Is Facebook Stock Approaching Bubble Territory?

Here is a list of the U.S. companies that are worth at least $300 billion today based on stock market value:

  1. Apple $522B
  2. Microsoft $392B
  3. Exxon Mobil $365B
  4. Berkshire Hathaway $357B
  5. Facebook $336B
  6. Amazon.com $318B
  7. Johnson & Johnson $311B

If you are surprised to see Facebook (FB) registering as the 5th most valuable U.S. company you are not alone. Given the company’s high growth rate, many investors do not mind the stock’s valuation. At $117 per share, the stock trades at 33 times this year’s consensus forecast of $3.54 per share of earnings. Given that Wall Street is currently estimating more than 30% earnings growth in 2017, this P/E ratio seems high, but warranted, if you are a true believer in the company’s future.

I am not going to delve into the company’s future growth prospects in this post, as I have been wrong about them so far. My thesis was that Facebook usage would decline over time as early adopters such as myself tired of the service and the network became overloaded with parents, grandparents, aunts, uncles, etc. That has proven to be wrong. Perhaps Facebook has evolved from a cool place to connect with friends to a crucial hub to connect with family. At any rate, the stock’s valuation is what has peaked my interest lately.

Facebook is one of a growing number of growth companies in the technology space that is overstating its profitability by paying its employees with stock and not treating it as an expense when speaking to Wall Street analysts. The official GAAP financial statements do disclose how much stock they dole out to employees (for instance, in 2015 the figure was a stunning $3 billion), but when investors quickly look at earnings estimates, they see the $3.54 figure for 2016 which does not include stock-based compensation.

So what happens to the stock’s valuation if we treat stock compensation as if it were cash? After all, if Facebook decided to stop paying its employees with stock, we can assume they would have to replace it with cash. Below I have compiled the company’s free cash flow generation since 2012 and subtracted the dollar amount of stock they have paid their employees. This simply tells us how much actual free cash flow Facebook would have generated if they compensated solely with good ol’ U.S. dollars and cents.

FB-FCF

As you can see, adjusted for stock-based compensation Facebook had free cash flow of $1.09 per share in 2015, which is about 50% less than their actual reported free cash flow ($2.13). Put another way, Facebook’s employees (not their shareholders) are being paid out half of the company’s profits.

From this perspective, Facebook stock looks a lot more overvalued. If you annualize the company’s first quarter 2016 free cash flow adjusted for stock compensation ($0.38 per share), the company trades at a P/E of 77 ($1.53 of free cash flow). There is certainly an argument to be made that such a price resembles bubble territory. That potential problem could be rectified if the company continues to grow 30% annually for the next five years, resulting in $4.05 of “adjusted” free cash flow in 2020. But buyers of Facebook stock today at paying about 30 times that 2020 estimate right now, which is still a very high price.

Below is a summary of Facebook’s stock market value relative to reported and adjusted free cash flow since 2012, as the stock has nearly quintupled in price:

FB-Pr-FCF

How do situations like these typically play out? One of two ways. The less likely scenario is probably one where Facebook’s growth hits a wall and investors quickly slash the P/E ratio they are willing to pay by 2-3 times. That would be ugly, but does not appear to be the most likely outcome given their momentum right now. The more likely scenario is the one that we usually see with very good companies that have staying power but simply have seen their stock prices get ahead of the fundamentals. In that case, the cash flow multiple comes down slowly over a period of several years, resulting in the stock price lagging the company’s underlying profits.

If I had to guess, I would say the latter seems like a real possibility going forward from here. Regardless, investors should check to see how much of a hit a high-flying tech company’s cash flow would take if stock compensation was factored into the equation. As Warren Buffett likes to say, “if stock-based compensation is not a real expense, I don’t know what it is.”

Full Disclosure: No position in Facebook at the time of writing, but positions may change at any time

LinkedIn: Another Overvalued Tech Stock Crashes Back To Earth

LNKD

Looking at the quote for career-minded social networking site LinkedIn (LNKD) today might convince you the company is in serious trouble. However, if you read the company 2015 financial results press release you will see that revenue hit $3 billion in 2015, double 2013 levels. Operating cash flow rose 42% to $800 million and the company forecast 2016 revenue of $3.6 billion, up 20% versus last year. So how on earth is the stock down nearly 50% today after releasing their results?

Valuation. Valuation. Valuation. Yesterday the company’s equity was valued by the market at $25 billion. Investors were willing to pay 8 times annual sales, more than 30 times operating cash flow, and more than 80 times annual free cash flow. That price was, to put it mildly, quite rich. The result was a bar that was set so high that it was quite likely LinkedIn could not jump over it. And then the stock gets crushed as investors realize they too can (and will) stumble relative to high expectations.

So should investors go out and back up the truck on companies like LinkedIn? Here’s the problem. The price was so high before today that even after a 45% decline, it is still not cheap. For example, LinkedIn reported $300 million of free cash flow in 2015. If you assume that figure will grow in-line with sales in 2016, it would reach $360 million this year. Not only does the stock still trade at 40 times free cash flow after today’s decline, but as a fast-growing technology company LinkedIn issues a very large amount of stock-based compensation. In 2015 it amounted to a whopping $510 million. In other words, if the company paid their employees with cash only, rather than cash and stock, the company would generate negative free cash flow. Accordingly, it is difficult to ague that investors are getting a bargain even with LinkedIn trading at $106 per share, down from a high of $276 within the last 12 months.

As is usually the case, sky-high valuations set companies and investors up for big problems down the road. High-flyer buyer beware.

Full Disclosure: No position in LNKD at the time of writing, but positions may change at any time

Sorry Goldman Sachs, Apple Is A Hardware Company Plain and Simple

Shares of Apple (AAPL) are rising $3 today to $116 after Goldman Sachs added the stock to its “conviction buy list” and raised its price target to $163 per share (from $145). Goldman’s thesis is that Apple is transitioning from a hardware company to a recurring revenue services business, which will allow it to garner a higher earnings multiple on Wall Street (which in turn would lead to meaningful price appreciation). While many of my clients are long Apple stock, I don’t buy this “Apple is really a software company” argument.

If we take a look at the numbers it is hard to argue otherwise. In fiscal 2015 Apple derived 9% of its total revenue from services, with 91% coming from hardware (led by the iPhone at 66% of sales). Okay, so Apple is a hardware company today but maybe the services segment is growing so fast that it will ascend quickly to be a huge part of Apple’s business? In fiscal 2014 services represented 10% of sales. In fiscal 2013 it was 9%. The mix isn’t changing at all.

So what services business will really start to grow in the future and allow this software thesis to play out? Goldman Sachs, among many others, point to Apple Pay. Apple’s receives a cut of every credit card transaction processed through its Apple Pay iPhone app (the press has reported the rate to be 0.15% but Apple will not confirm this). So if Apple Pay continues to gain market share in credit card processing, will that make a big difference to the company’s financial results? Not at all.

Total U.S. credit card volumes are staggering; more than $2 trillion per year. Let’s be optimistic and say that Apple Pay can grab 25% of all credit card transactions. The result would be about $900 million of Apple Pay service revenue. That sounds like a lot of money until you realize that Apple is booking more than $230 billion of sales annually. An extra $900 million comes to less than one-half of one percent of incremental sales. Even if we model that as 100% profit, it would add just 16 cents to Apple’s annual earnings per share. It’s a rounding error.

The bottom line is that Apple is a hardware company. Could that change in 5-10 years? Perhaps, but it’s not going to happen anytime soon and as a result, investors should not expect the company’s P/E multiple to expand materially. That is not to say the stock won’t perform well, I just don’t think it’s going to trade at or above the valuation of the S&P 500 index, which would be required if the stock is going to see $163 anytime soon.

Full Disclosure: Long shares of Apple at the time of writing but positions may change at any time.

Yahoo Update: I Might Be The Only Person Who Likes Marissa Mayer’s Turnaround Plan

Nearly three years ago I wrote a bullish article on Yahoo (YHOO) after ex-Google exec Marissa Mayer took over as CEO, with the stock at $16 per share (Does Marissa Mayer Make Yahoo Stock A Worthwhile Bet?). After the stock had doubled a year later I postulated that it was fairly valued, but for a while now I have moved back into the bullish camp. The skeptics point out (correctly) that the stock’s huge run since Mayer’s hire is mostly due to a massive increase in the value of its stake in Chinese e-commerce giant Alibaba (BABA), the last of which will be spun off to shareholders in late 2015 or early 2016.

The consensus view on Mayer’s efforts to reinvigorate the company’s core business is quite negative. Many of the hedge fund activists who pushed for the BABA spin-off have publicly called for Mayer’s exit. While Yahoo’s own financial results remain about where they were when Mayer took over three years ago, the make-up of that business has changed dramatically, which positions the company very well for the future.

Back in 2012 Yahoo’s core business was like a melting ice cube, as user preferences were moving away from both the Yahoo brand and from desktop search. Much to Mayer’s disappointment, the company had hardly any presence in areas like mobile and social media, even though that was clearly where online usage was going. So, Mayer made a big push into what she calls “Mavens” (mobile, video, native, and social). By revamping Yahoo’s mobile apps, acquiring upstarts like Tumblr, and refocusing the company on current usage trends, Mayer’s plan was to expand into areas of growth in order to offset the slowly declining legacy business (conducting internet searches on yahoo.com from a desktop computer is so 1995). Perfectly logical.

Mayer’s critics, however, are unimpressed. Yahoo’s annual revenue dropped from $5 billion in 2012 to $4.6 billion in 2014, as legacy declines more than offset growth in Mavens. Since Mavens started from practically zero in 2012, it is going to take a while for the new businesses to get large enough to overshadow the legacy ones, but when that happens Yahoo can begin to see absolute growth again. Mayer is making a lot of progress on this front. Mavens revenue in the second quarter of 2015 was $400 million, or 1/3 of total company sales, representing growth of 60% year-over-year. The plan is working despite the multi-year timeframe.

But the real reason I am bullish on the stock at current prices ($39) is the fact that Wall Street has basically decided that Yahoo’s core business has no chance of returning to growth, ever. The soon-to-be spun off Alibaba stake is worth $32 billion or $34 per YHOO share (the after-tax value is less — $22 per share — which is relevant if Yahoo cannot get IRS approval for a tax-free spin-off). Add in the market value of Yahoo Japan ($6 per share after-tax) and Yahoo’s current net cash position ($6 per share) and you can see that investors are getting core Yahoo for a pittance. Even assuming a fully taxed Alibaba stake, core Yahoo is valued at only $5 per share (around 1 times current annual revenue). Assume a tax-free spin of BABA and you get a ridiculous figure for core Yahoo’s value — negative $7 per share!

Given the momentum the Mavens businesses are seeing right now, coupled with the $7 billion of cash on the company’s balance sheet (fuel for more acquisitions, perhaps), I actually think Mayer can turn around the Yahoo ship in the not-too-distant future. Paying just $5 per share for the core business even in the worst case scenario makes the risk/reward trade-off  extremely favorable. For investors who are willing to hold the Alibaba stock for the long-term (that company is very well-positioned), I can easily see Yahoo shares being worth over $50 a year or two from now on a cumulative basis.

Full Disclosure: Long shares of YHOO at the time of writing, but positions may change at any time

New Amazon Disclosures Reinvigorate Bull Case For Investors

Amazon (AMZN) is a fascinating company for many reasons and their latest investor relations move has gotten the markets excited about their stock once again (it’s up 57 points today alone as I write this). Bulls and bears on the shares have long had a disagreement about the company. Shareholders argued that Jeff Bezos and Co. were purposely “losing money” in order to invest heavily in growth and attain massive scale. Bears insisted that the spending was required to keep their customers coming back, and that if the company started to show profits the business would suffer dramatically. Regardless of which camp you are in, one thing is clear; Amazon chooses growth over profitability in the short term if it thinks they can be successful.

So when the company announced that it would break out the financial results of its Amazon Web Services (AWS) business segment for the first time in its nine-year history starting in 2015, the consensus view was that the division would show losses. After all, if Amazon embraces short term losses in exchange for growth, and AWS is its fastest growing business, why would you think otherwise? So imagine the surprise last evening when Amazon announced that AWS is profitable, and not just a little bit. Operating margins for AWS during the first quarter of 2015 were 17%. Add back an estimate of depreciation expense and EBITDA margins are likely approaching 50%. And the stock price is rocketing higher on the news.

All of the sudden it is possible that Amazon does not hate reporting profits (some have speculated that income tax avoidance is a motivating factor). Instead, maybe they are being sincere and simply invest capital when they think they have a good reason, regardless of whether it results in short-term GAAP profits. And maybe the thesis that Amazon’s business model does not allow for profits is incorrect. That is surely what investors today are thinking. Given their corporate philosophy, there is no reason Amazon should be running AWS at a large profit, but they are. Why? Perhaps they have built a very good business. Simple enough.

The implications for the stock are important. We now have evidence that AWS is probably worth the $60 billion or so that the bulls have long thought. At the lows of the last year (below $300 per share), Amazon’s total equity value was only a little more than double that figure ($130 billion). The bears on the stock will probably stick to their guns that the current share price (approaching $450) is irrational, but if you actually run the numbers, it is not that hard to value Amazon in a range of $200-$250 billion based solely on what we know today, given that non-AWS annual revenue will approach $100 billion this year and AWS alone can account for 25-30% of that valuation. The stock is getting close to my personal fair value target, but is not quite there yet. And given that Amazon could very well surprise investors more going forward (they don’t exactly set the bar very high), I am not in a big rush to sell.

Full Disclosure: Long shares of AMZN at the time of writing, but positions may change at any time

Why Carl Icahn’s $216 Fair Value for Apple is Unrealistic

You may have read Carl Icahn’s letter published yesterday in which he outlines why he believes Apple stock is worth $216 per share today. With the stock currently fetching an all-time high of $127, making it the most valuable company ever, you might be wondering if a company already worth nearly $750 billion can really still be 70% undervalued. Quite simply, I do not believe so. Let me explain why.

First, I think it is helpful to look at a snapshot of the last five years, to give you an idea of where Apple stock has traded relative to its business fundamentals. Below is a chart I constructed that shows Apple’s revenue, earnings per share, ending stock price, and ending P/E ratio since fiscal 2010, along with consensus forecasts for the current 2015 fiscal year and Carl Icahn’s above-consensus estimates.

apple-feb-2015From this chart you should be able to see how Icahn is getting such a sky-high fair value estimate for Apple; he’s using an extremely optimistic P/E ratio assumption. There are many reasons why Apple shares are unlikely to fetch a P/E ratio of 20+ ever again. Some that come to mind are:

1) Apple’s current size – With annual sales of over $200 billion, investors are unlikely to assume dramatic growth rates from here, which limits the multiple of earnings they are willing to pay.

2) Apple’s industry – Though it may be hard to fathom right now, the tech sector has a decades-long history of musical chairs when it comes to market dominant companies, so investors often will discount their valuations if it seems as though things can’t get much better and a technological shift in consumer preferences is likely at some point in the future.

3) Apple’s poor capital allocation – When you are keeping $141.6 billion of net cash on your balance sheet investors will not always give you full credit for it since it is not generating an adequate return. When the cash pile reached $100 billion people were miffed and the hoard is more than 40% higher. For comparison’s sake, Apple’s total cash outlay for capital expenditures and acquisitions was $13.5 billion in fiscal 2014, making their cash “buffer” equal to more than 10 years’ worth of growth investment.

4) Apple’s historical valuation – Over the last five years Apple’s average P/E ratio at the end of its fiscal year has been 15. Carl Icahn’s insistence that Apple is worth 50% more than that does not make much sense. Over that five-year period Apple’s sales have tripled. A higher P/E ratio usually implies the expectation of higher growth. It will be very difficult for Apple to triple its business over the next five years, which would mean that the average P/E ratio during that time could very well be less than 15 (not over 20).

So what do I think Apple stock is worth? Well, first off let me point out that I am far from an Apple bear. I have been long the stock for many years and some of my clients have an average cost basis in the single digits per share. I just think investors’ expectations should be more muted than Carl Icahn’s. Consistent with the points outlined above, I think Apple shares will trade at a P/E ratio between 10 and 15 going forward. Using a $9 EPS figure for fiscal 2015 and giving the company full credit for its cash position, that gets you to a range of $114-$159 with the midpoint being $136 per share. Relative to today’s price of $127 Apple stock is neither dramatically overvalued nor undervalued.

 

“Profitless” Amazon Myth Lives On Thanks To Lazy Financial Media

Last night CNBC premiered their newest documentary entitled Amazon Rising. I tuned in, as I have thoroughly enjoyed most of their previous productions. I found this one to have a noticeably anti-Amazon vibe, but none of the revelations about the company’s business practices should have surprised many people, or struck them as having “crossed the line.” For me, by far the most annoying aspect of the one-hour show was the continued insistence that Amazon “barely makes any money” and “trades profits for success.” It’s a shame that the media continues to run with this theme (or at least not correct it), even when the numbers don’t support it.

Most savvy business reporters understand the difference between accounting earnings and cash flow, the latter being the more relevent metric for profitability, as it measures the amount of actual cash you have made running your business. There are numerous accounting rules that can increase or decrease the income you report on your tax return, but have no impact on the cash you have collected from your customers. A good example would be your own personal tax return. Did the taxable income you reported on your 2013 tax return exactly match the dollar amount of compensation that was deposited into your bank account during the year? Almost by definition the answer is “no” given that various tax deductions impact the income you report and therefore the taxes you pay. But for you personally, the cash you received (either on a net or gross basis) is really all that matters. One can try to minimize their tax bill (legally, of course) by learning about every single deduction that may apply to them, but it doesn’t change the amount of pre-tax cash they actually collected.

As a result, the relevent metric for Amazon (or any other company) when measuring profitability should be operating cash flow. It’s fancy term that simply means the amount of actual net cash generated (in this case “generated” means inflows less outflows, not simply inflows) by your business operations. In the chart below I have calculated operating cash flow margins (actual net cash profit divided by revenue) for five large retailing companies — Costco, Walgreen, Target, Wal-Mart, and Amazon — during the past 12 months. The media would have you belive that Amazon would lag on this metric, despite the cognitive dissonance that would result if you stopped to think about how Amazon has been able to grow as fast as they have and enter new product areas so aggressively. After all, if they don’t make any money, where have the billions of dollars required for these ventures come from? The answer, of course, is that Amazon is actually quite profitable.

AMZN-CFO-Margins

As you can see, if we measure “profitability” by actual cash collected from customers, over and above actual cash expenses, as opposed to the accounting figure shown on their corporate tax return or audited income statement, Amazon’s profit margins are actually higher than each of those other four companies. Shame on the media for giving everyone a pass when they insist Amazon doesn’t make money, or at least “barely” does so. They make more money, on a cash basis anyway, than many other large, well-known retailers whose profit margins are rarely questioned.

Full Disclosure: Long Amazon and Target at the time of writing, but positions may change at any time.

Zuckerberg, Facebook Move To Mimic Amazon & Google’s “Go Anywhere” Strategy

My last post about Facebook (FB) back in February speculated that its 15% valuation premium to Amazon was not justified (the spread has since narrowed and I continue to feel the same way today) but this post is more general in nature. Perhaps Mark Zuckerberg’s biggest challenge is figuring out what’s next for Facebook. He would likely admit privately that overall Facebook usage is likely to decline over time. Calling the site/app a fad is too harsh, but Facebook has already lost some of its cool factor (once your parents and grandparents are using the service, kids are likely to move on to something else) and it is entirely reasonable to expect that the average user today will spend less time on Facebook on a daily basis five years from now than they do now. So how does the company evolve?

I find this an interesting question because technology companies did not always move this fast. It used to be rare (and still is, to a large degree) that tech companies were much more focused. They rarely made 180-degree turns and ventured into completely unchartered territory, and those that did often failed (Microsoft, for instance, has maintained its lead in enterprise software, but has had numerous duds trying to gain traction in the hardware market — think Zune, Surface, Windows-based phones, etc).

In recent years, however, two companies in particular have challenged this focused strategy; Amazon (AMZN) and Google (GOOG). Jeff Bezos started out selling books online and now he will gladly sell you physical books, digital books, as well as Amazon-branded digital book readers, tablets, and streaming television devices. But it doesn’t end there. Amazon has cut out the middleman and now has its own book publishing unit, television production company, and game development studio. If something makes it more likely and/or easier for you to use Amazon, they are going to consider making it. It might seem like a disorganized strategy, but most of these products and services fit together in some way, if you take the time to think it through.

Google is very much doing the same thing, but it’s various special projects are less obvious in terms of cohesiveness. When you have hundreds of millions of people using your email service, file storing service, and search engine, it makes sense to sell your own tablets and phones (to make it easier to access those services and therefore less likely you will switch to a competitor). Self-driving cars and internet-connected eyeware do not exactly fit that mold, but when you have the money, desire, and brainpower to venture into new and exciting areas, why not? If not Google, then who?

With its IPO behind it, I think Facebook finds itself in a similar position. They have a bilion users, billions of dollars in the bank, and thousands of excellent engineers. As Mark Zuckerberg has stated publicly, the future of Facebook is not about the blue app on your phone (another indication he knows the original Facebook service will fade over time). Facebook’s future success depends on its ability to move into new areas and succeed in doing so. With a hugely valuable stock and plenty of cash, Zuckerberg has placed two big bets in recent months; $19 billion to acquire the WhatsApp messaging service, and $2 billion to acquire virtual reality goggle maker Oculus. Are these the right moves? Will the next five moves he makes be largely successful when we look back five or ten years from now? These are open questions.

Right now Wall Street is giving Facebook the benefit of the doubt. As an investor, I am more skeptical. While Facebook could certainly be the next Google or the next Amazon, I think it might be a tougher task for Facebook to succeed with the “go anywhere” tech strategy. Google will bring in over $65 billion in sales this year. Amazon will come close to $90 billion. Facebook is projected to be around $11 billion. And yet Facebook is worth more than Amazon and about 40% of Google, based on current equity market values. Of the three, I like Amazon most from a stock perspective as of today. Of the three, I think Facebook has the most risk, the most to prove, and the shortest track record from which to predict success.

It will be fascinating to see where Zuckerberg takes the company over the next few years, and whether he can come to dominate multiple domains like Amazon and Google have. These three companies have changed what technology business models look like, and for their efforts now sport a combined stock market value of two-thirds of a trillion dollars. Not bad considering that none of the three companies even existed in 1993.

Full Disclosure: Long Amazon at the time of writing, but positions may change at any time.

Amazon ($AMZN) Sales Growth Projections for Next Two Years Appear Overly Optimistic

Investors have been reallocating capital out of Amazon ($AMZN) shares fairly heavily since the company reported a lackluster fourth quarter earnings report. After peaking over $400 in January the stock has dropped about 75 points to the low 300’s. In fact, I actually think the stock is beginning to look compelling for long term investors, if you believe Amazon will continue to successfully enter new markets, as the shares now fetch only about 1.5 times 2014 revenue (after deducting net cash). While profit margins remain low (cash flow of $5.5 billion in 2013 equated to only 7.4% of sales), those that claim Amazon makes no money don’t seem to dig into the company’s financial statements very deeply.

All of that said, after looking at Amazon’s sales trends over the last 15 years, I believe that Wall Street is currently overly optimistic about sales growth at Amazon for the next two years. If you believe that investors will be focused on sales growth, in lieu of material profit margin gains in the intermediate term, it would imply that Amazon bulls can take their time building long-term investments in the stock over coming quarters.

So why do I think Amazon will be hard-pressed to achieve the current consensus estimates for sales in 2014 (up 21% to $89.9 billion) and 2015 (up another 20% to $107.6 billion). First, let’s look at Amazon’s annual sales since 1998:

AMZN-REV-1998-2015

Simply looking at this data may cause you to feel pretty upbeat about Amazon’s business. Over the past 15 years sales have grown an astounding 41% per year, rising from under $1 billion in 1998 to nearly $75 billion in 2013. Is it really a stretch to asssume that two more years of 20%+ growth could be in the cards?

The problem Amazon is going to begin to face is the fact that once you reach a certain size, it becomes nearly impossible to continue to grow at 40%, 30%, or even 20% per year. Finding an additional $15.4 billion of revenue in a single year (the incremental figure analysts estimate Amazon will book in 2014) is no easy feat. In fact, Amazon’s total revenue in 2007 was just $14.8 billion, so “2014 Amazon” must equal “2013 Amazon” plus “2007 Amazon.” With annual revenue approaching the $100 billion level, the company’s growth rate is likely to begin to slow soon.

Is there any way to know when exactly growth will decline significantly? Not really, but one of the numbers I like to focus on is incremental revenue growth, in dollars, from one year to the next. As a company gets larger and larger, the amount of incremental sales growth needed simply to maintain its growth rate rises fairly sharply. In fact, if we chart out Amazon’s incremental annual sales growth since 1999, we can see patterns emerge:

AMZN-INCREM-REV-1999-2015

For instance, between 1999 and 2006 Amazon was able to grow sales by between $1-2 billion a year (roughly). That figure rose to $4-5 billion from 2007-2009, and accelerated to $10 billion in 2010 after the recession ended. Interestingly, over the last three years Amazon has hit a wall. In both 2012 and 2013, incremental sales growth at Amazon failed to eclipse 2011 levels. I believe this could be the beginning of a period where we see Amazon’s sales growth slow materially.

Perhaps problematic, the current Wall Street consensus forecast calls for Amazon’s incremental revenue growth in dollars to reaccelerate to more than $15 billion this year, and again to nearly $18 billion in 2015 (look at the orange bars in the above chart). While there is no assurance that this figure cannot continue to climb, there will be a time when Amazon simply cannot continue to find that much new revenue each and every year (without making large acquisitions anyway, not something they have typically done). Given that a disappointment in merchandise sales growth has been a key driver of Amazon’s recent stock market weakness, I believe it is entirely possible that both 2014 and 2015 sales forecasts are too high. Maintaining annual sales growth of 20% for much longer seems unlikely, perhaps even starting this year.

As I mentioned at the outset of this article, however, I don’t necessarily think this would spell the end of Amazon’s stock market stardom, at least not long term. If Jeff Bezos is willing to show investors that he is willing to demonstrate that profit margins can be susteained at levels above those currently being attained, investors would likely be very pleased and any short term stock decline would quickly be reversed. After all, annual sales approaching $100 billion offer Amazon the ability to generate some very impressive free cash flow, which would make the stock’s current market value of $150 billion seem not so unreasonable.

In coming quarters, I will be focused on Amazon’s sales trends and if I am correct and the current consensus forecasts are too aggressive, any continued short-term weakness in Amazon shares could present investors with an excellent opportunity to continue building a long-term position in the stock.

Full Disclosure: Long AMZN at the time of writing, but positions may change at any time

Is Facebook ($FB) Really Worth 15% More Than Amazon ($AMZN)?

If you needed more proof that there is another bubble forming in Silicon Valley 15 years after the last one ended badly, how about this headline:

“Facebook to acquire WhatsApp for $19 billion”

This announcement makes the Facebook ($FB) deal to buy Instagram for $1 billion in 2012 look like the biggest bargain in U.S. corporate merger and acquisition history. Maybe the Snapchat guys were smart to turn down the $3 billion Mark Zuckerberg offered them. Their asking price is probably $10 billion now and they just may get it now. All of the sudden the debate over whether Twitter ($TWTR) is worth $40 billion with only $1 billion in annual revenue takes a back seat. Now WhatsApp, a company many people have never heard of, is in some eyes worth half that price without a penny of revenue (Correction at 5:05pm PT: The WhatsApp app is free for the first year, then users pay $0.99 per year, so they technically do have revenue, although 8 cents per month is not material in my mind).

Rather than debate whether startups without fully formed business models are worth tens of billions of dollars, the more interesting thing to me is that Facebook’s current market value is now $185 billion after you add in the $15 billion of new stock they are giving WhatsApp (along with $4 billion in cash). Amazon ($AMZN), after its recent post-earnings report decline, has an market value of just $160 billion.

I might be completely wrong about this, but if I had to pick one of those stocks at those prices for the next 5 years, I’d take Amazon over Facebook in a heartbeat, even ignoring the fact that I would be getting it at a discount. I just don’t think Facebook usage five years from now will be as high as it is today. They seem to share this view, based on their recent buying spree, which has resulted in them targeting competing apps that they intend to operate completely separately from the Facebook platform.

Essentially, it’s an “app grab” and they have plenty of money and equity-raising ability to pay huge amounts in order to place bets on which apps will dominate in the future. Given how fast consumers’ technology preferences change (if you looked at the top 10 most visited web sites from 10 years ago you would giggle), I think it will be really hard to know which apps will be long-term winners. And paying $19 billion for one seems truly remarkable to me.

Along those lines, for investors looking for a way to play their opinions on how these kinds of things play out longer term, I think you can make some interesting bets using paired trades to reduce your market risk. For instance, getting Amazon for a 15% discount to Facebook looks intriguing to me, and I am putting a little money on that paired trade; short Facebook, long Amazon. It’s a market-neutral bet that simply is a play on Amazon narrowing that valuation gap, and quite possibly overtaking Facebook, in the next, say, 3 to 5 years.

Now, I could be completely wrong here (and in technology it’s easier to be wrong than in other industries), but right now I just think the sentiment has shifted so much lately (to Facebook and away from Amazon, though not for the same reasons), that I’m willing to put a little money on the line. It wasn’t that long ago that Faecbook was written off shortly after its disasterous IPO and after a mediocre holiday quarter (in the eyes of some anyway), Amazon shares have dropped 60 points in short order.

From hero, to goat, to hero again, in less than 2 years...
Facebook: from hero, to goat, to hero again, in two short years…
Concerns about Amazon's low profit margins seem to be moot after the WhatsApp deal...
Concerned about Amazon’s low profit margins? $19B for WhatsApp has to help…

 

Full Disclosure: Long Amazon and short Facebook at the time of writing, but positions may change at any time