LOW PROFITS MAKE AMAZON A GAMBLE WORTH AVOIDING
INVESTORS often make the mistake of confusing a great product with a great investment idea. The latest stock to benefit from such a misperception is Amazon. The company’s shares skyrocketed by more than 15 per cent, after its earnings release last Thursday, despite the fact that it barely makes any money.
Don’t get me wrong. I love to shop on Amazon. I love the single-click buying, I love the choice of all the digital books on Kindle and I love the two-day delivery option that is available in the US and many other G10 countries.
Although its services are superb, the company made a paltry $192m profit in Q1 of this year, on revenues of $13bn. To put that number into perspective, Apple makes as much in profits in one day as Amazon did in full three months of operating its business. To add insult to injury, nearly 60 per cent of those Amazon profits did not come from operations but rather from one time gains in investments. Do such numbers justify a $100bn valuation for Amazon stock? I don’t think so.
Amazon reminds me of an old joke. When a hat manufacturer is asked how he will make money selling an item for $1.00 that costs him $1.10 to manufacture, he cheerfully replies, “We’ll make it up on volume!” The situation at Amazon is not nearly as dire – the company does make money – but its operating margins are razor thin, approximately 3 per cent versus 35 per cent or more for the likes of Apple.
Many investors look at Amazon and think that it will become the WalMart of the web. With expected revenues of approximately $60bn this year, and more than $80bn in 2013, the company is indeed the Goliath of online retailing. But I believe that most investors miss the key distinction between the online and the world of bricks and mortar. WalMart operates on a loss-leader principle. It will sell some items for less than cost just to get customers into the store. It knows that, once inside, they will inevitably overspend on spontaneous purchases. The online experience is quite different. When most of us shop online we generally focus on buying one or two items and then go about our way. That’s why the loss-leader model on the web is far less effective than it is in real life.
Amazon faces challenges on multiple fronts. In the media segment – its key product set – it has clearly lost music to Apple, won books and will have to struggle mightily to make inroads against Netflix in video. Hard as it tries, Amazon is not viewed as a “media company” that sells content in a software form but rather as a pedestrian peddler of products. Furthermore, its Amazon Prime service, which allows two day delivery for a one time annual fee of $75, is ripe for abuse. Imagine ordering a two pack of AA batteries every single week for a year and explain to me how Amazon can make money on such a transaction, with its two-day delivery guarantee. Its fulfillment costs is one of the reasons why the company is forced to run such razor-thin margins.
Yet despite all these shortcomings, for now, Amazon remains a structural rather than an event-driven sell. The short sellers in the stock were very badly bruised last week, as shares were squeezed mercilessly higher. Many seasoned traders know that shorting a rising stock on the underlying fundamentals alone is one of the most dangerous strategies to employ. Sentiment can often drive price to dizzying heights, beyond all rhyme or reason, which is why caution is in order when considering Amazon. Yet at more than 100 times current earnings, owning Amazon is akin to driving a car at more than 100 miles per hour. One small bump in the road could send you hurtling over the road barrier.
For Amazon, that bump could come from missing its revenue targets. If that happens sometime this year, the stock could become an opportunistic short. In the meantime, for those brave enough to buck the crowd, any shorts in the stock should carry tight stops or should be taken through long-term puts, where the risk is clearly predefined.