Value and Later-Stage Principal Investing Blog: Analysis and Recommendation for Amazon.com Inc

Recommendation: Short

‘Trees Don’t Growth to the Sky’ (but Amazon defies laws of gravity)

Amazon

Associated Financial Valuation Model:

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Thesis

Top Reasons to SHORT AMAZ:

  • Market consensus is universally dogmatic towards AMAZ unlimited potential, which is sure sign of something amiss
  • AMAZ management has shifted consensus perception towards consistent growth and away from little to no profitability in core business (ex-AWS segment)

  • Market consensus is confused re: which Free Cash Flow measure to based intrinsic valuation on

  • As Per FASB promulgation, in FY 2018 AMAZ will be forced to change accounting method for offbalance-sheet Operating Leases (which may shift perception towards actual FCF and implicit debt and leverage ratios)

  • An old Wall Street adage that ‘trees don’t grow [unrestrained] to the sky’

Top Risk Factors for AMAZ

  • Short positions based on overvaluation are very risky to pursue (w/out concrete HARD catalyst to correct mispricing)

  • AMAZ is a persistently overvalued co. and perhaps among the hardest short thesis to implement

  • AMAZ double digit top-line growth is main focus of consensus, so it will take a Δ in investor perception to correct mispricing

  • AMAZ share price can ‘stay irrational longer than short sellers can stay solvent’ (resulting in large loss before short thesis pans out)

Key Summary Metrics:

  • Current Share Price (05/18/2017)1: $1,003.74

  • 3 Yr. Price Target: < $700.00

  • % Downside (‘Margin of Safety’): ~ 20.0%+

  • Market Cap.: $499.6bn

  • Market Enterprise Value: $492.9bn

  • FY 2018 EV/EBITDA: 36.12x

  • 52 Week Price Range: $710.10 to $1,083.31

Investment Thesis (Short Version):

  • AMAZ is a classic ‘growth story stock’ whose actual intrinsic business fundamentals are completed ‘untethered’ to its actual share price. There appears a universal dogmatic consensus view of unlimited growth and disruption potential, making this bullish perception certain to be wrong (at some point)

Valuation:

  • FY 2018 Price / Sales : 3.17x

  • Price / Book Value: 19.56x

  • Price / Earnings Per Share: 240.1x

  • Return on Equity: 9.67%

  • Return On Invested Capital: 4.72%

Company Background:

  • AMAZ is an leading online retailer in the e-Commerce space…

  • AMAZ reports 3 operating segments:

    • –North America Retail

    • –International Retail

    • –Amazon Web Services (i.e. ‘AWS’)

  • AMAZ key growth strategy is additional spending on Fulfillment infrastructure to drive Operating Leverage and enhance profit generating profile

  • AMAZ Fulfillment choices consist of the following: (1) same-day delivery; (2) Amazon Prime; (3) Amazon Prime Now; (4) Amazon Prime Fresh; (5) Amazon Locker

  • Fulfillment by Amazon (‘FBA’) is another growth driver for AMAZ which allows 3P sellers to sell their products using AMAZ infrastructure

  • AMAZ is on cutting edge of using technological advances for Fulfillment infrastructure (i.e. Kiva robots for order fulfillment systems)

Investment Thesis: Go SHORT shares of AMAZ @ Current Share Price of ~ $946/share:

  • Investment Thesis:

  • 1. –Amazon is a classic ‘growth story stock’ which has mesmerized consensus sell-side analyst with its double digit growth in revenues. The common stock is BEYOND ‘priced to perfection’ and the stock price has completely escaped the core business fundamentals. There is a strong dogmatic view among bulls that this stock will continue to go higher and higher, completely disregarding the value investor old adage that ‘trees do NOT growth to the sky’

  • (1) Consensus View: There appears to be a strong dogmatic consensus view that AMAZ share price will continue to rise and that with each revenue growth guidance beat sell-side analysts keep raising their Price Targets (‘PT’) on AMAZ common stock

  • My View: Virtually every single PT in which AMAZ common are > $1,000 per share make explicit assumption that Operating Income margins will expand by FY 2019E to at least ~ 6.0% (i.e. long ago historical levels). However, there has been no historical evidence of this long anticipated Op Profit margin expansion. Consensus has been waiting so long to see evidence of improved profitability that its entire perception has shifted and fixated on growth at expense of profits.

  • (2) Consensus View: AMAZ bull thesis is premised on economies of scale from excess spending onFulfillment infrastructure, which serves as ‘economic moat’ and Operating Leverage to result in scale and Operating Profit margin expansion

  • –My View: A back-of-the-envelope calculation shows a 10 year Total Revenue CAGR of 34.1% growth. Over the same decade the Fulfilment Expense CAGR growth rate is 28.9%, in line with revenue growth. Yet over an entire decade period (i.e. one full economic cycle) nowhere did there appear this so called economies of scale and Operating Leverage which is certain (according to consensus view) to result in Op Profit margin expansion. The main consensus thesis is that eventually AMAZ will drastically cut back on CapEx spending on infrastructure investments, and the scale built into Fulfillment will result in more of the top-line revenue growth falling down to bottom line. Consensus has such dogmatic view that this is certain to happen that they categorically ignore ALL Operating Profit and EPS misses (no matter how far they come under consensus) and have shifted their entire focus on top-line growth potential. One would think that over a decade long period if economies of scale actually existed in the first place, they would have shown up by now in results. Operating margins have never really been that high in the first place given core business model of AMAZ, and fundamentally what drives share prices in the LONG RUN is earnings power or free cash flow, NOT double digit top-line revenue growth

  • (3) Consensus View: Consensus sell-side thinks AMAZ is worth > $1,000 per share due to very large TAM size and because AMAZ continues to gain market share in e-Commerce (i.e. AMAZ accounts for 20% of online retail sales) and has only ~ 10.0% existing U.S. online penetration level

  • –My View: It is true that the Total Addressable Market (‘TAM’) is very large and that AMAZ has good market share as well, and that its total US online retail penetration level is not at a saturation level. However, it appears that AMAZ is continually gaining market share via lowering prices – they highlight constantly lowering prices in AWS and increasing functionality – and that perhaps they are gaining market share while generating very razor thin Operating Income profit levels. It appears that AMAZ spending on Fulfilment and Technology & Content spending is always increasing in line with increasing sales, which results in perpetual compressed EBIT margins. If in fact AMAZ had economies of scale in its operating expenses, then one would assume by now that spending on Fulfilment and Technology would DECREASE by now and increased unit shipments would result in greater conversion from Net Sales to actual Operating Income profits. Or perhaps AMAZ is aggressively trying to gain market share and grow US online retail penetration levels by aggressively lowering prices which has come at expense of compromising its core profitability (which seems to have been the case now for many, many years for AMAZ shareholders). Once consumers are accustomed to lower prices psychologically it becomes very difficult to turn around and implement price increases

  • (4) Consensus View: The general market bulls in AMAZ are fixated on the very attractive Free Cash Flow (‘FCF’) generating ability of AMAZ core business, which to them justifies the very high stock price

  • 1. –My View: The REAL Free Cash Flow generating ability of AMAZ is NOT what the market is looking at but rather the (what I refer to as) ‘Net Unadjusted Free Cash Flow’. AMAZ management discloses 3 different calculations of Free Cash Flow in their 10-K filings under ‘Results of Operations’ within the MD&A section. The Free Cash Flow generating ability that management and the market is focusing on is a GROSS figure which does NOT reflect the ACTUAL economic measure of FCF (since Free Cash Flow is a Non-GAAP metrics and thus AMAZ management can define it however they choose). For instance, as of FY 2016 10-K filings, AMAZ discloses a [Gross Unadjusted] Free Cash Flow of $9.706bn. When factoring in the EXCESSIVE Off-Balance-Sheet Operating Leases which artificially reduces the leverage levels of AMAZ, this FY 2016 Free Cash Flow figure falls to $5.699bn. However, when actually capitalizing these excessive Off-Balance- Sheet Operating Leases to actual ‘Additions to PP&E’ under Cash from Investing Activities (i.e. ‘Capital Expenditures’), AMAZ [Net Adjusted] Free Cash Flow for FY 2016 falls to just $3.855bn. AMAZ market bulls will dismiss this as saying that ‘these Op Leases should NOT be capitalized anyway’ and that this Net Adjusted FCF figure is NOT the correct metric to focus on. However, a close reading of the footnotes of ANY 10-K filing will reveal that FASB has already set a precedent for all Off-Balance-Sheet Op Leases to be CAPITALIZED (effective Dec. 2018). Hence AMAZ disclosure of Off-Balance-Sheet Operating Leases will NEED to be capitalized, thus making the [Net Adjusted FCF] metric the MOST meaningful one to focus on in terms of ‘true FCF generating ability’. Practically all of the Off-Balance-Sheet Operating Leases are for the extensive AMAZ fulfilment center footprint, further making this [Net Adjusted FCF] the correct one for actual shareholders to focus on.

  • (5) Consensus View: Market sees very high, rapid double digit growth rates in top line sales in International Segment, which indicated very large opportunity for International expansion

  • –My View: an old adage of value investing is that ‘NOT all growth is profitable’. When reviewing the segment breakdown details in the MD&A 10-K filing, it is patently clear that on an Operating Profit basis (which is a good measure of core profitability from operations), the International segment has NOT contributed any profits to AMAZ on consolidated basis. AMAZ management has doubled down on emerging market opportunities (such as India and China) with increasing investments in these areas. Perhaps AMAZ management sees large growth opportunity in China; however, this market already has a dominant, fully entrenched incumbent e-Commerce leader (i.e. Alibaba). Increased spending in International segment to expand into emerging markets – especially China – is a severely flawed strategy as many years ago eBay attempted to expand its footprint in Asia and spend billions and in the end could NOT gain market share or penetrate the very large International market in Asia- Pacific region. Furthermore, consensus equity research anticipates that International segment Operating Profit margins will improve over time to positive territory and match North American Retail segment; however, the fact remains that Operating Profit margins in North America Retail itself are razor thin and unattractive from a shareholder’s profitability standpoint (even if this does materialize).

  • AMAZ has high Free Cash Flow generating ability….however, management has terrible capital allocation decision by reinvesting into core business that has NO REAL tangible economic moat

  • 1. –Historical ROIC levels for AMAZ core business model are pathetic…hence capital reinvestment into core business is very low return option

  • 2. –Management has squandered high Free Cash Flow to insisting to reinvest into a business model which quantitatively has practically negligible ‘economic moat’ (as demonstrated by miniscule ROIC levels) and very unattractive Return on Equity (‘ROE’) levels

  • 3. –Management would be better off to pay large dividends / pay down debt / opportunistically buy back shares (albeit later when shares are not so grossly overvalued)

  • AMAZ management discloses in 10-K filing their core focus on Free Cash Flow generation

  • 1. –however, based on AMAZ business model they have razor thin EBIT Profit Margins hence it will be difficult or next to impossible for them to increase FCF via improvements in EBIT when their core business model has historically had such very low Operating Profit Margins to begin with….

  • 2. –Their strategy is to increase sales growth rate…..however, no matter how fast they grow their top line, the fact remains that their core historical Operating Profit Margins remain razor thin based on the core business model that they have set up, which is a fact they like to ignore and not draw attention to

  • Consensus sell-side equity research loves AMAZ thesis due to very rapid growth rate in sales and do NOT acknowledge overvaluation based on relative value metrics

  • 1. –Bulls dismiss absurd AMAZ P/E multiple by casually referencing the double digit historical growth rates

  • 2. –A P/E multiple that high would imply a necessary growth rate for AMAZ indefinitely into the future which would not be realistic or possible due to market saturation

  • 3. –A current LTM FY 2018 P/E multiple of 240.1x is ABSOLUTLY ABSURD and indicative of gross overvaluation

  • 4. However, even on a PEG ratio basis, AMAZ trades at a 5 Year EXPECTED PEG ratio = 8.98×1 (note: a PEG ratio > 1.0x indicated overvaluation)

  • Doing a back-of-the-envelope calculation ‘sanity check’ on AMAZ current share price:

  • 1. –Assuming FDSO outstanding = 497.77mm, current AMAZ share price =$958.47, Expected P/E = median P/E = 39.38x, Operating Profit margin = 2%…

  • 2. –To achieve the expected P/E, Amazon has to increase sales to $605.77bn and using 5-year CAGR, it will take 10 years to achieve the revenue.

  • Bulls neglect the fact that AMAZ has generated effectively > 2.0% Operating Income profit margins and its main economic business model generated (effectively) ZERO economic profit for shareholders

  • AMAZ management has managed to distract the general market with its double digit top-line Revenue growth CAGR….and claims to using all its profits to further expand its ‘economic moat’ (i.e. durable competitive advantage)

  • 1. –However, if there was in fact a moat, it would be reflected in a > 15.0%+ ROIC (note: AMAZ historical ROIC is < 5.0%, indicative of a ‘greater fool theory’ as opposed to tangible [verifiable] durable competitive advantage)

  • From a purely ‘fact-pattern recognition’ perspective, AMAZ appears to be a compelling growth stock story similar to how Dell, Inc. was considered in early 1990’s

  • 1. –Dell, Inc. traded at very high inflated prices due to its so-called ‘novel, innovative’, just-in-time Inventory system (which effectively allowed it to have a NEGATIVE working capital position which was accretive to Unlevered Free Cash Flow generation).

  • 2. –Eventually Dell, Inc. came to be seen as a pure commodity PC manufacturer w/ negligible EBIT margins and thus spend years trying to transform into ‘Software & Services’ restructuring (similar to IBM and currently HP Enterprise)

Catalysts:

  • (1) AMAZ top-line revenue growth rate materially slows down

  • 1. –AMAZ is a classic growth story stock in which low to negligible EBIT margins are dismissed in lieu of double digit growth rates. Hence a very revenue growth rate expectations are already baked into the Price Targets in > $1,000 per share. If AMAZ hits a roadblock in double digit revenue growth then the stock price may collapse materially since consensus perception will shift from extraordinary revenue growth to weak core operating profit margins.

  • 2. –While we do NOT know what the explicit macro factor that will hamper growth for AMAZ will be (as it is an exogenous unknown factor), I would make an educated guess that (a) there is a very large overvaluation in VC-backed private Tech company start-ups (i.e. ‘unicorns’), and when this large asset bubble corrects itself (like it did in FY 1999 and FY 2000 in NASDAQ) perhaps due to (b) gradual increase in interest rates eventually above zero, this may cause a collapse in topline growth for AMAZ and subsequent collapse in share price.

  • 3. –From a bottom-up value investor perspective, it is not our core competency to attempt to forecast ‘macro variable’ (such as interest rates or levels of NASDAQ)….that being said, many smart money value investing veterans appear to feel that we are closer to the ’11th inning’ of the eventually market correction than the ‘3rd of 4th inning’

  • (2) FASB pronouncement accounting change re: how Operating Leases must be accounted for effective FY 2018

  • (3) SEC or FASB accounting change forces AMAZ to disclose Prime Membership subscriber details, and membership headcount growth disappoints market AND/OR details disappoint increased customer spend amt (and thus negate continued double-digit growth in core segments ex-AWS)

Valuation:

  • Based on M&A Accretion / Dilution analysis, the WFM acquisition will be accretive to EPS

  • 1. –This is mainly because entire deal was funded w/ low cost debt and cash

  • The stand-alone WFM valuation was actually done close to an entire month PRIOR to the actual deal announcement by AMAZ to acquire WFM

  • 1. –When the price of WFM collapsed in FY 2016 from a high of $50.00+ per share to low of $30.00+ per share, it became a buyout target

  • The AMAZ pro-forma combined valuation is conservative in the sense that the Unlevered Free Cash Flows are NOT net of Capital Leases and Finance Leases

  • 1. –However, despite using this much higher level of Free Cash Flow (which consensus is using), the valuation range still comes up well below consensus PT of > $1,000 per share, mainly due to (1) lower Terminal Value exit multiple applied in this model (which was based on publicly trading comps); (2) no assumed expansion in Op Profit margins in this model; and (3) aggressive step down in top-line revenue growth rate (to force assumed revenue growth to converge towards US GDP rate in terminal period of model to assume ‘steady state’ run-rate).

Investment Risks:

  • Risk Factor (1): ‘perma-bear’ thesis on AMAZ is NOT feasible nor practical to short this stock
  • 1. –Mitigating Factor: ‘a trend that cannot persist forever…must come to an end’. Perma-bears have not succeeded because since 2009 we have had a consistent 9 year bull market since GFC. There are MORE than one single way to reflect a short thesis on an common stock: you can buy a longdated ‘deep out of the money’ put option; presumably you can use some combination of put / call straddles to express your ‘net short thesis’ while implementing some level of hedge

  • Risk Factor (2): consensus opinion is actually correct re: eventual potential improvements in Operating Profit margins due to economies of scale from continual investment into Fulfilment infrastructure

  • 1. –Mitigating Factor: A full decade long Total Revenues CAGR growth rate approximates matching decade long CAGR growth rate in Fulfillment spending. Hence over an entire full business cycle period there has appeared NO tangible evidence of ‘economies of scale’ / Operating Leverage in Fulfillment infrastructure build-out to support dogmatic consensus view of enhanced Op Profit margin expansion to support current share price level


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