“I know you are a value investor, but if you were forced to own one growth stock with a hugely un-Peridot-like valuation, what would it be?”
I recently was posed this question and I have to say, even though it does go against my overall philosophy when it comes to investing, it is an interesting inquiry to ponder. I would actually say Amazon (AMZN) is the one overvalued stock I would not mind owning. Now, long time readers of this blog will recall I have long warned against Amazon shares. The valuation has always baffled me and raised red flags, but for years such caution was wrong, as the stock has done extraordinarily well. So why today, at $213 per share, 50 times trailing EBITDA, and 86 times 2011 earnings would I pick Amazon as an overvalued stock that might make sense owning? Well, it doesn’t hurt that they have defied my expectations for years, and I don’t think I am the only one.
I never really thought Amazon was going to be anything more than a great online retailer of other people’s goods. And while their position in that space will only strengthen as more and more people become comfortable buying online and allocate a higher percentage of their purchases from storefronts to the web, offering low prices keeps their margins minuscule. In fact, Amazon’s operating margins in 2010 were 4.1% compared with 6.1% for Wal-Mart and 7.8% for Target. It turns out that Amazon’s retail model is not more profitable than bricks and mortar stores, probably because they still need to maintain huge warehouses across the country (fewer bricks, yes, but bricks nonetheless), which is costly, and they have to offer rock bottom prices and free shipping to entice people to buy more online. Amazon has certainly perfected this strategy, but high margin it isn’t.
The part of the story I missed, frankly, was how strong they could be in new markets that they essentially help build from scratch. The Kindle e-reader was Amazon’s first real big venture outside of just trying to beat bricks and mortar stores at their own game. They successfully created a new market and more importantly, one that has the potential to be higher margin than traditional book printing (digital books). Sure, today they don’t make much money on each e-book sold, or the Kindle device itself for that matter (publishers are still setting prices for the most part and keep most of the revenue) but Amazon has the potential to eliminate the middleman in the years ahead. They could become the publisher and help millions of regular authors publish electronically. This is not unlike what Netflix is trying to do by funding their own original tv series now that they have millions of subscribers.
Next up for Amazon is an entrance into the tablet market sometime in the fall. With such a huge library of streaming music, movies, and television shows, there is nothing stopping Amazon from being a heavyweight in digital music and streaming video. Frankly, Amazon can offer a lot more to consumers with a web-enabled Kindle or Amazon-branded tablet versus the Barnes and Noble Nook or yet another me-too Android tablet like the Motorola Xoom or Samsung Galaxy Tab.
Other than Apple, Amazon appears to be the only consumer electronics player that could offer its customers differentiated products. The margins on commoditized Android tablets will head towards zero as everyone cuts prices to the bone to try and grab market share. Amazon seems well positioned to offer more with their products. As a result, they could easily be a formidable competitor to Apple in the tablet and e-reader markets. I’m not saying they pass Apple, but they certainly can pass Samsung, Motorola, HP, and whomever else to be the clear number two player, and I feel good about that prediction even before they have launched many of the products they have in the pipeline.
So what about the stock? Why could it go higher even at its current valuation? Look, at its current market value of $96 billion, I can’t possibly make a valuation case for Amazon stock based on cash flow and earnings in the near-term. However, if you simply look at their addressable market opportunity over the next 5-10 years and compare their market value with other leading technology and retail companies, you begin to see how a bullish argument could be made longer term. Apple is worth $330B. Google $170B. Wal-Mart $185B. Facebook could fetch $100B after its IPO. If Amazon continues to innovate like they have what would stop them from being worth $125B, $150B, or even $200B in five years?
I know I have completely changed my negative tune on Amazon as a stock investment (and don’t get me wrong, as a value investor I am not going to go out and buy it), but since I was asked the question, if I had to own one seemingly grossly overvalued stock, that would be the one I would pick. Given what they have done in the last five years, coupled with what they are planning and compared with the values of other companies they compete with, $96B seems a lot more reasonable if you ignore the fact that such a figure is 50 times trailing cash flow, or 86 times this year’s profits.
Full Disclosure: No position in Amazon at the time of writing, but positions may change at any time