Ding, Dong Amazon.com – Bubble Valuation Techniques in Action

Imagine you have been diligently working away as an analyst in your investment bank and someday your boss comes to you and offers a promotion into the Technology team, specialising in e-fulfilment. The largest stock in your coverage is Amazon.com and your first order of business is to establish a price target for the stock from which a recommendation can be derived.

All investment banks and brokerages require their analysts to provide price targets. Without them the sales function would struggle and it would be difficult to hang the logic of research recommendations on any peg.

Amazon.com presents a particular challenge. It is the second largest listed company in the world, with a market capitalisation of US$969bn and, with US$1.68tn traded in its shares in the past 12 months, is of great economic consequence for “the Street”. Bloomberg indicates that 51 analysts have flagged coverage of the company, 47 maintaining a BUY, 3 advising HOLD and just a single SELL recommendation: from a Mr Allen Gillespie of South Carolina.

Amazon.com has been a listed company for 21 years and profitable on a financial accounting basis only in the last 4. The company operates off very low margins, its net margin in the last reported year was 1.7%. Its trailing Price Earnings Ratio (PE) is 294x against 23x for the S&P500. Based on consensus earnings estimates for the next 3 years, 2018 PE ratio is 112x, 2019: 77x and 2020: 53x.

Analysts in recent years have drifted away from bottom-line based multiples. Partly because they are deemed to be overly reductive, also on account of the rising tide of sector analysis and the desire to put companies on a similar footing by excising accounting one offs. If you go far enough up the P&L, there are more positive numbers to apply a multiple to: EBITDA, EBIT, NOPLAT, NOPAT1 and the sparsest of all: price to sales. We might remember that, briefly in the 1997-2000 period, “price to eyeballs” caught on as a method to rationalise companies that “were the future, then” as David Cameron once addressed Tony Blair in the Houses of Parliament.

Price to sales for Amazon.com runs at 4.7x against the S&P500 average of 2.4x. We can observe that, irrespective of margins, Amazon.com is a pricey stock. Once margins are included, it becomes optically pricier still.

The general argument in favour of Amazon.com is that its margins are deliberately held down: via gigantic depreciation charges that run through its P&L, driven by its global build out and partly as deliberate policy to crush conventional retailers and assume dominance in as many categories of retail as it can.

On the first point, if depreciation charges are being heavily applied through the P&L, we should expect some flattening of the Price to Cash Flow multiple (PCF) which adds back non-cash depreciation charges. Amazon’s trailing PCF is 35x against 14x for the S&P, a 150% premium as against a 1,100% premium on the PE basis. That supposition is upheld.

The second point requires more imagination: what sort of quasi or real monopolies will Amazon.com be allowed to attain, should it achieve global retail dominance? In the US at least, it has been met by a strong fight back from Walmart on several high volume and basic categories. And yet, the market does not appear to be too convinced by Walmart, as its stock trades on 0.6x its sales base. Amazon is rated almost 8x more expensive than Walmart on a Price to Sales basis. Walmart may be doing Amazon.com a favour by supplying some credible competition (for now) and thereby supplying a smoke screen to the more predatory aspects of Amazon’s agenda.

There may be some value in thinking of Amazon.com’s core enterprise as being the fusing of two businesses: a low margin retailer (that may well remain low margin) tethered to a world leading logistics and e-fulfilment company.

In fact, with the expansion of Amazon into other global businesses, the picture is muddied by the fact that, should its media and cloud initiatives achieve pre-eminence inside concentrating markets then its consolidated margins may indeed rise even before any issue of customer gouging takes place. Goldman Sachs, for example, forecast that Amazon Web Services will account for 18% of consolidated sales by 2022.

Furthermore, in e-commerce, another player should be considered: AliExpress, the overseas arm of China’s Alibaba. Alibaba’s founding mission was the supply of third party manufactured goods via its platform. Third party goods are becoming progressively a larger part of Amazon’s offering. If AliExpress is able and willing to provide its vendors with more and better artificial intelligence than Amazon.com these vendors will have better outcomes on AliExpress channels and their market share will rise relative to Amazon. Several things could deter this outcome: US laws prejudicial against Chinese e-commerce or changes in pricing to country-of-delivery postal services on which AliExpress relies.

Answers to these issues are beyond the scope of this short note, so we turn back to the original question of how to back a valuation out of a nigh-on US$1tn market cap.

Goldman Sachs have a current price target of US$2,300 a share on Amazon.com which if realised offers a 16% return from the current share price. However, a closer look at the construction of this estimated of value reveals counter intuitive assumptions. For this stock, the analysts have deployed the discounted cash flow approach (DCF) by which future cash flows are discounted back using a weighted average cost of capital (WACC). Nothing wrong with that. There are several key drivers to such assumptions: the cost of equity, the cost of debt, the near-term forecast but none so sensitive as the perpetuity growth rate. That part, in this case growth from 2022 to the end of time has been assumed by Goldman Sachs analysts at 7.7%.

If we broadly assume that world nominal growth runs to somewhere between 2.5% and 3%, it is difficult to sustain the notion that Amazon.com could grow at 3x that rate for ever. If it were to do so, it would become the only commercial enterprise of note in the world. We would be eating Amazon cornflakes in the morning, driving to work in an e-Amazon car (soothed by Alexa chirping away in the background) and arriving at our work place, which would be Amazon.com. This is sci-fi, but not in a good way.

To better understand the contortion required to arrive at a fair value of US$2,300, plug in 6.7% and that becomes US$1,625, 18% below the current price. At a more modest terminal growth assumption of 3% , we derive US$825/share, less than half where the share price is today.

Across Wall Street, the folks at JP Morgan use Sum-of-the-Parts analysis for Amazon. Nothing wrong with that either. Amazon Web Services (AWS) is awarded an EV/EBITDA multiple of 18x on the basis it is a Software as a Service (SaaS) business akin to Salesforce. That accounts for 40% of the US$1tn valuation. My colleague Mike Flitton points out that AWS is not a SaaS business but primarily an IaaS (Infrastructure as a Service) business in which Amazon is so much a leader as to have no clear comparisons.

Parking that point, the retail business is awarded a 1.5x multiple of Gross Merchandise Value or sales. The methodology is explained as “we believe is justified as large retailer peer Walmart trades at ~0.6x GMV and as Amazon has a meaningfully higher growth profile.”

If that same analyst had applied the same logic but had awarded a 1.0x multiple (still a 66% premium to Walmart) he would have arrived at US$1,750 a share, 11% below the share price today.

Over at UBS a blend of valuation techniques is deployed, including sum-of-the-parts. On that basis, web services is awarded an EV/Sales multiple of 7.5x, first party sales 2x, third party sales 4.5x. That model sums to US$2,130/share. No particular explanations are given for the choice of sales-based multiples which are, at best, relative measures. Of considerable concern is that the underlying logic is possibly driven by Amazon relative to itself. The steepest price target extant currently is Morgan Stanley at US$2,500/share but their techniques and methodology are not known to us.

Do the analysts of large banks realise the extent to which they have pushed their forecasts? Mechanically speaking, yes. A number here, a number there, the methodology is being retrofitted to the current share price plus a bit. Amazon.com is a formidable commercial enterprise that currently has bubble valuations attached to it.

 

1EBITDA – Earnings Before Interest, Tax and Depreciation

EBIT – Earnings Before Interest and Tax

NOPLAT – Net Operating Profit Less Adjusted Taxes

NOPAT- Net Operating Profit After Tax

Added by the author:-

JMIU – Just Make It Up

CMWIAO – Call Me When Its All Over

 

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By |2018-09-17T09:00:15+00:00September 17th, 2018|Bottom Up, Cerno Capital Posts, Other Posts|

About the Author:

James is a co-founder of Cerno Capital and lead manages a number of the firm’s collective and private portfolios. After qualifying as a chartered accountant in London (Coopers & Lybrand, 1989) he relocated to Asia. Between 1991 and 2004 he worked as an equity analyst, head of research, and latterly as an equity strategist at WI Carr, Paribas, HSBC and UBS, based variously in Hong Kong, Singapore and Jakarta. James graduated from the University of St Andrews, Scotland with an MA in Philosophy & Logic in 1986. James is a Member of the Chartered Institute for Securities & Investment.