Do you think Jim Edwards of Business Insider gets his argument right? In a recent article, Mr. Edwards talks about the earnings release that saw Amazon climb $42 per share yesterday to $354 per share, for a one-day gain of 13.7%. Amazon reported profits of $0.45 per share, and given that Amazon is split up into 463 million pieces, we are talking about $200 million in profit from a company that is currently valued at $163 billion.
Here is the most important quote from Edwards’ piece: “In fact, analysts have a long history of misunderstanding Amazon. For years, investors have complained that Amazon is chronically unprofitable. In the early years, after Amazon was founded in 1994, a lot of serious people argued that perhaps Amazon was fundamentally broken, that it would never make money and would eventually collapse.
Instead, Amazon grew and grew, reporting bigger and bigger revenues year after year. But never any profits. A lot of people believe that if a company never makes money, it must, fundamentally, go bankrupt. This isn’t the case, as Amazon proves.
Here is how Amazon actually works: As long as the company can grow its revenues, it can spend any profit it makes on new lines of business that throw off more revenues. Those revenues may also be profitable, and those profits can in turn be immediately spent again on more growth. By eschewing profits, the company can also offer the lowest prices possible (which is why consumers are so loyal to it). Some parts of the company are profitable and fuel growth in others.”
You can click here to read the full argument, titled: “Amazon’s Profit Shows How Few People Understand The Way The Company Works.”
First, I want to comment on the sentence a lot of people believe that if a company never makes money, it must, fundamentally, go bankrupt. When a company makes a profit, the status quo can extend merrily into the future with no mandatory expiration date for the company. Even if Amazon only makes $1 in profit, the suppliers get paid, the employees get paid, the taxes get paid, and no shelf life is required.
However, the second a company ceases to become profitable, the Micawber Principle comes into effect: “Annual income twenty pounds, annual expenditure nineteen, nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought an six, result misery.”
As soon as a company starts losing money, it must access the credit markets to make up for the shortfall. You can either go to the capital markets—issue new shares of Amazon in exchange for cash to cover up your shortfall—or you can open up a credit line with a bank and start borrowing money.
In the case of Amazon specifically, the company really has been profitable for most of its corporate history—the issue has been that the profits have been negligible compared to the revenues and market cap of the stock.
It lost money in 1998 through 2002, and had to issue 50 million shares and borrow $800 million to cover up the shortfall. From 2003 through 2013, Amazon was profitable, eliminating the need to borrow altogether (annual profits were as low as $130 million and as high as $1.1 billion during that time). It was a fiction when investors were saying Amazon makes no profits—at the technical level, Amazon was profitable, and the criticism about no profits at Amazon was just shorthand for saying profits were extraordinary small in comparison to the amount of sales flowing through the website www.amazon.com.
For the 2014 year, Amazon lost over $300 million, and had to issue 4 million shares to bridge the difference (the balance sheet is in conservative shape, with only $3.9 billion in debt). So the image of Amazon as a rule-breaker immune from profitability is false; the truth is that it has been profitable for most of this past generation, and during the years when it has not been profitable, it had to borrow and issue shares just as you would traditionally expect.
To make a better argument—or at least, to give my side of the debate its fair due—it would be better for Mr. Edwards to tweak the statement a lot of people believe that if a company never makes money, it must, fundamentally, go bankrupt into: If a company never makes money, it must, fundamentally, go bankrupt unless outside investors are willing to lend the company money (presumably) based on the belief that the company will eventually become profitable.
Tech startups are notorious for this—they aren’t presently making money but angel investors lend them money for years on end in exchange for ownership interests or high-interest debt—because they believe they will eventually make a handsome sum of money when the business reaches its maturity. What makes Amazon so unique is that high profitability has not yet come in the past two decades, and investors have been waiting especially long for the golden days to arrive. Because Amazon will move over $100 billion worth of goods in 2015, you can at least understand the rationale for why investors believe that good days will eventually arrive.
Of course, most of this has been an academic discussion, and has little to do with the merits of whether Amazon will be a good investment going forward. My opinion is this: Amazon truly is an exceptional company. Financially, revenues have grown 29% annually for the past ten years. Qualitatively, Amazon has become an online Wal-Mart that has managed to out-compete Ebay, Wal-Mart, Target and a whole bunch of formidable competitors by making commerce convenient in ways that were mere pipe dreams a decade ago.
But a great business does not make a long-term stock. We all carry stories around in our heads that inform the decisions we make in life. I think back to the stories of the late 1920s when absolutely insane things were happening—blue-chip banks trading at 16x book value—that eventually went on to cause a whole lot of misery for shareholders during the Great Depression when the valuation fell to ¼ of book value. It was all such an unnecessary wipeout risk.
The thesis with Amazon has long been that profits will “snap back”—like Chevron seeing its profits go from $10 billion in 2009 to $26 billion in 2011—that will make concerns about valuation go away. Even if Amazon were to become immensely popular, and say, make $20 billion per year, that would only justify a double in stock price if the company were valued like Coca-Coca or Procter & Gamble. That’s not risk-adjusted investing when you need every best case scenario to play out in order to double your money.
When you try to put together a good life for yourself, you should stick to the opportunities you understand. I understand how Visa with a 4% earnings yield and 13-15% prolonged growth for 10+ years can create meaningful wealth, so I would rather focus on that. I’m not saying Amazon can’t work out as an investment; rather, I’m saying a lot of rules need to be broken and a lot of best-case scenarios need to be realized for the returns to be respectable. The problem with Amazon’s current valuation is that it waives a middle finger in the air to the entire margin-of-safety principle that was the bedrock of Benjamin Graham’s life work.
Originally posted 2015-02-01 13:20:14.