It seems as though everyone from the “man-on-the-street” to the world’s central bankers cannot agree on where we stand in terms of the outlook for the economy. One week’s good news is often offset by the next week’s bad news. The continual release of seemingly contradictory economic data keeps everyone a little off balance. While statistics are necessary when analyzing the economy, it is well known that data revisions, false signals and surprises are the norm. To quote Benjamin Disraeli: “There are three type of lies—lies, damn lies, and statistics.” As we, and others, attempt to predict the future of the economy, we must rely on statistics that are presented as valid. The debate comes when analysts try to determine what is fact and what is a supposition.
Last quarter, we commented on the slow growth recovery in the U.S. economy and some of the reasons why growth has been so disappointing. However, that slow growth has resulted in the third longest expansion ever recorded in the U.S. Given current global conditions, it is certainly possible that the expansion that started in June 2009 could extend for another two years making it the longest since the founding of the United States. The debate about the future of economic growth generally focuses on expected rates of change. Those that espouse the bear case focus on weakness in retail, low oil prices, low inflation and interest rates, and weak capital spending/investment. The bull argument looks to S&P 500 earnings being stronger than expected, improving global growth, central banks’ more hawkish moves, wealthier consumers, and a positively sloped yield curve. We fall into the Goldilocks camp where the economy is viewed as not too hot and not too cold, partly because central bankers around the world are intent on normalizing their economies. While deciding what “normal” is may be problematic, it most certainly involves higher inflation, higher GDP growth and better employment and wage data. Most monetary officials are cognizant of their limitations and thus, walk a fine line between too much stimulus and too much tightening. In different speeches on June 27th by two Federal Reserve officials, one can see the conflict. Fed Vice Chair Stan Fischer said: “…evidence suggests that periods of elevated risk appetite are frequently accompanied by a rise in leverage at financial intermediaries. This evidence implies that elevated asset valuation pressures today may be indicative of rising vulnerabilities tomorrow.” On the same day in London, Fed Chair Janet Yellen said that the U.S. financial system is “safer and sounder” than it was before 2008 and that while another crisis can’t be excluded, she suggested “it will not be in our lifetime.”
The world has been operating in an extremely low interest rate environment since global interest rates plummeted after the 2008-09 Great Recession. While strong demand for credit has played a role in keeping interest rates low, central bank quantitative easing (QE) programs have been the primary reason. The U.S. Federal Reserve holds approximately $4.5 trillion in bonds on its balance sheet and both the European Central Bank (ECB) and the Bank of Japan (BOJ) have equal amounts. The Fed, which ended its easing programs several quarters ago, has been raising short term rates and is about to begin reducing its balance sheet. The ECB intends to end its QE stimulus in 2018 and should start raising rates thereafter. Despite suggestions that inflation is rising, inflation data globally has been disappointing. Most developed economies have inflation targets of 2%, but only the U.S. has gotten close to its target. In the late 1940s, interest rates were at similar levels as today, and while there are obvious major differences, looking at the 30 years following WWII may give us an insight into our future. During the post WWII period, longer term bond yields rose only about 2.0-2.5% over rolling 10 year periods. (Rates rose and fell more than that during shorter periods as expansions led to credit tightening which then created recessions and lower rates.) It is possible that we are in a similar period now, at least in terms of how well our economy can absorb higher interest rates.
Higher inflation, especially in wages, is the key to fostering higher GDP growth, and higher inflation means higher interest rates. In the U.S., short term rates are essentially controlled by the Federal Reserve while longer term rates are driven by expectations of future inflation. While the Fed’s raising and lowering of short term rates will cool or stimulate economic activity, it has little direct effect on long-term rates. Bonds with longer maturities have more risk because of the uncertainty of future inflation, and an investor wants to be paid for that risk. The Historical Yield Curve chart (recessionary periods are shaded) shows that investors have generally demanded one to two percentage points more in interest to buy a bond maturing in 10 years versus three months. The spread has ranged from about 3.5% to slightly negative, but has been consistent regardless of whether interest rates were 2% (1940s and now) or 12% (early 1980s). When the Fed has raised interest rates to cool inflationary forces, the spread has moved toward zero which ultimately preceded a recession. Currently, the yield curve is still positive but as it has declined, investors have begun to worry that a recession is near. Our view is that until the spread is much closer to zero, a recession is unlikely. Furthermore, if the Fed believes that its actions are likely to create a recession, we are highly confident that they will defer further increases.
In summary, we believe that Goldilocks will prevail for a while longer and the Bears will stay at bay for at least two more years. Eventually we will experience a recession, but until the signals become a little stronger, investors should not worry…too much. One rule that does seem to prevail is that when no one is worried, that is when trouble strikes.
Amazon: The Disruptive Platform
Amazon’s bid to buy Whole Foods for $13.7 billion in late June shocked the retail sector and investors. Over the course of the last two decades, Amazon has morphed from an online seller of books to the preeminent online retailer in the world. Amazon now aims to dominate groceries. Given the disruptive nature of this move and Amazon itself, we believe it’s important to understand how Amazon has grown to its current stature.
The key to understanding why Amazon has been so successful is to drill down to what the company does well. Amazon invests a tremendous amount on meeting its customers’ needs in an automated fashion. The second pillar of the company’s business success is logistics. Amazon moves goods to where they need to go more efficiently than anyone. Finally, investors have provided the funding for the company’s growth, especially through stock compensation, without requiring Amazon to generate significant profits as discussed below.
Regarding customer services, Amazon has always had one of the easiest websites to navigate and purchase products seamlessly. The platform stores payment information, shipping addresses and makes searching previous orders a simple process. Deliveries are exceptionally quick and returns are also handled expeditiously. Amazon will most likely retain this customer service advantage since the company invested $16 billion on technology and content in 2016 and this figure appears to be growing at a rate of 30% annually.
Amazon is also relentlessly focused on driving efficiencies. The company’s goal is to get products and services to its customers as quickly and reliably as possible. In many cases, this goal requires building massive warehouses and transportation depots close to its customers. According to MWPVL, a logistics consulting company, Amazon has almost 150 million square feet of fulfillment centers and transportation hubs. The company has another 40 million square feet in development now. For comparative purposes, the same consultant estimates that Target has roughly 55 million square feet of space in its distribution centers. Amazon is also building its own transportation networks by leasing planes to deliver products between hubs and buying fleets of delivery vehicles in selected markets. The scale of these operations provides an inherent advantage.
Amazon has grown its revenue at an incredible pace. Over the last ten years, the company’s revenues increased almost tenfold from $14.8 billion in 2007 to over $136 billion in 2016. However, the profits generated in this period are much less impressive. Amazon’s profit was $476 million in 2007 and reached $2.3 billion last year. Regardless of the meager profit, investors have bid up the share price of Amazon from $68 per share in June of 2007 to $985 per share now. Amazon has then used its stock to compensate its employees. In 2016, Amazon paid its employees $2.9 billion in stock compensation. These funds allow Amazon to “buy” a lot of talent. Therefore, the markets have given Amazon a funding advantage over its competitors which the company uses to keep enhancing customer experience and distribution to dominate adjacent businesses.
Amazon’s bid for Whole Foods helps jumpstart its grocery business by buying a brand name with affluent customers. Online grocery delivery is growing very rapidly and Amazon should be able to leverage Whole Foods’ expertise to augment its offerings. According to a WSJ/FMI-Hartman Group Survey, the number of households that shop for groceries online “fairly often” or “almost always” increased from 5% to 11% from 2016 to 2017. Whole Foods also controls vital retail locations and its own distribution network that will meld with Amazon’s. Finally, the potential acquisition threatens Wal-Mart, one of the few companies large enough to still compete with Amazon. Wal-Mart is the largest grocer in the country by a significant margin as its annual grocery sales of over $200 billion are four times its next closest rival, Costco. Amazon’s potential acquisition of Whole Foods will compel Wal-Mart to dedicate precious resources to its food business which could allow Amazon to gain further market share elsewhere.
Amazon’s most profitable business is its cloud services where it rents computing power on its servers and networks to third parties. As businesses, academia and consumers migrate to the cloud, Amazon is there to provide the underlying infrastructure allowing customers to rent, rather than own their own hardware. Amazon competes fiercely with Google and Microsoft for this business, yet the earnings from their web services are impressive. While its retail business earns a small operating profit of less than 1% of sales, Amazon Web Services (AWS) produced $3 billion in operating earnings on $12 billion in sales in 2016 (equivalent to an operating margin of 25%).
Much of Amazon’s success has been due to Jeff Bezos, the founder and CEO. Bezos founded Amazon in 1995 after leaving DE Shaw, a quantitative hedge fund. Bezos focused on selling books online since he predicted that growing Internet usage would translate to tremendous retail opportunities. He chose books as the first market since an online store was not constrained by stocking a limited number of titles and volumes. He soon branched out into CDs and DVDs and was dominating multiple retail lines. In addition to his vision, Bezos has also directed the culture of the company to prioritize customer experience and logistics above everything else. Whether or not the corporate culture will be able to flourish without Bezos is an open question. Of note, every annual report since Amazon’s founding contains Bezos’s 1997 letter to shareholders. This repetition suggests that the culture will thrive since it is deeply ingrained in the workforce.
While Amazon’s success has been impressive, the company has failed in certain markets. Amazon purchased Drugstore.com with expectations that it would dominate pharmaceutical sales. This business never materialized. Amazon also tried to launch a cell phone brand, the Fire, to compete with Apple and Samsung that was similarly unsuccessful. However, the company is always experimenting.
Is Amazon’s Stock a Buy?
We follow Amazon closely, but have not added the stock to portfolios. Our investment philosophy is to buy profitable companies with high barriers to entry which trade at reasonable valuations. Through its investments described above, Amazon is continuing to increase the barriers around its business. However, its valuation is extended beyond what we think is reasonable.
We use a quantitative screen to generate ideas for research. Amazon doesn’t fall into the top 10% of our screen results because of its low earnings yield. Earnings yield, calculated as earnings over adjusted market value, shows how much cash an investor is making on a company. Amazon’s earnings yield is below 1% and less than over 90% of the other companies in the S&P 500.
Another way we like to value companies is through a discounted cash flow analysis which gives us an idea of a company’s intrinsic value. Two main components of this model are the assumed revenue growth and the future operating margin—higher revenue growth and an expanding margin increases a company’s intrinsic value. Analysts justify Amazon’s astronomical valuation by projecting high revenue growth and increasing margins. Revenue growth projections of 20% per year over the next 4 years, while tough to meet, may be achievable as more retail moves online and Amazon expands into new markets. The increasing margin is much harder to wrap our head around, and key to justifying its valuation as higher margins mean more cash generated with each dollar of revenue. Analysts estimate the operating margin will approach 9.5% in 5 years from the current 3%.
Amazon only reports on three separate segments: North America, International and Amazon Web Services (AWS). AWS enjoys a very high profit margin of roughly 25%. However, Amazon’s remaining businesses, which primarily include its retailing operation, only manage to achieve profit margins of 1% or less. Most years prior to 2015 actually showed losses in this segment. This low net margin includes revenue from Prime Membership that one would expect to be quite profitable. We do not believe that Amazon will ever reach its required margins of 9-10% because AWS is small relative to the retail business. For comparative purposes, Wal-Mart’s operating margin was 4.7% in 2016.
Amazon uses two accounting techniques to increase its cash flow. The company pays employees in Amazon stock and receives money from its sales much more quickly than it pays its suppliers. Using its stock to cover employment expense works well until the value of Amazon’s stock stops increasing since employees will demand real cash when the stock price falls.
In 2016, Amazon generated $9.7B in cash flow (cash from operations less capital expenditures). Of this amount, $3.9B was from a change in working capital and another $2.9B from stock compensation expense. Amazon has reduced its working capital by collecting revenue from a sale faster (days sales outstanding has fallen the last few years), keeping less inventory (inventory turnover has increased) and increasing the time it takes to pay off suppliers (accounts payable days has increased), resulting in a negative cash conversion cycle. Brick and mortar retailers generally have a positive cash conversion cycle. Amazon has also grown prime subscriptions and unredeemed gift cards, from which it collects the payment up front while recognizing the revenue over the year of the subscription and when redeemed, respectively. Cash conversion, prime subscriptions and gift cards have decreased working capital and increased cash flow, but Amazon can only stretch this so far. Vendors need to be paid eventually and subscriptions and gift cards won’t grow forever. In fact, in the first quarter, subscription revenue fell when compared to the fourth quarter of 2016.
Given the extended valuation based on earnings yield and when using a cash flow model, some would argue the real reason to own Amazon’s stock is that the company will grow to such an extent that it will force all of its retail competitors out of business. Amazon then will have a natural monopoly and raise prices so that its profits soar indefinitely. We do not believe this scenario will develop. Amazon’s largest retail competitor is currently Wal- Mart which generates $486B in sales which is roughly four times Amazon’s retail sales of $124B (excluding AWS). Wal-Mart has the distribution capabilities that Amazon does and with its acquisition of Jet.com it has increased its online focus. In other words, there isn’t a future where Amazon owns all retail and is then able to increase prices (and margins) to new highs. And it’s important to remember that Wal-Mart was considered an unstoppable force a decade ago. Costco is also worth mentioning as it requires members to subscribe (like Amazon’s prime service) and its stores are essentially giant warehouses, cutting out all the fat of fancy displays.
Our investment philosophy concentrates on “safer” companies, which has historically reduced overall portfolio volatility and led to relative outperformance. This strategy may miss exciting winners like Amazon, but this discipline also avoids companies like GoPro, which a few years ago, was supposed to revolutionize the action video market with both its cameras and a YouTube like action video network. GoPro peaked at $87 per share and now trends around $8.
Amazon has revolutionized online retailing. Going forward, we will continue to monitor the company’s stock. We will also pay close attention to its business operations since Amazon’s competitive DNA will continue to disrupt numerous industries.