Amazon: Growing Up to be Wal-Mart

October 5, 2009 at 2:00 am 2 comments

Toddler

Wal-Mart (WMT) got its start almost 50 years ago with its first store in Rogers, Arkansas (1962). Since then, the company has expanded to create a global franchise generating more than $400 billion in revenues with a market capitalization valued at about $190 billion. Amazon.com Inc. (AMZN) is a relative toddler (founded in 1995 by CEO Jeff Bezos) generating about $20 billion in revenue with a market cap about 1/5th that of Wal-Mart. Mr. Bezos graduated summa cum laude, Phi Beta Kappa in electrical engineering and computer science from Princeton University in 1986, and we know he has no problem in thinking big. The evidence can be found in his space travel company, Blue Origin, which is expected to initiate human travel in the upcoming years. Beyond space, Mr. Bezos is presented with a multitude of growth opportunities that have the potential of elevating Amazon from a young toddler into a mature adult like its cousin Wal-Mart.

So how does Mr. Bezos get the company through puberty to adulthood? Well actually, all I believe it will take is just more of the same. The company has created an incredible franchise with huge barriers to entry, if you consider the billions spent on the technology, infrastructure, and its distribution dominance as compared to its e-commerce brethren. Bolting on new categories (whether its jewelry, sporting goods, groceries, private label or digital downloads) can be extremely profitable since unlike Wal-Mart, Amazon doesn’t need to build or reconfigure thousands of stores to expand into new categories. For example, Wal-Mart has opened over 600 Sam’s stores nationally in order to target the wholesale club market. Once a new category is added, the blue-print is rolled out nationally and then eventually internationally. And just like Wal-Mart, as economies of scale are achieved, the cost savings are rolled back into lower prices, which then brings more customers, and even more scale advantages. This virtuous cycle then creates deeper and deeper moats separating itself from competitors.

GROWTH OPPORTUNITIES

Besides just the natural expansion of users purchasing more online and Amazon adding to existing categories, here are some other fertile areas for future growth:

  • Amazon Prime (Free shipping membership is driving incremental revenue and usage).
  • Kindle (This digital reader is already estimated to account for 35% of Amazon’s book sales and some analysts see $2 billion in Kindle revenues by 2012).
  • Zappos.com (This acquisition provides instant dominance in shoes and adjacent product lines).
  • International Expansion (Joyco.com acquisition in China is an example of how Amazon is expanding into emerging markets).
  • New Categories (There are virtually limitless potential categories, but the migration to digital will be key).
  • Cloud Computing, Storage & Other Services (EC2 cloud computing, S3 storage, and other outsourced technology services offer promising opportunities).

TREND IS AMAZON’S FRIEND

Source: U.S. Department of Commerce

Source: U.S. Department of Commerce

E-Commerce sales account for only about 3.6% of total retail sales ($32.4 billion in Q2’09), but as you can see from the chart, the upward sloping trend is the friend of Amazon. With the proliferation of broadband and the natural aging of our next generation of computer-savvy internet users, not only is the number of online shoppers increasing, but the amount of time spent online is escalating as well. If you consider catalog sales (e.g. Land’s End, L.L. Bean, Eddie Bauer, etc.) have represented about 7-8% of total retail sales, there is a lot of head-room left for online sales to catch-up or replace these  sales. Mr. Bezos believes online industry sales can ultimately reach 15% of total retail sales (double catalog sales). Top-rate online franchises like Amazon will be natural beneficiaries of these trends and funnel shoppers through their internet aisles, as a function of these demographic and behavioral tailwinds.

CAPITAL ADVANTAGE

Even when you account for the significantly higher revenue growth rates and growth initiatives (e.g., Kindle, E3, digital, etc) for Amazon relative to Wal-Mart, the capital intensity (as measured by CAPEX/Sales) is still about 70% higher for Wal-Mart as compared to Amazon. For one thing, Amazon does not need to support the some 8,100 stores in 15 countries that Wal-Mart is saddled with, and in turn Amazon can redeploy that capital into areas such as new products, services, and lower delivery costs. Surviving the dot-com bubble bursting, along with paying down billions of debt has afforded Amazon even more capital flexibility.

VALUATION

Valuation can be tricky, especially when you’re talking about a high growth company like Amazon. The exercise becomes a little easier once you realize Amazon is generating about $1.5 billion in free cash flow per year, with $4.3 billion in cash/investments on the balance sheet with virtually no debt in the middle of one of the worst recessions in a generation. At roughly $90 per share, AMZN is trading at over 53x’s Wall Street analysts’ projected earnings of $1.68 for 2009. Jeff Bezos and the rest of the management make it very clear the company is managing their business to one key goal – maximize free cash flow per share (music to my ears – see my article on cash flow). On that basis, AMZN trades at about 25x’s trailing free cash flow and closer to 22x’s if you strip out the $4 billion+ in cash on the balance sheet. If AMZN can grow 15% for the next 5 years (not a given), the valuations just mentioned above could be chopped in half, if price levels and share count remained constant.

With the large run-up in 2009, I have locked in some gains this year, but tactically I will be doing what “Deep Throat” advised in the movie All the President’s Men, and that is to follow the money (cash). If Bezos and Amazon can continue on its current growth trajectory in the coming years, this toddler will mature into a company more closely resembling its cousin Wal-Mart.

Wade S. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management and client accounts do have direct long positions in AMZN and WMT at the time article was originally posted. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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