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:
WMT
Rev + Income 1980: $1.258bn / $41 mil
Rev + Income 1994: $67.345bn / $2.333bnMSFT
Rev + Income 1986: $198 mil / $39 mil
Rev + Income + FCF 2000: $22.956bn / $9.421bn / $10.547bnAMZN
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.
Second, you need to have Amazon’s business mature and for them to reduce capital expenditures along the way. Most of the folks we admire who are holding the stock use analysis which slaps 5% profit margins on their copious sales levels. We wonder why Amazon is running so far behind Walmart and Microsoft’s history in their progression toward earnings and free-cash flow. To a certain extent, it is not what is being demanded by Amazon’s current and potential shareholders; therefore, there is no disappointment. Growth has outperformed value the last couple of years in the U.S. stock market.
We think Amazon should be concerned with what we call the “be careful what you wish for” effect. If a classic high-growth company slows revenue growth and reduces capex spending to become highly profitable, it allows earnings metrics which are useful in computing value. Microsoft and Walmart certainly became poorer performing stocks when their P/E ratio contracted, even though profitability and free-cash flow moved higher later. If Amazon became significantly and meaningfully profitable and did generate consistently high free-cash flow, it would be easier to value. In the land of high P/E growth stocks, we think that is a bit of a faux pas.
Third, the recent New York Times article, “Inside Amazon: Wrestling Big Ideas in a Bruising Workplace,” which criticized the environment at Amazon, can’t be the beginning of the kind of push back which Walmart and Microsoft experienced. The public viewed Walmart negatively for putting smaller retailers out of business via their presence and low prices. At least Walmart put smaller competitors out of business to create a profit and paid income taxes on those profits. The market share taken from other retailers by Amazon has moved the revenues from a place that produced profit in the past to one which has yet to show significant or consistent profitability. In effect, Amazon was a “non-profit” organization in 2014.
By the late 1990s, the public and the media accused Microsoft of being a monopolist, so much so that the television show The Simpsons dedicated an episode to Bill Gates buying out Homer’s company. The backlash occurred because Microsoft did something which nobody else did. Their software allowed humans to use computing without having to write code themselves and was put into almost every major computer manufacturer’s product. Being hated as a corporation, especially if you are trying to sell people something is not a plus.
Fourth, like Microsoft, Amazon must perpetuate what former Microsoft CFO Greg Maffei called, “the virtuous circle.” Folks are willing to work very hard for five to seven years at a time if there is a sizable carrot on the end of the stick. Maffei described a circle at Microsoft where extremely bright folks would accept a lower salary with a stock option package. The lower salaries and company performance caused a rising stock price. The share price momentum caused huge additional option exercise compensation. This attracted more talented people and the circle was perpetuated. The tech bubble broke in 2000 and, combined with a business slowdown for Microsoft, the “virtuous circle” stopped in the early 2000s. Amazon is at the mercy of a gracious bull market which likes high sales growth stories and has kept their circle in force.
Finally, Amazon must prove that providing the transportation of the goods purchased by the buyer is a winning formula. I’ll never forget when the senior managing partner at Anderson Consulting (now Accenture) left the company to lead a startup dot-com IPO called Webvan. He walked away from massive wealth created by the public offering three years later of Accenture (ACN) and Webvan joined the list of failed grocery delivery companies. Can any business be highly profitable which delivers to the customer and absorbs the cost of delivery?
Based on Amazon’s patchy history of earnings and free-cash flow generation, two of our eight criteria are violated. It appears to have a strong moat, but can it be profitable while absorbing the transportation and logistical expenses? The stock would appear very expensive even if it does step off the gas and allow a 5% profit margin on its massive sales volume. The company’s virtual nature and worldwide participation make its future success seem unlimited and we think that is the main attraction for growth stock investors.
Microsoft and Walmart went through the same kind of explosive growth which Amazon is seeing now. Since then, they both lost their glamour P/E ratio and are now questioned for their ability grow. Some would argue they were too profitable too soon. Their experience is still useful in consider the way common stocks are valued in the marketplace, including companies like Amazon.
Warm Regards,
The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
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