I have to tell you, I want to like retail juggernaut Amazon.com, Inc. (NASDAQ:AMZN) as an investment. I really do. I am a committed fan of Amazon as a consumer and happily pay up for its Prime service every year. Like most customers, I find the $99 annual fee a small price to pay for free two-day shipping for the year, access to Prime entertainment (though I rely more heavily on Netflix, Inc. (NASDAQ:NFLX) and other perks I am sure I do not use like I should.
The success of AMZN stock has been so resounding that it is frequently mentioned as THE reason that bricks-and-mortar retailing is in crisis mode.
A recent retail survey in the Atlantic details that nine retail bankruptcies have already occurred in 2017, and a multitude of store closures across the current operators. Meanwhile, Amazon’s retail sales have grown firm $16 billion to $80 billion since 2010.
It’s difficult to think of a traditional retailer who is thriving these days. I gave up on investing in Ralph Lauren Corp (NYSE:RL) and Urban Outfitters, Inc. (NASDAQ:URBN) some time ago. Sears Holdings Corp (NASDAQ:SHLD) is thought to be close to bankruptcy, Macy’s Inc (NYSE:M) is closing stores and Staples, Inc. (NASDAQ:SPLS) may eventually sell office supplies online and through its mail-order services that its business customers prefer.
Why Amazon Stock Is King
AMZN stock is benefiting from the convergence of the internet, communicating via mobile devices and cloud computing. Amazon customers shop the internet via mobile phones, and do so while at competing stores. I just did it while at a Barnes & Noble, Inc. (NYSE:BKS) store — a book I purchased was nearly 40% cheaper on Amazon, and I got it shipped to my house the next day.
Amazon also happens to be one of the biggest operators in the cloud. Its Amazon Web Services reported $3.5 billion in sales during the most recent quarter and operating income that is approaching $1 billion quarterly. That was a high percentage (71%) of total company operating income of $1.3 billion.
As you might have guessed, AMZN stock is growing rapidly, and it is expected to continue to do so. Sales growth is projected just above 20% in each of the next two years and should hit $200 billion by the end of next year. Profits are expected to jump from $7.24 per share to $12.44 per share over this same period.
Given the current share price of $918 per share, that is still a pretty rich earnings multiple (187 and 73, respectively). Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL), parent of Google, is growing nearly as fast, and trades below 30 times earnings projections.
This is where the wheels come off for me in terms of investment appeal. I just can’t get comfortable with where the current valuation is for AMZN stock. At a 30 times multiple, the share price should be closer to a ballpark between $21 and $36 per share. In my mind, a $100 share price seems a stretch given the current reported earnings levels — even considering hyper growth for the foreseeable future. Nine times that level just seems silly.
The cash flow picture calms my nerves only slightly. I was excited to read Amazon’s financial slides covering its fourth-quarter 2016 financial results. Page 3 states the following: Long-term goal — optimize free cash flows. The same slide details full year free cash flow (operating cash flow less capital expenditure) jumped 32% year-over-year to $9.6 billion, or close to $20 per share.
A 30x multiple off of that cash flow figure (which is also growing briskly) gets me to $600 per share. However, free cash flow less principal repayments of both capital and finance lease obligations was only $5.7 billion, or less than $12 per share. Now, I’m back to $360 per share — max.
These capital lease obligations essentially account for the massive warehouse space Amazon is having to secure to support its growing empire. It is reasonable to include them as an annual cost of doing business, and therefore subtract them from free cash flow. It will likely slow in the future — Wal-Mart Stores Inc’s (NYSE:WMT) lease obligations are under $1 billion per year.
This brings us to one of the key arguments for investing in Amazon stock — it is ambitiously investing for its future. This future should have ample free cash flows for investors that care about an eventual return on their capital. But, at what price?
Bottom Line on AMZN Stock
My conclusion is that there is too much uncertainty to get comfortable investing in Amazon stock at the current share price. Revenue growth is easily as good as you’ll find with such a large company, and the profits are starting to really come in. But much of the profitability is from AWS, which is another fantastic growth avenue, but also fiercely competitive.
This means, as it stands currently, Amazon doesn’t make much money from its core retail operations. It also has to spend heavily to expand warehouse space. It’s also building out its own fleet of jets to ship goods. Plus, it wants to spend heavily to develop its own entertainment content. Its ambitions are enviable, but also potentially reckless.
And the trading multiples for AMZN stock (both based on earnings and free cash flow) are just too high based off of current profit trends. At this price, I would be inclined to gamble on the recovery of a traditional retailer that trades closer to 10 times earnings. Or invest in Alphabet, which is a comparative steal at closer to 30 times earnings (and cash flow). It may turn out that Amazon benefits its customers most, which I am just fine with.
As of this writing, Ryan Fuhrmann was long shares of Alphabet.
