Monday, October 3, 2011

Amazon Sells Kindle Fire Below Cost

Well, can't say I'm exactly surprised. This Barron's article on Amazon's (AMZN) new $ 199 Kindle Fire tablet points out the cost per unit is higher than what they sell it for at $ 209.

In contrast, Apple's (AAPL) iPad (the original) sells for an entry level price of $ 499 and has a 46% gross profit.

I think Amazon has a pretty good chance of having a superb business down the road (it's not too bad now, of course).

The company has many strengths but its business success up to now is assisted by 1) the willingness of shareholders to put up temporarily with its rather modest profitability ("investing for growth") along with 2) a stock "currency" that has consistently had an extreme valuation.

Amazon's stock success has been, up to now at least, assisted by shareholder willingness to pay for promise yet to be realized.

Shareholders that bought Amazon while it was more reasonably valued (i.e. some of the smart long-term holders who bought it before roughly 2007) have already done just fine. There is also more than a reasonable chance that those shareholders end up making very nice risk-adjusted returns relative to what Amazon's intrinsic value will be in five or ten years.

In contrast, those that have bought or are buying the stock at a more inflated multiple will, at least on a risk-adjusted basis, likely get somewhat less than satisfactory returns in the long run (even if the stock happens to go up much higher near-term).

The share count of Amazon has grown from 364 to 460 million in ten years (a 26% increase). Allowing the share count to grow when the stock is generally expensive is not necessarily at all unwise. Shares could even be sold to raise capital while it trades above intrinsic value.

A good thing for shareholders who paid a reasonable price?

Possibly.

A good for the shareholders "paying for promise" and, as a result, buying well above intrinsic value?

Less likely.

When it comes to Amazon, I've never been able to come to estimating intrinsic value in a meaningful way. That's why I've never considered owning it. Others, no doubt, have a better idea what it's worth now and what it might be worth down the road.

Shareholders in Amazon today own a stock with a market value of roughly $ 100 billion that is expected to earn less than $ 1 billion in 2011.

That 2011 earnings number has actually shrunk year over year.

As a comparison, Apple will actually earn more like $ 26 billion this year, up from $ 14 billion the year before, and has  ~22% of its market value in cash and investments with no debt.

In fact, it won't surprise me if Amazon continues the process of going from very overvalued to even more overvalued. (Though, as always, I have no specific view on near-term or even intermediate-term price action.) That process often continues, for many years sometimes, up until the point when the business materially fails to deliver on its promise or, somewhat counterintuitively, does deliver on its promise but it's clear that growth is slowing. At that point, the earnings multiple contraction process (what investors are willing to pay per dollar of current earnings) usually seriously hurts whoever got in late.
(Of course, Amazon's growth rate will eventually inevitably slow but the question is when. Another important question is: When and how long will it be before Amazon starts making some real money?)

Once that happens, there is the inevitable shift from the extreme growth-oriented investors and momentum traders to those more long-term value-oriented. It's during that kind of transition where bargain valuations sometimes arrive.

To some extent, that is what happened to eBay (EBAY) when investors began seeing growth of its marketplace business wane (interestingly, eBay never got the "investing for growth" pass from shareholders because the top line revenue wasn't growing enough even though earnings and free cash flow was superior to Amazon's).

High Growth eBay in 2004
Enterprise Value (EV) = $ 78 billion
Earnings = $ 778 million
EV/Earnings = 100x

Slow Growth eBay in 2010
Enterprise Value (EV) = $ 19 billion
Earnings = $ 1.8 billion
EV/Earning = 10.5x

More than 2x earnings power yet valuation dropped by more than 75%.

So the promise of growing $ 778 million rapidly was 4 times more valuable than the reality of earning $ 1.8 billion at a slower rate of growth.

Back to Amazon. So while Amazon is not of much interest now to most value-oriented investors, if it did become a bargain during the transition, that's precisely who could become interested as long as it was clear a sustainable economic moat had been built.

The high-powered return potential would be gone along with the possibility for high-powered losses. Missing a potential big winner is not a big deal. Exposure to a potential big permanent loss of capital is unacceptable.

If Amazon does get cheap someday and builds a durable moat around its business, value investors should be sure to thank all of those investors/traders who paid "too much", made very little on a risk-adjusted basis in the aggregate*, but at least ended up creating an environment (intentionally or by accident) over the years that allowed Amazon's business to be built into something worthwhile and durable.

Too often, management at a company is forced into managing the business to meet quarterly expectations.

Still, paying an extreme multiple is only admirable if, as an investor, one views the high probability of making modest or worse returns at great risk in order to support a company's cause to be a good thing.

Well done to those that bought Amazon reasonably cheap many years and stuck with it.

Again, at least for me, Amazon has been and remains a very tough to value company.

So, in some ways, I think a better description may be difficult-to-value instead of overvalued. If I can't value something within a narrow enough range, it's pretty tough to decide how much of a discount to that value is needed to protect against future uncertainties. Amazon may, in fact, justify its valuation someday. I certainly have no idea. It's just that investment is not about valuation ultimately proving to be justified; it's about getting a satisfactory or better return considering risks and alternatives.

Others may, of course, find estimating Amazon's intrinsic value to be more doable. Those who think they can estimate the company's value (with a confidence that's warranted) will be better suited to invest in the shares than myself.

Adam

Long position AAPL and EBAY; No position in AMZN

Related post:
Technology Stocks

* There will be plenty who traded it right, of course, but we likely won't hear much from those who did not. The point is that, in the aggregate, long-term risk-adjusted returns aren't likely to be great from near current prices. Near its current price, the risk of negative returns seems uncomfortably high if things go a bit less well than expected. Having said that, sustained high return on capital over 2 or 3 decades eventually does make an initially expensive looking investment make sense. In the very long run, results tend to be drawn like a magnet toward the return on capital earned by the business. I don't think I have any capacity to even roughly estimate Amazon's return on capital or its sustainability over such a long time horizon.
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