Security Valuation: What Can Microsoft and Walmart Teach Us about Amazon?

by William Smead, Smead Capital Management

While most investors and the media consider the merits of Amazon’s workplace environment, we at Smead Capital Management would like to think about the purpose of owning a business and how today’s stock market chooses to price securities. In our case, we choose to analyze companies as if we were buying the whole business at current quotes, not just a small part. We think about Amazon the way we think about all companies—being the receiver of the future profits and free-cash flows.

We study business models and reflect on them in relation to our eight criteria for stock selection. We appreciate the technological simplicity of Amazon’s website and their high customer satisfaction. It meets an economic need, the first of our eight criteria for stock selection. Also, Amazon has created huge wealth in stock price appreciation over its life as a public company. So does this make for a meritorious investment to value investors like us?

To understand how we think about securities and Amazon (AMZN) in particular, we will look back at the profits and free-cash flow of Microsoft (MSFT) in its first 14 years as a public company and the sales and profits of Walmart (WMT) from 1980 to 1994. We chose these time periods because they included some of their fastest revenue growth as public companies. Additionally, we like the comparison because Amazon is both a massive retailer and a big technology organization. The attraction Amazon’s common shares have in the stock market comes from rapid sales growth and a low price-to-sales ratio. Rapid sales growth is scarce today and Amazon’s sales success exists in an economy that has had a hard time producing sales growth the last five years.

Here are the numbers:

Rev + Income 1980: $1.258bn / $41 mil
Rev + Income 1994: $67.345bn / $2.333bn

Rev + Income 1986: $198 mil / $39 mil
Rev + Income + FCF 2000: $22.956bn / $9.421bn / $10.547bn

Rev + Income 2000: $2.762bn / -$1.411 Bn
Rev + Income + FCF 2014: $88.988bn / -$241 mil / $1.949 bn

*All income numbers are GAAP
Source: Bloomberg

Walmart grew its sales more than fifty-fold in 14 years and turned an operating profit of $2.3 billion in 1994. In defense of Amazon, Walmart didn’t have positive free-cash flow until 1998, as store openings caused capital expenditures to be very high during its heaviest growth phase. However, Amazon reported an operating loss of $241 million last year (2014) with $1.9 billion in free-cash flow on nearly $89 billion of revenue.

Microsoft grew revenue 110-fold in their first 14 years as a public company and produced $9.4 billion of operating profit by 2000. Their free-cash flow was a gusher at $10.5 billion. Amazon has grown 32-fold in sales and produced a fifth of the free-cash flow. Since its stock trades at a total market value of $250 billion, its shares trade at a multiple of over 125 times last year’s free cash flow. The average stock in the S&P 500 Index traded at a multiple of trailing free-cash flow of less than 20 at the end of 2014.

To justify the current price of Amazon, we think you need some major things to happen. First, you need a market that is willing to pay up for scarce sales growth to continue. The worst thing that could happen in the U.S. for Amazon would be a shift to home buying and household formation in a prosperous era of economic growth. Most of the economic prediction experts are dour bond market professionals and lean toward promoting a Malthusian view of the future. This period of austerity seems to be a key component of Amazon’s strategic success (low prices, free delivery, etc.) and could go on a long time.

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