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Amazon has been in the news a lot lately, thanks to
today's unveiling of the new Kindle Fire tablets. There's much excitement
surrounding these new tablets and no shortage of commentary we could make on
the potential impact of the new devices or the "tablet wars" in
general – like how Amazon entered the tablet space less than a year ago
and by the second quarter of 2012, it had already captured 5% of the global
market; or that the Kindle Fire captured 22% of tablet sales in the US in its
first nine months on the market, according to the company. Such figures,
while important on their own, will play an important role in the more general
topic we're addressing today: Is Amazon.com (AMZN) overvalued?
It's not hard to find Amazon haters. And you might be
able to find some who claim it to be one of the most overvalued companies in
tech. A quick search on Seeking Alpha yields dozens of articles bashing the
company and the stock for being overvalued. The basic arguments against
Amazon generally go something like this:
- The company is basically just a retailer and
should trade at a multiple similar to Walmart's
price-to-earnings (P/E) ratio of about 15, but the stock is currently
trading at a sky-high P/E of nearly 300 based on the trailing
twelve months' results.
- Operating efficiency and overall profitability are
deteriorating in recent quarters, as operating margin has shrunk to less
than 1% of revenue in the most recently reported quarter and net income
rang in at just 1 cent per share.
- Guidance is calling for continued weakness in Q3
– and the company expects to post its first quarterly loss since
2003.
Arguments against Amazon for being overvalued are
nothing new. It's been going on since the tech bubble burst. Check out these
excerpts from an April 2003 Barron's article titled Bubble Redux:
Amazon's
valuation is the most egregious of the Net trio [meaning Yahoo, Amazon, and
eBay]. It trades for 80 times projected "pro forma" 2003 profit of
32 cents a share…
It's notable
that Amazon's current market value of $10 billion is about four times the
combined market capitalization of its two main "bricks and mortar"
competitors, Barnes & Noble and Borders, which together are expected to
generate twice the profit of Amazon this year. In the bubble era, such
comparisons drew scorn from "Net" fans, who argued that cyber
stocks deserved enormous premiums over their mainstream rivals, thanks to
their fantastic growth prospects. But while Amazon should enjoy decent
revenue gains – 20% this year and 15% in 2004 – its growth
certainly won't be fantastic.
It's been less than ten years since that article was
written, and Amazon's market cap has increased more than tenfold over that
time, to a whopping $111.3 billion. So during ten years of claims for being
overvalued, Amazon's stock price has climbed ever higher.
Impressive. And the main reason for this is something
that Amazon's detractors often overlook: revenue growth. That last sentence
of the old Barron's article reads: "But while Amazon should enjoy
decent revenue gains – 20% this year and 15% in 2004 – its growth
certainly won't be fantastic." That's where most analysts were wrong.
Amazon's growth was and continues to be fantastic. Despite the predictions in
the Barron's article, revenue growth in 2003 and 2004 was 34% and 31%,
respectively. In fact, from 2002 through 2011 Amazon grew total revenue at a
compound annual growth rate (CAGR) of 32%.
Because of this incredible growth, Amazon continues to
trade like a growth stock. Growth stocks are often valued by the market on a
price-to-sales basis rather than a price-to-earnings basis. [Ed. Note: The
use of the terms "sales" and "revenue" are
interchangeable here. So when we write "price-to-sales," we also
mean "price-to-revenue."] In Amazon's case, its historical average
price-to-sales ratio over the period of 2002-2011 is 2.3, with a high of 4.2
in 2003 and a low of 1.2 in 2008. Today, Amazon trades at a multiple of 2.0
times trailing twelve month sales and just 1.8 times forecasted 2012 sales.
Thus, in historical terms, Amazon is not currently overvalued at all on a
price-to-sales basis.
At this point you might be saying: "Well, so what?
Yes, Amazon has grown revenue like a weed, but that has not translated into
profits." In other words, perhaps Amazon has generated that growth at
the expense of profits. And that's why it's so overvalued – because the
stock price keeps going up but profits are not. It's a valid point. And if
you're looking at things from a purely historical perspective, it would be
correct. But remember, valuation is all about expectations for the future. An
investor buys a stock because of the future benefits (in terms of dividends
or capital appreciation) he or she expects to accrue from ownership of that
stock.
Of course, it's true that the historic performance of a
company plays a part (often a big part) in our assessment of what will happen
in the future. But if a firm is in the process of transforming itself into
something completely different than it has been historically, then we should
not weight past events and performance as highly in our analysis. Such is the
case with Amazon today. And this is why there's so much disagreement on the
company's valuation – it's basically morphing into a new entity before
our eyes, and analysts have different expectations about how this will play
out in the future.
Our take is that Amazon stands poised to capitalize on
the major trends in online business – the continuing disruption of
traditional retail and growth of e-commerce in general; the rise of e-books,
tablets, and e-readers; the growth in digital music and video distribution;
and migration to the almighty Cloud.
Here's the story:
Retail e-commerce sales in the US totaled $194.28
billion in 2011, up 17% from the previous year, according to data from the
Census Bureau. Over the same period, total retail sales grew by less than 7%.
The comparison is much more pronounced when we look
back just five years. In 2006, total retail sales in the US rang in at $3.94
trillion, slightly above the figure in 2010 and just 6% below the $4.20
trillion generated in 2011. While total retail sales have remained basically
stagnant over the past five years, retail e-commerce sales have jumped by
more than 85% in that same period of time.
And these are just the figures for the US. The same
trend is playing out throughout the developed world.
Of the nearly $195 billion in US retail sales online
last year, no company was more dominant than Amazon.com. The online
superstore collected more than $26 billion in retail sales in the United
States alone – more than 13% of the total retail shopping market online.
Another $21 billion of its retail revenues were generated globally, outside
of its home country.
Not only is Amazon dominating the online retail-sales
game, it is growing its share of the market. Amazon's revenue grew at an
annual rate of 40% last year, effectively doubling the rate of growth of the
overall e-commerce market. (Growth in the US still slightly outpaces
international growth, but international growth improved from 33% in 2010 to
38% in 2011.)
And this where the interesting story lies. When most consumers
think of Amazon.com, they think of physical goods like books, toys, games,
electronics, and even clothing. But while those physical goods are still the
largest and fastest-growing part of the business – the company grew
electronics and general-merchandise sales from $18.4 billion in 2010 to $28.7
billion in 2011 – there is another figure buried in those growing piles
of t-shirts and gadgets. $2.7 billion: that is the estimated (Amazon won't
break out actual numbers) gross revenue the company took in from sales of its
Kindle line of e-book readers and tablets in 2011. That's more than 20
million units. The jump from just a few hundred million in sales the year
before was dramatic – especially considering that the company lowered
prices of the entry-level Kindle from $259 to $99 in less than two years.
That lower pricing and increased interest translated to Kindle unit sales
jumping more than 177% during last year's holiday season, according to
Amazon.
But even more dramatic are the sales that follow on for
the company. Those Kindle owners generated an estimated $1.7 billion in
digital book sales last year. In the summer of 2011, before the big holiday
sales jump, e-book sales rose fast enough to outnumber total sales of both
paperback and hardcover books at Amazon. And considering that a large number
of those new Kindle users didn't see their devices until late in 2011, that number is poised to rocket upward.
In fact, most analysts are pegging Kindle franchise
growth to be in the range of 40-50% this year, driving sales north of $6
billion in total for the year between devices and the digital sales that
follow. That would mean that Kindle would then represent more than 10% of
Amazon's total retail sales. Juniper Research expects global annual revenue from
e-books to increase more than 200% over the next five years.
Those numbers are important for various reasons. First
and foremost is margin. While Kindle devices are sold near cost, according to
most supply breakdowns, the digital sales that follow are much less costly to
the company than its traditional retail sales. No warehouses, no shipping, no
returns to manage. For a company like Amazon that has frequently struggled
with razor-thin margins, competing largely on price, this changes the nature
of its profitability. As online sales increasingly turn to digital goods like
e-books, Amazon's margins should improve and profits expand faster than
revenues – though that has not happened yet.
Second, those digital sales are expanding beyond just
books. With the introduction of the Kindle Fire tablet computers, Amazon has
opened up an important new channel with sales of music and video content. Its
digital sales outside of books are still nascent, but the company has begun
to partner with electronics manufacturers to bundle access to its digital
video services with televisions and Blu-Ray players, putting the company head
to head with Apple and its dominant iTunes store.
Of course, while Amazon owns e-books, with greater than
70% market share today, the company has a long way to go to catch up with
Apple in the rest of the digital-media market. A total of 68.7 million
tablets sold in 2011, according to research firm IDC, and only 4.7 million of
those were from Amazon's Kindle Fire, introduced late in the year. But Amazon
is making up ground. As we noted earlier, the Kindle Fire reportedly captured
22% of tablet sales in the US in its first nine months on the market. Given
that annual tablet sales are projected to increase more than 54% to 106.1
million units sold in 2012, Amazon has a tremendous opportunity to grow both
its share in the market and overall revenue in a significant way. If the
company can just maintain its current market share in that environment,
Kindle Fire sales would surpass $3.2 billion for the year, and the company
would blow out that $6 billion total Kindle sales projection by a long shot.
Of course it's not all roses. Amazon must overcome the
challenge of moving from a warehouse-centric business model to a
software-development and digital-distribution powerhouse. For the company,
this has meant lots of hiring and a short-term spike in costs even greater
than the 40% growth in revenue seen last year. There are many risks ahead
regarding execution, and the competitive landscape is only becoming more fierce. But we see a bright future ahead for Amazon.
The company today is much more than a low-cost online retailer – it's
reinventing itself as part Apple, part Netflix, with a little bit of
Rackspace mixed in as its cloud-hosting services business grows, and a touch
of Walmart remaining as the core business is going
nowhere, not with a brand this strong.
Going back to the original question of whether Amazon
is overvalued – we'll leave that up to you to decide, based on your
expectations of the future. We will say that our models indicate that the
stock is fairly valued around $245, but the price could continue to run up
toward $300 over the next couple of years if the company delivers in its
transformation efforts. But of course, a hiccup in growth or a failure to
deliver over the next six to eight quarters could send the shares down hard.
Right now analyst consensus estimates are calling for
$4.40 in earnings per share in 2014. And we should know by then whether
Amazon is going to transform its high growth into high profits. Regardless,
it should be an interesting trip along the way.
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