Amazon Is Caught in Wall Street’s Trap

AmazonAmazon (AMZN) is a fine business. It’s vacuuming up sales and dominating online retail in a truly extraordinary way. In fact, it’s managed to grow sales by more than 25% over the past five years and by nearly 29% over the last decade. With growth last year of 20%, Amazon just racked up $107 billion in sales versus a meager $8.5 billion in 2005. To put it another way, Amazon’s sales growth of $18 billion in 2015 was more than twice as much as the company sold in total in 2005. That’s the power of compounding. Unfortunately, that hasn’t translated into substantial profits, though last year the company recorded its highest operating profit ever. And this is all contributing to a significant dilemma.

Amazon’s preference for market share over profit is exposing it to a dilemma, even as it helps expand the online behemoth. The thing is, sales growth is bound to slow. Trees don’t grow to the sky, and Amazon cannot own all of ecommerce, try as it might. For now Wall Street has decided that it’s willing to forego its usual demand for profit as Amazon continues to build out its business. Every year some starry-eyed analyst thinks “Gee, this is the year Amazon will turn a substantial profit.” But every year Amazon continues to re-invest its cash into new endeavors across the business spectrum. Amazon management has made it about as clear as possible that it’s not interested in profits.

How Amazon is diworsifying

That’s where the dilemma lies. To sustain its valuation, Amazon has to keep doing things that keep sales growth rising quickly, and that has the potential to turn the company into a 21st century example of diworsification. Much like it did for the conglomerates of the 1960s, the Wall Street hype machine is providing Amazon with a very, very cheap cost of capital through its willingness to bid the stock ever higher (last month notwithstanding) as long as sales keep growing. Currently Amazon has a P/E of 463 on a trailing basis, and an EV/EBITDA multiple of 31, though the vast majority of EBITDA is depreciation.

With that kind of valuation, it makes financial sense for Amazon to do a lot of things that otherwise wouldn’t make sense, either financially or operationally. The 60’s conglomerates just kept buying up other businesses because Wall Street rewarded sales growth. Their stocks spiraled ever higher for years and then finally lower and then much lower.

That process may be repeating with Amazon now, as it expands into businesses that it has little historical operational expertise in, in a bid to maintain sales growth to keep its stratospheric valuation.

Amazon’s investments

Here some of the more recent investments or potential investments:

  • Expansion into trucking. Amazon has already purchased thousands of trailers (but not the trucks) to move merchandise between distribution centers. While Amazon insisted that the trailers will be used by existing partners, former employees claim that the retail giant is looking ultimately to eliminate its shipping partners entirely. Some are suggesting that Amazon may also move into owning trucks as well as the trailers.
  • Expansion into drone delivery. This one has already received plenty of press.
  • Expansion into bricks-and-mortar retail. Amazon already operates one retail location, but a recent comment from GGP (since rescinded) suggested that Amazon was interested in opening 300-400 physical locations. But further reports suggest that Amazon is looking at a 200-store footprint.
  • AmazonFresh grocery delivery. This service is available in just a handful of cities.
  • Expansion into original video content
  • Lukewarm expansion into tablets and smartphones. These have been largely busts, though the Kindle has performed well.
  • Amazon-branded basic products
  • Amazon Web Services. This has been a notable success.

My point isn’t that Amazon isn’t doing a good job or that these investments will be busts. Some areas make a lot of sense, since they fill out and complement Amazon’s core offerings. Amazon-branded goods perform much the same function as traditional store-brand goods at supermarkets, for example, and Kindle allowed Amazon to sell books electronically and create higher customer retention, much as its well done Prime product did. And grocery delivery, if Amazon can get it right, seems like a huge opportunity.

Still, I have to wonder if Amazon’s foray into delivery infrastructure is a good idea. It does allow the company to continue growing sales rapidly. That’s the intention, of course. But it’s also a trap. To continue its robust growth and maintain its high multiple, Amazon has to keep that sales growth up. And that comes at the cost of expanding into businesses that will not add any profit to the company, while making it more difficult for investors to analyze.

Moreover, expanding into bricks-and-mortar can make sense for businesses whose products require customers to experience them in person, but it’s unclear how this channel makes sense, given that Amazon’s already been able to expand its sales so rapidly. How will an Amazon retail experience be markedly better than what’s already out there? Part of the selling proposition thus far is that Amazon would sell books at its online price. So then why should customers go to their stores at all?

No longer a pure play?

So, finally, the less Amazon looks like a “pure play” company, the less attractive it becomes due to its complexity. This was a key lesson of the conglomerate binge of the 1960s. Companies just continued buying other companies (using their inflated stocks as currency) because Wall Street awarded a higher multiple to growth, regardless of how much business sense it made.

In contrast, Amazon is making investments that do (or should) allow its core retail sales to grow, but at the expense of complexity. It’s defying the trend toward simplified and compartmentalized businesses of the last 30-40 years. But like so much else, the company may yet be able to defy conventional wisdom and convince Wall Street to not only continue ignoring its meager profits but also to ignore its increasing complexity. Still, I suspect, some day Wall Street will want to see the money.

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