<THE RULE BREAKER PORTFOLIO>
What Happened to Fool Port?
Looking at Blodget's Assumptions
By Louis Corrigan (TMFSeymor@aol.com)
Atlanta, GA (Dec. 18, 1998) -- The Rule Breaker broke more new ground today, digging out another 3.03% gain to unearth a stunning 150.18% return for the year. Meanwhile, the S&P added 0.68% and the Naz another 2.07% as those techs continue to lead the market higher.
Portfolio newcomer Amgen (Nasdaq: AMGN) jumped $2 1/16 today on reports that it won an arbitration battle against Johnson & Johnson (NYSE: JNJ) and so gets to keep all the rights to its one dose per week version of the important drug Epogen. Meanwhile, Starbucks (NYSE: SBUX) added $2 1/8, no doubt because it's finally gotten cold in Atlanta and people are racing in for hot lattes.
On the e-commerce front, America Online (NYSE: AOL) sprinted ahead $5 13/16 on news that last minute shoppers can get what they need in a hurry by going to keyword: Last Minute Gifts. You can choose any of 500 items, and AOL's merchants will have it at your uncle's door within 24 to 48 hours. Then there's Amazon.com (Nasdaq: AMZN), which soared another $9 15/16 because, well, that's just what Amazon does.
Today, I actually do want to talk more about Amazon because the Rule Breaker port report hasn't offered a close examination of the $400 twelve-month price target announced Wednesday by CIBC Oppenheimer analyst Henry Blodget. Since the market reacted so decisively to that projection, we should take a closer look. My first reaction was pretty mainstream: What an insane target! Was Blodget on an eggnog high when he penned this recommendation, or what?
I should say upfront, though, that I have limited credibility on the Amazon front. I argued in February that Amazon was still a buy at a split-adjusted $29 1/2 a share. I've also written favorably about it several other times, and I've warned against shorting it. Still, I'm also on record as saying that it looked fully valued at half the current quote. I even went so far as to ask why the Rule Breaker port wasn't cashing out. Guess that's why I'm not managing this portfolio!
Now that I've swallowed my crow sandwich, what about Blodget's report? Well, the guy is not nuts. With Amazon trading at $240, he wrote that the stock is "incredibly expensive relative to near-term expectations" and "scary to buy." His "Strong Buy" is based on some aggressive estimates about Amazon's long-term growth and Blodget's sense that people simply believe the story and will continue to do so based on Amazon's extraordinary revenue growth. Still, where does the $400 target come from?
Blodget ran three different valuation "exercises" and then kinda blended together the results. First, he took the current price-to-forward revenue multiple of 15, plugged in his official year 2000 estimate of $1.5 billion, and came up with a $380 target. Second, he took his aggressive year 2000 growth estimate of $3 billion and multiplied that by 10 and got a price target of $500. Note that both of those valuation stabs are based on revenue models. The third exercise addressed earnings. For that, he took his five-year aggressive growth earnings estimate of $10 a share and discounted it back to the present at a 20% rate to come up with a $300 target. Add up the three targets and divide by three, and you get something around $400.
David and Jeff, our Rule Breaker managers, pretty much agree with Blodget when he says that investors have made the most money on Internet stocks when they've "had the foresight to invest in the stocks of the leading companies before their business models were proven." The Rule Breaker bought AOL before it was profitable and when the idea of Tom Hanks and Meg Ryan getting together via AOL must have seemed farfetched, to say the least. (Ok, it's still farfetched.) Still, as fellow Fool Warren Gump suggested in his discounted cash flow model for Amazon, projections like the ones Blodget makes include a lot of assumptions, some of which are pretty much guesses. Before you embrace one analyst's target price, you need to look at the assumptions behind the numbers.
For a quick look at the revenue models, let's figure that Amazon will do $190 million in sales in the current quarter for a total of about $550 million for FY98. Blodget's models, then, point to somewhere between 65% and 133% annualized growth over the next two years. Of course, Amazon will no doubt beat the $190 million Q4 estimate, immediately reducing Blodget's growth assumptions.
On the other hand, even with fabulous revenue growth, the price-to-revenue multiple will surely depend on what kind of profit margins Amazon can manage or can be expected to manage. Many high-volume, low-margin retailers trade at price-to-sales ratios of anywhere between 0.3 and 2.5. So a multiple of even 10 times sales for Amazon seems quite high unless you assume Amazon will be more than twice as profitable as a Wal-Mart (NYSE: WMT), which carries 3.2% net profit margins and trades at about 1.3 times sales. Taking Blodget's aggressive estimate of $3 billion in sales for 2000 and giving Amazon a price-to-sales multiple of just 6, his model #2 target would fall 40% to $300, pretty much destroying his overall projections.
But let's look at the earnings model directly. Assuming 70 million shares outstanding in 2003, then $10 per share in earnings would amount to $700 million in net profit, or about $1 billion in pre-tax operating profit given Blodget's view that Amazon can manage 10% operating margins. So that means Bezos & Co. will have to do about $10 billion in sales in 2003. Based on Blodget's aggressive estimate for 2000 revenues, that assumes Amazon grows revenues at a 50% annualized clip between 2000 and 2003.
I'm not sure where Blodget gets his estimate of 10% operating margins, which I'm calling a 7% net margin, but let's imagine Amazon perfects its hybrid business model. It will offer high-turnover, low-margin books, CDs, videos, and so on while also cashing in on much higher margin lease or ad or transaction or whatever you want to call it revenues from being a shopping intermediary. If we assume 80% of its sales generate net margins of 2.5% and that 20% of its sales generate 25% margins, then we arrive at 7% overall net margins. Of course, this model I'm sketching out assumes Amazon takes in a pretty stunning $2 billion in high-margin "lease/ad/whatever" revenue five years from now.
As I understand Blodget's discounting of those $10 per share in 2003 earnings, he's assuming a 2003 target price of about $750. Under my assumptions, that would value Amazon at over $52 billion, or five times what I'm guessing is his projection of $10 billion in 2003 sales. If you think Amazon can meet those revenue projections with 7% net margins and continued strong growth, Blodget's numbers don't look insane at all.
Still, his discount rate assumes that Amazon's investors will be happy with a 20% annual return from here. Given that the company's business model is unproven, investors might well insist on more than a 20% compound annual return, perhaps even as much as 40%. Discounting that $750 year 2003 target by 40%, fair value would be $140 today and $196 over the next twelve months. In other words, even using Blodget's aggressive assumptions, one might not want to pay more than $140 for the stock.
Of course, change some assumptions and you change the whole target price. Blodget's 10% operating margins are "optimistic." Yet, he also thinks margins could end up higher if we actually see pure digital delivery of music, books, and software. Then again, that assumes that any savings from downloading an album online rather than shipping out a CD will go to the distributor, and the music industry has said don't count on it.
The point is that, as investors, you need to think about the assumptions in any model and figure out whether they make sense to you. You should also put together your own models and determine whether a realistic scenario will compensate you adequately for the risk you're accepting.
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Day Month Year History Annualized R-Breaker +3.03% 20.84% 150.18% 739.59% 62.73% S&P: +0.68% 2.09% 22.42% 159.16% 24.35% NASDAQ: +2.07% 7.01% 32.85% 189.67% 27.56% Rec'd # Security In At Now Change 8/5/94 1100 AmOnline 1.82 104.94 5673.09% 9/9/97 440 Amazon.com 19.74 286.69 1352.48% 5/17/95 1960 Iomega Cor 1.28 7.38 475.99% 10/1/96 84 LucentTech 23.81 98.38 313.20% 8/12/96 130 AT&T 39.58 72.75 83.82% 4/30/97 -1170*Trump* 8.47 4.00 52.77% 12/4/98 450@Home Corp. 56.08 67.13 19.69% 2/20/98 200 Exxon 64.09 75.94 18.49% 12/16/98 290 Amgen 85.75 88.13 2.77% 7/2/98 235 Starbucks 55.91 53.38 -4.53% 2/20/98 215 DuPont 59.83 53.13 -11.21% 2/20/98 270 Int'l Pape 47.69 41.75 -12.46% 1/8/98 425 3Dfx 25.67 12.25 -52.27% Rec'd # Security In At Value Change 9/9/97 440 Amazon.com 8684.60 126142.50 $117457.90 8/5/94 1100 AmOnline 1999.47 115431.25 $113431.78 5/17/95 1960 Iomega Cor 2509.60 14455.00 $11945.40 10/1/96 84 LucentTech 1999.88 8263.50 $6263.62 4/30/97 -1170*Trump* -9908.50 -4680.00 $5228.50 12/4/98 450@Home Corp. 25236.13 30206.25 $4970.12 8/12/96 130 AT&T 5145.11 9457.50 $4312.39 2/20/98 200 Exxon 12818.00 15187.50 $2369.50 12/16/98 290 Amgen 24867.50 25556.25 $688.75 7/2/98 235 Starbucks 13138.63 12543.13 -$595.50 2/20/98 215 DuPont 12864.25 11421.88 -$1442.38 2/20/98 270 Int'l Pape 12876.75 11272.50 -$1604.25 1/8/98 425 3Dfx 10908.63 5206.25 -$5702.38 CASH $39332.55 TOTAL $419796.05
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