Jubak's Journal
Why Amazon.com is worth only $6.80 a share
Amazon recently reported a plan to become profitable by fourth-quarter 2001. But I don't think they can do it. Here's why the current earnings report points to lower numbers -- including the share price you should consider paying.
By Jim Jubak
I’m sure a lot of investors who own Amazon.com (AMZN, news, msgs) are wondering if the stock can ever get back to $91.50, its 52-week high. I’m sure others, who don’t own shares, are trying to figure out if the stock is a buy on the possibility that it can bounce significantly off the recent price of $17.75.
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For my part, I’m not willing to buy into either of those bets. By my calculations, Amazon could be worth as little as $6.80 a share on the company’s fundamentals. And that makes the stock far too risky for me at its current price. Don’t believe that number? Well, here’s my case. Shoot holes in it if you can. (And let me disclose right here that I don’t own shares of Amazon and I’m not now, nor do I intend to ever be, short the stock.)
Profitable in Q4 2001? Yeah, right
The big news out of Amazon’s Jan. 30 earnings release and conference call was the company’s promise that it would turn profitable on an operating basis in the fourth quarter of 2001. Now, operating profit is a far cry from net income or earnings at Amazon. In the fourth quarter of 2000, for example, the company reported a pro forma net loss of just over $90 million. If you throw in all the non-cash charges, such as amortization of good will from Amazon’s acquisitions, however, the loss climbs to about $550 million for the quarter. But even accepting operating profit as the goal, I simply don’t see how the company can reach it by the end of the year.
And that’s because at the same time that the company was drawing this line in the sand on profit, it was also busy lowering its forecasts for revenue growth during 2001. Instead of the 47% growth in revenue to $4 billion that Amazon had projected in October for 2001, now the company estimates that revenue would grow by 20% to 30% to somewhere between $3.3 billion and $3.6 billion in 2001.
I think you can see the bind that these reduced growth projections create for Amazon. At the same time that the company is promising operating profits by the end of the year, it is reducing its projected revenue growth rate for the period. Less revenue coming in but more profits coming out? How is that possible?
Only one way to do that, of course. Cut costs. And that’s exactly what Amazon intends. The company has already announced that it will cut 1,300 jobs, about 15% of its workforce, and close its McDonough, Ga., distribution center, shut a customer service center in Seattle and turn the Seattle distribution center into a seasonal facility.
I don’t think that’s enough to get the job done. In fact, those moves might even make some of Amazon’s immediate costs go up. But more importantly, in my opinion these moves don’t do anything to fix the basic problem with the company, a problem built into the business plan that has turned Amazon into an online retailer with stores selling everything from lipstick to patio furniture. Unless the company radically restructures -- shedding entire business lines, for example -- I don’t see it reaching profitability in 2001, and maybe not in 2002, either.
2 businesses in 1
The best way to understand Amazon’s problem is to realize that the company is really two very separate businesses. First, there’s the relatively mature, but profitable, book, music and video business. And then there are the faster growing but money-losing new businesses, dominated by the consumer electronics store.
The book, music and video business has made immense strides toward reaching operating profitability. This business, which showed a pro forma operating loss of 4% in the fourth quarter of 1999, recorded an 8% operating margin in the fourth quarter of 2000. This business has already met the operating profitability goal that Amazon set for the end of 2001.
But the book, music and video business isn’t growing very fast. In the fourth quarter, revenue grew by just over 11% from the December quarter of 1999. Since this business accounts for about 60% of Amazon’s revenue, that barely double-digit growth rate is quite a problem for a company that has set a goal of growing revenue by 20% to 30% in 2001.
That’s where all the businesses, such as consumer electronics, kitchenware, and tools and hardware, that Amazon lumps together in a category it calls new business come in. Revenue for the new business group grew by 118% in the fourth quarter of 2000 from the fourth quarter of 1999.
Unfortunately, these businesses aren’t very profitable. Most of them, in fact, are in extremely low-margin industries. Take the consumer-electronics business, for example. The net margin at Best Buy (BBY, news, msgs), a traditional consumer-electronics retailer, is a mere 3%. At Circuit City Group (CC, news, msgs), just 2%.
The best way to track just how far Amazon has to go before it reaches even that very modest level of profitability is to look at gross margins at these retailers and in Amazon’s electronics business. Gross margins at Best Buy were 23% for the last 12 months and 21% at Circuit City. According to Prudential Securities, the gross margin for the consumer-electronics business at Amazon was, at best, 8%. Quite a gap to close.
But the difference is actually even larger than those numbers suggest once you start to add in all the company-wide costs of fulfilling orders, promoting sales and finding new customers at Amazon. Prudential Securities estimates that once you’ve included those costs, the margin in Amazon’s consumer electronics business is a negative 42%. Every $1 of consumer-electronics revenue shipped out the door cost Amazon.com $1.42.
The question for any investor interested in Amazon is, can the company close that gap between revenue and the cost of revenue -- without killing revenue growth? Lowering fulfillment costs will help, but the company hasn’t delivered rapid improvement in that area even in its existing businesses. Fulfillment costs dropped to 13% of total sales in the December quarter, but that was still above the 12% target that many analysts were hoping for. Cutting promotion costs by eliminating advertising and free shipping would also help, but at some point, reduced spending in those areas produces reduced revenue growth as well. Although Amazon added 4.1 million new customer accounts during the fourth Quarter of 2000, the company’s own figures show that the average Amazon customer stays active for only about two years. Clearly, with that kind of turnover the company can’t reduce spending on acquiring new customers by very much without putting a crimp in revenue growth.
Putting a value on Amazon
Using all these numbers, I think we can begin to set a range of potential values for Amazon shares. If you believe that the company can reach profitability as promised and can achieve the 30% revenue growth that marks the top of the range for 2001, according to the company, I think you get a fair market price of about $17.30 a share for Amazon. I get this number by working from the price-to-sales multiples the market awards to Barnes & Noble (BKS, news, msgs) and Best Buy. Averaging those two companies' price-to-sales ratios of .39 and .72, respectively, I get a blended ratio of .56 and then I triple it to 1.68 to give Amazon full credit for its higher revenue growth rate and its stature as the premier Internet retailer. (That seems extremely generous since Wal-Mart Stores (WMT, news, msgs), which is growing revenue at 20% a year and is clearly a profitable, premier retailer, shows a price-to-sales ratio of just 1.3.) Dividing the $3.6 billion in projected revenue that Amazon gave as the top of the range for sales in 2001 by the 350 million shares outstanding, I get projected revenue of $10.29 a share. Multiply that by my generous 1.68 price-to-sales ratio and you get a price of $17.30 a share.
I’d call that my best-case price for Amazon. Now to the worst-case price.
Imagine that instead of reaching profitability as promised by the end of 2001, Amazon finally has to admit that it can’t produce 20% to 30% growth in its business without generating rivers of red ink. By the end of the year, it’s increasingly obvious to investors that Amazon owns a viable but slow-growing book, music and video business, and an unsustainable set of new businesses that have to be shut down or sold off.
The value of Amazon then gradually sinks to the value of the book, music and video business alone. That book business continues to earn an 8% operating margin, about 150 basis points more than Barnes & Noble. If Amazon’s book, music and video business grew at 11% in 2001, then revenue for 2001 would come to $2.2 billion and operating profit to $175 million, or 50 cents a share. Give Amazon a significant premium to Barnes & Noble’s price-to-earnings ratio of 20 and set Amazon’s multiple at 25. That gives me a market capitalization for Amazon.com of $4.4 billion. Subtract the approximately $2 billion in convertible debt now on the company’s books to get a capitalization of about $2.4 billion. That gives me a price of about $6.80 a share.
Is that a ludicrous valuation? Not at all. At that price per share, Amazon would have a market capitalization of $2.4 billion, well above that of a retailer such as Williams-Sonoma (WSM, news, msgs) at $1.5 billion or Barnes & Noble at $1.7 billion, and probably generous when you consider that shutting down or selling off Amazon’s new business might well generate a liability rather than a profit.
The gap between these two numbers, the $17.30 of my best case and the $6.80 of my worst case, is an indication of exactly how much is riding on Amazon’s ability to stem the tide of red ink at its new businesses and turn at least some of them into profit-generating engines of company growth. Taming that growth without destroying it is a tough task for any management. The difference between $17.30 a share and $6.80 a share is a measure of exactly what’s at risk if Amazon can’t pull it off.
Frankly, although I don’t intend to put a dollar into the stock, I’m hoping that Amazon will beat the odds. If Amazon, a richly funded company with extremely solid management, goes down in flames, it will take the entire concept of Internet retailing down with it. Promising new ideas that are still on paper will stay on paper. Promising concept companies won’t be able to raise the capital they need to bring their ideas to a wider market.
And that would be a shame. As a consumer, I’m rooting for Amazon. As an investor, however, I think I’ll sit this one out.
Update: New Developments on Past Columns
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Shopping for a strong stock? Everything’s relative
On Jan. 29, Ariba (ARBA, news, msgs) announced that it would buy Agile Software (AGIL, news, msgs) for $2.55 billion in Ariba stock. No doubt about it, this acquisition is expensive: Ariba is paying 22 times estimated calendar year 2001 revenue for Agile Software. In the short run, the high price knocked Ariba’s shares down by about 3% in the four sessions after the deal was announced. In the long run, however, I think this deal is exactly what Ariba needs. Analysts have, rightly in my opinion, asked when Ariba would begin to fill the holes in its business-to-business commerce strategy so that the company could offer customers a complete solution to managing everything from design to orders to inventory to procurement to purchasing. The acquisition of Agile Software, which specializes in software to manage the design process from sourcing to distribution, fills in a major missing piece for Ariba. Agile Software is the leading player in design collaboration software. Its 630 customers include Dell Computer (DELL, news, msgs), Hewlett-Packard (HWP, news, msgs), Lucent Technologies (LU, news, msgs) and the medical division of General Electric (GE, news, msgs). But while I’m pleased from a long-term perspective that Ariba is extending its product offerings, this acquisition does convince me that other deals could be coming. Ariba still needs to either develop or buy technology to extend its reach into the supply chain management area now ruled by I2 Technologies (ITWO, news, msgs). Another deal would take another bite out of the stock in the short run. So as of Feb. 2, I’m lowering my target price for Ariba to $70 a share by October 2001 from the previous $82 a share.
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How to find mighty mo’ in an otherwise meek market
It makes me feel comfortable with a company if it manages to execute well in a difficult economic environment. And that’s exactly what GlobeSpan (GSPN, news, msgs) did in the fourth quarter of 2000. On Jan. 25, Globespan reported earnings of 20 cents a share, a penny above analyst estimates, on revenue of $131 million, about 1% above projections. Revenue grew almost 19% from the third quarter of 2000, which seems to indicate that GlobeSpan is gaining market share in the DSL (digital subscriber line) market. I look for the company to increase that share further and to open up new markets at the core of the network with products that are now sampling. A 16-port DSL central office product began sampling in the December quarter as did a new multi-mode chip that can handle both the asymmetric and symmetric flavors of DSL. Over all, GlobeSpan recorded more than150 design wins for new products during the December quarter. The stock isn’t out of the wood yet -- the company’s three biggest customers Cisco Systems (CSCO, news, msgs), Lucent Technologies (LU, news, msgs) and Nortel Networks (NT, news, msgs) have all hedged their forecasts for the first quarter of 2001. But with the stock now trading at just 43 times projected 2001 earnings per share of 87 cents while earnings are forecast to grow by better than 70% this year, the stock seems very reasonably priced for solid gains in 2001. To reflect the current limited visibility at many of GlobeSpan’s customers, however, I’m cutting my target price on the stock to $63 a share by December 2001 from the current target of $155 by June.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Ariba, Cisco Systems, GlobeSpan, and Nortel Networks.
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