Amazon.com ? 2 August 1999
2
Summary. As Amazon.com?s revenue growth slows, the
shareholder base is transitioning from momentum to
longer-term investors, and, in the process, the stock?s
multiple is compressing. We still expect that a confluence
of positive catalysts in Q4, as well as investor excitement
about the new product offerings, Electronics and Toys,
will drive the stock higher in Q4, as shorter-term investors
are lured back in. Because several of the company?s key
operating metrics?customer acquisition, customer-acquisition
cost, and revenue per customer?are flattening
or deteriorating, however, we continue to believe that
Amazon.com?s shareholders should be prepared to settle in
for the long haul. We continue to believe that
Amazon.com will be one of the industry?s long-term
winners?a large, profitable, fast-growing company that
will be around 5-10 years from now?and that its market
capitalization will ultimately be several times the current
$20 billion. If the trends in the operating metrics don?t
stabilize or improve, however, we believe that
shareholders might have to wait a few years for additional
appreciation in the stock, as the company?s fundamentals
catch up to the valuation.
Many great long-term technology stocks exhibit similar
patterns as the businesses go through different phases.
In the first phase, which we might call hyper-growth, the
stocks are driven by strong sequential revenue growth, and
traditional valuation measures are insufficient tools for
predicting performance. In this period, multiples (on
either revenue or earnings) continue to expand until the
revenue growth trajectory flattens, and valuations often
reach levels that appear ludicrous when juxtaposed with
the rest of the market. When sequential revenue growth
begins to slow (and, not coincidentally, when companies
begin to meet but no longer exceed ?Street? forecasts),
momentum investors who rode the stock all the way up
begin to sell out, driving the stock down, and, ultimately,
valuation begins to matter again. If revenue does not
reaccelerate, the stocks often consolidate well below their
highs and remain in a trading range until the fundamentals
catch up with the valuation. If the companies are strong,
and growth settles into a consistent rate, the stocks then
appreciate at a more stately but steady rate, remaining
within a more typical multiple range. As we have noted in
the last two quarters, we believe that Amazon?s stock is
transitioning between the two phases, as the company?s
growth trajectory changes and momentum investors move
out. We believe that Q4 will provide ample catalysts to
drive the stock higher, but we would not expect to see
sustained appreciation until the company?s revenue growth
rate stabilizes.
Amazon.com?s key operating metrics are trending in the
wrong direction for multiple expansion. Until they
stabilize or start moving in the right direction, the stock?s
multiple, on balance, is likely to compress. Specifically,
revenue growth is decelerating, revenue per customer
(both new and existing) is decreasing, customer acquisition
is flattening, and customer-acquisition cost is increasing.
There are reasonable explanations for all of these trends?
and for most, it was always a question of ?when,? not ?if??
but they nevertheless represent a deterioration of the
fundamentals that have been driving the stock. Multiples
rarely expand in the face of deteriorating fundamentals,
and until the trends stabilize or reverse, we expect
AMZN?s average revenue multiple to remain steady or
compress.
We believe there should be significant upside for long-term
holders?and there are few management teams and
opportunities to which we would rather entrust capital
over the long-term. We continue to believe that
Amazon.com will be one of the industry?s long-term
winners. The combination of one of the strongest, deepest
management teams in the industry (perhaps any industry),
an enormous opportunity, a strong brand, and a great
service offering should allow the company to grow at
impressive rates for a decade or more. Back-of-the-envelope
calculations like those described below,
moreover, suggest that there is significant of upside to the
market capitalization?enough to provide an acceptable
long-term return. We expect, for example, that online
retailing will eventually amount to about 10% of the total
$2.3 trillion annual retailing market, or about $230 billion.
Amazon.com has clearly indicated its intention to be
involved in most aspects of this market, and in most
markets, the industry leader usually ends up with 30%-40%
share. Thirty percent of $230 billion is about $70
billion. Five percent (an estimated net income margin) of
$70 billion is $3.5 billion. A P/E of 40 times $3.5 billion
would generate $150 billion of market capitalization?
about 7.5X Amazon.com?s current market capitalization of
$20 billion. If it took the company 15 years to achieve this
market capitalization, the long-term investor would
recognize a 12% annual return (assuming 3% annual
share-count dilution). If took ten years, the return would
be closer to 20%.
The issues. Amazon analysts are closely watching three
aspects of the company?s performance: revenue growth,
customer acquisition, and revenue-per-customer. We
discuss each of these in detail below.
Deceleration in sequential and year-over-year revenue
growth. It would be impossible for any company to grow
30% sequentially forever?and Amazon.com did it longer
than any company we know of. In the last two quarters,
however, Amazon.com?s sequential revenue growth rate
has dropped from an average in the low 30%-range to 16%
in Q1 and 7% in Q2. Because the major driver of
Amazon?s stock over the last two years has been sequential
revenue growth, it is obviously important to understand
why the growth is slowing, and when it might stabilize.
Amazon.com?s revenue growth is slowing for two reasons:
1) the company?s rate of new customer acquisition is
slowing, and as a result, new customers (which have
higher revenue-per-customer than existing customers) are
contributing a smaller and smaller percentage of overall
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