Amazon.com, Inc. (AMZN) is a compelling short at current levels. AMZN has shot up over 70% in the last two months, most recently on its “blowout q1″ earnings report, a typically seasonally weak quarter in which AMZN reported EPS higher than their seasonally strong q4. Revenue growth has accelerated, and high hopes for new initiatives (digital distribution, web services, etc.) have fueled a speculative furor not seen in the name since the height of the boom. Analysts are excited by the prospect of amazon as a “media” company, rather than a online retailer of low margin products, trading at a over 100x earnings, with PEG multiples higher than Google (GOOG) and eBay (EBAY), both of which are more attractive, higher margin businesses.
For a variety of reasons, I believe these growth avenues are overblown, and that AMZN is more likely than not a leading online retailer with a strong online marketplace, low operating margins, and moderate but not spectacular growth going into the foreseeable future. I will argue that even if AMZN overnight became a leader in all areas they hope to grow into, the company would still be overvalued and likely to disappoint given current expectations. AMZN is overpriced on both an absolute basis, as well as relative to peers, and could see a upwards of a 30% drop based solely on a return to its prior lofty valuation levels, or upwards of a 50% drop if valuations were more in line with comps (which, arguably, are overvalued themselves), and potentially see further decreases as new ventures fail and their core retailing business receives continued pressure from offline and other online retailers, as well as the inevitable levy of an internet sales tax, which could wreak havoc on already tiny margins. Given the low PEG, as well as revenue and earnings growth going forward, I believe the risk of multiple expansion or multiples staying the same is relatively low, and that AMZN is an attractive low risk/high reward short.
Q1 “Blowout”
Amazon surprised analysts and everyone following the name. Though there were some legitimate business drivers for the gains (lower than expected margin compression, slightly better sales, etc.) the majority of the earnings surprise can be attributed to lowered R&D investment, a favorable tax situation, and foreign currency gains. These are not the kind of operational improvements that merit such an enormous increase in stock price, but instead served to artificially show earnings growth well above the real growth in the business.
Business Overview
AMZN is the largest pureplay internet retailer, with $10.7B in sales in 2006, and has grown its revenue at about 25-30% per year for the last few years. Though AMZN is primarily known to US investors for their domestic presence, the company has become an international force, deriving 55% of sales from the US vs. 45% internationally. The company continues to grow outside its core media products into other categories (electronics, etc.), but media–composed of books, dvd, and cds, still account for 66% of revenue.
AMZN is entering other popular spaces, including distribution of online music, dvd rentals, and its much hyped Amazon Web services. These businesses are all in their infancy, but are being relied upon to deliver growth coming forward, which I do not believe will come for several years, if at all.
Amazon’s Non-Retail Businesses
Before delving to much into the economics of AMZN’s core business, I think it is useful to discuss the prospects of Amazon’s non-core operating businesses. I will argue that even if AMZN were to overnight become a leader in each of these new business, the total value of these business would not amount to more than $3B, or 1/10th AMZN’s market cap.
Amazon Web Services
This business has received hype for sometime–despite being offered for the last couple years and not gaining much traction. The sales pitch here is that Amazon can sell its best in class technology and logistics solutions to other companies rather than those companies needing to worry about managing their own proprietary solutions. Outside their impressive e-commerce engine, which has been the bulk of the services hype, AMZN has a handful of other tools (a mediocre search product, selling excess storage an computer power, alexa, etc.) that have limited commercial value. Some analysts speculate that this opportunity could become larger than the entire business. I don’t think any of these services–particularly the ecommerce service–will ever take off.
Reasons include:
1) Amazon is essentially trying to sell its technology to its main competitors (offline companies coming online). This is a lose/lose situation. Either it works and you make your competition stronger, or it doesn’t and your business suffers.
2) Unsurprisingly, companies are not too keen on the prospect of outsourcing anything to a large competitor. If you are best buy, for example, how would you feel about licensing technology and trusting your infrastructure to your biggest online threat? It makes no sense to put the core infrastructure of your business into the hands of someone with a clear conflict of interest. Frankly, I can’t see this business taking off as long as AMZN also acts as a retailer.
3) AMZN’s e-commerce solution, in particular is not friendly with other solutions. If you are a offline retailer building an online presence, you want to be able to integrate your storefront with your webfront with your catalogue. It is very difficult to do this with amazon’s solution, and this will never be something they are good at, given that they do not have a retail presence themselves. If you cut offline retailers out of the market, who are you left with, other than a few small niche online retailers who have themselves spent millions developing their own systems?
4) AMZN’s other services (search, storage, cloud computing, etc.) are of questionable value, and are not related to their core competency (ecommerce). They might be able to make a few million from selling some extra memory and bandwith to startups (as they do now), but in my mind these don’t representative particularly valuable near term or long-term business models.
For many of these reasons, Amazon has been eaten alive by GSIC in the e-commerce services space, which is the only area where I believe AMZN has a potentially valuable product. GSI, originally operator of small website Fogdog.com, has taken many of amazon’s customers and won many contracts in head to head battles with e-commerce behemoth. GSIC reported $600M of revenue in the last fiscal year with its business here. Though AMZN does not break out this revenue, its other bucket for $263M for FY2006, so at the very least this business is half that of GSIC’s and most likely more like a third or a quarter. Anyhow, for arguments sake, I will assume that this division is currently worth GSIC’s EV ($1B), despite my belief that these businesses will continue to drain cash, and not be worth much of anything at all.
