Valuation Analysis: Apple vs Amazon

In performing a valuation study on Amazon.com and Apple Inc. it is evident that both stocks are priced with high expectations for growth and profitability. Both trade at high P/E multiples; that doesn’t automatically signify that the two are overvalued as long as solid justifications for the high multiple can be ascertained. Decomposing the value assumptions (expectations) which are implied by the current share price, an understanding of future performance required to support the share price can be obtained.

I evaluated Amazon and Apple and made some comparisons with respect to P/E multiples and DCF model valuation. I concluded that Apple’s current valuation is reasonable based on input assumptions I believe are sensible given historical performance and growth momentum. Amazon, on the other hand, I determined it’s overvalued primarily due to my operating margin assumptions.

The key underlying factor implied in Apple’s market valuation is the continuation of rapid growth and stout margins for many future years. This attainable, in my mind, given Apple has already demonstrated the capability to create new products and attract customers. Amazon’s market value hinges in the expectation that margins will expand. Amazon has yet to prove that it can boost margins consistently for years now. Until Amazon exhibits consistent improvement in its margins, I will use historical op margins of 4% in my valuation assumptions. Without rising profit margins of at least 6%, AMZN is overvalued.

Relative Valuation- Price/Earnings Multiple
APPLE:
Apple ($185) currently trades around 37x 2008 consensus EPS estimate of $4.97. On the surface, it’s a pretty rich multiple, yet in reality, Apple’s multiple is lower when taking account of a couple issues.

First, Apple always provides very conservative guidance. This is no secret; Wall Street adjusts its earnings estimates in response to management’s low-balling, yet Apple still manages to mightily exceed the consensus earnings number. Hence, history suggests that one should assume that future estimates are too low. AAPL has averaged 32% earnings surprise for the last four quarters, and for the last 2 years, earnings came in approximately 25% higher than estimates on average. Those figures don’t account for the revisions during the months leading up to an earnings announcement. In the past 2 months, Apple’s 2008 full year estimated earnings were revised upward about 13%, and we still have almost a whole year until 2008 earnings are released. Actual 2008 earnings might possibly be 10-30% higher than the current consensus estimate.

Second, EPS is an accounting measure based on accruals not actual cash received by the firm. Apple’s special accounting treatment for its iPhone spreads revenues over a 24 month period even Apple receives cash for the device sale up-front. Thus, the cash pouring into Apple pockets is recorded as deferred revenue on the balance sheet. When taking into account “cash earnings” opposed to accounting earnings, EPS would be somewhat higher depending on the level of iPhone sales / deferred revenue accruals.

In sum, investors pay a multiple based on their earnings expectations, not necessarily on the publicized consensus estimate- a whisper pro-forma estimate that adjusts for accounting issues and conservative guidance, Hence, for relative purposes, there’s a strong case for saying AAPL trades at lower P/E, possibly in the low 30’s.

Apple’s growth has been extraordinary the past couple years. Assuming that this will continue, a 30ish price multiple is likely justified. On average, analyst project 23% earnings growth annually for the next 5 years which produces a PEG ratio less than 1.5 (using a 33 multiple). Apple’s earnings have grown 150% the past 5 years according to Yahoo.

AMAZON:
Amazon ($90) trades 56x its $1.61 FY08 estimate. Historically, AMZN reported EPS has been in a close range of the Street’s estimates, except for a couple of blow-out quarters. Thus, no clear, consistent earnings pattern exists to assume that estimates are too high/low. Amazon’s sales figures have been fairly consistent, but its profit margins are volatile. Amazon’s multiple 56x multiple is likely realistic.

The 5 year projected growth rate for AMZN is about 23% making the PEG greater than 2. That’s expensive but if you believe that margins will expand significantly then growth will be much greater and consequently AMZN shares less overvalued.

Discounted Cash Flow Valuation: FCFF
APPLE:
According to my DCF model the fair value of AAPL shares is $175 versus recent market price of $185. The input assumptions are fairly aggressive: expectations for sales growth and operating margins to maintain their strong momentum for many years going forward. The model uses 22% annual revenue growth for next 5 years, and for years 6-12 annual growth transitions from 15% to 5%.

Sustaining high annual growth rates becomes increasingly difficult due to the law of large numbers. Revenues only have to increase by about $5 billion to equate to 22% growth rate next year, yet in year five, a $11 billion annual sales increase is required to attain 22% growth. Apple will need to attract new customers in larger and larger increments to generate the level of expected sales implied by the share price.

Key Point: To justify Apple’s current share price, margins and sales growth must remain strong for a considerable period of time. Apple has significant momentum in its favor: massive brand power, innovative product design, and a strong portfolio that leverages individual products to boost demand of other products (“Halo Effect”). Apple products receive very high customer satisfaction, almost seeming every new user of Apple products end up loving them. However, there is a possibility that much of the low hanging fruit has been picked, and attracting new customers will be more difficult if they are not pre-disposed to adopting Apple’s products.

Conclusion: I am more confident than not, Apple will/can match these expectations. Yet, I am not completely confident Apple will meet or exceed the price-implied growth/profitability expectations. In my opinion, expectations are neither too high/low to assert comfortably that shares are over/under-valued. In essence, AAPL is fully-valued and to assume otherwise would entail prophetic guessing, in my opinion.

AMAZON:
Amazon’s intrinsic share value is $60 based on the DCF model compared to $90 market price. 5-year expected annual sales growth is 24%, then transitions (7yr) from 21% to 5.5% starting in year 6. Input assumptions for operating margins hold steady @ 4% during the 12-year horizon. I believe achieving high sales growth levels will not be a problem for AMZN. Amazon Margins are the primary factor behind the discrepancy between market and model values.

Key Point: Amazon shares are priced on expectations for margin expansion in future years. Amazon’s operating margins have shown significant volatility in past periods, and the firm has yet to demonstrate it can attain above 4% consistently.

Amazon must offer discounted prices to generate revenue. Since many retailers sell the same products, competition is based on price. Competitors with the lowest cost structures can offer the lowest prices, thus business strategy revolves around attaining economies scale and cost efficiencies. Amazon sales have increased 100-fold in ten years but the operating leverage and cost advantages have not been so robust, as one would naturally expect.

In order to avoid price competition, Amazon must differentiate its offering. Amazon has been working to accomplish this, yet the increases in R&D spending shaves margins. The hope is that the high R&D expenditures will materialize in fatter profit margins as AMZN diversifies its revenue streams.

Conclusion: We have yet to observe solid evidence than Amazon will be able to boost margins above levels for the average retailer. Investors have been expecting that to happen, and management says that it will, but until then I am skeptical.

Summary:
Both firms have lofty expectations to live up to, but Apple has the hot hand as of now. That’s not a secret, hence the reason AAPL is trading at a high multiple. Amazon is very rich at its current share price, but historically investors have been patient, and I don’t foresee a major drop in the share price in the near-term. If higher profitability doesn’t eventually come to fruition at Amazon shares will definitely come under pressure.

I don’t expect stock returns to be above normal for both Amazon and Apple in the coming quarters due to all the good news and the high expectations currently reflected in their share prices. But, both are terrific companies and If I owned them I wouldn’t want to sell them. In the long-run both should do well.

I do not have a position in any of the stocks mentioned.

Amazon.com Trading Based on Technical Factors-Not Fundamentals

Amazon shares continue to defy gravity even with increasing amount of discussion stating shares are overvalued. Barron’s (article) has been the latest to opine stating “The Bottom Line: At 56x 2008 EPS estimates, AMZN are too expensive.
Best to take substantial profits and wait for a better deal later on.” I gave a similar opinion in a piece earlier this month (my article) based on my belief that multiples are just too extreme given paltry margins and lofty growth expectations.
While fundamental analysis strongly suggests AMZN is overvalued to peers, I advised against shorting and further added that shares could go higher in the short-term due to price momentum. Amazon has been trading up mostly due to the technical factors underlying trading activity:

1) Buying stemming from short covering
2) Price strength and momentum dissuades profit taking by longs
3) Investor apprehension to go short fueled by sharp gap-ups

Daily volume has averaged about 11 million shares for the 144 day trading period since the start of 2007. Volume exceeded 15 million only 18 days, exceeded 20 million on 14 days, and only 7 times did daily volume exceed 30 million. There were 5 sessions where shares increased more than 5% and only 1 session where AMZN was down more than 5%. Nearly all of AMZN’s move up occurred on 3 days: 2 days following Q1 earnings release & day after Q2 announcement.

4/25/2007: $56.81 + $12.06 (26.9%) 104m
4/26/2007: $62.78 + $5.97 (10.5%) 62m
5/21/2007: $68.30 + $5.00 (7.9%) 36m
7/25/2007: $86.18 + $16.93 ( 24.4%) 60m

AMZN Short Interest (shares): According to Nasdaq.com
4/13/2007: 48.5m
5/15/2007: 53.9m
6/15/2007: 46.2m
7/13/2007: 40.6m

With YTD daily volume averaging aprox 11m, -6m over the period leading up to the first major break-out, normal volume is quite thin considering there are close to 50m shares short that eventually will have to be purchased. After the first spike on 4/25 short interest increased from April’s 48.5m to 53.9m in May but subsequently declined the following two months. It appears from the short interest rising 11% in May that shorts become more aggressive , thinking if it’s a short at $40 - even more the case at $60. As the data reports, shorts lost resolve and covered 13.3m shares in the time period leading up to the July figure. It will be interesting to see next month’s figure after the huge pop in 7/25. My guess is that short interest will have declined significantly since much of the price jump was probably due to buying associated with decreasing short interest.

Amazon’s Q1 surprise and increased EPS estimates sparked robust share demand as the market acted to price-in the revised expectations. Shares rose almost 38% in two sessions on exploding volume.
Impressive Q2 earnings results accompanied with a brighter than expected outlook again caught the Market by surprise. In the subsequent session, shares rocketed 24% on heavy volume.

Taking advantage of the bombshell dropped on short-sellers, new buyers take a position betting that shares will go even higher stemming from heavy short covering. Some current longs are less hesitant to sell and take profits knowing that the pent-up share demand will push prices up even further. As the price rises, losses snowball for those whom are short. Nasty short-squeezes prompt covering at any price to escape additional punishment. Shorts aren’t concerned about buying at overvalued prices if it results in minimizing potential losses. This creates price-equilibrium distortions since share demand is predicated on supply factors and not expected future cash flows. Thus, we have investors basing buy/sell decisions on supply & demand factors and not necessarily valuation and fundamentals. This implies that the market is inefficient since higher prices foretell even higher prices and in an efficient market past prices do not predict future prices.

In the case of AMZN, we know that higher prices will predict even higher prices since is very probable that demand will swell from: longs buying to lean on the shorts and from shorts buying to get out from underneath the longs. These instances provide some vindication for technicians who claim price / volume data can predict future price moves. In my opinion, the widespread recognition of this pattern creates a self-fulfilling prophecy due to many investors sharing the exact same expectations and acting collectively resulting in the expected price movement becoming the actual price movement.

Even though, future price moves may have been predictable, it would have been rather difficult to exploit fully in the case of Amazon since share prices reacted so quickly to news. As I mentioned earlier, AMZN shares were relatively quiet except for just the handful of sessions surrounding major news events.
The general assumption is that the Market is efficient, if shares overreact to the upside and become overvalued, longs take profits and shorts rush in to make profits. The onslaught of selling pushes shares down to its rational, fair value. The process is reversed for situations when stocks are oversold.

AMZN shares were driven mostly by buying related to technical factors and not fundamental factors. Sure, earnings expectations rose warranting a rise in value, but not to the extent that occurred. AMZN needed the positive news just to support its current price, not causing shares to double and stretching valuations further. Generally, when share prices overact longs sell and short-selling increases thus guiding prices back down to a value reflecting the collective expectation of future cash flows. Longs may be less eager to sell an overvalued stock if they feel technical factors are present to support lofty price levels. Hence, significant short interest representing future demand.

Another tenet of an efficient market is overbought imbalances are corrected by short-selling and profit-taking increasing supply.
Additionally, no matter how outrageous valuations become, after short-sellers are burned once they become apprehensive about making the same mistake again. Thus, there isn’t the proper lever present to adjust overbought shares sporting stretched valuations. AMZN had a sizable short position when the stock was in the 40’s, which increased 11% after the stock shot up to the 60’s yet shares continued to rise and short interest steadily declined. It appears selling pressure has had only a slight impact on AMZN shares.

AMZN Short interest has declined in the last two months reported. That suggests that some of the buying boosting AMZN was from short covering and that shorts have been less sanguine about shorting AMZN. It may be that shorting AMZN is analogous to putting a nail in one’s own coffin: Rising short interest attracts demand from investors attempting to “squeeze” short players anytime there is positive news released.

It just seems most probable that the factors I mentioned above are partly at work regarding Amazon’s doubling in price. With so many voices expressing concern about Amazon’s unjustified valuation, I would expect to see that sentiment come in to fruition by AMZN shares returning to reality. That has yet to really happen; just some observations to think about. It will be interesting to see the upcoming months’ short interest numbers and Amazon’s share price behavior.

Amazon.com (Nasdaq:AMZN)- Not Worth the Price

Trading near $70 per share at the end of the first week in July, Amazon appears overvalued. The price is very steep considering its volatile past and its razor thin profit margins. One thing AMZN has delivered is top line growth. Sales have been increasing at a very robust rate, yet very little falls to the bottom line. This means little cash is left to distribute to shareholders.

Even though Amazon retains all income to plow back into growth, stocks are valued on the premise of CF that could be distributed if the company so chose. Revenue has grown an average 28% annually the past 5 years, yet operating margins have average just a little more than 4% and net margins less than 2%.

Currently AMZN trades at 68x this years estimated earnings and 52x next year. Google trades 32x next year’s eps and Ebay trades at 24x. Both have Similar growth prospects as Amazon, but their margins are extremely higher and they also don’t have to invest in physical inventory such as AMZN.

No matter how fast Amazon expands, the fact is profitability will remain weak due to intense competition endemic to the retail industry. Amazon has to offer low prices to bring consumers to cyberspace as opposed to the bricks and mortar outlets. Prices also have to be low enough to offset the cost of shipping. Many large bricks and mortar companies are becoming more savvy with creating and managing their online stores. As they continue to improve, Consumers can shop online and possibly have the option to pick the items up from a physical store if one exists nearby.

Amazon is working on providing more web-based services and downloadable media products but competition looms there as well. In that aspect, Amazon is up against the likes of Google, Ebay, and Yahoo, all of whom have been in the game much longer. Additionally, AMZN has had to spend heavily on research and development in those endeavors essentially offsetting much of the benefits it provides. Amazon's share price has nearly doubled since April on the heels of improved earnings and outlook.

Some of theEPS improvement can be attributed to an artificially low tax-rate due to loss-carryovers, favorable forex translation, and cutbacks in R&D. So, the question is: are those conditions sustainable in the long-run?

3 years ago AMZN earned $1.39 / share with the aid of a negative tax rate and a lower R&D spending the next two years EPS declined to $.78 then to $.45. This year’s EPS is expected to be up @ $1.02 but with rates rising and a tired consumer, sustaining EPS growth will still be difficult even if AMZN has additional help with low tax rates and forex gains.

Revenues have to continue their rapid pace for a substantial length of time and margins have to expand in order to justify the current price. At AMZN’s current level, the required rate of return is too low given the involved risks. Amazon has to meet very high expectations just to keep to stock where it is now, eliminating upside potential and creating huge downside risks.

Many of Amazon’s peers trade at lower multiples and they are better performers. That’s contrary to fundamental logic of paying up for higher returns. It doesn’t make sense to pay more and get less.

A more realistic valuation in my opinion is $45/Share. I definitely believe the stock has gotten ahead of itself, and short covering has definitely helped push the stock higher as 8 million shares of short interest got squeezed out last month.

I wouldn’t bet against this price momentum either; I wouldn’t short it unless the technicals completely collapsed. I wouldn’t buy it either unless it dropped into the low 40’s.