Amazon’s Unfair Advantage

Aug
25
Written by: and

Investors are gaga over Amazon.com.  As of late July, Wall Street analysts had thirty-eight buy ratings, five hold ratings and just one sell rating on the stock.  The average twelve-month price target of these analysts was $1,472.  With its current price of $967, that’s a 52% increase.

And, yes, the accolades and excitement are well-deserved.  The business that Amazon founder Jeff Bezos created is nothing short of phenomenal.  It’s a true testament to American ingenuity and the power of harnessing and leveraging technology.  As frequent Amazon customers, we don’t dispute the value and convenience the company provides.

This essay is not a prediction of the direction of Amazon’s stock, especially in the short-term.  We have no idea.  Its valuation is beyond our understanding.  Instead, this note is simply the other side of the story – a negative argument about Amazon’s valuation and its business challenges that goes against the consensus.

Another way to think of the price-to-earnings ratio, the most common method of valuing stocks, is as the number of years – at the current level of earnings – it would take a company to earn an amount equal to its market value.  For Amazon, that’s roughly 250 years.

But, the argument in favor of Amazon goes, valuation doesn’t matter.  Instead, the company will one day dominate the market so entirely that they will flip a switch and raise prices, trim expenses, and thereby reap copious profits.

The problem with this line of thinking is that dominance doesn’t last forever.

Harlow Curtice, the General Motors CEO from 1953 to 1958 and Time Man of the Year in 1955, said “General Motors has no bad years, only good years and better years.”

There was a time, in the 70s, when Sears employed one out of every 204 working Americans.  The company printed 315 million catalogues per year, making them not only America’s largest retailer, but America’s largest publisher.

In 2000, when General Electric was the largest American company by market cap, Fortune Magazine named long-time GE CEO Jack Welch as the “Manager of the Century.”

Various fates have befallen these three once dominant and invincible companies.  GM filed for bankruptcy on June 1, 2009, wiping out all equity and many debt holders.  Sears issued a “going concern” warning on March 21st of this year, effectively cautioning investors that bankruptcy is likely.  And the once heralded Jack Welch of GE is now widely regarded as the architect of a house of cards that since 2000 has lost more than 60% of its value.  At their heights, nobody foresaw the fate of these behemoths.

Even Amazon’s growing market influence over a variety of disparate sectors presents significant downside.  With Amazon looking to dominate everything from groceries to digital entertainment, Amazon’s ability to focus is at risk.  And the more businesses a company is in, the more competitors it has.

Experts largely discredit the concept of conglomerates, businesses that operate in many areas of the economy, because they have generally failed to thrive over the last fifty years (many once believed being a conglomerate was optimal).  Even Sears was a conglomerate that owned the Wall Street investment bank, Dean Witter; the credit card company, Discover; the real estate brokerage, Coldwell Banker; the property casualty insurance company, Allstate; plus the brands Craftsman, Kenmore and DieHard.

The inherent problem with conglomerates, and why most have suffered, is because they lose focus.  It’s exceedingly difficult for a centralized management team to oversee many distinct businesses.

Currently, Amazon is in the general merchandise business, the technology device business (Echo, Kindle, Fire), the streaming and studio businesses (Amazon Prime and Amazon Studios), the on-demand cloud computing platform business (AWS, or Amazon Web Services) and the grocery business (Whole Foods and Amazon Fresh).

And according to various media reports (and to the detriment of stocks in any of these industries) they are planning to launch electronic healthcare records, virtual doctor’s office visits, pharmacy, defense, event ticket brokerage, custom clothing manufacturing, etc.

All the while, Jeff Bezos owns the Washington Post and Blue Origin (the rocket and space travel company), which are, arguably, his passions.

Doing too many things can mean doing none of them particularly well.  By stretching itself thin, Amazon exposes itself not only to execution risk, but also competition from many corners.

In just its AWS business, Amazon’s primary driver of profitability, they face growing competition from the likes of Microsoft, IBM, Oracle and Google.  In technology devices, Amazon must compete with Apple, Samsung, Google and Microsoft.  In their streaming and studio businesses, they need to challenge Netflix, Disney, Time Warner and Viacom.  This is just the tip of the iceberg.

Amazon boosters say that competition isn’t an issue because Amazon is destroying the competition.  But, there is a giant problem with that argument.  Amazon isn’t playing by the same rules.

Most of Amazon’s competition, in any business it is in (or proposes to be in) must manage for profitability.  Running a business for profit is unlike running a business for growth.  Someday investors will demand that Amazon deliver large and consistent profits.  Growth will no longer be enough.  It’s impossible to know when this day will arrive, but, we assure you, it will.

For perspective, in two decades as a publicly traded company, Amazon has made a cumulative profit of $5.9 billion.  In 2016 alone, Walmart had a profit of $14.7 billion.

Presently, Amazon faces no hard choices, whereas a business that is expected to show consistent profits must constantly make difficult choices.  The market punishes traditional companies like Wal-Mart, Nordstrom and Starbucks when they invest in their digital businesses.  Most businesses can’t try everything and risk losing billions, instead they need to be far more cautious in choosing opportunities (and they often choose the wrong ones).

Amazon, on the other hand, can try anything and face little accountability when things go wrong (like their disastrous Fire Phone) and only upside when things go right.  Amazon can take on costly risks now, but the future might not be so forgiving.  Amazon grows fast because it relentlessly reinvests in its businesses, but that is only possible because its investors don’t demand profits.  Such a rope is only so long.

Investing is all about perspective. You can find pros and cons in most any successful company and, for now, investors are optimistic about Amazon. But that won’t last forever—nothing does.  Admittedly, today’s market is rewarding growth.  However, when the market again trends toward value or if Amazon’s growth slows, Amazon might find investors tugging on its rope.

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