Why is Amazon such an expensive stock?

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boglerocks
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Why is Amazon such an expensive stock?

Post by boglerocks » Tue Jan 08, 2013 4:46 pm

I'm baffled by Amazon's share price given that they don't make any money. Bezos says his business model is not about profits but instead about something called "free cash" which I don't understand:

http://www.insidermonkey.com/blog/amazo ... zos-34917/

I've read they want to attract customers through cheap shopping so they can sell them higher-margin stuff like the Kindle, but profits aren't even the goal according to the article above. I don't get it. Does anyone else?

genjix
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Re: Why is Amazon such an expensive stock?

Post by genjix » Tue Jan 08, 2013 4:48 pm

I think because of potential, they are taking out big box stores like best buy and growth hasn't peaked. Walmart should be afraid of them too, the good thing is walmart has food which people like to buy live, not digitally

Or more likely
there is probably a ton of short positions, so major institutions probably long it to create a short squeeze and tons of retail investors getting margin calls and losing their shirts. Once a big batch of short positions are squeezed, then the institutions will short and there you see the correction

Edit**
Last edited by genjix on Tue Jan 08, 2013 5:16 pm, edited 3 times in total.

assumer
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Re: Why is Amazon such an expensive stock?

Post by assumer » Tue Jan 08, 2013 4:51 pm

It seems to me from reading that article that they aren't focusing on maximizing the profit per item sold, which companies may do.

Rather, with low profit margins (but still positive), they have huge volumes of transactions, and almost no comparable competition. So they attract the volume with low profit per item, which ends up yielding a lot of profit in the end, but that isn't necessarily their "original goal."

That's my take on the article.

illcrx
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Re: Why is Amazon such an expensive stock?

Post by illcrx » Tue Jan 08, 2013 5:04 pm

I am with you on this one, I trade stock actively and while AMZN is at all time highs they still dont make much sense on the fundamental basis, they make no money on their kindle, they are branching off in so many directions that if something goes wrong there is a lot of risk there.

Yes they grow well but its like a supermarket, their margins suck but they flow through so many clients they can make money. I guess they are waiting for the one day Amazon jacks everything up 20% lol then they'll have some good EPS numbers.

I dont trade or invest in it.

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ryuns
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Re: Why is Amazon such an expensive stock?

Post by ryuns » Tue Jan 08, 2013 5:16 pm

I read an interesting article/theory on this recently: http://www.slate.com/blogs/moneybox/201 ... y_all.html
An inconvenience is only an adventure wrongly considered; an adventure is an inconvenience rightly considered. -- GK Chesterton

ProfessorX
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Re: Why is Amazon such an expensive stock?

Post by ProfessorX » Tue Jan 08, 2013 5:19 pm

Walmart.com is cheaper on many items than even Amazon, and their online ordering system + free shipping is almost as good.

For many items, like Diapers for my son, I almost exclusively order from Walmart these days because of the price savings.

genjix
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Re: Why is Amazon such an expensive stock?

Post by genjix » Tue Jan 08, 2013 5:22 pm

ProfessorX wrote:Walmart.com is cheaper on many items than even Amazon, and their online ordering system + free shipping is almost as good.

For many items, like Diapers for my son, I almost exclusively order from Walmart these days because of the price savings.
Probably true, but a lot of people order from amazon because of their return policy, especially the higher end items.

ProfessorX
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Re: Why is Amazon such an expensive stock?

Post by ProfessorX » Tue Jan 08, 2013 5:28 pm

genjix wrote:
ProfessorX wrote:Walmart.com is cheaper on many items than even Amazon, and their online ordering system + free shipping is almost as good.

For many items, like Diapers for my son, I almost exclusively order from Walmart these days because of the price savings.
Probably true, but a lot of people order from amazon because of their return policy, especially the higher end items.
I would rather order from Amazon for higher end items too; in particular I just bought a Panasonic p50ut50 Plasma TV from Amazon. Walmart didn't even list this item on their web page.

On the other hand, I just bought a "3 Sprouts Storage Bin" for my Son. Amazon was selling these things (it was an Amazon reseller) for almost double MSRP. Walmart had them for regular price with free shipping. The "3 Sprouts Storage Bin" is actually a hard to find niche item, but Walmart had it for the regular price.

latentpricing
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Re: Why is Amazon such an expensive stock?

Post by latentpricing » Tue Jan 08, 2013 5:42 pm

Here is a good long thesis on AMZN which explains why some investors are willing to value the company using such a high multiple.

swaption
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Re: Why is Amazon such an expensive stock?

Post by swaption » Tue Jan 08, 2013 5:51 pm

There is a great book I read about A&P, the supermarket chain. Many may not realize that for several decades into the early 60's, A&P was the largets retailer in the country, at some points by a wide margin. Bigger than Sears and many other noteoworthy companies. The book was a fascinating read as it was Schumpeter's creative destruction in action, with all the technological advances enabling the growth that crushed the smaller markets (refrigeration, automobiles, etc.). Not surprisingly, and particularly so given that this covered the depression, the government played a big role in the story.

Besides being a great book, the story brings Amazon to mind. I can't really say where it all goes, but seldom do trends such as these reverse themselves. It may almost sound funny to refer to Amazon as the next A&P, but this is probably what investors have in mind.

jcw
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Re: Why is Amazon such an expensive stock?

Post by jcw » Tue Jan 08, 2013 6:15 pm

The article is confusing but my interpretation is that Amazon is trying to maximize operational cash flows. That is the money you generate from operations minus working capital needs (inventory, accounts payable), employee, marketing, and other operational expenses. If you have a ton of operational cash flow, you could use that money to invest in capital expenditures (like servers, delivery services etc). This, in turn, allows your business to scale up and serve your customers cheaper. In business terms, it lowers your marginal cost to serve. Once you have scaled up and taken over the market (like walmart), it becomes almost impossible for another competitor to serve a customers as cheaply as you and you win the market (if price is the only differentiator). At that point you focus on profits by reducing marketing, capital expenditures, and other costs.

Take Amazon Web Services as an example. Let's assume they generate $100 in operational cash flows. But then they spend $500 on buying new servers and creating better software, etc. Their bottom line profit this year is thus negative (don't know exact calculation because capex shows up in income statement thru depreciation but the point remains). But by investing in the servers and software (fixed costs), they can reduce the cost to add new customers by some amount (and cost to serve existing customers). For example, let's say onboarding a new AWS customer used to cost $10 total and that customer pays $10 per year. It takes a year to break even on that customer. However after you invested in new hardware/software, you can onboard a customer for $5. Now it takes only 6 months to break even, and if your cost to serve is less than competitors, you can do predatory pricing to destroy competition and take larger market share (indeed AWS is pretty cheap!). Additionally, your operational cash flow margins (operating margins) are improved because every new customer you acquire is profitable faster. So even though you were not profitable this year, your operational cash flows should improve a lot next year (due to improved margins and lowered customer acquisition cost). Thus, you can increase operational cashflow and still not be profitable.

By the way, this is what a lot of asset light companies do and why Software-as-a-service/Cloud is so awesome. Even though salesforce is not currently profitable, their marginal cost to bring on a new customer is super low due to capex and the nature of SaaS. If you were to look at Salesforce's income statement and remove the marketing/SG&A expense, they would be HUGELY profitable. It's just that they are trying to acquire as many customers as possible (scaling up) right now. That is why they trade at crazy P/E ratios.

Hope this helps. And someone correct me if I'm wrong.

Valuethinker
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Re: Why is Amazon such an expensive stock?

Post by Valuethinker » Wed Jan 09, 2013 4:32 am

jcw wrote:The article is confusing but my interpretation is that Amazon is trying to maximize operational cash flows. That is the money you generate from operations minus working capital needs (inventory, accounts payable), employee, marketing, and other operational expenses..
Cash Flow from Operations (accounting definition) is usually Operating Profit + Depreciation + Amortization + other non cash items less tax less working capital needs.

The usual metric by which companies are measured is Free Cash Flow = CFO - CFI (cash flow spent on the purchase of fixed assets, net of sale of fixed assets)

Valuethinker
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Re: Why is Amazon such an expensive stock?

Post by Valuethinker » Wed Jan 09, 2013 4:39 am

boglerocks wrote:I'm baffled by Amazon's share price given that they don't make any money. Bezos says his business model is not about profits but instead about something called "free cash" which I don't understand:

http://www.insidermonkey.com/blog/amazo ... zos-34917/

I've read they want to attract customers through cheap shopping so they can sell them higher-margin stuff like the Kindle, but profits aren't even the goal according to the article above. I don't get it. Does anyone else?

it is priced for perfection in execution on their business model. In effect to become the world's largest retailer (in many categories, anyways).

Valuethinker
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Re: Why is Amazon such an expensive stock?

Post by Valuethinker » Wed Jan 09, 2013 5:21 am

jcw wrote: By the way, this is what a lot of asset light companies do and why Software-as-a-service/Cloud is so awesome. Even though salesforce is not currently profitable, their marginal cost to bring on a new customer is super low due to capex and the nature of SaaS. If you were to look at Salesforce's income statement and remove the marketing/SG&A expense, they would be HUGELY profitable. It's just that they are trying to acquire as many customers as possible (scaling up) right now. That is why they trade at crazy P/E ratios.

Hope this helps. And someone correct me if I'm wrong.
Until the market calls 'time' on waiting. Hence the bust of the dot com bubble.

It really depends on whether the customer, once acquired, is lifetime profitable. Ie what is the 'churn' and the true margin of an acquired customer. So with the mobile companies the contracts turned out to be very profitable (but there were bubbles and busts through the evolution of the mobile phone companies, and lots of issues vis a vis funky valuation techniques which did not work etc.).

When an industry finally gets valued on PE ratio, it is mature. Until that time, you see these wild swings of sentiment towards the sector as the market falls in and out of love with the story and the valuation technique.

What is striking about tech companies is that there is a group that has *always* been profitable (and cash generative). I am thinking Microsoft, Apple (various ructions, but fundamentally very high margins on the hardware side), Google, Ebay.

I don't think Amazon really fits that group.

jcw
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Re: Why is Amazon such an expensive stock?

Post by jcw » Wed Jan 09, 2013 5:49 pm

Valuethinker,

Thanks for the clarification on FCF. I always hated doing discounted cash flow analysis and could never remember the details. I could never be a banker or finance guy!

Good point on the customer lifetime value. Amazon should know the churn/retentation rate and will be able to calculate their customer lifetime value. Knowing that allows them to price properly and turn a profit eventually. Perhaps the theory doesn't always work out in real life though.

The tech companies you mentioned that were always cash-flow positive were either hardware companies, multisided platforms, or both. For reference, ebay is a platform play in which they have very little assets and serve to connect two different sides (seller/buyer in this case). The reason they were profitable from the get-to is that they don't have high fixed costs. But more importantly, once a market tips to a platform, people generally don't leave (think Google for search/ads, Facebook for social, Craiglists of classifieds, airbnb for home rentals).

I actually think Amazon does fit that group. They sell hardware (eBook reader) and are also a platform for buying/selling and media distributions (ebooks, tv shows, streaming music). The most interesting thing about amazon is that they are really the only company to have successfully diversified into many completely different models (reseller, msp, hardware, media, infrastructure, cloud).

FYI, I don't own Amazon, have never worked there, and would not advise speculating on their stock. I just think it's an interesting, well run company, with lots of cool products.

awval999
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Re: Why is Amazon such an expensive stock?

Post by awval999 » Wed Jan 09, 2013 6:05 pm

I just want to jump in here for a second--- for a bunch of index investing losers, we are pretty damn good at evaluating a stock when we have to.

Ah yes... AMZN. One of my favorite companies. I literally only do my online shopping on Amazon. But I've long been aware of its ridiculous price. I just had to go check it's P/E. Google tells me it's 3559/1. I lol'd. AMZN is an amazing company. But I wouldn't touch it's stock with a 10 ft pole (not withstanding what is already in my index funds--- of course :D )

Valuethinker
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Re: Why is Amazon such an expensive stock?

Post by Valuethinker » Thu Jan 10, 2013 2:29 am

jcw wrote:Valuethinker,

Thanks for the clarification on FCF. I always hated doing discounted cash flow analysis and could never remember the details. I could never be a banker or finance guy!
Technically the Free Cash Flow you use to do a DCF is different. As per the McKinsey book (Koller) it uses a pro forma (unleveraged) tax charge-- ie you take the tax rate x the EBIT (interest would lower your tax payable).

(FCF in accounting terms is CFO - CFI ie includes the actual tax charge paid).

The tax effect in the model comes through changing the WACC- the weighted average cost of capital. Because interest is tax deductible (cost of debt = borrowing rate x (1 - tax charge), debt is normally cheaper than equity. More leverage, lower discount rate.

I'll shut up now ;-).
I actually think Amazon does fit that group. They sell hardware (eBook reader) and are also a platform for buying/selling and media distributions (ebooks, tv shows, streaming music). The most interesting thing about amazon is that they are really the only company to have successfully diversified into many completely different models (reseller, msp, hardware, media, infrastructure, cloud).

FYI, I don't own Amazon, have never worked there, and would not advise speculating on their stock. I just think it's an interesting, well run company, with lots of cool products.
I agree via innovations like Amazon marketplace, Kindle, Cloud, streaming Amazon has diversified into non-retail businesses. They can still be capital intensive (one of Google's early keys was its use of very cheap inhouse built servers-- Google is hugely capital intensive, with all those data centres).

The question with Amazon (of which I have no view) is whether the growth in those revenue streams offsets its core catalogue & fulfilment business, which tends to be lower (and absolutely low) margins.

In every new industry (think Henry Ford) there is a visionary who grasps the economics of what make the industry work. Larry Ellison and Oracle (scale, market share, pricing, acquisitions). Bill Gates and the PC (wintel dominance, monopoly). Insull (the electricity industry). Whoever drove AT&T. Thomas Watson in the computer business for IBM. The team at Google. John D Rockefeller at Standard Oil. Sam Walton at WalMart (value pricing, logistics efficiency, stand alone big box stores etc.-- a lot of modern logistics was invented at WMT). These are seldom the most technically innovative companies, but they grasp the industry dynamic and execute more successfully.

The winners (see David Wu's masterful book on the comparisons between the internet and the telephone and radio industries) will take all-- build monopolies that will last for generations. Think Ma Bell, or Standard Oil.

That is what drives Bezos. Whether he will succeed or not I don't know. MSFT was the most successful tech stock of its generation, but in the age of the internets, it is struggling.

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