Monday, December 3, 2012

Why I Have Trouble Buying Stock in

Last Friday I went to hear Carlos Kirjner, U.S. Internet Analyst at Bernstein Research.

Carlos follows such names as Google and EBay.  He's a good analyst, and is widely followed by investors.  His recent upgrade of Facebook to a "buy" caused the stock to jump +7% in one day, for example.

Carlos also follows Amazon (AMZN).  In his remarks last week, Carlos mentioned that Amazon is by far his favorite stock in the group that he follows.  In his opinion, Amazon will "out, out perform" the market over the next few years.

Amazon has already been an amazing stock, as the chart above indicates.  Investors who plunked $100 into five years ago have seen the value of their holdings rise to $267, while the market has remained essentially unchanged.

Still, Carlos feels that the good news for Amazon holders has only just begun.  Their eCommerce franchise is of course incredible.  The company is now also expanding into sectors like Amazon Web Services, a highly profitable business for Amazon which offers businesses a variety of internet services.

I wish I say that I have been an aggressive buyer of over the years. My family and I love the company, and have been for years.

But I have largely stayed on the sidelines.

Here's my problem:

While Amazon's revenue growth has been amazing - +35% compound growth rate for the past five years - it still remains only barely profitable.

In 2012, Amazon is expected to generate $62 billion in revenue.  Profits, however, are expected to be just $139 million:  a net margin of 0.2%.

Plugging this in a traditional price/earning metric, Amazon is now trading at a P/E multiple of 3,150x last 12 months earnings.

Next year's earnings are expected to be better.  Even so, if analysts' projections are correct, Amazon is still trading a 142x.

My old-fashioned approach to security analysis has clearly cost me on this stock. Throughout my career I have always looked to buy companies that are trading at a discount to their future earnings potential.  In Amazon's case, however, this approach is apparently not appropriate.

Amazon's bulls have correctly noted that the company's earnings are depressed by the huge amount of capital spending that has done over the years to grow its business.  Company CEO Jeff Bezos was one of the first to recognize the incredible opportunity in commerce that the internet offers, and he passionately believes in reinvesting. Amazon spends virtually all its free cash flow, and gives little back to shareholders.

Under Generally Accepted Accounting Procedures (GAAP), large cap ex in rapidly depreciating assets mean big annual charges against earnings, and understate the earnings power of the Amazon franchise.  Thus, in 2011, earnings were $631 million, but free cash flow (FCF) was $2.5 billion.

Wall Street argues that EBITDA (earnings before interest, taxes, depreciation and amortization) is the more appropriate measure for rapidly growing companies like Amazon.

Comparing the Amazon's valuation versus FCF or EBITDA rather than GAAP earnings makes the valuation less eye-popping.

But I have long had a problem with EBITDA.  Just because there isn't a real cash outlay doesn't mean that there isn't a real economic charge. In this, I think that I am not alone. Here's Warren Buffett's comments in his 2002 Berkshire Hathaway annual report:

Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice.  Doing so implies that depreciation is not truly an expense, given that it is a"non-cash" charge.  That's nonsense.  In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business.

While one can argue that paying attention to Warren Buffett when it comes to investing is almost always a profitable path, in the case of Amazon is has not been helpful.

So far, at least.