Roughly a year ago, we examined whether shares of Amazon could continue to levitate in the face of the company’s minuscule profitability. See A River of Doubt – June 25, 2012.
Since then, AMZN shares have continued their ascent into the ether, climbing from $220 then to $307.33 as of a few minutes ago – an increase of nearly 40%.
The question is whether this can continue.
By traditional valuation metrics, the contrast between AMZN and another enormous, technologically sophisticated retailer – Walmart – is striking (the table shows, for instance, that AMZN’s price/sales ratio is currently 4.0x that of WMT’s).
Click on the charts to enlarge.
Readers could be forgiven for being confused as to which of the two companies was actually making money.
Since Amazon is barely profitable now (and in fact, the company had negative net earnings for 2012), the bull case is based on the belief that this sad state of affairs won’t continue much longer, for two reasons: 1) retail margins will increase; and 2) the higher margin cloud computing business (Amazon Web Services, or AWS) will drive an ever higher proportion of the company’s revenue stream.
Let’s examine each of these assertions in turn.
What if, for example, Amazon’s margins grew to those of Walmart? (click to enlarge)
At its current price, AMZN would still be trading at a P/E of roughly 60.
AMZN is facing a number of headwinds, too.
- Most large states now require the company to collect state sales taxes.
- Amazon’s efforts to build out physical delivery centers will not provide much of an advantage. Competitors such as Walmart already have delivery centers – quaint little facilities called “stores.”
- While Amazon has driven many brick and mortar retailers out of business (the “showrooming” phenomenon), the survivors are responding in creative ways not conducive to increased Amazon profitability. See The Emporium Strikes Back (Economist July 13, 2013).
So what then for Amazon’s stock price?
WMT trades at a P/E of 15.2. WMT valuation metrics and some heroic assumptions about Amazon’s ability to raise its operating margins, translates into a $75 stock, not a $300 one.
Alert readers, however, will ask one final question: what about the cloud?
Since Amazon does not break out AWS revenues or profitability in its financial statements, this number is really just an analyst’s guess. At the moment, AWS services appear to constitute about 10% of the company’s revenues, though these are growing rapidly.
Amazon Web Services generated $2.1 billion in revenues in 2012, according to an estimate by Ben Schacter, the Macquarie Capital analyst who is thought to have one of the strongest information pipelines into AWS. Those revenues will grow to $3.8 billion in 2013 and $6.2 billion in 2014, he has said in his reports on Amazon. See Amazon Cloud Mystery Persists (Information Week).
The trouble, as the article notes, is that the Cloud is becoming ever more competitive every day, with other large, well-financed competitors like Microsoft jumping into the fray.
We’ll conclude by leaving the reader a table and a chart. In the table, RAX is Rackspace, a fast-growing pure-play cloud computing enterprise.
Surprisingly, Rackspace’s PE to Growth ratio is lower than Amazon’s, while its Return on Assets is not much higher than Walmart’s.
In a concluding note, the chart below repeats the point that Amazon has never achieved the operating profitability of Walmart – and most likely never will.
This does not mean that the stock will plunge tomorrow – only that when it does, it will be a long way to the bottom.