By Chris Wood, Senior Analyst
Amazon has been in the news a lot lately, thanks to today's unveiling of the new Kindle Fire tablets. There's much excitement surrounding these new tablets and no shortage of commentary we could make on the potential impact of the new devices or the "tablet wars" in general – like how Amazon entered the tablet space less than a year ago and by the second quarter of 2012, it had already captured 5% of the global market; or that the Kindle Fire captured 22% of tablet sales in the US in its first nine months on the market, according to the company. Such figures, while important on their own, will play an important role in the more general topic we're addressing today: Is Amazon.com (AMZN) overvalued?
It's not hard to find Amazon haters. And you might be able to find some who claim it to be one of the most overvalued companies in tech. A quick search on Seeking Alpha yields dozens of articles bashing the company and the stock for being overvalued. The basic arguments against Amazon generally go something like this:
Arguments against Amazon for being overvalued are nothing new. It's been going on since the tech bubble burst. Check out these excerpts from an April 2003 Barron's article titled Bubble Redux:
Amazon's valuation is the most egregious of the Net trio [meaning Yahoo, Amazon, and eBay]. It trades for 80 times projected "pro forma" 2003 profit of 32 cents a share…
It's notable that Amazon's current market value of $10 billion is about four times the combined market capitalization of its two main "bricks and mortar" competitors, Barnes & Noble and Borders, which together are expected to generate twice the profit of Amazon this year. In the bubble era, such comparisons drew scorn from "Net" fans, who argued that cyber stocks deserved enormous premiums over their mainstream rivals, thanks to their fantastic growth prospects. But while Amazon should enjoy decent revenue gains – 20% this year and 15% in 2004 – its growth certainly won't be fantastic.
It's been less than ten years since that article was written, and Amazon's market cap has increased more than tenfold over that time, to a whopping $111.3 billion. So during ten years of claims for being overvalued, Amazon's stock price has climbed ever higher.
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Impressive. And the main reason for this is something that Amazon's detractors often overlook: revenue growth. That last sentence of the old Barron's article reads: "But while Amazon should enjoy decent revenue gains – 20% this year and 15% in 2004 – its growth certainly won't be fantastic." That's where most analysts were wrong. Amazon's growth was and continues to be fantastic. Despite the predictions in the Barron's article, revenue growth in 2003 and 2004 was 34% and 31%, respectively. In fact, from 2002 through 2011 Amazon grew total revenue at a compound annual growth rate (CAGR) of 32%.
Because of this incredible growth, Amazon continues to trade like a growth stock. Growth stocks are often valued by the market on a price-to-sales basis rather than a price-to-earnings basis. [Ed. Note: The use of the terms "sales" and "revenue" are interchangeable here. So when we write "price-to-sales," we also mean "price-to-revenue."] In Amazon's case, its historical average price-to-sales ratio over the period of 2002-2011 is 2.3, with a high of 4.2 in 2003 and a low of 1.2 in 2008. Today, Amazon trades at a multiple of 2.0 times trailing twelve month sales and just 1.8 times forecasted 2012 sales. Thus, in historical terms, Amazon is not currently overvalued at all on a price-to-sales basis.
At this point you might be saying: "Well, so what? Yes, Amazon has grown revenue like a weed, but that has not translated into profits." In other words, perhaps Amazon has generated that growth at the expense of profits. And that's why it's so overvalued – because the stock price keeps going up but profits are not. It's a valid point. And if you're looking at things from a purely historical perspective, it would be correct. But remember, valuation is all about expectations for the future. An investor buys a stock because of the future benefits (in terms of dividends or capital appreciation) he or she expects to accrue from ownership of that stock.
Of course, it's true that the historic performance of a company plays a part (often a big part) in our assessment of what will happen in the future. But if a firm is in the process of transforming itself into something completely different than it has been historically, then we should not weight past events and performance as highly in our analysis. Such is the case with Amazon today. And this is why there's so much disagreement on the company's valuation – it's basically morphing into a new entity before our eyes, and analysts have different expectations about how this will play out in the future.
Our take is that Amazon stands poised to capitalize on the major trends in online business – the continuing disruption of traditional retail and growth of e-commerce in general; the rise of e-books, tablets, and e-readers; the growth in digital music and video distribution; and migration to the almighty Cloud.
Here's the story:
Retail e-commerce sales in the US totaled $194.28 billion in 2011, up 17% from the previous year, according to data from the Census Bureau. Over the same period, total retail sales grew by less than 7%.
The comparison is much more pronounced when we look back just five years. In 2006, total retail sales in the US rang in at $3.94 trillion, slightly above the figure in 2010 and just 6% below the $4.20 trillion generated in 2011. While total retail sales have remained basically stagnant over the past five years, retail e-commerce sales have jumped by more than 85% in that same period of time.
And these are just the figures for the US. The same trend is playing out throughout the developed world.
Of the nearly $195 billion in US retail sales online last year, no company was more dominant than Amazon.com. The online superstore collected more than $26 billion in retail sales in the United States alone – more than 13% of the total retail shopping market online. Another $21 billion of its retail revenues were generated globally, outside of its home country.
Not only is Amazon dominating the online retail-sales game, it is growing its share of the market. Amazon's revenue grew at an annual rate of 40% last year, effectively doubling the rate of growth of the overall e-commerce market. (Growth in the US still slightly outpaces international growth, but international growth improved from 33% in 2010 to 38% in 2011.)
And this where the interesting story lies. When most consumers think of Amazon.com, they think of physical goods like books, toys, games, electronics, and even clothing. But while those physical goods are still the largest and fastest-growing part of the business – the company grew electronics and general-merchandise sales from $18.4 billion in 2010 to $28.7 billion in 2011 – there is another figure buried in those growing piles of t-shirts and gadgets. $2.7 billion: that is the estimated (Amazon won't break out actual numbers) gross revenue the company took in from sales of its Kindle line of e-book readers and tablets in 2011. That's more than 20 million units. The jump from just a few hundred million in sales the year before was dramatic – especially considering that the company lowered prices of the entry-level Kindle from $259 to $99 in less than two years. That lower pricing and increased interest translated to Kindle unit sales jumping more than 177% during last year's holiday season, according to Amazon.
But even more dramatic are the sales that follow on for the company. Those Kindle owners generated an estimated $1.7 billion in digital book sales last year. In the summer of 2011, before the big holiday sales jump, e-book sales rose fast enough to outnumber total sales of both paperback and hardcover books at Amazon. And considering that a large number of those new Kindle users didn't see their devices until late in 2011, that number is poised to rocket upward.
In fact, most analysts are pegging Kindle franchise growth to be in the range of 40-50% this year, driving sales north of $6 billion in total for the year between devices and the digital sales that follow. That would mean that Kindle would then represent more than 10% of Amazon's total retail sales. Juniper Research expects global annual revenue from e-books to increase more than 200% over the next five years.
Those numbers are important for various reasons. First and foremost is margin. While Kindle devices are sold near cost, according to most supply breakdowns, the digital sales that follow are much less costly to the company than its traditional retail sales. No warehouses, no shipping, no returns to manage. For a company like Amazon that has frequently struggled with razor-thin margins, competing largely on price, this changes the nature of its profitability. As online sales increasingly turn to digital goods like e-books, Amazon's margins should improve and profits expand faster than revenues – though that has not happened yet.
Second, those digital sales are expanding beyond just books. With the introduction of the Kindle Fire tablet computers, Amazon has opened up an important new channel with sales of music and video content. Its digital sales outside of books are still nascent, but the company has begun to partner with electronics manufacturers to bundle access to its digital video services with televisions and Blu-Ray players, putting the company head to head with Apple and its dominant iTunes store.
Of course, while Amazon owns e-books, with greater than 70% market share today, the company has a long way to go to catch up with Apple in the rest of the digital-media market. A total of 68.7 million tablets sold in 2011, according to research firm IDC, and only 4.7 million of those were from Amazon's Kindle Fire, introduced late in the year. But Amazon is making up ground. As we noted earlier, the Kindle Fire reportedly captured 22% of tablet sales in the US in its first nine months on the market. Given that annual tablet sales are projected to increase more than 54% to 106.1 million units sold in 2012, Amazon has a tremendous opportunity to grow both its share in the market and overall revenue in a significant way. If the company can just maintain its current market share in that environment, Kindle Fire sales would surpass $3.2 billion for the year, and the company would blow out that $6 billion total Kindle sales projection by a long shot.
Of course it's not all roses. Amazon must overcome the challenge of moving from a warehouse-centric business model to a software-development and digital-distribution powerhouse. For the company, this has meant lots of hiring and a short-term spike in costs even greater than the 40% growth in revenue seen last year. There are many risks ahead regarding execution, and the competitive landscape is only becoming more fierce. But we see a bright future ahead for Amazon. The company today is much more than a low-cost online retailer – it's reinventing itself as part Apple, part Netflix, with a little bit of Rackspace mixed in as its cloud-hosting services business grows, and a touch of Walmart remaining as the core business is going nowhere, not with a brand this strong.
Going back to the original question of whether Amazon is overvalued – we'll leave that up to you to decide, based on your expectations of the future. We will say that our models indicate that the stock is fairly valued around $245, but the price could continue to run up toward $300 over the next couple of years if the company delivers in its transformation efforts. But of course, a hiccup in growth or a failure to deliver over the next six to eight quarters could send the shares down hard.
Right now analyst consensus estimates are calling for $4.40 in earnings per share in 2014. And we should know by then whether Amazon is going to transform its high growth into high profits. Regardless, it should be an interesting trip along the way.
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