Above the noise: Play AMZN directly or indirectly?

I really respect David Einhorn due to his outstanding performance as a hedge fund manager and lately for his extremely precise call on shorting Green Mountain Coffee Roasters (GMCR). If you have not heard about this story I recommend you Google it and read his firm's 110 page presentation about why GMCR was a great short candidate - undoubtedly some of the best investigative research I have read.

Yesterday, David Einhorn was on CNBC talking about many things of which Amazon was one of them. His perspective got me thinking and as a result I wanted to analyse Amazon which is probably one of the greatest success stories in the US stock market during the last 15 years. The share price has grown 39 percent annualised since mid-1997 (see chart below). That is truly amazing Amazon!

Source: Bloomberg L.P.

Amazon is killing the competition: the case for shorting Best Buy
Einhorn's view is that Amazon is difficult to deal with, both for long-term investors and competitors. His main point is that Amazon's first priority is not necessarily making profit in the short term but rather expanding the business as quickly as possible. This is also the reason why the company has always aggressively slashed prices on every item (including its Kindle Fire tablet recently) and also invested heavily in other business areas (robotics, niche online retail acquisitions etc.) which in effect has driven down its operating margin for almost two years now. This makes it difficult for investors to value the investment case because the main portion of the value will (maybe) be extracted well into the future. We will get back to that later.

For competitors the situation is terrifying as Amazon is annihilating its competitors along the way through magnificient precision in operational execution, productivity gains leading to lower cost structure and lower prices, and a hyper-efficient supply chain. It sounds pretty much like the strategy Standard Oil employed back in the 19th century when it came to dominate the US oil business.

One of the main competitors suffering from Amazon's execution is Best Buy (BBY) which is down 39.1 percent during the last year and 66.8 percent from its all-time peak in 2006. According to a Barclays' analyst, Best Buy has worse pricing than Amazon on most items and at the same time more and more use Amazon as their infrastructure for online showrooms. On almost all parameters Amazon is superior to Best Buy and it really smells of Nokia/Research in Motion, albeit Best Buy still produces good cash flows. 

The best argument against shorting Best Buy right now is its very low forward P/E of 5.4 and the fact that its share price is already heavily down. Add to this that US real retail sales are still growing at a healthy pace and things look quite bouyant. Maybe the timing for shorting will be better if the US economy deteriorates further.

Amazon is the 21st century's Wal-Mart Store: the case for buying Amazon.com
Focusing on only Amazon, then how do you properly value the company? Most investors would run upon hearing that Amazon’s forward P/E is 186 despite the fact that the company is growing 25-40 percent year-on-year through recessions and expansions alike.

Let us first look at some facts. Amazon has seen 12-month rolling revenue grow 34,683.2 percent since 1997 or 50.8 percent annualised to USD 51.4 billion in the last quarter.

As the log curve on revenue shows, the growth rate has been remarkably steady despite its growing empire. Since the dot-com bust, the EBITDA margin has been stable between 4-7 percent but lately it has fallen to 4 percent due to large investments in the future and aggressive pricing of its Kindle Fire.

My theory is that Amazon will be the Wal-Mart of the 21st century (or at least in its first half), so let us look at Wal-Mart to establish a reference point for its valuation and growth perspectives.

Wal-Mart has grown 12-month rolling revenue by 286.4 percent or 9.9 percent annualised since 1997 to USD 455.8 billion in the last fiscal quarter. In this period the EBITDA margin has been extremely steady and rising continuously from around 6 percent to slightly below 8 percent.

If you compare the two companies, Amazon grows at around 35-40 percent annually compared to Wal-Mart's around 7-8 percent. Amazon trades at 47.5 times its 12-month rolling EBITDA while Wal-Mart trades at 6.9 times its, which is around 30-40 percent lower than investors were willing to pay back during the last expansion before the financial crisis.

I see Amazon's strategy as trying to become the largest retailer in the world as quickly as possible, no matter what. Short-term profit is not a goal in itself. Outright growth and annihilation of competitors is the goal. By keeping costs low, Amazon can set prices lower and win market share - just as Wal-Mart did and still does. As I see it, Amazon is just better positioned for the future than Wal-Mart is as Amazon has 15 years of experience in online retailing, the lowest possible cost structure and the finest brand in online retail - something Wal-Mart does not have.

Also to get an idea of their experience curve on costs read about Amazon's acquisition of the German industrial warehouse robotics firm Kiva Systems. This will significantly drive down costs on inventory and warehouse management and further cement its position as a leader in its industry in terms of costs.

If we do a quick 'back-of-an-envelope' calculation on Amazon we get a sense of its growth potential. If we assume that its annual growth rate declines by 5 percentage points each year from the current 40 percent then revenue will grow to 189.6 billion in 2017. This is by no means unrealistic. If we at the same time assume that the EBITDA margin returns to 6.5 percent then 12-month rolling EBITDA will be 12.3 billion. If we further assume the EBITDA valuation multiple has dropped to 25 times from the current 47.5 then we are looking at a market capitilisation of USD 307.9 billion compared to the current 98.4 billion. This translates into a share price potential of 25.6 percent annualised. Is 25 times EBITDA realistic in 2017? If Amazon grows at 20 percent annualised in 2017 then it is by no means unrealistic - in fact Wal-Mart traded at this valuation in the late 90s and earlier.

The Wal-Mart lesson
Whether or not Amazon's growth can continue at such high rates though is the obvious concern. I remember reading the book Sam Walton: Made In America where Sam Walton (the founder of Wal-Mart) tells that since 1960 Wall Street analysts have been repeatedly sceptical about the continuation of its sales growth. Even when Wal-Mart reached the 100 billion sales mark analysts remained sceptical about its growth prospects and now the company has almost five times as much sales. I think that understanding this story is key to understanding why Amazon can keep growing for decades at above market growth rates.

The essence to this analysis is the fact that current P/E ratios of Amazon do not tell the complete and true story. Growth can continue for longer than most think is realistic. Amazon probably has a tremendous amount of growth ahead due to its position and cost structure. You could play Amazon directly or indirectly by shorting Best Buy. The latter is dependent on timing though and right now it hardly seems to be right. The bullish case on Amazon is also risk laiden with the biggest risk being its expansion into various business segments where it competes head on with more powerful players e.g. against Apple on tablets and Google: Lately, rumours are also rife that Amazon wants to make a smartphone. I am not sure that is so 'smart' though but only the future will tell.