How Will Amazon Have to Continue to Grow to Justify Pe

People ask me all the time… "why is Amazon's P/E ratio so high?"

That Amazon (NASDAQ:AMZN) is a company with "zero earnings" is probably the worst kept secret on Wall Street. The stock has a P/E exceeding 170x – meaning if there was no growth and you'd invested in it when Thomas Edison was born in 1847, you would have recouped your original investment today.

Another way to look at it, is that you'd need an annual growth rate of 30% for 20 years before the investment even starts to make sense.

So the question is, can a global phenomenon the likes of Amazon – with annual revenues of $136 billion last year – continue to grow at 30% for the next 20 years?

Actually, no. That's the wrong question to ask. The real question is – what exactly are people seeing in this thing?

By any conventional measure, AMZN is a stock which has far outgrown any reasonable valuation. P/E, EV/EBITDA, P/FCF, P/S – you name it, it's priced in bubble territory.

To put things into perspective, if Amazon were to grow its revenues by just 15% for 20 years, that would make its annual revenues in 2036 a mindboggling $2 trillion – roughly the GDP of India today.

So how can profits grow by even more than that, when they haven't really budged for the past 10 years?

The flip side is, AMZN has been trading at over 100x P/E for a pretty long time. Its P/E was 30x during the depths of the financial crisis in 2008, 60x in 2009, 70x in 2010, 120x in 2011… then 600x in 2013, and more recently 500x in 2015.

Oh, and why didn't I mention its P/E during 2012 or 2014? Because its P/E was negative during those years.

I mean, even a 5-year old would tell you that those are some astonishing numbers. And you'd believe it.

So why is Bill Miller – Chief Investment Officer of the $700 billion AUM Legg Mason Capital Management – making a blistering bull case for AMZN even at today's prices?

If you've never heard of Bill Miller, don't worry, he's not in uncharted territory. Even Warren Buffett thinks that Amazon is a wonderful business, and by his own admission Jeff Bezos is a "terrific" businessman. He even sold a $900 million position in Walmart primarily because of fears of competition from Amazon.

So what is this earthshaking investment thesis that's causing even the giants of the investing world to pile praise onto a stock with a P/E of over 100x – something Benjamin Graham probably wouldn't even touch with a 10-foot pole?

Let's find out.

Peeling back the numbers, we see that Amazon made a profit of $2.3 billion in 2016, up from $594 million in 2015, and a loss of $241 million in 2014. While those are some respectable numbers, at first glance it still doesn't really justify a valuation of… $400 billion.

And it's not like there are many one-time adjustable losses in the Profit & Loss statement (P/L) that could be backed out to bring the valuation back to earth. Amazon's P/L statement is remarkably clean; the most meaningful detective work you'd gather out of it is that most of its Administrative Costs are derived from the line item 'Fulfilment'. This simply means that Amazon is spending a lot of money on trucks, warehouses, robots and employees to pack your goods and ship them to your home.

What about the much-bandied about AWS (Amazon Web Services) that's got the tongues of Wall Street wagging? Even if you believed in the AWS growth story, it still represented only 8% of revenues and $3 billion in profits in 2016. Respectable as always, but still nothing that will support a $400 billion valuation.

So if the P/L is basically 'what-you-see-is-what-you-get', how do the numbers justify the insane 100x P/E valuation?

This is where it pays to heed the advice of the Oracle of Omaha, where Buffett says to "look at stocks as a business". Or in other words, to see stocks as a part ownership of the actual business; not merely as prices bouncing around on an exchange.

This is the part where you have to pull your head out of the financial models and take a good look at the business landscape, in order to gain a true appreciation of what Amazon's potential really is. No amount of conventional modelling in Excel – starting from its current revenue/profit figures – is going to result in a valuation of $400 billion. (as mentioned above, revenues would have to grow to the GDP of India)

Before we continue, I'd highly recommend you pause and watch this 13-minute video by Mark Mahaney of RBC Capital: How Amazon can become the world's first trillion-dollar business. It really puts into perspective the true potential of Amazon.

Too long; didn't watch? Okay, that's alright. Let me try and summarize it.

Basically, you'd first need to understand that Amazon is operating in the retail industry – specifically the e-commerce retail sector. Which means it's competing with the Walmarts, Tescos and Whole Foods of the world – to deliver groceries and thingamajigs to your doorstep.

Now, profit margins in Retail can be particularly brutal, often in the low single-digits. Walmart's Net Profit Margin in 2016 was 3%, Costco's was 2%, and Tesco's was less than 1%. Everyone knows that these colossal hypermarkets make their money by selling on volume – so even if they only retain a sliver of each dollar of revenue, they'd still make a healthy chunk of cash.

Amazon's retail segment really isn't any different in this regard. Its retail segment has two sub-segments – the part where they actually procure and sell you stuff themselves; and the other part where they simply act as a platform for third party sellers and skim a commission on the final selling price (like eBay).

While the latter's net profit margin is significantly higher than the former's, Amazon still only retains a combined net profit margin in the low single-digits from both operations at the end of the day. In that regard, it's not that different from Walmart.

So if Amazon isn't earning a much bigger slice from its revenues than its competitors, why is its P/E so much higher? (Walmart P/E: 16x, Costco P/E: 30x; Amazon P/E: 170x)

Answer: the real money in Amazon isn't found by scouring the financial statements – it's found by looking outside, in the real world.

If you've been following the retail industry, you'd notice a trend – the entire retail industry as a whole is slowly being disrupted. More and more, people are buying their stuff from home and having it delivered to their doors (i.e. e-commerce) – as opposed to driving down to their nearest Walmart and picking up their groceries there (i.e. brick-and-mortar retail).

This chart shows how e-commerce is steadily making gains into total U.S. retail market share. After all, if you can buy stuff for just as cheap and it reaches your home in 2 days, why bother suiting up and driving down to the store, right?

Nor is this just a singular trend in the United States. We're seeing the same upheaval in buying behavior all across the globe – in Korea, Japan, China, Europe, Southeast Asia, Australia, India – throw a dart on a map, e-commerce is more likely than not already there.

As more and more people choose e-commerce, less and less people are leaving their homes and buying stuff from brick-and-mortar (B&M) stores. And since these large B&M guys operate mostly based on volume and high operating leverage, that's a death knell if there ever was one.

Meanwhile, this young upstart named Amazon is leapfrogging all its competitors in retail. Revenue growth exceeded 20% in 23 of the last 24 quarters; and despite that, it still only owns only 10% of all retail sales in the US.

That means there is plenty of room for Amazon to continue stealing market share from B&M retail; which also means it has a long runway ahead of it before the industry becomes saturated.

And if that's not enough? There's the rest of the world to conquer. Even if Amazon somehow manages to capture say only 30% of all retail sales in the US and plateaus there, it can still move into China and India, where there are a combined 2.5 billion people to sell stuff too.

Yes, of course there's this little problem called Alibaba; but regardless, the sky's literally the limit for Amazon.

And why stop there? Why not South East Asia, where there are another 500 million potential customers? What about South America? Africa? Europe? Russia?

Even if you only had a net profit margin of 2%, you'd simply have to capture just 10% of the world's retail population for it to grow into today's valuation. And Amazon seems poised to do just that.

Let's rewind a bit. What about that 170x P/E we were talking about earlier? Well, if you believe this article aptly titled Why Amazon Has No Profits and Why It Works, you'd realize that there's something strange going on.

Notably, despite revenue growth exceeding 20% per quarter for the past 10 years, profits haven't really budged at all. Sometimes you'd get a blip of profit, other times a blip of loss – but until 2016, profits have simply fluctuated around zero.

Why?

Could it be because they're managing earnings to give the impression that they're not profitable? Could they be actively trying to hide their growth, by timing their expenses to show zero profits? Are they deliberately trying to keep expectations low, so they can focus on the long game rather than dance to the tune of shareholders, like most publicly listed companies do?

I mean, their annual Operating Cash Flow (OCF) has grown from $3 billion in 2010 to $16 billion in 2016. Likewise, their annual Free Cash Flow (FCF) has grown from $2 billion to $9 billion over the same period. So even if you're growing the retail business at a rapid pace, you can't possibly be performing that badly, right?

Which is why most value investors prefer to use Gross Profit as a benchmark for actual performance – since the Gross Profit of a retail giant typically reflects sales volume growth. From 2010 to 2016, Gross Profit grew from an eyepopping $7 billion to a worlds-colliding $47 billion.

If we assume that the average selling price (ASP) of the average item sold remained roughly the same, that means they sold over 600% more stuff in just 6 short years – or a 35% CAGR! Cut that growth rate in half and extrapolate it over the next 4 years – they'll be selling nearly twice today's volume by 2020!

Of course, all this is just conjecture. But judging by the share price performance, I guess enough people believe in it.

And we haven't even talked about AWS yet!

In case you're wondering, we've barely scratched the surface behind understanding the details of Amazon's valuation. The AWS segment is itself a high 30% net margin business which has similar room to scale. On top of that, Amazon has been experimenting with a bunch of other ventures – like the Fire Phone, Alexa, and my favorite, the PrimeAir drone delivery campaign.

Sure, most of these probably won't turn out to be wild successes, like Retail or AWS. But if they keep trying, they'll probably strike gold, right? It's not like they'll run out of money if they fail.

Now this is not a recommendation for you to run out and buy Amazon's stock. I personally haven't performed a proper analysis of Amazon yet, just a cursory one. And as Buffett is fond of saying, "risk comes from not knowing what you're doing".

But if there's a moral to this story, I hope I've impressed upon you the importance of understanding the business before investing. Don't view stocks as merely P/E ratios or line items to be tweaked on an Excel spreadsheet. Truly view stock analysis through the lens of a business, as if you were going to become the CEO of the business tomorrow. Understand the inner workings of the industry, appreciate the trends that are taking place, try out the products they are selling. Do your homework, do your scuttlebutt.

Remember, as a shareholder you're a part owner of the business. Take the time to understand your business. Your wallet and your portfolio will thank you.

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Source: https://www.linkedin.com/pulse/much-ado-amazon-nasdaqamzn-aaron-pek

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