes that no such risks exist. It also assumes an aggregate level of profitability (or a growth rate) that isn't likely to happen. It may not even be possible. The laws of gravity can be defied for a short time, but not forever. Investors in Amazon think it is a perpetual motion machine, but it is not immune to reality.

The Internet enhances competition, so the company is battling a constant assault on its profit margins. They aren't huge to begin with. Net margins are 3 to 4 percent, on par with Wal-Mart (WMT). That's the company with huge physical stores, 2 million or so employees, and countless blue shopping carts.

So much for virtual superiority.

To make matters worse, Amazon's share count has increased every year since its 1997 IPO. This despite frequently touted (but less frequently executed) share repurchases. In addition to constant dilution (can you say "stock options"), shareholders enjoy a no-dividend policy. Gotta fund that growth, right? Isn't the soporific effect of a rising stock price a wonderful thing!?

Add all the profit numbers above and you'll see that the $5 billion sitting on the balance sheet is (at best) what you get as a shareholder. That's it. And if the company repurchased all the dilutive shares, the cash would be gone.... oops.

For all the hype surrounding this company, Amazon just isn't that profitable. The company is expected to earn between $1.25 to $1.5 billion in 2010 profits. The current valuation translates to 40+ times earnings. That's assuming the share count doesn't grow (again). Don't hold your breath!

Amazon's $4 billion (or less) in lifetime profits wouldn't look so inadequate if not for the pie-in-the-sky value assigned to the company. But maybe Amazon can spearhead a new metric. Price-to-10 years of earnings... or should we go back to price-per-click?

Price check!

Disclosure: No position. (Never underestimate irrationality)


  1. great post. what do you think of EBAY? looks undervalued to me with no debt, $5 billion in cash and p/fcf of 13.5. curious to hear your thoughts.

  2. Thanks Jordan.

    I liked Ebay at $12 and sold between $24 and $25. Until we know what management plans to do with the cash, I believe it is trading firmly in "fair value" territory. There isn't a solid argument that it should trade dramatically higher. But I think it is worth the current quote so any drop from here may provide a buying opportunity.

    Hope this helps...

  3. Great Post! I recently came across your blog and have become instant fan.
    Common Sensical, Insightful and simple to understand evaluation is what draw me to your posts. Thanks again for sharing knowledge. It is definitely a great education for me.

  4. Hi,
    I recently came across your blog and instantly turned into a fan. Clear explanation, great insights and application of value based principals is an education to me.
    Thanks for sharing.

  5. Your timing for this write up is impeccable - AMZN dropped 1/3 since you wrote this. It could have gone the other way, for markets will stay irrational longer than one can remain solvent.