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Wednesday, December 4, 2013 - 13:00

Forget Drones: Here's Why Amazon's A 'Sell'

Wednesday, December 4, 2013 - 1:00pm

As the Thanksgiving weekend wound to a close Sunday night, I happened to watch the "60 Minutes" interview with Jeff Bezos, the billionaire CEO of Amazon.com (Nasdaq: AMZN).

At the end of the interview Bezos unveiled a "surprise" for correspondent Charlie Rose and his TV viewers, revealing that Amazon is working on building flying drones that can deliver packages directly to customers.

I thought that was maybe a bit far-fetched, but certainly interesting. However, the media grabbed onto the drone story and ran with it. All day Monday, every news channel I watched -- financial and otherwise -- was talking about Bezos, Amazon and drones.

Bezos certainly knows how to create a buzz. What has yet to be seen is whether he can generate profits for Amazon shareholders.

The Buzz Is Great -- How About Some Profits?
Amazon is a fantastic and innovative company. I don't dispute that for a minute -- I think that's an inarguable fact. But another fact that I think investors should be aware of is that this company does not generate significant profits or free cash flow.

It is a bit hard to believe considering that the company is well into its second decade, but it's true. When you consider Amazon's lofty stock market valuation, I think that lack of profitability creates a lot of risk for investors who own shares at the current price.

I think the numbers speak for themselves in this case. Amazon has roughly 460 million shares outstanding and a share price around $390. That gives the company a market capitalization of $180 billion. That is big.

Would you like to know how much net income Amazon is on pace to generate in 2013?

None. Same as last year.

Now before you accuse me of being shortsighted, let me tell you that I "get" the strategy. Amazon intentionally keeps its margins extremely thin to build customer loyalty and critical mass. The company also spends a large amount every year on research and development to further strengthen its online dominance.

I don't just "get" the strategy, I agree with it. What I don't agree with is the price investors are currently willing to pay for Amazon shares. I think is a mistake for investors to buy shares in a company with zero profits and a $180 billion market cap.

I believe that exposes investors to all kinds of risk of loss, while offering very little chance for long-term gain.

The "Wal-Mart Of The Web" Vs. Wal-Mart
Amazon's strategy is to become the Wal-Mart (NYSE: WMT) of the Internet, a company that can dominate potential competitors because it is always able to offer the lowest price to its customers. It makes sense then to compare the current valuations of Amazon and Wal-Mart.

Amazon has a market capitalization of $180 billion. Wal-Mart has a market cap of $260 billion.

YouTube/WSJDigitalNetwork
Amazon is currently working on building flying drones that can deliver packages directly to customers.

Amazon's shareholders get ownership in a company that generates no net income. Wal-Mart's shareholders get ownership in a company that is generating $17 billion of net income.

Wal-Mart's share price and market valuation are supported by some very real income that the company is generating. Amazon's share price and market valuation are based on nothing more than the belief that the company will someday generate tens of billions of net income.

Amazon's stock price is built on faith, not on profits. And that is dangerous business for investors. All it will take is for one negative thing to appear that raises some doubt about Amazon's ultimate potential for profits and that belief could be weakened. And when a stock price is built on faith instead of profits, there's no telling how far it can fall when doubt emerges.

I have no doubt that Amazon will at some point be a very profitable company -- but I do question how profitable. To justify a $180 billion valuation, I would suggest Amazon would eventually need to make $9 billion a year (which would be a price-to-earnings ratio of 20).

Amazon is going to have sales of about $65 billion this year. To go from zero profits to $9 billion would require some huge margin expansion -- and much higher prices for customers.

Wouldn't that do serious damage to Amazon's business model? And how much product could Amazon sell with such an increase in prices?

Creating enough income to ultimately justify a $180 billion market capitalization is going to be difficult. Creating enough income to justify an even higher market capitalization will be nearly impossible, and if not it will take many years to do.

I think buying shares of Amazon at this valuation is all risk and very little chance for reward.

Risks to Consider: Shorting any company is very risky, as there is no limit how high share prices can go. Over time, valuation matters, but in the short and medium term, valuations can get progressively more irrational.

Action to Take --> If you own Amazon, you should probably sell it. If you don't, a small short position might be profitable. The upside potential from a valuation of $180 billion is nowhere near the possible downside if investors lose faith. Eventually, earnings and cash flow matter.

P.S. Investing doesn't have to be complicated. If you invest in simple businesses that dominate their industries and return billions of dollars to investors through dividends and buybacks, you stand to make a killing in the market over time. It works. In fact, the stocks in our latest report, "The Top 10 Stocks For 2014," have gained 129.5% on average over the past five years following this simple strategy. To learn more about our top picks for 2014 -- including several names and ticker symbols -- click here.

Jody Chudley does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.