On June 30, 1994, Jeff Bezos quit his job at quantitative hedge fund D.E. Shaw in New York and started driving across the country. He arrived in Seattle five days later and founded Motley Fool Stock Advisor pick Amazon.com (Nasdaq: AMZN ) .
At D.E. Shaw, Bezos made millions of dollars using superior brain and computing power to outwit competitors in securities markets. In his current role, not much has changed. Although Bezos is now worth billions instead of millions, and although he no longer uses stocks, bonds, and derivatives as his competitive advantage to exploit retail markets, he does still use quantitative data. As the owner of roughly a quarter of Amazon's stock, he directly keeps 25% of every dollar of appreciation in Amazon stock, rather than a hedge fund's usual 20% cut, which is before expenses and taxes.
The next Wal-Mart?
I read a Fool article yesterday about disruptive innovation. I believe Amazon will be one of those disruptive innovators and change retailing as we know it, because it doesn't have to play by the same rules as other retailers do. Three of the most important aspects that retailers compete on are location, pricing, and customer service, and I believe Amazon can capitalize on all three.
Location, location, location
It's no surprise that with our busy lives, we tend to shop at the nearest store that can supply our needs. Wal-Mart (NYSE: WMT ) and Target (NYSE: TGT ) have become retailing behemoths because they offer low prices and a broad line of products, and they're usually in the neighborhood occupying the choicest retailing real estate.
But Amazon might have the most valuable real estate of all: Internet real estate. The local Wal-Mart or Target enjoys a huge advantage because of its proximity, but I believe Amazon enjoys a similar advantage because of its brand. Some 57 million customers shop at Amazon every year, and Amazon has built its brand to become the first online retail destination customers think of when they want to buy something online.
The beauty of this "virtual" real estate is that it is not limited by physical boundaries. Amazon sells to all of North America using a grand total of seven fulfillment centers. In contrast, Wal-Mart and Target have to build out and pay rent and personnel costs for thousands of retailing locations. Every year that goes by, Amazon widens its moat by adding more customers, more products, and more third-party sellers. Amazon stocks 1 million unique products in inventory, whereas grocery stores stock roughly 50,000, and supercenters stock around 125,000. What's more, Amazon sells out its entire inventory 14 times per year, which is more than Costco (Nasdaq: COST ) , Wal-Mart, and Best Buy (NYSE: BBY ) , whose inventory turns are 12, eight, and eight times.
Furthermore, Internet real estate doesn't require Amazon to make monthly lease payments. But Amazon, in turn, can collect rent from other retailers by "renting" out its virtual real estate. In fact, Amazon made roughly $3 billion last year, or 30% of sales, from outside sellers by "renting" out its Internet real estate to third-party sellers.
Amazon continually lowers the bar on pricing. Its 24% gross margins are roughly equivalent to Wal-Mart's 23% and Best Buy's 25%. Because Amazon's biggest disadvantage is the time and cost of shipping products to customers, the company continually whittles away at that barrier by offering customers faster and cheaper shipping options. For $79 per year, Amazon customers can prepay their entire year's shipping fees and receive every purchase within two days, or they can get overnight shipping for just $3.99. The $79 fee seems steep, but is it really that different from the membership fees that Sam's Club and Costco charge? There's reason to believe Amazon can lower the bar even more on pricing going forward. Whereas bricks-and-mortar retailers' real estate and personnel costs inexorably increase over time, the cost of computing and technology inevitably decrease, and because of Amazon's heavy reliance on technology and relative lack of reliance on personnel and real estate, its cost advantage should become greater over time.
Thanks to its quantitative-oriented founder, Amazon has become adept at using its massive amount of customer data. By virtue of the Internet, Amazon can track its customers' every move, including their entire purchase histories. Not only can Amazon tailor its site to its customers' preferences and offer relevant recommendations, but it can also offer much more useful data to customers to facilitate purchases. Retail competitors simply cannot replicate Amazon's customer reviews and its ability to provide detailed product data at the point of purchase.
Here comes the tricky part. By almost any metric imaginable, Amazon is overvalued. It trades at roughly 50 times trailing net income. So buying Amazon's shares at current valuations requires a leap of faith. One must believe in Bezos' vision and trust that current costs and expenditures will create abundant future free cash flow. In the past 12 months, technology spending amounted to $485 million, an increase of $166 million. Amazon also spent $192 million on net shipping charges, an increase of $45 million from the previous year, and capital expenditures increased to $221 million from $186 million. If Amazon chose to raise prices, cut shipping incentives, and reduce capital expenditures, it could easily boost short-term profits and free cash flow and make the current stock price look much more attractive.
However, Bezos adamantly sticks to his plan of incurring short-term costs to build long term value, and at the end of the day, Bezos ultimately gains the most from any future appreciation. Amazon's stated long-term goal is to earn triple-digit returns on invested capital, which translates into a goal of more than $1.5 billion in free cash flow, more than quintuple current levels. (I'd also like to note that Amazon is one of the only companies I know that reports the cash flow statement before the income and balance sheet statement.)
As a value investor, I have a tough time investing at seemingly nosebleed valuations. No matter how much I believe in the Amazon story, old habits die hard. However, I believe that Amazon will be worth substantially more in the future, and I'm waiting patiently for Amazon shares to slip to a more attractive price.
For additional value-investing ideas, start up a risk-free 30-day trial toMotley Fool Inside Value, where Wal-Mart is a recommended stock. Amazon, Best Buy, and Costco are allMotley Fool Stock Advisorpicks.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.