Let me get this out of the way… I am an Amazon customer, they offer great prices, Prime, 2 day shipping etc. What’s not to like?

Let me also say that (since the late 90′s,) I have never invested or shorted $AMZN or $AMZN options. I do however – along with almost any value investor I have talked to about it – have a negative and bearish bias against it.

Why? Well, where to start? How about its TTM negative earnings? How about operating margins averaging around 1% the last four quarters? Should we talk about their free cash flow (or lack thereof)? Or maybe the quality of most of their cash flow (working capital, stock compensation)?

It’s not difficult to see why many investors have shorted and continue to short $AMZN.

For years, I thought $AMZN was a plain-vanilla “momentum” name. Meaning, as long as (earnings &) revenue growth came in ahead of expectations, people will overlook their nose bleed profit ratios, their low margins etc. and the stock would continue to rise.

But then last year the company missed revenue estimates multiple times. They even guided down revenue and profit estimates, and although the stock initially fell on a couple of these releases (trapping many shorts), it rebounded almost immediately and ended up huge the following day/week.

#FF list‘s @firstadopter tweeted a perfect summation yesterday…

1 yr ago when $AMZN was $100 lower street est. for Q4-12 +39% y/y sales growth, GAAP EPS 85c, Non-GAAP EPS $1.23. AMZN reported +22%/21c/46c

— firstadopter (@firstadopter) January 30, 2013

A typical momentum name would have gotten smashed on these numbers.

After the second one of these quarters, I tweeted “Are there any fundamental investors who own this stock? And if yes, Why?”

For the most part the answer I have received is either something like “you have to forecast years ahead – the company will become tremendously profitable, all they need to do is turn off the spigot, and then margins will skyrocket.”

The thesis here, is that the company’s spending is voluntary and totally discretionary, and if the company wanted to, or better yet – completed its build-out, – margins and profits will explode higher.

The other answer I’ve received is that $AMZN’s value is all about its replacement value. I.E. – If another company wanted to duplicate what $AMZN has already built, it would cost billions & billions of dollars.

Let’s delve into both of these answers.

Forecast years ahead…

(I have previously written about $AAPL and how discount rates have to be higher the further out you go, AND the more uncertain their earnings are. (Please read the article, it turned out to be a key in this recent $AAPL pullback.))

I challenge anybody to look back at any of the last few years & read any DCF model of a bullish $AMZN analyst. See what they modeled for earnings & cash flows etc. for 2012, and then look what $AMZN reported.

With a company like Amazon that continues to spend to build and invest to earn, any & all earnings that are now being expected in the future must be discounted way more than your average retailer or eCommerce company.

Replacement Value…

The replacement value of a existing home vs. buying a new lot & building a new home makes a lot of sense. For collectibles (with no real replacements) it’s even more amplified. But how about something like the Egyptian Pyramids? I’m sure the cost of replacing them is tremendous, but if they’re not in demand (like art/other collectibles , and/or not producing any cash flows, who cares how much it would cost to replace it?

Obviously, what $AMZN built isn’t worthless, and it can (and most probably will) produce plenty of cash flows. But that’s the key… How much? When? When valuing a company, you need to figure out the amount of cash flows, and then discount them by an appropriate rate, and again – the higher the uncertainty the higher the discount rate = the less the future cash flows are worth today.

So to answer @biggercapital‘s tweet —

@microfundy Why bad to choose platform + push CF back 10 yrs if economics make sense? Issue with pushg back is our CFA pea brains can’t cope

— Michael Bigger (@biggercapital) January 30, 2013

—because pushing back cash flows MAJORLY effect valuations. And this is even if they are certain to come – which in $AMZN’s case is far from certain.

Brick & mortar retailers aren’t staying pat (see $TGT price matching etc.), I also – importantly – do not subscribe to the thesis that the company can just “turn off” their spending. A huge portion of the company’s “extra” spending comes from Amazon selling Kindles at or below costs, losing money on shipping, giving more & more things (content costs for movies/music) to Prime users etc. All these costs are NECESSARY spending to build & keep alive their ecosystem. Without them they’re just another e-tailer fighting tooth & nail vs. tons of others.

So what’s the dilemma?

When I short (or buy puts on) a company like this, it’s normally right after it “cracks”. There’s typically an event when the momentum story breaks, the stock tanks 15-20% in one day, and while some people that missed the whole way up might go ahead and buy, thinking it will regain its pizzazz, and then boom – the stock continues to crater and eventually settles at much lower prices. Think $TASR/$TZOO in the end of ’04, $CROX in ’07, $GMCR in ’11 etc. All of these stocks “broke” at one point and settled at much lower prices over time, but from after the breaking point until the eventual settling range – that’s where it’s best to short these “momentum” stocks. The key is waiting until a “real” break – something that causes the story to change – the theme behind the momentum investors over-exuberant enthusiasm changes.

This should have happened in my opinion with Amazon last year, when revenue and earning growth missed & guided down. And herein lies the dilemma. If that did not break the stock, what will? According to almost all fundamental investors, the original momentum thesis is already broken, so now what should I look for? When can I short? If the stock pulls back $20 or $30 points, what changed? Would that be a real “break” or will it be yet another bear trap?

One thing I am pretty confident in, is that one day $AMZN will break, something will change and cause momentum guys to flee, and at that point it won’t stop at prices where typical growth investors want in, it won’t stop until it trades at such depressed levels that value guys will start scraping at it… and on most of that way down, I will partake, and do so with immense pleasure.

- MicroFundy