So far 2014 has been a tough year for Amazon CEO Jeff Bezos. In recent weeks, his net worth reportedly shrank by up to $1 billion thanks to a 16% drop in Amazon’s share price since the start of the year.
The immediate cause of this decline was a worse-than-expected $126 million loss for the second quarter of 2014, but many value investors will be wondering what took the stock market so long to dump Amazon shares.
In his 1997 letter to shareholders, Bezos laid out his plan to build the then fledging internet retailer into a market leader. He asked these early backers to be patient about profits and assured them that “it’s all about the long term”.
The company has since grown into an e-commerce behemoth, with a market cap of $147 billion and sales of its core products of over $70 billion in 2013, more than the next 10 biggest online competitors combined according to data from the trade publication Internet Retailer.
Bezos’s long term plan for Amazon
True to his word, Bezos has relentless invested profits back into the business to expand Amazon into new markets and attract new customers. The result is a 17-year-old company that defies investment logic: it is one of the largest e-commerce firms in the world yet barely turns a profit. Despite this disregard for the bottom line, today Amazon shares are trading at around $333 after hours and those who got in at the ground floor would have seen the value of their stake increase by over 6000%.
Through the years some investors have scratched their heads at the ever rising share price, despite financial multiples that make the company look more like a startup than a market leader. Even with the recent drop in share price, Amazon’s price to earnings ratio is now over six times higher than its peer group average. Both theory and experience say that such a high multiple suggest that the stock is overvalued, as investors are willing to pay much more today for the promise future Amazon earnings than for similar companies like Ebay or Netflix.
“A $300 in your share price implies that the company has $20 of earnings power at the same time. But investors are earning something like a dollar per share,” said Michael Pachter, a digital media analyst for Wedbush Securities. “This difference is the dream that they will magically turn on the profit tap one day,” he added.
Amazon currently performs badly when it comes to measurements of profitability. The company’s return on invested capital, used as an indicator of a company’s ability to turn capital into profitable investments, is 1.76% compared to its peer group average of 18.6%.
So why is this only now starting to bother Amazon shareholders?
“I think the general investor perception coming into 2014 was that they would be exiting an investment cycle and return investors more profit,” said Eric Sheridan, a U.S. internet equity research analyst for UBS.
Amazon’s new investments
Instead Amazon continued to plough revenue into a series of new capital hungry investments. This year it launched the Fire smartphone and Fire TV, a home media streaming console, and announced plans to invest $100 million in media content for its streaming platforms over the coming 12 months.
“Revenue is generating a 25% gross margin, so what are they doing with the rest of it? Some is growing infrastructure and fulfilment centres as well as content spending. But they’re spending it on losing money with Fire TV and Fire phone,” said Pachter.
Another large drain on profits was its cloud computing department, known as Amazon Web Services, which recently dropped its prices while the firm renewed infrastructure investment.
The market may have begun to lose faith in Bezos, as seen by the 10% drop in Amazon’s share price following last month’s disappointing quarterly results, but the majority of bank analysts still have confidence in the Bezos strategy.
“Amazon is not an unprofitable company, they can be profitable if they want to be. It’s a great company and a great brand and it has become mission critical in many people’s lives,” said Sheridan.
The UBS analyst pointed to Amazonfresh, the firm’s same day grocery delivery service, as an example of why the company is on the right track. “That is a perfect amalgamation of what their strategy is. Groceries are not a high margin business and its going to cost a lot of money for refrigeration. But you become that more integrated in people’s lives and are gaining a bigger share of their wallets,” said Sheridan.
Amazon expansion into Asia
This strategy of expanding into every corner of e-commerce in the U.S. and Europe has turned Amazon into one of the world’s top 50 most recognisable brands, according to Forbes magazine. But some of its overseas expansion is worrying analysts. In China and India for example, Amazon is spending billions trying to establish itself in two rapidly growing markets. Yet it faces tough local competition in the form of Flipkart in India and AliBaba and JD in China.
Chinese authorities have become increasingly hostile to foreign firms trying to establish themselves in the country. Officials recently used anti-trust rules to investigate the software giant Microsoft, German carmaker Daimler and the U.S. chip maker Qualcomm.
“The issue of a U.S. internet company being successful in China does raise questions, is it a good idea to lose money in China in a 20 year plan?” said Sheridan.
Bezos’s ambition is well chronicled in ‘The Everything Store’, journalist Brad Stone’s book on Amazon, but at some point such ambition becomes hubris. “The guy is determined to be the biggest retailer in the world, the only real question is how big is big?” said Pachter.