Are Investors Finally Demanding Earnings From Amazon?

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Amazon has been a phenomenal stock since its 1997 IPO with cumulative gains of 600 percent in the past decade (down from a 900 percent gain at its peak a few months ago). Amazon has also been a fantastic business success in terms of revenue growth, now grossing around $80 billion per year. Yet, where Amazon has fallen short is in earning a profit. That is normally a severe shortcoming for a business, but until the past few months it had not seemed to hurt Amazon. The question now is, are investors finally starting to evaluate Amazon's stock price according to normal metrics or will they continue to award the company a stock price with no relationship to business fundamentals?

Amazon's revenue growth is quite high (23 percent in the last quarter), but even growth that rapid does not generally lead a stock to trade at a price to earnings (P/E) ratio of over 400 as Amazon has done in recent times. Amazon's trends don't warrant the stock price as revenue and profit growth both have been declining recently.

The story behind Amazon's stratospheric stock has always been the company's future and the top line growth in customers and gross revenue. People trusted CEO Jeff Bezos' strategy of capturing eyeballs and turning them into buying customers in the belief that down the road he would make money off of them. Bezos has also stated that the company's goal is to make customers happy. Perhaps investors thought that would translate into profits down the road, but most years it has not.

Currently, Amazon's profit margin is running around one-half of one percent. That is vanishingly small. Wal-Mart is a low margin business, with margins that have been shrinking for years as it expands into the famously low-margin grocery business; yet Wal-Mart still earned a 3.36 percent profit margin over the past year.

Coca-Cola has only slightly more than half the revenue of Amazon, yet earns nearly 80 times more profit. Amazon is growing faster, but to produce the same dollars of profit as Coca-Cola, Amazon will need to hit revenue of $1.7 trillion given its current profit margin. That is over three times the size of Wal-Mart, so that is a very big revenue number.

Making recent matters worse for Amazon is the shift in tax treatment for its online sales. Amazon now pays sales tax in twenty states and this number will continue to rise as Amazon clears the decks for its anticipated rollout of same-day delivery. Such rapid delivery will necessitate warehouses in nearly every state, obviating Amazon's past arguments for avoiding sales tax in states in which it did not have an operational footprint.

Some research reported by Jason Del Ray of CNBC suggests that Amazon's sales fell over 9 percent after its customers had to pay sales tax. This makes each customer less valuable and weakens the argument for capturing lots of customers in order to later figure out a way to profit from them.

Amazon supporters have some facts on their side; most importantly, that Amazon spent about $6 billion last year on research and development. Without this R&D spending (which is not normal for a retailer), Amazon would have been running an 8 percent profit margin which is not too bad for a retailer these days. Of course, this begs the question of whether all that R&D will produce something profitable or simply more customers and more revenue.

Amazon is already one of the largest retailers in the world when measured by annual revenues. That suggests that its growth rates will have to slow simply because it will run out of new markets to conquer at some point in the not too distant future. Historically, Amazon's stock has been priced to reflect two premia: one for its growth rate and one for the expectation all those customers would turn profitable at some future date. Today, Amazon's growth rate is slowing and its customers are becoming not more, but less profitable (at least unadjusted for the R&D spending).

The future of Amazon's stock price thus rests on whether enough people remain willing to value the stock based on the same metrics that have applied for the past fifteen years or if its valuation becomes tied to the metrics used for other old, established blue chip stocks. Cisco used to have soaring growth rates and a triple-digit P/E ratio and now sports one in the teens. If Amazon is treated as a mature stock like Cisco, its price will fall a lot further; potentially its stock could go to $15-25 per share.

There is no rule that the market has to value stocks according to fundamentals or any particular metric. As much as economists and finance professors love to talk about efficient markets, stock prices reflect the supply of and demand for that particular stock. For years, demand by investors for Amazon stock has been strong enough to keep its stock price sky high. Business fundamentals cannot predict when that might end. However, if investor psychology changes and Amazon joins the list of other established tech companies that now get valued like old-economy companies, shareholders are in for a frightening fall.

 

Jeffrey Dorfman is a professor of economics at the University of Georgia, and the author of the e-book, Ending the Era of the Free Lunch

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