Amazon’s Cash Flows Remain Nearly Impossible To Value For Investment Purposes

Over the course of the January-October snapshot of this year, shares of Amazon have tumbled 30% (recently settling into a range in the $280s, below its recent high of over $400 per share). Two of you have written to ask me whether this is an opportunity purchase a growth stock investment at a value price.

My answer? This is a situation that firmly belongs in the “too hard” pile, an idea borrowed from Charlie Munger. One of the things that is an important with investing—among other things—is to figure out your circle of competence and stick to making decisions there. I can look at the extent of BP’s oil reserves, take a look at the likelihood of a big settlement/measure its potential effect on the company, and figure out that it’s wise to purchase the stock in the low $40s if you have a 10+ year time horizon in mind. The amount of money you make from reinvesting the dividends along the way, plus the capital appreciation, seems so likely that I’d rather spend my time focusing on building on strengths there rather than making actual financial decisions on things I don’t understand as well (really, the vastness of BP continues to be underestimated in most financial commentary I read on the company—its current profit engine is to the tune of $14 billion per year, even with all the asset sales, it is still 7x as profitable as the legendary American grocer Kraft that I just wrote about).

Amazon, meanwhile, remains perplexing because it keeps growing all this revenue but is unable to convert that revenue growth into profits. There’s no doubt that the business keeps getting bigger and bigger—its revenue has grown at a 29% annual clip during the 2000s and 2010s. It went from generating $6.9 billion in revenue in 2004 to having a realistic chance of crossing $90 billion in revenue this year. Each share went from representing $17 in revenue in 2004 to almost $200 per share in 2014.

The problem? Those revenue gains have not, and do not, get converted into profits that can be extracted from the business. In 2010, Amazon made $1.1 billion in profit, and that proved to be the high—things have steadily drifted downwards since then, with Amazon essentially expected to break-even this year (most recent profit forecasts expect $10-$50 million in profit this year, a mere rounding error when compared to Amazon’s market cap figure of $132 billion). Its current profit margin is 0.4% (Wal-Mart’s profit margin, in contrast, is 3-5% depending on the item).

There’s a compelling pro and con side to those predicting Amazon’s future:

The pro side argues that once Amazon achieves thorough market domination, it will have eliminated so much of the competition, and will have become such a habit of customers, that it will be able to raise prices without losing many customers. This is the coiled spring Amazon theory—all these revenue gains represent potential profit that could materialize very quickly once the time for price hikes come. This is why you see some analysts predicting that Amazon will make $8 billion in profits five years from now.

The con side of the argument will respond by saying this: The reason Amazon has been able to achieve its growth is because it essentially runs its business at cost. If it tries to reach for profits, people will just drive five minutes to Wal-Mart, or browse Craigslist or Ebay to get the item they want. The reason Amazon doesn’t make a profit is because its business model doesn’t lend itself to high profits—if it raises prices to pass on dividends or share buybacks to its shareowners—it will lose significant market-share. For the past ten years, analysts have been predicting lucrative profits down the road in a couple years, but that hasn’t come. Maybe it’s because Amazon can’t.

Furthermore, the valuation on the stock doesn’t lend itself very well to a margin of safety concept—let’s say Amazon does make $8 billion in profits in 2019, and trades at 25x profits then (a recognition of the upper limit valuation range for mega-cap, mature companies). That gives you a $200 billion market cap valuation range. In this regard, the $400 to $280 price decline does make Amazon more attractive; when Amazon topped out as a $188 billion company in January, it seemed to be priced in at its potential fair value five years from now (under optimistic conditions). Now, with a $130 billion market value, you can at least see a path to positive returns five years from now if things worked out according to a realistic best-case scenario that took its market-cap justifiably to the $200 billion range in 2019 (Note: normally, I wouldn’t use market cap changes as a proxy for total returns, but since the company has been keeping its share count mostly static in recent years and doesn’t pay out a dividend, it makes for an accurate comparison of investor returns. When these conditions change, market cap would quickly become an inaccurate tracker of investor returns).

Even though Amazon stock is more attractive than it was earlier this year, I still share similar thoughts concerning the stock. Analysts continue to expect Amazon to make significant profits a few years from now, and I think it’s worth keeping in mind that this is a rosy projection we’re talking about—after all, Amazon has never sustained profits above $1 billion per year for two years in a row. That’s a problem when you’re talking about companies with a valuation north of $100 billion. And even if those profits do come (which is speculative, but not wildly so) someday, you’re still going to have to deal with an eventual valuation in the 25x profits range. Could Amazon post very high profits five years from now and trade at something like 40x profits? Sure, of course. But the number of things that need to go right are substantial enough that buying Amazon stock still seems to go against the spirit of everything Graham and Dodd advised.