Sunday, July 23, 2017

Five reasons not to buy Amazon

I think Amazon is a bad investment at today's price of $1025 per share, which is 157 times its estimated 2017 earnings, and I recommend that investors either avoid buying it or, if they already own the stock, sell it now.

To preempt likely criticism: yes, this is a superficial article, and no, I haven't done a thorough analysis of Amazon's subsidiaries or its expansion efforts. I believe the best arguments against owning Amazon are general and don't require a deep understanding of the company, especially with its stock trading at such a high valuation.

Here are five reasons not to buy Amazon stock.


1: Amazon faces intense competition
Over its life as a public company, Amazon has grown dramatically. From its start as an online bookseller, it's expanded rapidly into other retailing categories and eventually into non-retailing businesses, most notably Amazon Web Services.

The single biggest concern I have with Amazon is that it's now expanding into many “hot” areas with intense competition. Content and streaming media, cloud infrastructure, transportation and logistics, and grocery retailing are all priorities for Amazon. They're also priorities for many other deep-pocketed companies.

History shows us that companies with high asset growth underperform companies with low asset growth in the stock market. Simply put, higher investment leads to lower returns. The same dynamic holds for industries as a whole, as Marathon Asset Management describes with its capital cycle theory.

Jeff Bezos was far ahead of the curve when he realized that cloud computing would change IT and capitalized on that by launching Amazon Web Services. This foresight let him build a large, profitable business before tech rivals like Google and Microsoft could respond with their own offerings. But now, in my opinion, Amazon bulls are extrapolating that success to areas where Amazon won't have a first-mover advantage and the competition will be much fiercer, suppressing returns.


2: Acquisitions are fraught with risk
Last month, when Amazon announced that it would buy Whole Foods, investors reacted with enthusiasm. They generally felt that Amazon was making a good acquisition because its customer base overlaps with WF's customer base and because WF's grocery stores complement Amazon's non-grocery retailing business.

I'm less sanguine. While Amazon and WF have many of the same customers, they have very different ways of doing business. For instance, Amazon is obsessive about efficiency and reducing costs, while WF spends a lot of money (both capital and operating expenditures) to position itself as an up-market retailer. And acquisitions of complementary businesses fail far more often than one might expect. According to Billion Dollar Lessons by Carroll and Mui:

[Bain & Company's] five-year study of 1,850 companies concluded that most sustained profitable growth comes when a company pushes out the boundaries of its core business into an adjacent space. Unfortunately, the research also shows that adjacency moves usually fail. Of the companies Bain studied, 75 percent saw their moves into adjacent markets fail. Only 13 percent achieved what Bain called “even a modest level of sustained and profitable growth.” These companies grew earnings and revenues at least 5.5 percent a year (adjusted for inflation) and earned their cost of capital over ten years.

And Amazon is buying Whole Foods in a cash deal, which will require it to issue $14 billion of new debt, so the acquisition involves financial as well as operational risk.


3: Amazon's current earnings are minimal
As mentioned, Amazon trades at 157x estimated earnings for its current fiscal year. This is much higher than its competitors' earnings multiples: Google trades at 29x current estimates, Microsoft trades at 22x, and Wal-Mart trades at 17.5x.

Amazon's earnings are artificially low because the company constantly reinvests its cash flow in growth efforts, which require high current expenses. But even if Amazon pared back its expansion to boost earnings, it would still trade at a rich multiple.

And the strategy of constantly deferring earnings makes Amazon's stock risky for a couple of reasons. One, run-rate earnings are one of the basic metrics that investors use to value stocks. If a company's earnings are irrelevant, as Amazon's are, then investors will have difficulty valuing the company. And if valuing it is difficult, then the stock will tend to trade on investor sentiment, which is far more volatile.

Two, it makes Amazon vulnerable to rising interest rates. With real rates at historically low levels, the present value of Amazon's expected future earnings is relatively high. Conversely, if real rates increase, its future earnings will be worth less. I'm not arguing that a 1.5% rise in the ten-year rate will destroy Amazon, but I think that ZIRP has artificially boosted its stock price.


4: The stock's appreciation creates an unstable feedback loop
Amazon gives its employees a lot of stock compensation. I believe the high stock comp creates an unstable positive feedback loop: while the stock is rising, stock comp becomes more attractive to employees and potential employees. This allows Amazon to pay less compensation in cash, which boosts its cash flow, and the higher cash flow enables it to grow more quickly, which boosts its stock further, and so on.

If Amazon's stock tanks, this dynamic will likely reverse: stock comp will become less attractive, and Amazon may have to pay more compensation in cash, pressuring cash flow and growth and tanking the stock further.


5: Sentiment is extreme
From talking to other investors and reading financial commentaries, I feel that sentiment on Amazon is extremely, unsustainably positive. Some value investors have bought Amazon even though it's a world apart from traditional value stocks. Others can't bring themselves to buy the stock at 150x earnings but admire the company's business model and Bezos' skill as a corporate leader.

One manifestation of the extreme sentiment is that people have begun measuring all other retailers by how vulnerable they are to competition from Amazon. Will Amazon start selling auto parts and put Autozone out of business? Will Amazon start distributing industrial parts and disrupt Fastenal and W.W. Grainger? Et cetera.

Retail bankruptcies in the United States have surged over the past 18 months, and Amazon has recorded strong growth over the same period, so many people understandably associate the two with each other. But I think a closer look suggests that Amazon isn't on the verge of destroying physical retailers.

Best Buy was one of the earliest purported victims of Amazon's expansion. Five or six years ago, people talked about the “showroom effect,” the idea that people would visit Best Buy to look at electronics they were interested in buying and then go online and order them from Amazon at lower prices. But contrary to pessimistic predictions, Best Buy's earnings have slightly increased over the past five years and its stock is near an all-time high.

Many of the retailers that have gone out of business, or are on the verge of doing so, are victims of leveraged buyouts gone wrong: Claire, Gymboree, J. Crew, The Limited, Nine West, Payless, Rue21, True Religion, etc. Retailers often have volatile operating income and high implicit leverage in the form lease obligations, so they're not ideal LBO candidates.

And the United States has more retail space per person than nearly every other country in the world. Some of that is justified by our higher average income and lower population density versus other countries, but I don't think that's the entire explanation. The U.S. simply has more retail space than it needs, which has pressured retailers' profitability. And that isn't necessarily a good thing for Amazon: the glut of retail space may lower rent costs for the surviving physical retailers.

In 2003, Fast Company published an article called The Wal-Mart You Don't Know (hat tip to Petrichor Capital). It portrayed Wal-Mart as an unstoppable predator that used its market power to squeeze its suppliers and competitors. Today Wal-Mart is seen as a has-been, while Amazon is cast as the unstoppable predator. Wal-Mart's stock was flat for many years after the article. I expect Amazon's stock to be a similar or worse disappointment going forward.

5 comments:

  1. This is a fabulous article and I'm so glad you wrote it. I have been looking at all of these dynamics with interest and I am hoping that Amazon is slowed down so that other businesses will be able to grow and catch up to some of the E Commerce advantages that it has.
    There is also plenty of antitrust chatter around Big Tech in general these days.

    I think one thing to say as a counterpoint, would be that Amazon has exhibited willingness to change and evolve. So per the Best Buy example, Amazon is actually planning on establishing a Geek Squad of their own to assist customers. This makes them even scarier to me. However, more employees means more expenses and how long can they really remain non-union. We all know how much Amazon runs their employees ragged.

    So indeed, hopefully real life costs will catch up with them nicely, and it's possible the stock languishes here for a while as real world, brick and mortar, and new employee integration slow them down.

    I'm definitely keeping my eye on things and I appreciate the article.

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    1. Thanks!

      You bring up a good point about anti-trust. Wired published an article last month about how there's growing awareness of the big internet companies' market power, and how the companies are vulnerable to changes in anti-trust philosophy. Maybe you've seen it already, but if not it's worth a read:
      https://www.wired.com/2017/06/ntitrust-watchdogs-eye-big-techs-monopoly-data/

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  2. Amazon is going to do Pharmacy tie-in next with physical location to confirm initial scripts at Whole Foods locations and subscription format thereafter.

    Industrial/construction is coming with site delivery or a couple dozen drive thru bays for pick up of orders.

    They should come out with browser to replace Chrome.

    The key question is when to they start monetizing? Druckenmiller said it might not be until after he's dead, but Bezos is a businessman and will monetize at some point. - SC

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  3. Dammit, nobody can keep secrets anymore: http://www.cnbc.com/2017/07/26/amazon-1492-secret-health-tech-project.html - SC

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    1. It'll be interesting to see if they can make this work. Health care seems like an area that would benefit disproportionately from tech investment, but also one where there are a lot of vested interests that are likely to thwart change. I'm pessimistic, but I hope they can pull it off and transform the sector.

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