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By Jeffrey Ptak, CFA | 06-25-2015 03:00 PM

Nygren: Why Amazon Was Misunderstood

Amazon's third-party-selling business and investments for 'supernormal growth' were not well accounted for in the market valuation, says Oakmark manager Bill Nygren.

Jeff Ptak: Let's talk about one name that perhaps is misunderstood, especially on a multiple basis. That's Amazon (AMZN), which is a relatively recent purchase--actually, one that appears to have performed quite well in your portfolio.

Bill Nygren: I've never been asked about that one [laughing]. Everybody expects it in a value portfolio.

Ptak: I can't imagine that anybody has ever asked you about it. It sounds like part of your thesis was that the valuation of that stock was somewhat misunderstood and misinterpreted.

Can you expand on that a bit, particularly as it pertains to the third-party-selling business that Amazon engages in and how that might distort the way people perceive its valuation?

Nygren: For starters, when we think about retailers, we're usually looking at an enterprise value/sales ratio, with the assumption that if the retailer is well managed over a longer period of time, its margins can migrate toward industry average margins. Now, Amazon certainly doesn't look cheap on a P/E ratio. They hardly make any money right now. But one of the reasons is because as they invest for, what I would call, "supernormal growth," most of the costs of that investment run through their income statement. So, when you step back and look at sales, Amazon didn't look like it was selling at much of a premium to most brick-and-mortar stores.

And then, secondly, a lot of their business, as you mentioned, has shifted to third-party business. So, when you or I go on Amazon as a customer, we oftentimes don't even notice whether it's Amazon selling us a product or a third party using Amazon fulfillment selling to us. If I buy a product for $100 and Amazon is the seller, that counts as $100 of sales. If I buy a $100 product and you were the seller using Amazon fulfillment, that might only count as $13 of sales.

So, we grossed up those third-party sales to what the retail value was. And when you look at the total volume of sales that Amazon was doing, at the price we purchased Amazon for about a year ago, we were paying a little less than $0.80 on the dollar to the multiple of what brick-and-mortar stores we're selling at.

Now, to think that's the right number, you either had to believe Amazon couldn't grow like the other brick-and-mortar stores--and I don't think many people thought that--or they could never get their margins up to that level.

We looked at the way Amazon was investing to get roughly 20% growth faster than brick-and-mortar stores at the expense of giving up one year of income. I think that's a trade-off any brick-and-mortar store would take today. And if you believe, as we do, that Amazon for multiple years can continue to grow 2,000 basis points faster than the retail industry, their margins will start migrating up toward the average retailer.

The interesting position this puts us in is as long as management believes they can create that excess growth through investing in the income statement, I believe they should and will continue to do that. When they pull back on it, Wall Street is going to cheer, because that means more money falls to the bottom line. For us, that'll be a red flag, because that might mean that the growth opportunities are no longer as visible to them.

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