Weeks ago, we wrote in detail about the investment criteria for our new high-growth study. To review, the following are our high-growth investment criteria, greatly condensed.
Our high-growth company must have:
- Expanding new business opportunities;
- Attractive opportunities for existing business(es);
- A growing relevance in the world, as measured by increasingly relevant products, more strategic agreements, and more media coverage;
- A very likely 17-year period of significant growth for the company itself, not just the industry (in other words, strong visibility and competitive positioning);
- Honest, upfront management and investor relations who are willing to speak with us;
- Annual five-year sales growth rate of at least 20%, or the promise to exceed that;
- Annual five-year earnings per share growth of at least 25%, or if unprofitable now, a strong promise to soon exceed 25% annual earnings growth;
- A sustainable advantage over competitors and potential innovations;
- Self-financed operations and cash of more than 1.5 times long-term debt (much like a Rule Maker);
- Strong working capital and cash flow, along with a Cash King Margin of 20% or more, and a Foolish Flow Ratio below 1.4, or the promise to exceed these numbers;
- The higher the gross margin and return on invested capital, the better (this is considered on an individual basis);
- A market capitalization between $300 million and $50 billion.
We're adding two new criteria today (remember, this is a work in progress). The first one is that management must have a long-term focus, as indicated through its business plan, company mission statement, in conference calls, and through its business results. The second new criterion, taken from legendary investor Philip Fisher, is this: Management must have good relations with its employees.
This brings us to Amazon.com (Nasdaq: AMZN). The company is on our high-growth study list. In making cuts to that list, we asked you, Fools far and wide, to share your preferences on Amazon: Do we cut it or keep it? The votes favored cutting Amazon by about five-to-one for clearly stated reasons.
Some Fools are concerned that Amazon is too risky for us. It isn't profitable yet, and although many people believe it will eventually be profitable, nobody can reasonably estimate how profitable. Will it be profitable enough to merit substantial stock value creation from the company's current enterprise value of nearly $10 billion?
Rather than valuation, my main concern involves Amazon's current and lasting sustainable advantages, and in relation to that its potential profit margins. One of our criteria is a high (20%) Cash King Margin. This high margin implies lasting sustainable advantages. If a company does not have sustainable advantages, competitors swoop in and decrease its profitability level, knocking margins into single digits. High margins and sustainable advantages go hand-in-hand. Amazon is not poised to have large amounts of either.
Retailing is by nature low-margin and highly competitive. Several dozen large retailers compete for your retail dollars, and most of them are moving online (the large off-line names are steadily building websites). One of the most frequently used weapons in retailing is price, and the lower product pricing falls, the lower profit margins decline. In addition, online price wars are likely to be constant. Given its current business model, and even imagining potential variations on the current model (ad and referral revenue, for example), it is unlikely that Amazon will have profit margins much above 5%.
Now, high volume and efficient inventory management could still result in huge amounts of positive cash flow, which means that Amazon could still be a powerhouse -- just look at $200 billion Wal-Mart (NYSE: WMT) to see how that works. However, Amazon comes up short on other criteria, too.
The company has more debt than equity (its equity balance is actually negative and it has $2 billion in long-term debt); Amazon's management has not addressed its Commerce Network losses (Pets.com, Living.com, etc.) as candidly as we'd like; also, the past two holiday seasons, Amazon has needed to fight to keep employees happy, so unionizing has been threatened.
Finally, it is questionable how many new business opportunities exist for an online retailer that is best known for books and music, and that has tried other things with so-so results. Think about this: It's difficult for Amazon to expand its already-existing businesses in this country, short of opening bricks-and-mortar locations. The Internet's traffic is not growing the way that it used to. This lends to poorer visibility regarding future results. For all these reasons, we're going to side with most of our readers and drop Amazon from our high-growth study.
So, the companies that have advanced to the next round of our study so far are (listed in my current, but casual, order of preference): Genentech (NYSE: DNA), eBay (Nasdaq: EBAY), Millennium Pharmaceuticals (Nasdaq: MLNM), Paychex (Nasdaq: PAYX), Ariba (Nasdaq: ARBA), Mercury Interactive (Nasdaq: MERQ), Redback Networks (Nasdaq: RBAK), and Openwave Systems (Nasdaq: OPWV), formerly Phone.com. The entire list of contenders is linked in the top right of this page. To discuss the study so far, visit us on the Drip companies board.
Happy holidays, everyone! Fool on!