big day for Amazon (AMZN)–why?

AMZN reported 2Q15 results after the close last night.  They were very good.

Sales were up 20% year-on-year; expenses rose by 17%, three percentage points less.  As a result, the company reported an operating profit of $464 million vs. a loss in the second period of 2014.

More than that, AMZN’s cloud services division, AWS, had revenue growth of 81% yoy and a quintupling of segment profits (basically operating profits less stock option expense) to $391 million.  AWS, broken out as a separate segment for the first time after 1Q15, remained a bit more than a third of the AMZN total.

 

AMZN posted an overall profit of $.19 a share for the quarter, vs. analysts’ expectations of a loss of $.13 a share and a deficit of $.27 per share in the year-ago quarter.

On the announcement, the stock immediately rose by 15% in aftermarket trading.

AMZN opened up by 20% this morning, before drifting down steadily during the day to close +9.8% in a market that was down just more than 1%.

 

Why the strong advance?

I have no good explanation, although I do have some ideas.

1. The obvious factor that changed overnight was the earnings announcement.

It contained a significant positive earnings surprise, one that makes it more likely that the company will earn, say, $1- a share in the current year. It makes the analyst consensus of $2.78 a share for 2016 more believable.   On the other hand, the stock was trading at $482 before the earnings report, or 173x the 2016 consensus.  Looking at the stock price another way, let’s say that at maturity for its businesses (whenever that may be), AMZN shares will be trading at 20x earnings.  To sustain the pre-earnings report price, that would imply a burst of rapid growth that shoots earnings up to around $24 a share.  That would be something like a doubling of earnings each year for the next five or six.

That’s already baked in the cake.  A buyer of the stock at this level must believe that $24 a share in eventual earnings is way too low.

I find it hard to believe that a $.32  per share earnings surprise during one quarter–when expectations were already sky-high=-would be enough to add 20%, or even 10%, to AMZN’s perceived market value.

2.  A second hypothesis…

What if investors are beginning to separate AMZN into two parts, AWS and everything else, and are doing a sum-of-the-parts evaluation.  To me, this sounds a little more plausible.  What would the numbers look like?

Let’s say that in 2016 AWS will comprise half of AMZN’s earnings and AMZN Retail the remainder.  To make the figures easier, let’s say each half earns $1.50 a share next year.

Let’s assume AMZN retail can grow in earnings at 20% a year for a long time, and that we’d be willing to pay 50x current results–a big number for a retail stock–for that future profit stream.  If so, AMZN Retail is worth $75.  To reach a sum-of-the-parts value of $482, AWS must therefore be worth about $400, or close to 270x its 2016 eps.  Ok, while I personally wouldn’t be willing to pay that much for AWS, I can see how someone else might.  However, I still don’t understand why confirmation that a holder at 270x earnings isn’t insane would cause the multiple to expand.  (Also, before I’d be comfortable valuing AWS as a separate company, I’d want to know more about how AMZN apportions revenues and costs among segments to ensure the published numbers don’t flatter AWS.  I’d also think long and hard about the possible effect of stock options.)

3.  The explanation for AMZN’s rocket ship ride that I’m leaning toward, however, is more technical.  Two factors may be involved.  At what Google Finance reports as 21+ million shares, today’s trading volume in AMZN was 7x normal.  The sharp opening spike suggests to me that algorithmic trading computers were at work reacting to the earnings report, not humans.  Humans, I think (?!?), would have a better sense of valuation.  I also suspect that the report and immediate upward move triggered a lot of short covering.

I’m partial to #3 because I think the whole reaction is a little  crazy.

Why is any of this important?  AMZN is a high-profile, large-cap stock with almost two decades of operating history.  There’s got to be a way to make money from the possibility that something like AMZN’s big move will occur with other similar names.

 

 

The Signal and the Noise

I’ve been reading statistician Nate Silver’s 2012 book The Signal and the Noise.  He makes three points that I think are useful for us as investors:

1.  Some ostensible information sources aren’t really that.

TV and radio weathermen, for example, deliberately forecast more rainy days, and amp up the amount of rain that will fall, than they actually think will occur.  Why?  People apparently like to hear about bad weather.  Also, we only get mad if the weather is worse than predicted.  If it’s better ,we regard it as a pleasant surprise.  So there’s every reason for TV and radio to have a consistent “wet” bias–and they do.

Same thing for shows on politics.  Pundits on the McLaughlin Group, for example, have a startlingly bad record at making political predictions.  The show’s many fans don’t seem to care.  Broad, sweeping views, confidently and articulately presented, are all that matters.

It seems to me the same applies to TV financial shows.

 

2.  The group with the absolute worst forecasting record is professional economists.  In fact, predictions about the course of the overall national and world economies are not only highly inaccurate, they’ve gotten worse over time, not better.

In other words, don’t bet the farm on a macroeconomic forecast.

 

3.  Foxes are better thinkers than hedgehogs.

Silver separates forecasters into successful = foxes (he’s one), and really bad = hedgehogs.

The differences:

hedgehogs

highly specialized

“experts” on one or two narrow issues that define their careers; contemptuous of “generalists”

often in the academic world

all-encompassing theories

theory over facts

believe in a neat universe, defined by a few simple relationships

highly confident, meaning resistant to change

foxes

interdisciplinary

flexible

self-aware and self-critical

facts over theory

think the world is inherently messy

careful, probabilistic predictions.

In other words, be careful of highly confident people with overarching theories and elaborate forecasting systems.

 

 

 

Toshiba and the Japanese business establishment

First there was the Fukushima Dai-ichi nuclear disaster, where nuclear power plants were installed incorrectly and both the utility and government regulators falsified inspection reports to cover this up.

Then there was Olympus Optical, whose tip management lost billions in stock market speculation because it was unwilling to restructure loss-making operations and covered up the fact for over a decade by fabricating its financial statements.

Now there’s Toshiba, which falsified results for years, under pressure from unrealistic profit goals set by a series of CEOs  (shades of Jack Welsh at GE).

 

Not that surprising, in my view, given the Japanese corporate world’s widespread adherence to a samurai-like code of absolute, unquestioning obedience to instructions given by older/more senior managers in one’s company.  After all, many of these enterprises have their origin in samurai cast adrift as regional warlords were marginalized during the early shogun days.

This mindset is also a reason why a lot of Japanese business is still stuck in the 1980s–that the world is changing at a fast clip, but you pretty much have to have white hair before anyone will listen to what you have to say.  To be clear, I don’t think this samurai-ness is a universal attitude in Japan as a whole.  Unfortunately,it thrives in the Tokyo/Osaka-based, export-oriented industrial sector which is the primarily beneficiary of the deep depreciation of the yen engineered by PM Abe.

Why don’t out-of-date sixty- and seventy-somethings just retire and let a younger generation take the reins?

For one thing, speaking as a sixty-something myself, it’s hard to go from being king of the world to being just another nameless retiree.

I think, however,that there may also be a deeper, more damaging reason than the ego problems of the people in charge:

One of the first companies I followed as an analyst was a small copier manufacturer/distributor.  The firm was in enough financial trouble that it bought breathing room by selling a large chunk of its plant and equipment and leasing it back from a bank.  That netted $50 million or so in cash.

Soon afterward, Carl Icahn bought  5%-10% of the company’s stock and threatened to make a hostile bid for the rest.  The firm quickly bought back Icahn’s shares for, as I recall, about a 30% premium.  I was shocked.  I didn’t get it at all.

Only when the firm subsequently went into Chapter 11 did I learn the CEO, a former accountant, had been fiddling with the books for years.  That fact was the real leverage Icahn had over his target, whether he knew it or not.  The CEO couldn’t let an outsider in, because the accounting shenanigans would be discovered and he would be disgraced.

I don’t know, but I suspect–because I’ve seen the same pattern in numerous smaller firms in Japan that Olympus and Toshiba are only the tip of the iceberg in Tokyo.  If I’m correct, Abenomics is even more problematic than I’ve been writing.

 

 

 

 

 

 

the A&P bankruptcy

a Chapter 11 filing

The Great Atlantic and Pacific Tea Company has just filed for Chapter 11 bankruptcy protection.  According to the radio reports I heard yesterday, this is the second time in three years and the fifth overall bankruptcy filing for the venerable supermarket chain.

A&P said it did so in order to preserve the flow of fresh produce and other perishables into its stores.

In one sense, it’s not surprising that supermarket chains might be in trouble, given the relentless expansion of Wal-Mart into grocery over the past couple of decades, the rise of Whole Foods et al, and the change in lifestyle and consumption habits being spearheaded by Millennials.

A&P as a useful template for investors

A&P, however, is also an important illustration of how creditworthiness can deteriorate in ways investors seldom suspect.

the key:  trade creditors’ bankruptcy standing

The key to understanding what is going on is to realize that in Chapter 11, trade creditors go to the bottom of the list of who gets repaid.  They rank ahead only of equity holders, who as a general rule are wiped out completely.  Trade creditors usually fare little better, if at all.The amounts involved can be substantial.  In the A&P case, for example, McKesson is listed as a major unsecured creditor, owed $39+ million.

trade creditors defending themselves

Knowing that any outstanding bills will likely be voided by a bankruptcy court, suppliers of inventory and services watch the creditworthiness of their customers very carefully.  They hire third-party credit services to provide periodic reports, and they monitor any differences in customer payment patterns very carefully.

If a customer shows A&P-like symptoms (according to Bloomberg, A&P had been having net cash outflows of $14.5 million monthly during fiscal 2015), a vendor can take several related actions to lower its risk:

–it can send less merchandise on credit to the worrisome customer

–it can send lower-value or lower-quality merchandise, or only items that have an extremely short sales cycle

–it can refuse to extend credit; it will demand payment in advance.  This is a lot more serious than it sounds, since the customer may be depending on being able to use the cash from a sale for a week before paying the vendor.

(An aside:  I’ve even seen instances where a trade creditor has sued the customer for payment, knowing that a favorable judgment will force bankruptcy.  The idea is that some third party who doesn’t want a Chapter 11 filing–a bank or other long-term debt holder, or an equity holder–will settle the debt while the case in court.)

Of course, none of this is good for the cash-strapped concern.

reversal of form

Once the firm is in bankruptcy, the situation reverses completely.  Suppliers no longer have to worry about having unpaid bills nullified.  And the bankruptcy judge will ensure that trade creditors are put at the front of the line to be repaid.  So just as the flow of new merchandise into a cash-short enterprise slows down as Chapter 11 becomes a realistic possibility, it speeds up again once the company has filed.

 

 

Samsung and Elliott Associates

I’m not an expert on Korea.  In fact, I think of Korea in much the way I think of India or Indonesia–or Japan or Italy, for that matter.  They’re all places where very powerful family controlled industrial groups have enormous economic and political power.  As a result, the rules of the stock market game are very different from those that prevail, say, in the United States.  Piecing them together can take an enormous amount of time and effort.  I’ve believe that, except in the case of Japan in the 1980s, the reward for mastering these markets would never be large enough to justify the effort involved.

In the case of Korea, government policy, both formally and informally, is heavily tilted in favor of a set of family controlled industrial conglomerates called chaebols (much like the zaibatsu/keiretsu of Japan).  In my view, these are not American-style corporations.  They care little for profit growth/maximization or for the welfare of ordinary shareholders–Korean or foreign.  I’ve found the laws and regulations that govern them to be bewilderingly complex and their financial statements (admittedly I haven’t read one carefully in well over a decade) unreliable.

Recently, Samsung, a major chaebol, decided that one affiliate, Cheil, would buy another, Samsung C&T, at what appears to be a bargain basement price. US activist investor, Elliott Associates, then bought a bunch of Samsung C&T stock and challenged the takeover.  Its objective was presumably either to have its stake bought out at a higher price by some other Samsung company or to compel Cheil to raise the acquisition price for everyone.

My initial reaction on reading this was that Elliott was fooled by superficial similarities with the US and didn’t understand the deeper political and cultural barriers it would face in Korea.  That has, so far, proved to be the case.  Shareholders have voted in favor of the acquisition as originally proposed.  Elliott is apparently continuing to sue to try to prevent/reverse this outcome.

The situation is a little more interesting than I’d thought, though, and bears watching:

–the Elliott effort to have Samsung C&T shareholders reject the takeover failed by only 3% of the shares voted.  This is a surprisingly small amount, in my opinion.  On the other hand,

–the deciding vote in favor was cast by the government-connected National Pension Fund, which ironically has previously been a critic of chaebol behavior.

My guess is that it’s ultimately Elliott’s foreignness that swayed the voting, particularly at the NPS.  Were a Korean equivalent to attempt the same thing, the outcome might have been different.  If so, there may be hope for investors in Korea after all.  I’ll continue to be on the sidelines until there’s more tangible evidence of change, however.