Before we get to any numbers, charts, of information, let’s establish one basic premise. Just because a company offers customers a great value does not automatically mean the stock is a buy. Investors have to understand that great businesses don’t always make great investments. Peter Lynch outlined this concept perfectly when he talked about companies from Polaroid to RCA, that were world famous brands, but the stock got ahead of the fundamentals. The stocks were bid up to many times their expected growth rate, but when their growth slowed, their stocks either went sideways or nosedived. I know some will say I’m crazy, but there are cold hard facts that suggest Amazon.com, Inc. (NASDAQ:AMZN) may be on the path to being one of these companies.
Let me get this out of the way first. I use Amazon, I have Amazon Prime, and my family bought a lot over this last holiday from Amazon. I’m not suggesting that Amazon isn’t a good business. What I am saying is Amazon is trading based on an investment thesis that is breaking down before our very eyes.
Why Are They Better?
Some of the most talked about reasons for buying Amazon stock is their efficiency, their push toward digital sales, and their huge sales growth. Many investors would scoff at the idea of buying Wal-Mart Stores, Inc. (NYSE:WMT) and their projected EPS growth of 9.2% in the next few years, when analysts are calling for over 41% EPS growth at Amazon. Even if you compare eBay Inc (NASDAQ:EBAY) and their 14.63% expected growth rate, it looks pedestrian compared to Amazon.
Amazon also offers digital content that eBay doesn’t participate in, and Walmart can’t match. Amazon offers the Kindle lineup, and Amazon Prime. Prime is a great hook for future sales, with fast shipping and a streaming video library that is beginning to rival Netflix, Inc. (NASDAQ:NFLX).
Why Are They Worse?
For each of Amazon’s strengths, their competition does a few things better. For instance, neither Wal-Mart nor eBay are projected to grow faster than Amazon, but both generate consistent free cash flow. In fact, while Amazon invests for the future, Wal-Mart generated more than $1 billion in adjusted free cash flow last quarter, or about $0.02 for every dollar of sales. EBay generated about $500 million in free cash flow, or an impressive $0.23 for every dollar of sales. Wal-Mart doesn’t have the huge fulfillment expenses because most of their sales are in store. EBay has a much higher margin business because they essentially help other people sell their wares. In the bigger picture, there are three issues facing Amazon today, and all three are getting harder to overcome on a quarter to quarter basis.
A Digital Breakdown
Amazon has gone to great lengths to tout its digital selection, and the popularity of the Kindle lineup. If digital sales are the future of the company, you wouldn’t know it from the last year or so. Take a look at the growth rate of media sales over the last six quarters:
One would expect as more Kindle devices are sold that media sales would pick up, but the opposite has happened. At best, Amazon managed 19% sales growth, and in the most recent quarter sales growth was just 8%.
What Happened To Their Hyper-growth?
If Amazon isn’t going to make a name for itself in media sales, what about general merchandise sales? If Amazon is killing Best Buy Co., Inc. (NYSE:BBY) due to show-rooming, you would expect merchandise sales to stay strong. While general merchandise sales have grown from 60% of total sales, to 63% in the last year, there is no question that growth is slowing.
Six quarters ago, general merchandise sales grew at a 54% clip. In the last quarter, sales growth slowed to 28%. While 28% growth is nothing to sneeze at, think about this slowdown in concert with the slowdown in media sales and you’ll understand why Amazon reported 22% overall revenue growth.
Every Quarter They Become More Of A Physical Retailer
Each time Amazon commits to building a new multi-million dollar warehouse, I can’t help but think, at what point do all of these expenses pay off? These warehouses increase Amazon’s fixed expenses and require staffing.
In the last year and a half, Amazon’s headcount has increased every quarter by an average of almost 10%.
What’s The Big Deal?
Some investors might be able to ignore all of this and say just wait and see what Amazon can do in the future. I’m suggesting that this isn’t the same fast growth stock it has been in the last few years. Think about it, Amazon is reporting 48% slower growth in merchandise, 58% slower growth in digital sales, and they have 72% more employees than just a year and a half ago.
The big deal is, everyone points to Amazon as the future of retail efficiency and profits. Analysts were surprised by Amazon’s gross margin in the current quarter. I’m not sure why, as their gross margin of 24.13% is still lower than Wal-Mart at 24.94%, and was lower than Amazon’s full year margin of 24.75%. The real model of online efficiency is eBay and their nearly 70% gross margin.
The Bottom Line
Even if Amazon meets analysts targets, shares trade for almost 180 times 2013 projections and 73 times 2014 estimates. Considering the company missed estimates three of the last four quarters, these estimates should be questioned. At 4.39 times their growth rate this year, and even 1.78 times their growth rate next year, the stock carries a significant premium.
Looking at the last year and a half, Amazon’s sales are slowing, their fixed costs are growing, and investors have happily continued buying the shares. Amazon is a great business, but not a great investment at these prices. There is a difference between the two, and I’m afraid some investors are going to learn this lesson the hard way.
The article These 3 Charts Tell A Story, Are Investors Listening? originally appeared on Fool.com and is written by Chad Henage.
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