EBay, Mr. Market, and Amazon's Q2 Results

Mr. Market is a funny dude. At this writing AMZN is trading up about five percent on the day. The reason? eBay.

Well, eBay plus lofty expectations that Amazon's current positive trend continues through its Q2 earnings announcement next Thursday. A look over the last few quarters of the relationship among earnings expectations, actual earnings, and Mr. Market's reaction...let's just say it shows an interesting dynamic.

The eBay Angle

eBay announced its Q2 results last night and exceeded every consensus expectation on the metrics Wall Street uses to gauge its performance. (See Scot Wingo's always well-informed discussion of the results at eBay Strategies here.) Mr. Market has pushed its price up over 10 percent on the day, touching - ever so briefly - its own 52-week high.

One of those important Wall Street metrics is eBay's Gross Merchandise Value (more or less its auction and marketplace revenue) growing at 15 percent, which pretty much matches the growth rate of the overall e-commerce market.

So here comes Mr. Market's logic...

Since Amazon has been crushing the e-commerce growth rate, outpacing it 2:1 with Q1 results in April when Amazon increased revenue 34 percent. And...with eBay showing it can match industry growth in the most recent quarter, then there must be some good tailwinds for e-commerce right now. Ergo...Amazon is going to kill it with Q2 results next Thursday! So let's bet on Amazon! 

Well, Mr. Market, you may be right. I'll grant that Amazon will probably outpace industry growth yet again. But what happens if earnings - once again - don't follow revenue growth? Moreover, what if earnings  (gasp!) disappear altogether for Q2 as Amazon has suggested is a distinct possibility?

Going Back in Time (But Just a Little)

Let's go back in time to look at Mr. Market's previous reactions to Amazon's earnings. We'll use some charts based on Wall Street analyst estimates of Amazon's performance (provided here by Businessweek) and go backwards from most recent.

Last quarter, Q1 results, Amazon surprised Mr. Market by earning .28 cents per share. This after his consensus estimate was .07. The stock shot up about 15 percent in the two trading sessions immediately following the news. It was the second such positive report, which leads us to...

Q4 of 2011 Amazon reported .38 cents per share. Mr. Market has expected .18. A 110 percent upside surprise. The stock actually fell seven percent on the news. Maybe that's because Mr. Market still had not recuperated from the hangover caused by the previous quarter's different kind of surprise...

In Q3 of 2011 Mr. Market had high hopes for Amazon. He was expecting .25 per share after Amazon had posted a hefty .41 cents per share in the previous period. He was hoping for the trend to continue, and in anticipation of it he had run up the stock price by about ten percent since the last earnings announcement. Amazon only earned .14 cents per share. Mr. Market's great hopes were dashed, and he punished Amazon, sending its stock price plummeting from about $225 to about $200 within a couple days. It went as low as $173 before starting to climb back up again.

Over this past year, Amazon has been nothing if not volatile. Google Finance is quick to highlight its 52-week range as 166.97 - 246.71. That's a wide spread, indicative of Mr. Market and this game of expectations he likes to play...and the bi-polar extremes that take over depending on whether Amazon has lived up to his expectations.

Q2 2012 and the Profitability Bias

Well Mr. Market's expectations for next week's results are not too lofty. At least as conveyed by the consensus estimates. It's at .03 cents per share (though the range is quite wide: .17 cents on the high side and .23 LOSS on the low side).

But the reaction today to eBay's results suggest to me that there exists loftier expectations than he's letting on to with the estimates. I think he secretly expects HUGE revenue numbers that will wow investors into paying even more for the privilege of owning shares.

I wouldn't bet against that happening. But even if the big revenue numbers come in and earnings disappoint, this faith in Amazon's upward performance trend is going to be dashed. And Amazon losing money in Q2 is a very real possibility. (Its guidance from the Q1 press release said this: "Operating income (loss) is expected to be between $(260) million and $40 million, or between 229% decline and 80% decline compared with second quarter 2011.") We know how heavily the company is investing in growth, and how willing it is to let those growth costs eat up profits. (See Amazon's Rapid Sales Growth...Buying the New Business?)

So, even if revenue growth blows us away, losses tend to shake investors' faith. Why? The profitability bias. It's almost as if we have an instinctive visceral reaction to seeing losses in a business that was previously showing earnings. We just can't help but think more losses are coming, that there's something wrong with the company, and that the losses will extend into future quarters. We have very weak stomachs for these things. Even if we know the business has staying power, is investing heavily in initiatives to make even better profits in the future, or is just going through a temporary funk. We just get spooked. We overreact and send the price down.


That's the basis for the Shleifer Effect (discussed in such detail on Adjacent Progression). 

Note that I'm making no predictions for Amazon's results next week. I am, however, highlighting the appearance of high expectations combined with the POSSIBILITY (nothing more than that) of Amazon not satisfying those expectations. Plus, we've seen what happens to the stock price when Mr. Market's expectations are dashed.

I'll end with this incredibly inappropriate teaser...

Amazon finished today at 226.17. That's almost exactly where it was immediately prior to the Q3 2011 update when it disappointed and proceeded to fall to its year lows over the next three months.

Amazon Entering Smartphone Game...Why?

Bloomberg reported this morning that Amazon has its own smartphone in development, that the company is working with Foxconn in China for production, and that it has actively been acquiring wireless technology-related patents in advance of the launch. See the story here. 

Even more so than its decision to challenge Apple's dominance of the tablet market by introducing the Kindle Fire, this move into smartphones is likely to leave a lot of consumers and investors scratching their heads. What business does Amazon - a web retailer - have getting into the phone market? 

Let me take a stab at that...

Convergence of the Tech Giants

Though Jeff Bezos will deny it until he's blue in the face, this is a classic move of defense by playing offense.  

There's a convergence going on in technology.  Apple, Google, Facebook, and Amazon are quickly converging on the same base of customers. To be sure, there is a growth imperative at play, too. Each of these companies has become accustomed to growing at a rapid clip, and each has the ambition (and gall) to believe it should continue growing. And as each runs out of room to expand in its core markets, it will seek new growth by introducing services that poach customers from the other tech giants. The spheres in which they operate, once so placidly independent of each other, are beginning to overlap. If you put a Venn diagram of their markets on time-lapse video, the shaded areas of market overlap would grow darker and darker with each passing year. Convergence is happening.

And in a converging marketplace, if you don't play offense by actively growing into your competitors' markets, you run the risk that they will grow into yours in the near future. Offense becomes the best form of defense. It compels you to grow, thus the growth "imperative."

(To put this in the appropriate context, you should take a look at Farhad Manjoo's The Great Tech War of 2012, published in Fast Company back in October 2012.)

An Aside on Google

Google has been the most interesting case study for both the growth imperative and how a company reacts to convergence. For the time being, Google is spinning like a dervish. It seems to believe it must compete with each of these giants...and NOW. Its rivalry with Facebook has been well-documented with Google+. (See James Whittaker's Why I Left Google blog entry.) That's a competition for the future of advertising dominance, and I think it makes sense.

What makes far less sense to me is Google's foray into retail with its "Prime" one-day delivery deal with bricks-and-mortar shops (see this WSJ blog description and the best overview from amazonstrategies.com here). Google benefits from competition among lots of retailers selling the same products and bidding up adword search prices to get premier listing on the search engine. But with Amazon becoming the ubiquitous web retailer, more consumers are skipping Google altogether and just going straight to Amazon for searches. This is costly for the search engine. And so it goes on the offensive, putting its considerable clout (and resources) behind an attempt at a competitive retail offering.

According to a Walter Isaacson (the Steve Jobs biographer) HBR.org essay back in April, Larry Page visited Jobs in his dying days looking for advice. Jobs asked him..."What are the five products you want to focus on? Get rid of the rest, because they’re dragging you down. They’re turning you into Microsoft. They’re causing you to turn out products that are adequate but not great.”...FOCUS! Isaacson credits Page with taking the advice to heart. I think there's plenty of evidence to the contrary.

Amazon Devices to Prevent Apple iTunes Dominance

But back to Amazon and the smartphones. Amazon dips its toes in the water a lot. It's renown for its constant A/B testing and its devotion to running with winning concepts while ditching the losers. So once it decides on a strategy, Bezos brings the company all-in. 

In that regard, the smartphones can viewed as an extension of the reasons Amazon developed the Kindle Fire. A sizable chunk of its business is electronic media (songs, games, apps, movies, and books), and that media is being consumed more and more on mobile platforms. Apple gained an early lead in the market for those platforms with iPod, iPhone and iPad, creating a close-looped ecosystem of content to boot. Jobs and company might let others sell their content on iTunes, but they extracted a pound of flesh in return. This was problematic for Bezos and Amazon. To prevent total dominance by iOS, he had to present an alternative.

So we received the first iteration of Kindle Fire. But we know that electronic media is consumed on other devices as well, so it's only logical that Amazon continues its all-in philosophy to ensure it gets a piece of that action, too. I would expect more (and better) tablets in the future. I would expect better links into television sets (Amazon branded set-top boxes). I would expect music players. And I'm not surprised by the smartphones.

So What Should We Anticipate from the Amazon Move?

First, lots of hiccups. We saw this with the early Kindles and with the Kindle Fire. It's unavoidable when entering a sophisticated new market with complicated electronic technology. Amazon was not a device manufacturer a few years ago, but it is nothing if not a learning organization. Expect it to build on its experience, constantly improve, and ruthlessly eliminate defects. So, hiccups at first, but Amazon will only get better. 

Second, a low price. Amazon is committed to the low-margin/high-volume business model. It has the capacity to suffer, a willingness to take losses on the early batches of inventory while it grabs market share and improves its cost structure. 

Third, potential volatility in its stock price. Going all-in on phones - while juggling lots of other growth initiatives simultaneously - has the potential to move Amazon from profits to losses. And Bezos is not afraid of letting his company lose money for a while if he believes it will pay off in the long-term. The market, however, will not take kindly to this. It's reasonable to anticipate bad financial press and a hit to its stock price if the company sports losses over multiple quarterly earnings reports.  

Return of the Land Rush Metaphor

In 2001 Bezos told Charlie Rose (here) that Amazon understood the early days of web retailing (especially 1998 through 2000) through the heuristic of a land rush metaphor. That era was also dominated by a growth imperative. If Amazon didn't move at an almost reckless pace to establish scaled operations, expand its product selection, and improve its technology, it risked another retailer - fueled by a steady stream of venture capital cash - converging on its markets and earning the trust (and the habits) of customers. 

Bezos recognized the risk of being outflanked, so he engaged in the land rush. He bought into every niche retailer that sold a product that he thought Amazon might want to sell someday, better to bring your enemies close than let them flourish outside your control. He invested heavily in technology and distribution infrastructure. He priced his selection as aggressively as he could to attract customers. He bled cash, almost recklessly, because it kept Amazon in front of the pack and reduced the risk that another retailer could gain a toehold in its market. 

That land rush mentality came from Bezos' survey of the landscape at the time telling him that a convergence was afoot then, too. We see what he did to ensure he came out of the convergence as the dominant power.  Indeed, he came out of the dot-com bubble burst as the sole hegemonic power of web retailing. Despite the Amazon stock price falling from $106 to $6, despite losing countless hundreds of millions in equity investments in competing web retailers, and despite losing upwards of $500 million in personal fortune as the stock plummeted...the bursting of that bubble took all the outside cash out of the web retail industry. Everyone had to fend for themselves, and Amazon was the only one that could. Bezos did alright through it all.

If he's reading the current technology situation with a mind to his experience in the early days of web retailing, I think we can expect him to turn to a page from his old playbook. He will compete ferociously, bordering on recklessness. He will lean heavily into his investments. He will play to dominate the markets. 

This post was originally published here on Adjacent Progression.

Amazon Secrets Hiding In the Open

People continue saying Bezos is secretive, and I continue to contend that he simply hides his secrets in places where everyone can find them...but leaves the thinking part (to understand the secrets) up to them. The result? People continue saying Bezos is secretive.

Amazon provides a lot of information about how it works inside of its SEC filings. If you're interested in understanding what the business is doing over the long haul, the filings are very informative. If you're just eager to get a scoop on the next piece of technology, next partnership, or next earnings results...you're going to be disappointed. Bezos continues to be very hush on specifics.

Here's a piece included in the 2011 10-K that provides a high level view into the strategy of running Amazon. 

We seek to reduce our variable costs per unit and work to leverage our fixed costs...Our fixed costs include the costs necessary to run our technology infrastructure and AWS; to build, enhance, and add features to our websites, our Kindle devices, and digital offerings; and to build and optimize our fulfillment centers. Variable costs generally change directly with sales volume, while fixed costs generally increase depending on the timing of capacity needs, geographic expansion, category expansion, and other factors. To decrease our variable costs on a per unit basis and enable us to lower prices for customers, we seek to increase our direct sourcing, increase discounts available to us from suppliers, and reduce defects in our processes. To minimize growth in fixed costs, we seek to improve process efficiencies and maintain a lean culture.

Very dry stuff, right? Yes, but in the appropriate context, it's incredibly meaningful. The first thing to understand - points driven home by Bezos on any interview that includes the topic of Amazon's business model - is that ecommerce is a scale business. (See what he said here in a 2001 Charlie Rose interview.) Businesses operating on small- or medium-scale cannot compete against those operating on a large-scale. Scale comes into play with the size and complexity of the software, the purchasing power of the business, the distribution capabilities (among other factors). These are fixed costs.

Growth is a tension between timing your increase in fixed costs (in a way that is necessarily messy as you increase headcount, expand your fulfillment centers, improve your software, etc.) with the additional profits those investments should bring. Proponents of Economic Value Add (EVA) insist that growth must show a quick return by way of earnings boost that demonstrates higher value added than the cost of the capital invested to generate it. 

It makes me think of Yogi Berra's "In theory there's no difference between theory and practice. In practice there is." 

Messy growth requires extended time frames. That's not to let management off the hook. They still must make good decisions with allocating capital. But it would be plain silly to avoid investments that take several years to develop and mature if, at the end of the investment period, they provide strong returns and are protected by some sort of competitive advantage. That's the whole idea of having a franchise. 

The interesting part of this comment in the 10-K is that it tells anyone willing to pay attention, exactly what happens as Amazon starts cleaning up the messy part of its growth. When it grows into a new geography or with a new category of products, Amazon does it with a mind to win customers. It builds selection quickly. It prices the products competitively. It uses sheer effort to make up for what it lacks in systems. It markets more heavily than usual, rewarding its affiliates with a higher percentage of sales for referrals. All of this to build the customer base quickly and help them create the habit of buying those specific products from Amazon. This is the messy part.

Then, as the main thrust of the growth subsides, Amazon circles back and cleans up the mess. Among the most important things it does is cozies up to product suppliers. Where it has been going through middlemen to source new products, it hammers out deals directly with the manufacturer to cut its price. Where it has been buying in small lots as it attempts to learn its customer's demand for products, it aggregates its purchases and demands better pricing for the higher volume. And then it just reduces defects.

When we look at the Amazon numbers, we must ask: what is hidden in the expenses? Amazon is that rare business that has long demonstrated an ability to grow customer demand as quickly as it expands its own capacity to service that demand. And if that growth is messy and costly (showing up in the expense category, thereby reducing earnings; or showing up on the balance sheet, thereby increasing invested capital)...just how profitable would this business be if it slowed down its growth?

I don't know the answer. It's probably impossible (even for Bezos) to come up with a precise response. But it's fair to say owner earnings are much higher than reported earnings. 

This is why Amazon trades at such a high multiple to its earnings...a good chunk of its expenses are investments in growth. These value of these investments will compound with time, and those earnings will grow as a result. 

This post was originally published here on Adjacent Progression.

Contemplation on Owner Earnings: Buffett's 1986 Letter

One of my college professors revered Abraham Lincoln, seeing him not only as a remarkable leader but also placing him among the pantheon of great political thinkers.  As such, this professor enjoyed sharing anecdotes and insights gleaned from the life of Lincoln. 

I recall one insight in particular. 

Aesop's Fables was one of the few books to which Lincoln had access as a child. And so he read it assiduously for years, memorizing his favorite tales and ruminating on the meaning of each. According to my professor, the stories shaped Lincoln as he carried the morals with him throughout life. But perhaps more importantly, Lincoln internalized the practice of narrow-yet-deep reading in which he allowed his mind to fumble through the many layers of nuance in what he read, struggling with the material in an effort to internalize its lessons and understand it at the deepest level.

The professor urged us to develop the same skills, assigning us the task of writing papers on the briefest excerpts from Plato, Thucydides, or Montesquieu. We were not allowed to go to other sources for hints at what the philosophers might have meant. Our job was to struggle with the original text, fumble through the possibilities, and dig deep to explain its meaning in our own words. 

This was torture! My skill - refined by much practice - was making a cursory run through the material, pulling in quotable commentary from published scholars, flowering my prose with SAT vocabulary words, and punching the essay home with a nice summary. I became quite good at writing long papers with very little actual thinking required.   

I still struggle with going deep. My attention span still prefers wide-and-narrow reading versus Lincoln's narrow-yet-deep approach. But every once in a while I'm pulled back to learn and re-learn from old pieces. So, without further ado, here's the segue...

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Buffett Defines Owner Earnings (1986)


If ever there were a single piece of valuation wisdom worth revisiting again and again to internalize its lessons, it just might come from Warren Buffett's 1986 Letter to Shareholders in which he outlines the case for owner earnings versus those required by GAAP reporting. Berkshire Hathaway's purchase of Scott Fetzer provides the example. (Scroll to the appendix, entitled Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy.)

Buffett writes:   

If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges...less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c).

Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes - both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes's observation: "I would rather be vaguely right than precisely wrong."

...Most managers probably will acknowledge that they need to spend something more than (b) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists - that is, when (c) exceeds (b) - GAAP earnings overstate owner earnings. Frequently this overstatement is substantial...

..."cash flow" is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, (c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment - or the business decays.

When one first reads this passage, one is tempted by the variables. One is eager to plug them into a simple formula, the values for which one might pull straight from an accounting statement. One hopes the quick calculation yields the secret of the true value of the business.

Owner Earnings = (A) Reported Earnings + (B) Various Non-Cash Charges - (C) Capex and Working Capital Necessary to Retain Current Competitive Position 

(A) and (B) give one much hope. But alas, (C) is confounding. It requires tremendous knowledge of the business and the economics of the industry to come up with even a reasonable guess of that value. Even managers of the company can be very wrong when trying to determine what portion of the earnings must go back into the assets or working capital just to keep the business from losing ground.

Owner earnings are those that are available to be plowed back into the business in order to create even more earnings in the future (capital investments, investment in expense infrastructure, or acquisitions) or paid-out (dividends, share buybacks, debt repayment) to shareholders.  They are the only portion of earnings that provide economic value to owners! If you owned the business outright, they are the portion you can strip from the business for different purposes while remaining confident you have left enough that it keeps laying golden eggs for you year after year. 

In his 1984 letter, Buffett calls these unrestricted earnings. In essence, the managers can use their discretion when deciding how to use this money without fear of injuring the competitive position of the business. 

By way of contrast, restricted earnings - which are the same as (C) and which Buffett calls ersatz* - cannot be pulled out of the business without causing damage. (It's like running to stand still. By continuing to reinvest the restricted earnings, the prize is standing your ground...not ceding market share to your competitors; keeping earnings at the same level as today. But if you don't reinvest, your business decays over time.) 

The trick, for managers and investors alike, is figuring out what portion of capital expense and/or increased expense structure is needed to maintain the current earnings versus how much is going toward promoting earnings growth in the future.   

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Amazon.com In This Context

In a previous post we noted that Amazon.com is being criticized that its torrid pace of revenue growth has not been matched by proportional earnings growth...at least not over the past few quarters. Its expenses are soaring as it leans into its growth and into shoring up its competitive position in key markets.

This is the question I want to explore...

Is Amazon increasing its spending - and thereby reducing its profits today - because

1.) It has no choice and is acting out of defense to preserve the current stream of earnings? In other words, Amazon has increased its spending in order to hold off competition and maintain market share. If it weren't investing in price reductions, subsidized shipping, content, engineering talent, etc. competitors would be stealing customers, market share, etc. 

Or...

2.) By design, it is on the offensive? It's making investments in gaining market share or otherwise strengthening its competitive position with the objective of expanding earnings in the future?

We'll consider those questions next.

*Ersatz Earnings...Restricted vs. Unrestricted (Buffett's 1984 Letter)

...allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.

The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let’s call these earnings “restricted” - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.

Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential...

...Let’s turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business.

This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.

This post was originally published here on Adjacent Progression.

Contemplations on Russo's "Capacity to Suffer"

Tom Russo of Gardner, Russo & Gardner delivered an insightful speech at the 2011 Value Investor Conference in Omaha. While thinking about Amazon.com and its heavy reinvestment in the company's expense infrastructure, I revisited portions of the presentation. I'll draw heavily from it below. (You can access the full speech in pdf format here.)

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It's Hard to Make a Dollar Bill Grow...You Need the Capacity to Suffer

It's hard to make that dollar bill grow, that's the problem. And in public companies typically it's the case that managements are not prepared to invest as fully as they could in pursuit of the growth of the dollar bill...So what I've looked for are businesses that for one reason or another are willing to invest hard behind their growth. And what that means is they have the capacity to suffer. 

When you invest money to extend a business into new geographies or adjacent brands or into other areas, you typically don't get an early return on this. And this is a very important lesson. 

Most public company managers worry about...[what]...they may encounter...if they invest heavily behind a new project, they may show numbers that are unattractive and they worry about the loss of corporate control. 

Suffer Through Reinvestment Case Study One: GEICO and Net Present Value of Adding New Policy Holders

He [Buffett] told management at GEICO just to grow the business even though each new policy holder that was put on the books cost an enormous amount of losses the first year. They had high net present values and you've seen the history. I think the number insured at GEICO, because of Berkshire's willingness  to show the losses up front, have grown from just under a million policy holders to almost ten million. And his spending to drive that growth that just burdens operating income up front has grown from $30 million a year to almost $900 million....

...But the fact is by spending up front, having the elasticity, the willingness, to burden your income statement and then getting the results in the future is a very nice trade off. 

Suffer Through Reinvestment Case Study Two: Starbucks in China

One of the examples that comes to mind...is Charles Schultz, the chairman of Starbucks, who several years back spoke to investors, and there was one nettlesome young analyst who kept asking the head of Starbucks when they would show profits in China. 

And the dialog went back and forth: When will you show profits? He said, how big do you want us to be? When will you show profits? How big do you want us to be? And it went back and forth like this. 

And the answer was - and I think it's the true one - if you want us to dominate China, then let us not show profits for a long time. And if you permit that, we will end up at the final analysis with a dominant position in an important market with moat-like characteristics. If you try to establish, as so many American companies did, a base in China and do it without impacting earnings, you'll do it with a very small business that won't have a competitive franchise. 

And that trade off is just as clear an expression of this notion of the capacity to suffer. Now Schultz  isn't going to lose Starbucks because he has enough stock to keep it on the course that he chooses. But there are many companies that don't have that control. Most don't. And so they favor short-term results versus the long term. 

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Capacity to suffer. I like that. To Russo's point, there is a common thread that unites his GEICO and Starbucks examples, a thread which can extend to our evaluation of Amazon. That is, an ownership structure that keeps investors at bay because someone (or some entity) has enough control to keep to a strategic path that offers long-term benefit despite short-term suffering...trading the opportunity to build a franchise for less profit (or losses) today.

With somewhere around 20 percent of Amazon shares under his control, CEO Jeff Bezos remains firmly in control of business strategy and is willing to forego instant gratification as he builds a franchise for the long haul. He is hailed as a genius when revenues grow but panned by the financial media when there are signs of slowing down. All the while, the dude abides. He stays the course of his longer term vision for the franchise.

It would be easy enough to straddle the fence between investing for the future and satisfying the call for ever improving profits. It's called earnings management. Most managers of guilty of it to varying degrees.

Though I've never sat anywhere near the catbird's seat in a publicly traded company, I can imagine the temptation to do this is profound...that there's always a nagging itch from employees with options, shareholders, your own net worth measurements to make a little compromise here, hold back on some needed investment there...to feed the earnings machine, pacify Wall Street, and prop up the stock price. Just scratch the itch a little bit. It will feel so much better.

But once you scratch it, does the itch actually ever go away? Doubtful. You end up getting caught up in the endless game of analyst expectations. By bowing to it, you become complicit, and it's hard to tap out.

I expect plenty of managers have a strong sense of where they can invest their dollars to fortify their competitive advantages, expand their moats, and grow their franchise. But they are too invested in the earnings management game to take the short-term hit that's likely to follow.  Or they know it could threaten their tenuous hold over strategic control. Or they suspect they would lose their job if Wall Street says results are in decline. Even if they had the intestinal fortitude to suffer through the tempest, their job could be pulled from them before they had the chance to show that ability.

This post was originally published here on Adjacent Progression.

Investing In the Compounding Machine

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. 

– Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter

The following exchange took place during the Q&A portion of the 2011 Berkshire-Hathaway Annual Meeting. It is paraphrased from this account provided by Ben Claremon of The Inoculated Investor blog.

Question: The only option for a shareholder nearing retirement to get income is to sell shares of Berkshire-Hathaway stock. This is because the company doesn’t pay a dividend, even though you like to collect dividends. So, when would you consider paying a dividend?

Warren Buffett: Charlie and I will pay a dividend when we have lost the ability to invest a dollar in a way that creates more than a dollar in present value for the shareholders…Every dollar that has stayed with Berkshire has grown much more than it would have if it had been paid out as a dividend. As such, it is much more intelligent to leave a dollar in…There will come a time – and it may come soon – when we can’t lay out $15 billion a year and get back something that is worth more than that for shareholders. The stock will go down that day. And it should because paying a dividend means the compounding machine is dead.

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Like all businesses, Amazon has decisions to make about what it does with its cash. There really are only a handful of choices: pay it out to investors (dividends, share buybacks, and debt pay-off), plow it back into the business (capital investment, expense investment, and acquisitions), or let the cash accumulate.

If Amazon management has good reason to believe that plow-back investments are likely to produce greater earnings power in the future - and by that I mean the returns on the investment are in excess of the cost of the capital, or what a reasonable investor might expect to earn on the cash if he were to deploy it outside of Amazon - then they should reinvest in the business. If they believe that the plow-backs will allow them to create a franchise with enduring competitive advantages, I would go so far as saying they have a fiduciary responsibility to continue reinvesting in the business.

Many value investors like companies that are quick to return cash to shareholders. I understand that. There's security to getting that cash out. It creates warm and fuzzy feelings, and it lets you deploy it for other purposes like consumption (that new iPad or the bracelet your wife wants) or alternative investments. 

Theoretically speaking, when businesses return cash to shareholders they're confessing to one of two things. 

One, that they can grow earnings without reinvesting more cash. They simply don't need the cash. These businesses are gems and equally as rare (or at least too pricey for value-minded investors to consider).

Two, that they cannot reinvest that cash in a way that produces satisfactory returns. They are running out of profitable growth opportunities. And in that case, returning cash to investors is the responsible thing to do. 

(I write "theoretically" at the outset because oftentimes managers return cash to shareholders irrespective of reinvestment opportunity because they have a history of paying out dividends and any change to that history will cause much consternation in the shareholder base. They don't want the stigma of being the managers who cut the dividend, ticked off legacy investors, created concerns - legitimate or not - about the business health, and caused a dip in the stock price.)

When we wish for the security of dividends, it usually means we're wishing the companies we have invested in have run out of markets for profitable reinvestment. It means we don't want them to grow as much as perhaps they could. It means we're welcoming the day the compounding machine died.

Should current owners of Amazon wish the company stopped its investments in...

• subsidized shipping to pull more shoppers to the web and away from traditional retail?
• lower prices on products and services to entice more consumers into utilizing Amazon and becoming repeat customers? 
• content to encourage more customer loyalty via Amazon Prime membership?
• increased fulfillment capacity in warehouses whose proximity guarantee faster delivery of an even wider selection of products?
• software that makes buying easier, faster, and more secure?
• devices like Kindles which encourage consumption of high margin digital media as well as increased shopping on Amazon.com?
• technical talent to extend market dominance over the burgeoning field of cloud computing?
• more server and hardware infrastructure to attract more cloud computing customers?
• little (expensive!) orange robots that will drastically reduce the company's dependence on (expensive!) manpower (and air conditioning) over time?

In business, as in life, there are always trade offs. If we want Amazon to show us more earnings now, or to share the cash with us, we must be willing to give up the long-term advantages created for the business by making the investments listed above. We must trade future earnings for immediate cash.

The question becomes...how much do the investments above enhance the value of the business by allowing it to generate greater earnings in the future?

Quick answer: I don't know...but it's still worth thinking through some possible scenarios.


This post was originally published here on Adjacent Progression.

Shleifer Effect in Play?

I've been thinking a lot about Amazon.com lately. The business is in an interesting place. 

Few would argue against it being the dominant web retailer (let's call this Amazon's Business One), a market which provides plenty of runway to grow by expanding into new product lines and new geographies. Few would argue that its competitive advantages in web retail are not pronounced and formidable. 

Yet a huge chunk of its revenue comes from media (Amazon's Business Two). Indeed, books and music and video and games, these provided the foundation for Amazon as a fledgling business and still (for 2011 at least) account for nearly 40 percent of sales.  The manner in which each of these products is consumed (and sold) is in major flux, transitioning from tangible inventory to digital formats. Where does Amazon fit in the world of digital media? Can it manage the cannibalization of its strength in the domain of physical media and segue into digital?

And now a growing chunk of its expense structure is devoted to a relatively new business, Amazon Web  Services (AWS/Cloud Computing...Business Three), which seems to produce paltry revenue compared to the resources the company throws its way.  At least for today.  Amazon is convinced that cloud computing represents tremendous growth potential and that it's a market whose economics lend themselves to one of the company's strengths...namely, the capacity to drive high volume through low margins to earn nice cash returns. Amazon believes it can dominate this market.

*****

In 2011, Amazon's revenue grew $13.8 billion over the previous year while operating expenses grew $14.4 billion. Management is plowing cash back into all three of the businesses.  As a result, net income dropped in half. 

For most of 2011 Amazon was riding a multi-year wave of do-no-wrong sentiment from investors. Since 2006, revenue grew from $10.7 billion to over $48 billion. The business was stringing together five consecutive years of EPS growth, an increase of more than 5x from 2006 through 2010.  Media coverage was effusive in its praise; the story was a good one. The stock price soared from $38 at the end of 2006 to a high of $246 last October as investors were rubbing their palms together in eager anticipation of a trend line pointing forever north-by-northeast. 

Now Amazon was not necessarily cultivating this investor mentality. By most accounts, CEO Jeff Bezos is inclined to take a stoic view of the stock price, abiding to his long-term goal of building an enduring franchise and leaning into investments today to achieve market dominance tomorrow.

But as the Shleifer Effect teaches us, investors have a tendency to get excited by what they perceive to be a trend, and five straight years of EPS growth taps into that tendency to generalize a trend far into the future.

Here is the progression of headlines from the previous five quarters:

• 1/27/2011: Amazon.com Issues Q1 2011 Guidance; Revenue Guidance In Line with Analysts' Estimates. (Stock price about $170 and ranges between $160 and $190 over the next few months.)
• 4/26/2011: Amazon.com Issues Q2 2011 Mixed Guidance. (Amazon says sales will be in line with analyst estimates, but operating profit will be well below their guess. Stock at $182, a low point for the next few months as it climbs as high as $218 before the next guidance/results.)  
• 7/26/2011: Amazon.com Issues Q3 2011 Guidance; Operating Profit Below Analysts' Estimates. (Again, Amazon says sales will be in line with estimates but operating income will not. Stock at $214 and begins a bumpy three months with a low of $177 before rocketing above $247 just before the next announcement.)   
• 10/25/2011: Amazon.com Issues Q4 2011 Guidance; Earnings Guidance Below Analysts' Estimates. (Amazon says sales will be on the low end of analyst expectations, and operating will fall far below their guess...perhaps even come in at a loss. Stock plummets to $198, ultimately going as low as $173.)  
• 1/25/2012: Amazon.com Issues Q1 2012 Guidance; Earnings Guidance Below Analysts' Estimates. (Amazon says sales might meet the low end of analyst expectations, or perhaps miss altogether. Analysts keep anticipating an operating gain, but Amazon suggests they will lose money in the quarter. Stock at $179, reached a high today of $193.)  

The Shleifer Effect suggests that a few tenets of behavioral finance might be in play here. First is the representativeness heuristic.  Investors get so excited about the uninterrupted revenue and EPS growth between 2006 and 2010 that they infer a growth trend that will continue. They conclude that it's worth paying a premium for Amazon shares, and over time the share price grows from $38 to $246.

The second is the conservatism heuristic. The idea of the trend is set in the mind of owners of the stock and the idea has been reinforced with impressive performance quarter over quarter. Now they run into the first signs of evidence to the contrary.  What do they do? Nothing. They are defensive in their views. They aren't going to change their minds at the first sign of storm clouds. So, even as Amazon guides toward lower earnings quarter after quarter, they hold steady. They keep their wits about them and perhaps even buy more shares. The stock price actually hits all time highs despite reduced EPS and guidance suggesting lower earnings to come.

The third part of the Shleifer Effect now comes with overreaction. After two or three consecutive quarters of guidance toward lower EPS, shareholders begin changing their minds. They see net profit cut in half from 2010 to 2011 and they lose their resolve. They begin subscribing to a new representative heuristic, i.e. after several consecutive quarters of declining performance, the new trend must have a down slope. Sell! The stock price ultimately falls to a multi-year low.  

When observers begin to believe a new down-slope trend has set in, the long knives come out. A company and its executives can quickly fall from media grace. One day all stories are written to extol their virtues, the strength of their business, the genius of their vision, the wisdom of their philosophy. And the next day, a barrage of criticism roles out...

In February, Barron's says It's Time to Rein In Bezos. 

The blogs call Amazon a "secular short," calling out initiatives to grow market share (like Amazon Prime) and doubting the strategy of making investments in the expense structure in anticipation of growth.  

Others note the exodus of guru investors like George Soros and Julian Robertson. 

*****

So, back to my opening point: Amazon is in an interesting place. For five years it showed the world an ability to grow sales at a blistering pace without much damage to EPS. In 2011, that has changed. On the surface it would seem that Amazon believes it can accelerate investments now to solidify its place as market leader in web retailing, digital media, and cloud computing.  And it's very willing to sacrifice quarter-to-quarter results by leaning hard into these investments. 


All investors, existing and prospective, should be on the edge of their seats to see how this plays out. 


On the one hand,  there is reason to believe Amazon is preparing to take its current owners on a bumpy ride by going all in with Amazon Prime (shipping subsidies and freeby services like streaming movies), Kindle devices, and building a bigger-better-cheaper AWS. EPS are very, very likely to suffer. Current owners must develop a steely resolve and recognize this will be turbulent. The Shleifer Effect is in play.

On the other hand, it's not a stretch to interpret these investments as bets with pretty decent odds behind them. They have the hallmark of informed managers investing in their moat...recognizing their competitive advantages and spending heavily in their defense. Sure, that will lead to a short- or mid-term reduction in earnings, but it should create significantly more value over the long-term. 

Next, I want to explore whether it makes sense to forego those profits today for the possibility of even greater profits down the road.


This post was originally published here on Adjacent Progression.