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Ask the Investor

Question: "Is Amazon a company I should invest in?"

By: Ryan Fulmer, Vice President
Monday, July 3, 2017

In the dot-com stock market bubble one of my friend’s fathers used to ask me, “What does your father, Denny (Beese Fulmer’s co-founder), think of Lucent Technologies?” In the 1990’s Lucent was a high-flying stock that many retail investors chased, but ultimately were disappointed in when the stock price crashed.

 

In many ways, Amazon reminds me of those conversations back in the 1990’s about Lucent Technologies and it seems to be the one company that many clients and friends ask about.

 

The broad stock market currently trades at about a projected18 times the estimated earnings for 2018 with expected net income growth of about 7%.  Amazon currently trades at a projected 85 times the estimated earnings for 2018, but that is because they bring very little of their revenues down to the bottom line.  Their net income is growing much faster than the broad stock market at about 100%, but largely due to starting from such a low net income base.  As a result of the tremendous profit growth, many investors feel the very expensive price-to-earnings multiple is justified.

 

For the last two-and-half years, I have written that the valuation you pay when investing does matter. If the company’s earnings triple, but as an investor you paid too high of a valuation (or gave them too much credit for the growth), then the return on your investment could be close to zero or even negative!

 

This is what happened for many investors during the dot-com stock market bubble. Large companies such as Cisco, Juniper Networks, and Microsoft still exist today, but had you invested late in this technology bubble your return might still be negative even though the earnings have grown considerably over the last decade.

 

Bull investors on Amazon argue that their competitive moat, or what protects them from competitors entering their space, is the incredible size and infrastructure.  This allows them to provide structurally lower prices than their competitors.

 

As a frequent user of Amazon, I appreciate the low prices and convenience of the many products to choose from and direct shipping to our home (free shipping with a Prime subscription).

 

But with very low profitability and a high price-to-earnings multiple the questions become; “How valuable is a company if they are operating on a very low profit margin?” and “When in the lifespan of Amazon will they mark-up the products they sell to earn a reasonable profit?”

 

And, if they do start to mark-up their products to become more profitable, “Will their customers remain loyal or shop somewhere else?”  I also wonder about their expansion into other product categories such as apparel or food.  One analyst speculated that the only profitable retail product category they have is books.

 

As a conservative investor, one of the mental tests I use is to think about what a potential business will look like in three, five or even ten years into the future. What parts of the business do I have confidence in predicting? What areas am I unsure about?

 

How will competitors try to dislodge the company’s niche? Do I feel reasonably certain that they can fend them off? If so, then why?

 

It is hard to answer many of these questions about how Amazon will be able to respond to the marketplace. Sometimes investing in companies with uncertain futures is prudent if all investors agree and the valuation is cheap, but investors seem to be quite bullish on Amazon’s future.

 

 

I’ll continue to be an active user of Amazon, but they need to improve their profitability before I am willing to invest.

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