Whole Foods (WFM) and Amazon (AMZN)

I was a big proponent of WFM in its early days but haven’t owned it for a long time.

My quick look at the company’s financials this morning tells me it’s an odd duck among food distributors.  Successful distribution is all about low margins + rapid inventory turnover + shrewd working capital management + rising sales leading to strong profit growth.  WFM exhibits only one of these characteristics:  rapid inventory turnover.  The number I get from the annual report, which I find almost too good to believe, says that WFM’s annual sales are 30x its average inventory.  This compares with 10x for AMZN and 15x for Kroger (KR).

On the other hand, WFM’s operating margin is more than 50% higher than KR’s and nearly triple AMZN’s.  The excess of payables (what a firm owes to suppliers) over receivables (what customers owe the merchant)–and a key measure of operating strength–is about 1% of sales for WFM, while 3.6% for KR and about 15% for AMZN.  In addition, WFM is no longer growing–the main reason, I think, the company’s PE has been cut in half over the past couple of years from about 40x to 20x (pre-AMZN bid).

WFM’s problem isn’t simply that its margins are too high to induce people to buy more than they do of what the company has to offer.  Nor is it the assertion by some that WFM is very inefficient and should be making a higher margin than it actually does.

Rather, it’s that the current market situation is highly unstable, on several fronts:

–WFM-like offerings are increasingly available from less expensive chains like Trader Joe’s or even regular supermarkets

–having severely damaged the profits of incumbent grocers in the UK, deep food discounters from Germany–Aldi and Lidl–have both announced that their next target is the US.  Even if the two are unsuccessful, increased competition is bound to mean lower prices

–AMZN has decided that the time for online food delivery on a large scale in the US has come.  It’s also possible that it too is worried about the potential effect that Aldi and Lidl may have and has sped up its food distribution plans.

 

how will the takeover work out?

It’s hard to know.  WFM’s management hasn’t covered itself in glory over the past decade.  It needed to be bailed out from operating difficulties by Green Equity Investors in late 2008.  And it doesn’t seem to have responded well to increased competition since.  On the other hand, AMZN’s experiments in food delivery have had indifferent success so far. At the very least, though, AMZN brings a strong record in controlling distribution operations, expertise which WFM seems to me to need; WFM brings a brand name and the grocery equivalent of Amazon lockers.

My thoughts:  the one thing I’m confident of is that food prices will generally be lower for consumers in a couple of years than they are now.  I’d prefer to look for places where extra discretionary income can be spent than to try to play food directly.

 

the holiday retail season: Millennials vs. Boomers

Conventional wisdom in the US has long been that 30-somethings want a house, a car and clothing suitable for work.  Fifty-somethings want a vacation home, jewelry and a cruise.

As the Baby Boom generation became more important, therefore, an investor wanting exposure to consumer spending should have shifted away from homebuilders and carmakers and toward high-end specialty retail, luxury goods and hotels and cruise lines.

Of course, there were other secular forces at work, as well–the move from the cities to the suburbs and the dismembering of the traditional department store by specialty retail, just to name two.

Today we’re in the early days of another significant demographic change.  Millennials now outnumber Boomers in the US.  Millennials only earn about half what Boomers do.  And they were hurt much more severely than the older generation by the recession.  But they’re on the up escalator, while Boomers as a group will see their economic power wane as they retire.

Playing the aging of the Boomer generation had two aspects to it, one positive and one negative.  The positive side was hard–finding the small, relatively obscure companies like the Limited or Toys R Us or Home Depot/Lowes or Target or (later on) Coach that would catch the fancy of the Baby Boom.  The negative side was easier–avoiding the losers who didn’t “get” what was going on.  These included American carmakers and the department stores.

In 3Q15 corporate results, we’re already beginning to see the new generational change begin to play out.  Home improvement stores are doing surprisingly well.  Large retail chains are reporting relatively weak results.  What strikes me about the latter is that the worst-affected seem to be the most heavily style-dependent and the firms that have put the least effort into their online presence.  In contrast, I’m struck by how many small online, even crowdsourcing, alternatives to bricks and mortar there now are to buy apparel.

How to play this emerging trend?

The negative side is easy– avoid the potential losers, that is, firms whose main appeal is to Boomers and companies with a weak online presence.

The positive side is, as usual, harder.  Arguably, many of the winners–Uber, and the sharing economy in general being an example–aren’t yet publicly traded.  Absent a pure play, my best idea is to invest in the winners’ onlineness.  The easiest, and safest, way to do so is through an internet or e-commerce ETF.

 

One other point:  for many years, economists have tracked the activity of Boomers as a way to estimate the health of the economy.  To the degree that they, too, fail to adjust quickly enough, their assessments, like department store sales, may understate growth momentum.

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.

 

 

thinking about Amazon Prime Day

Yesterday was the first Prime Day for Amazon (AMZN).  The company’s press release indicates it was a very successful event, one that it will at least repeat in 2016.

My thoughts (I don’t own the stock, except maybe in a sector ETF):

the name  

It’s Amazon Prime Day.  If it sticks, it’s an incredible plus for Amazon.   Unlike Black Friday, which is when we’re all supposed to run amok buying stuff from anyone willing to sell, Prime Day is when you’re supposed to go to AMZN to buy.

sales volume

The company said that it sold “more units” on Prime Day than “the biggest Black Friday ever.”  I read this as meaning that AMZN sold lots of low-priced stuff yesterday.  If dollar volume were through the roof, I suspect AMZN would have said that.

sales composition

We know that a quarter of AMZN’s operating income comes from cloud services.  Let’s say that the company strives to break even overall on things it sells itself, but makes most of the rest of its money by selling for third parties (Fulfillment by Amazon).

–“Hundreds of thousands” of new customers signed up for trials of Prime, making it the biggest day of its kind ever for AMZN.

–It either sold, or sold out of, a lot of AMZN eco-system devices.

–Fulfillment by Amazon had its biggest unit sales day ever, nearly quadrupling worldwide unit volume from July 15, 2014.  Third parties had to commit in advance to having enough inventory in the AMZN distribution system to enable Prime delivery of items bought yesterday.  My guess is that this was a significant limiting factor for FbA sales, implying that 2016 sales could be a lot higher.

where did the sales come from?

Wal-Mart probably knows, but no one else.  The issue is whether AMZN redirected sales that it would have captured on other days of the month to the 15th, or whether AMZN took sales for itself that would have gone to other merchants if not for the Prime Day promotion.  My guess is that it’s primarily the latter.

stockouts and social media

The media focus I’m seeing this morning is on customers who are unhappy because they weren’t able to buy merchandise before deals were sold out. This is being portrayed as bad.   It seems to me, however, that this is free publicity doing two good things for AMZN:  in reinforces the idea that Prime Day is all about AMZN, and it highlights that the sale wasn’t all just random junk but did include a significant amount of desirable merchandise.

 

None of this is enough to make me a buyer of the stock.  Still, the first Prime Day seems to me to be a significant coup for AMZN.

What Amazon (AMZN) said about its web services Thursday night

AMZN shares rose by 15% last Friday, after the company gave its first income statement details about Amazon Web Services (AWS), its cloud business.  In its quarterly reporting from now on, AMZN will break out three business segments:  US sales, International Sales and AWS.

IN the late Thursday earnings release, Jeff Bezos said that AWS is growing fast and “in fact, it’s accelerating.”

the data

operating income

–during calendar 2013, AWS had segment operating income of $673 million, according to the GAAP accounting rules used in financial accounting.  That was 35.3% of AMZN’s total segment income.

—for 2014, AMS had segment operating income of $660 million, or 36.5% of the total

–in 1Q15, AMS had segment income of $265 million, 37.5% of the corporate total

cash flow

–on GAAP principles, AWS had cash flow of $2.4 billion last year.

capital spending

–AWS represents over a third of AMZN’s plant and equipment of $17 billion.  With $4.3 billion in plant additions in 2014, AWS was almost half the company’s total capital spending.  Of the $4.3 billion in new plant, $3 billion was acquired using capital leases–meaning a kind of financing which looks like a loan but which allows AWS to buy the stuff cheaply at the end of the lease.

plant life

–if we divide last year’s depreciation into the average of 2013 and 2014 plant, we get an average plant life of 4 1/2 years.

–return on capital

–last year AWS earned $660 million, using capital of $4.6 billion, meaning a return of 14%.

what to make of this

It’s hard to make a lot out of two years’ data, especially in such a fast-moving and capital-intensive business as AWS’s.

The GAAP numbers look good. Nevertheless, AWS is cash-flow negative, which isn’t troubling if we’re certain that the company will continue to earn a significant return on the capital it is pouring into AWS.  Also, although there’s no way to tell for sure, it seems to me likely that on its IRS books, AWS is losing money.  How so?   …tax breaks for technology investment, including depreciation that’s heavily front-loaded (vs. spread out evenly over the assumed life of the equipment, as GAAP calls for).

Certainly, if Wall Street’s view has been that AWS is bleeding red GAAP ink, the reality is hugely better.  As time goes on, we’ll be better able to judge how insatiable AWS’s need for capital is–or whether, as one would hope, AWS will turn cash flow positive .  My guess is that before then, AWS will be more than half AMZN’s profits, as well.  So holders will have to figure out whether or not it’s an uptick to hold shares in an internet infrastructure business that happens to retail stuff online, too.

 

 

Amazon’s no-show profits

Amazon’s 2Q14 results

When Amazon (AMZN) reported 2Q14 results last Thursday, not only did the company post a bigger operating loss than anticipated but it said that the 3Q14 red ink would dwarf the 2Q14 actuals.

The news came as a surprise  …and not one that Wall Street took favorably.  The stock dropped 11% in Friday trading.

At the same time, the news media were filled with red-faced portfolio managers and analysts complaining that Jeff Bezos should be more sensitive to their need for more robust profits, which–allegedly–would make the stock go up.

To me, this is a case of being careful what you wish for.

Let’s do some back of the envelope calculations to see why…

is AMZN’s valuation reasonable?

The analyst consensus is that AMZN will earn around $2 a share in 2015.  That’s a forward PE of 160x.  How could anyone pay that price to own a share of any company?  For someone who holds AMZN, he must be thinking something like this:

–the company consists of a US business that makes a considerable profit and a foreign one that is flirting with breakeven.  If we assume that foreign operations can equal the US in size and profits at some point, then that $2 a share will sooner or later become $4 a share at some point.  On this basis, the multiple is “only” 80x.

–the company spends a lot of money on computer software.  In a very real sense, this is capital spending.  That is to say, as is the case with any capital asset, the expenditure on software should arguably be registered on the balance sheet and written off bit by bit against revenue over the lifetime of the programs.  Because of past accounting abuses, however, programming costs are recognized as expenses immediately, even though the programs may last a long time.  This depresses current income.

AMZN also writes off startup expenses for new ventures right away. This is a conservative approach, but it also depresses current income.

To pluck a figure out of the air, if AMZN were less conservative and if it could treat software costs as capital items, $4 would be $8–and the future PE multiple is a “mere” 40x.  That’s too rich for my blood, but it’s not absolutely crazy, provided AMZN continues to grow.

what will likely happen if/when AMZN’s profits start to surge

What would it mean if AMZN began to show large amounts of current income?

The most likely scenario–and the one pms and analysts are calling for–would be that the company is no longer incurring software creation expense and  hefty startup costs for new ventures.

…in other words, it would imply that AMZN had run out of growth opportunities!  Surging profits imply AMZN is going ex-growth.

In my experience, there are few things worse, in stock market terms, than holding a growth stock that has suddenly gone ex growth.

In my judgment, a +30% increase in earnings by AMZN would be accompanied by a gigantic price earnings multiple contraction.  A halving of the PE would be my best guess.  If that’s anywhere near correct, the end result would be a loss of a third of AMZN’s market value.

As I said above, be careful what you wish for.  It also strikes me that the Wall Street complainers have no clue about the kind of stock they’re dealing with.

 

 

Kindle Unlimited: publishers as collateral damage?

At one time there was only the Kindle.

Then came the Kindle Fire and Amazon Prime.  Now there’s the Fire phone and Kindle Unlimited–all five programs (along with a bunch of smaller ones) launched by Amazon (AMZN) to bind customers ever closer to the shopping service and get them to buy more stuff through it.

For AMZN, it’s not that important that any of these be moneymakers straight out of the box.  That can always be straightened out later, when the customer has been transformed from a buyer of X who happens to use AMZN to an AMZN customer who happens to want to buy X.

Kindle Unlimited, the just introduced subscription service for e-books and audio-books, is a particularly interesting instance.  That’s because it may end up being the tipping point in AMZN’s favor in its long-running battle with the five big publishing houses for control of the English-language book reader.

Another intriguing aspect of Kindle Unlimited is that AMZN has more relevant information, I think, than any other party at the table–but it isn’t talking.  So analysts, both the Wall Street kind and the planners inside the publishing companies, have less than normal to work from as they create their castles in the air.

Here’s how I view the situation:

1.  For $9.99 a month–about $120 a year–Kindle Unlimited lets subscribers read as many e-books as they want, from a collection of over 600,000, as well as to listen to as many Audible audiobooks, from a list of “thousands.”

No titles from the big five publishing houses are included, although, for example, all the Harry Potter books are.

The rollout of KU suggests that the very public spat between AMZN and Hachette, the smallest of the big five, may have been aimed at persuading Hachette to take part.

2.  Most industries exhibit a “heavy half.”   The idea is that, say, 20% of the purchasers buy a huge amount, usually put at 80%, of the stuff.  For e-books, only AMZN knows what the exact proportions are.  My guess is that heavy users easily spend $50 a month ($100+?) on e-books.  For them, signing up for KU is a no-brainer.

3.  It seems to me that KU users will dig deeper into “free” content in the 600,000 titles instead of buying expensive bestsellers launched by the big five.  Presumably, AMZN has surveyed the heavy half, and maybe even run small tests to figure out what will likely happen.  Certainly AMZN must believe that KU will redirect a lot of e-book use away from the big five and toward AMZN self-published content, or content from smaller presses that may sign up.

4.  Until yesterday, I hadn’t looked at AMZN’s financials for years.  From my perusal, I’ve decided, for no particularly good reason, that AMZN makes $60 million in operating profit per quarter from e-books in the US.  The company could easily let that drop to zero, as sales of high-priced best sellers wane. However, AMZN seems to be indicating–who knows whether bluster or not–that it is willing to go deep into the red to get KU off the ground (remember, AMZN is generates about $5 billion in yearly cash flow, so it can afford to lose money on KU for a l-o-o-ng time).  Last night it guided to a possible operating loss of over $800 million for the coming quarter.

5.  The big five could be squeezed in a number of ways.  KU users switch away from them, constricting their cash flow.  Fewer pre-orders from KU users would mean new titles fall off the bestseller lists, hurting sales further.  Authors complain about diminished royalty payments and ponder self-publishing through AMZN themselves, where, for sales in the US, the author receives 70% of the sales price vs. 25% from the big five.

6.  AMZN has lots of customer information; the publishers probably have much less.  Therefore, this negative money cycle may end up being much larger than the big five anticipate.  One or more may break ranks.

It will be interesting to see how this plays out.