Call: Short Amazon

Nasdaq: AMZN Contributor: John Griffin.

Firm: Wildehond Capital.

Type: Hedge Fund.

Location: New York, NY. Timeframe: 1-2 Years.

Recent Price: $265.00.

Target Price: $150.00.

Strategy: Other. Disclosure: The author of this report held an active position in this security at the time of its posting. Disclaimer: This is a reduced version of a full SumZero report republished with the author's consent. The opinions expressed reflect those of the contributor and not SumZero, Inc.

Conversation with Taz, an AMZN shareholder

Introduction

Me: Hey you look happy today, what’s up?

Taz: Great quarter for AMZN!

Me: Really? I thought they missed on revenues, missed on EPS, guided down both top and bottom line, bled cash flow like a wounded…

Taz: Yeah but did you see that operating income!

Me: Yes, 1% margin, that’s better I suppose…but don’t they have a P/E of like 1,000 now?

Taz: You don’t get it. This Q shows that its all going according to plan. They are going to rule the world! Bezos is a genius!

Me: He may indeed be a genius, but isn’t revenue growth already declining, and in the low 20s?

Yes but they are a big company now so of course growth will slow. They may even be closer than we think to ruling the world!

Me: Let’s get to the ruling the world part in a minute, but what kind of multiple do you place on other mega cap secular growers with declining growth rates? Quadruple digits?

Taz: But that’s what’s so convenient about the P/E being NM.

Me: Exactly my point. If AMZN did actually post a profit, say annual EPS of $1.00, then your mind, guided by your training and habits, would naturally focus on that number and make projections of revenue growth, and margins, and then what EPS will be in say 10 years, incorporate a discount rate, and then apply a multiple…do you think you’d value the stock at a P/E of 300+ if you went through that process?

Taz: Ha!…My boss would fire me if I argued for a P/E of 300 on any mega cap stock…

Me: …right but you don’t have to with AMZN because they don’t have any profits or losses. Net income is conveniently close to zero, so you can let your imagination run wild…

Taz: Its much more fun that way…AMZN is going to rule the world!

Me: Yes, we’ll get to that. But have you thought about the possibility that Bezos is posting zero net income to abet this thought process and stir your imagination?

Taz: You’re making him sound like some sort of a crazy genius or something…

Me: I’m not calling him crazy, and you yourself called him a genius…

The Blueprint

Me: So, Let’s suppose that AMZN is successful in growing revenues like you say. The plan is to grow revenues for like 10 years, then decide to drop an e.g. 6% operating margin into the business?

Taz: YES!! You’re finally starting to get it.

Me: ‘cause Bezos can decide his own operating margin…oh never mind. But why would Bezos do that? Why would he ever stop?

Taz: Because he said he would!

Me: But who stops growing an empire on purpose? You’re placing a lot of hope in this man. Is he some secret Ben Graham acolyte and I just don’t know it?

Taz: Well he’s made a profit before…

Me: Yes I saw that AMZN made a profit in 2003…net margin of 0.6% if I’m not mistaken…and decent FCF too…

Taz: You see!!

Me: …Not really.

Q4 Operating Income

Taz: But what about Gross Margins! They grew in the quarter. The smart, slick, rich-looking Tech guests on cable TV all said this means operating margins are going to grow!

Me: But isn’t it just mix shift? I mean, if you’re shifting your business from low gross margin, zero operating margin businesses to higher gross margin, zero operating margin businesses like AMZN is, wouldn’t gross margin naturally grow?

Taz: Yes, but operating margin grew too!

Me: Well, I have my theories on that.

Taz: Yeah, like what?

Me: First, we’re talking about a few tenths of one percent, which is sort of like a rounding error. And certainly within the margin of…well I won’t say manipulation but a big complex firm like AMZN has a certain amount of control over the accounting results they post.

Taz: What on earth makes you think they may be doing that?

Me: Well, the cash flows certainly didn’t confirm the operating income.

Taz: But they don’t run the firm for cash flow.

Me: They say they do.

Taz: Oh. Well you can’t tell much from one quarter’s cash flow.

Me: Or operating income.

Me: Second, it appears they are shifting some costs from above the operating income line (e.g. rental expense) to below the line (interest expense).

Me: Third, they guided to much lower margins in the next quarter, so it seems that this is NOT the beginning of a trend.

Taz: Yeah but it shows what they can do in the future when they decide to.

Me: OK, lets take a look at that, business by business.

Taz: Finally!

Future Operating Income (Amazon Will Rule the World!)

Me: Let’s start with the base retail business. It reminds me of an old Saturday Night Live skit where a banker explains that his business plan is making change. ‘we’ll give you 5 nickels for your quarter. We can even give you ten pennies for your dime…How do we make money? Simple: Volume!’ Do you remember that one?

Taz: I wasn’t alive back then.

Me: Right, of course not.

Taz: But AMZN doesn’t make zero profit on its base retail business.

Me: No, they make losses.

Taz: But not in the future!

Me: How will they make profits in the future? Isn’t this a very low margin business?

Taz: But they will be able to raise margins in the future when AMZN is the only place to go to buy stuff online.

Me: Why would it be the only place to go?

Taz: Because everyone will be doing all their shopping there, and they will be so tied into the AMZN world, it won’t make sense for people to look elsewhere for stuff!

Me: But people don’t have to look elsewhere. There are websites that comparison shop for you, right?

Taz: Yeah, I guess so. But AMZN has a cost advantage over all their competition!

Me: What is that?

Taz: Shipping costs!

Me: Oh, so if the bank in the SNL skit just had to pay round trip shipping on the coins, they would have made money…

Taz: No, no, no, you’re not getting it. AMZN has built all these warehouses, and so they don’t have to ship stuff very far to get it to the customers!

Me: Ah, the leveraging shipping costs method to world domination. Even I hadn’t heard that one before. Must have been daydreaming during that B-school class.

Taz: But it’s a real cost advantage!

Me: Yes, but is there anything proprietary about those warehouses?

Taz: They have cool robots…

Me: Has AMZN patented the robots?

Taz: I don’t know…but the point is that no other web retailer has the scale to build out such a network themselves!

Me: Have you ever heard of contract warehousing?

Taz: Oh.

Taz: But their 3rd party business is growing!

Me: Yes, it is. Actually rather impressive. So, they just sort of rent space on their website and take a cut. OK. But the analysis is similar…why will they be able to hike rents to earn supra-normal returns?

Taz: But hey there is the Kindle!

Me: Doesn’t the Kindle suck?

Taz: Yeah.

Me: Is it a profitable product?

Taz: No.

Taz: But when someone has a Kindle, they will be hooked like a Coke-fiend and will buy everything they purchase from AMZN, and AMZN will leverage those ship…nevermind.

Taz: But then Kindle owners download music and movies and…

Me: Oh, so AMZN is going to simultaneously beat Apple at its own game, and Netflix at its own game, all with the same product? Is AMZN going to create its own content, too, and beat Hollywood at Hollywood’s own game? And by the way, how are NFLX’s margins?

Taz: But now AMZN is going to let Kindle customers read Kindle books on their iPads! But I’m not sure how that’s good…

Taz: But there is Amazon Prime. It encourages loyalty too, and share of spend!

Me: Right, so if you give away money (AMZN pays your shipping for you), people will take your money. And this is the path to profits. Brilliant.

Taz: OK, but what about Amazon Web Services! Like Cloud and Storage!

Me: Aren’t there plenty of competitors?

Taz: Yeah.

Me: Why would AMZN do it better?

Taz: I don’t know.

Me: Isn’t Amazon bragging about how they’re cutting prices so much on AWS? “24 times since 2006”. Maybe this is their margin enhancement strategy? I must have missed that class in B-school too.

Taz: But what about all the products and services that AMZN doesn’t even sell yet! They will be so big and powerful, they will be able to create new products and services and muscle in on existing markets too!

Me: Yes that’s possible. What’s their track record with generating profits that way?

Me: Besides, now this is starting to sound like FB...

Taz: That's our 2nd biggest position!

Me: You don't say...

Hope

Me: You sure do seem to be hopeful, Taz.

Taz: You sure do seem dour!

Me: Indeed. So let’s sum up here. AMZN makes no money right now.

Taz: Right.

Me: But you are hopeful that they will grow revenues prodigiously in the future.

Taz: Yes.

Me: And you are hopeful that at the correct time, Jeff Bezos will decide to run the business for cash flow.

Taz: Yes.

Me: And you are hopeful that Bezos will be able to earn good size profit margins on businesses that are competitive in nature…

Taz: Yes!

Me: …and where AMZN does not have strong barriers to entry…

Taz: Yes!

Me: …and where AMZN has shown no ability to generate profits to date…

Taz: They’ve just chosen to lose money! They could be making tons of profits, they just don’t want to!

Me: …and they will want to in the future…

Taz: I’ve already said Yes! Bezos said so!

Me: …and you predict that AMZN will be able to create and/or enter new markets in the future, profitably.

Taz: Yes!

Me: Is there any reason for the stock to trade where it does today except that many investors are as hopeful as you?

Taz: I suppose not.

Me: What happens when investors’ focus shifts from what may be to what may not be? From being greedy (hey AMZN is going to rule the world and I want in!) to fearful (what if there is no pot of gold at the end of the Bezosbow)? What if investor’s focus shifts from 10 years in the future to say 10 months in the future?

Taz: Why would that happen?

Me: All I know is that it often does.

Taz: Oh.

Me: What would support the stock in that case?

Taz: I can’t think of anything, really.

Me: What would keep it above $200? $100?

Taz: Maybe they’ll start paying a dividend!

Me: Ugh. I’m hungry. Let’s get a taco.