Captain Ahab in the Amazon

July 26, 2011

Well huzzah to AMZN for convincing the investment community that profitability doesn’t matter as long as the “moat” in under construction and developing a remarkably compliant sell side following.  Though we see a lot of parallels with the NFLX story here, conference calls aren’t one of them as they conducted an interactive though CEO free call (apparently guys named Jeff only appear on GE calls) .  And again we have only the stars to thank that this is our first call as an official AMZN short, as we would have been similarly dumbfounded at the proceedings therein a year and a hundred points ago.   We also note the appearance of the CSOI metric on the call and now owe an apology to Groupon which apparently didn’t concoct the “earnings before expenses” metric all by itself though to their credit AMZN is incredibly conservative by comparison.

What we see as a massive earnings guide down for September, with operating income guided down to a $20-170M range from $201M for EPS of $0.20 or so assuming below the line items are similar compared to $0.48 expectations,  the market apparently sees as something more exciting.  What we see as a wonderful on line retailer with razor thin margins that are declining, and a modestly interesting business that generates a couple hundred million in profit a quarter, others see as a $100B juggernaut.  We will continue to scale in short, cognizant of overplaying a somewhat blind hand but also remembering a few other tough deals that worked out post flop.

What we don’t see is the scale in the model.  For the question must be what is a business that generates $200M in operating income (and zero free cash flow in the current period)  per quarter, a number which is headed lower, worth.  And under normal circumstances, the answer is something between $5 and $15B (borrowing AMZNs penchant for wide ranges) depending on how quickly that number is declining.  So there is clearly a bit of a delta here, one that must be based on an assumption of future “wild profitability” (to borrow from Groupon’s Chairman) once the company decides to quit growing so fast. 

Walmart is currently doing a 5.7% operating margin, compared to 2% at AMZN, growing low single digits on $100B in quarterly sales and trading at an EV/Sales multiple of about 0.5x.  Gross margins in both cases are about the same, around 25%, with the balance of Amazon’s expenses around fulfillment (part of COGS?) marketing and G&A where we might see some leverage on the latter though a very small amount at 2% of sales.   So if we stipulate that the best AMZN is likely to do is emulate WMTs model at scale (with equivalent tax treatment?) then the current share price discounts fivefold growth in AMZNs revenue to $200B compared to $40B currently.

As for new businesses, one certain impediment to current profitability, and likely contributor to current multiples, is Amazon web services.  Based on commentary on the call it is clearly in loss mode, and a major contributor to Amazon’s fourfold increase in capex to over $400M in the quarter which erased free cash flow in the quarter.  While the “cloud” aspect surely contributes to the non retail multiple currently accorded the company, we are again faced with an entity that will apparently be profitable one day after it achieves scale.   Key questions include bandwidth and infrastructure costs associated with effort, and whether AWS can really compete for mission critical applications in large enterprises given recent major outages.  We will confess to suppressing a laugh in reading a recent release regarding SAP compatibility on AWS, and are as interested in getting a list of companies that are willing to put their MRP in the cloud as anything else discussed in this note though it appears the deployment is limited to analytics at this point.

The real parallels with the Netflix story, outside of both companies “feeling great” about most everything,  center around one concept; something for nothing.  Amazon is not taxed like the brick and mortar retailers it’s putting out of business, and Netflix is not required to pay for the bandwidth it consumes.  No taxes equals’ free shipping, no bandwidth costs equals $8 streaming.  We think both of these situations are unsustainable in the investment horizon. Like NFLX, AMZNs predatory response to the mere suggestion of tax parity with its peers has weakened their hand at the regulatory and policy making table.   It’s hard not to see a parallel between NFLX (apparently) underpricing its offering, enabled to lose money by its growth obsessed public market following, putting its traditional competitors out of business and then dramatically raising prices.  As indicated above an examination of AMZN’s operating model leaves us hard pressed to find any other options for the company to deliver the holy grail that is “easy” according to one sell side questioner today, and also fully price into the shares.