Thursday, March 29, 2012

Amazon (AMZN): Playing Offense or Defense? Part A. Subsidized Shipping

Reported Earnings Overstated - The Impact of Restricted Earnings
Owner earnings are those that can be extracted from the company for the benefit of shareholders (dividends, buybacks, debt reduction), plowed back into the business to create even greater earnings in the future (growth capex, investments in expense infrastructure, acquisitions, etc.) or held as surplus cash. They are "unrestricted" in that management has significant discretion on how to use them without damaging the current earnings ability of the business. 

Reported (GAAP) earnings do not discriminate between the portion of earnings that are unrestricted and the portion ("restricted") that management has no option but to plow back into the business just to keep things current. Examples are replacing obsolete equipment, refreshing old stores, responding to a competitor's pricing tactics, or ramping up customer service because clients are threatening to leave without it. They are all necessary investments, but they don't create incremental earnings. At best, they prevent the erosion of existing profits. 

Reinvestment of the restricted portion of earnings creates the unpleasant sensation of running to stand still. You can expend a lot of energy without taking the business anywhere. 

You won't find a line on the income statement called restricted earnings. As Buffett said in his 1986 letter to shareholders, determining which portion of earnings are unrestricted versus which are unrestricted is tricky. Indeed, it's quite different from industry to industry. For a manufacturer in a highly competitive market, a large chunk of its reported earnings may not be available to reinvest for growth or to pay out to owners. Why not? Because every five years it must spend tens of millions to retool factory assembly lines to accommodate new designs, to engineer more efficient production techniques, or to begin construction of new products that replace obsolete models.   

Reported Earnings Understated - Making "Productive" Investments in Expense Infrastructure

But the idea can cut both ways. Most businesses will report earnings that exceed the actual dollars available to benefit owners. But some businesses (particularly those in growth mode) will report earnings that dramatically understate the amount of cash being plowed back to grow future earnings ability.  For example, they may report $1 million earnings but in reality they plowed $10 million into marketing to acquire new customers that will produce more earnings power in the future. That is certainly the case with GEICO that Tom Russo talked about at the Value Investing Congress last year (and which we discussed here).  

In that scenario, do we value the business based on the $1 million in reported earnings? Or do we value it based on the $11 million it would have generated if not for the investment in acquiring more customers?

Well - no surprise here - it depends.

The dilemma is that we don't want to use this idea to rationalize investments by bloating the target company's earnings. It can be a slippery can argue with yourself to exhaustion trying to justify buying a company with a great growth story at its current high price-to-earnings ratio. One must err on the side of caution.

When considering this sort of situation, the first filter I might apply to the decision is how confident you can be that the increased expenses that lead to lower reported earnings are actually investments with the high likelihood of paying off in the future. And in this thought process, apply a high burden of proof on the company. One is wise to evoke the wisdom of Richard Feynman...The first principle is you must not fool yourself, and you are the easiest person to fool.

Another useful filter is to ask whether the increased spending (or whatever caused the reduced earnings) comes from the company playing offense or playing defense. This is important. Is the increased spending a result of the business understanding its competitive advantage and investing heavily in it? Or is it a reaction to a competitive move in the industry where, if the company doesn't respond, its business is harmed? 

In the former, it's likely (though not conclusive) that the company is spending in a manner that creates future value for shareholders (again, like the GEICO example) even if it reduces reported earnings today. It's fair to consider those investments as unrestricted earnings and count them among owner earnings when valuing the business.

In the case of the latter, the defensive spending, I would argue that this is likely an example of restricted earnings that are rightfully withheld from reported earnings. Increasing Spend = Offense or Defense?

Let's bring this back to Amazon. The business clearly operates in a market with growing demand for its products and services. Year-in and year-out, Bezos et al must make educated guesses about consumer demand one-, two-, three-plus years in the future and invest in their infrastructure accordingly. Sure, they could stop those investments today by declaring their wish to optimize throughput of existing assets, pushing more sales across existing infrastructure (fulfillment centers, technology, marketing efforts, personnel, etc.) and probably create sizable profits for investors. But that would be choking the golden goose, seriously affecting its ability to lay more golden eggs in the future. Instead they build out in anticipation of what's to come.

Here are several categories of that type of investing...were they offensive or defensive in nature?

A. Subsidized shipping to pull more shoppers to the web and away from traditional retail.

In the beginning, Amazon treated shipping as a source of income. Later, its goal was making shipping a break-even proposition. Now, the company proudly uses shipping as a loss-leader, accepting the glad trade-off that quick-and-cheap shipping translates into wider consumption from customers who would otherwise give the business to Target or Best Buy.

From 2010 to 2011 Amazon plowed $1.1 billion into subsidized shipping, increasing its net shipping costs 76 percent...far above the additional shipping revenue that came in with 41 percent overall sales growth.

Should we expect this to change? No. This is the ultimate offensive move in two ways.

First, consumers are quick to tally shipping charges into the total bill when comparing costs of buying online versus bricks-and-mortar. Amazon recognizes that much of its growth will come from prying shoppers from trips to Wal-Mart and the mall. One way to achieve this is to provide a lower "landed" price than what they would get when getting in the car to shop with competitors. Shipping is part of that landed price, and Amazon is willing to invest in making it cheaper and cheaper for buyers.

It's important to note that shipping is included in Amazon's overall cost of sales calculations. In 2011, COS was about 78 percent of revenue. For Wal-Mart, COS was about 76 percent of revenue...and Wal-Mart has a tremendous overall advantage in its purchasing in that it carries far less selection and buys in volume that's easily 10x that of Amazon. Its COS should reflect much cheaper product acquisition costs. Yet its advantage over Amazon is negligible.

In other words, Amazon is earning comparable gross margins despite subsidizing shipping. As Amazon improves other drivers of its COS (e.g., volume purchases leading to product acquisition cost discounts), I expect it will subsidize shipping even more. And as Amazon builds more fulfillment centers nearer to its customers, its costs of shipping will go down.

One can easily imagine a day when Amazon subsidizes the full cost of shipping, retains product cost advantage over traditional retailers, and provides overnight (or even same day) delivery. All the while maintaining a gross margin sufficient to cover its operating expenses and provide a tidy profit.

Second, the subsidized shipping presents a formidable challenge to other online retail competitors. Amazon is the trend setter. The more they set the standard for low-cost shipping, the more consumers expect it in all online transactions. If the competitor cannot provide it - and the consumer can purchase the same or similar item from Amazon for a cheaper price - the competitor loses the business.

This creates a powerful barrier to entry. Smaller operators that can't match Amazon's scale (and none can) will only be able to subsidize shipping by charging a premium purchase price. And if the buyer can get the same item at Amazon...

(As an aside, online retailers that find ways to compete with Amazon in this regard - Quidsi's and Zappos both come to mind - are quickly neutralized. Amazon offers their inventory, undercuts their prices, attempts to replicate their service advantages, or acquires them. See the Business Week story of Quidsi here. The moral of the story: Amazon is deadly serious about preventing other retailers from gaining a toehold in their business...they want complete web retailing ubiquity.)

Conclusion: Definitely offensive. An investment in long-term competitive advantage that hurts competitors, garners greater share of online and traditional retailing markets, and leads to accelerated scale benefits. 

This post is getting too long, so I'll split it up. Next, we'll consider whether lowering prices is an offensive or defensive move.

Tuesday, March 27, 2012

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...

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.   

***** In This Context

In a previous post we noted that is being criticized that its torrid pace of revenue growth has not been matched by proportional earnings 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. 


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.

Friday, March 23, 2012

Amazon (AMZN): 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 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.)


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 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. 


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 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 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.

Amazon (AMZN): 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.

QuestionThe 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 BuffettCharlie 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.


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
  • 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 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.

Thursday, March 22, 2012 (AMZN): Shleifer Effect in Play?

I've been thinking a lot about 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:

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.

Wednesday, March 21, 2012

Dun & Bradstreet (DNB): Contemplations on Wasting a Moat

I've been thinking about the role of competitive advantage in evaluating investment opportunities after watching this interview with Clayton Homes CEO, Kevin Clayton (here is the YouTube video). As a subsidiary of Berkshire Hathaway, Clayton benefits from such horse's-mouth management wisdom from Warren Buffett as..."Deepen and widen your moat - that competitive advantage that keeps your opponents at bay - everyday." 

It occurs to me that "generate loads of profits" is neither an inspiring rally cry for the troops nor an enduring moat. Herein lies a flaw with so much focus on concepts like Economic Value Add (EVA) or Total Shareholder Return (TSR). While noble - and I believe accurate - in principle, these ideas are often bastardized by management in their execution at the business level. Oftentimes managers become enamored of sending so much cash back to shareholders that they stop protecting their moats, opening themselves to attacks by capable foes.

Dun & Bradstreet (DNB) comes to mind. I spent some time looking at the business last November when it was trading around 61 per share, its 52-week low, while sporting a respectable ROIC, nice dividend payment, low capital requirements and demonstrating a willingness to throw plenty of cash (even in the form of new debt) at buying back its shares. 

On face value alone, it was a compelling investment candidate...The DUNS Right number is supposedly the ubiquitous mechanism for businesses to evaluate the credit worthiness of trading partners. DNB has honed its process for a century, and - according to them - created a proprietary database of such size and sophistication as to be impossible for a competitor to replicate. In a previous life, I remember my CFO turning to DNB immediately if he had questions about a partner, competitor, or new customer.

That sounds like a good moat, right? 

Well, I believe it really was at one time. But over the years DNB has allowed this resource to wither. They have starved the golden goose in the name of total shareholder returns.

Assuming that the DUNS Right process was the dominant way to evaluate your potential trading partners at one time, what should DNB have done to deepen and widen that moat everyday?

1. DNB should have continued investing behind the data and its uses, employing the best engineers and marketing minds available to make it better and expand its uses. 

2. DNB should have priced it out reasonably and looked for opportunities to reduce its price to make it impossible for new entrants to even attempt a competitive offering.

What did DNB do instead?

They handed all the golden eggs back to investors (and management) and stopped feeding the goose. They turned a powerful tool with long-term earnings prospects into a dwindling asset. They sought to return cash to shareholders first - reducing capital investment, cutting expenses to the bone, and increasing prices on customers - and ignored their competitive advantage.

In the process they alienated customers with an arrogance that suggested a belief in "where else will they go?" They chopped away research and development, choosing to squeeze existing assets instead. (Not coincidentally for a company no longer investing in itself, a quick dig through the scuttlebutt demonstrates that DNB is not considered a good place to work.) They preyed upon their sources of data, calling small business and extorting them for $500 to monitor and update their Paydex scores so other companies saw them as credit worthy. (This makes the input for DUNS Right data suspect, destroying the air of impartial data needed for customers to really trust DNB as trustworthy source of credit info.) 

DNB has returned a lot of cash to shareholders, no question. Not investing sufficiently to protect the competitive advantages of the business can feel really good to short-term investors. Since I considered the investment, the stock price has soared over 30 percent! But for those holding on for the long haul, they must consider the damage done by management. They have taken what should have been an impenetrable fortress surrounding their competitive advantage, neglected it in the name of TSR, and weakened the defenses to a point where competition is entering the market. (Equifax is treating business credit as an adjacent expansion of its consumer credit offerings, Cortera is a start-up exploiting the distrust of DNB and its high cost to crowd-source an alternative at a much cheaper price, and trade associations are pooling information on creditworthiness for their members.)

I passed on DNB despite its apparently cheap price tag. It started with such a strong position in the market, but in neglecting its moat has lost its advantage. While I can't say the competition will prevail, I can say that DNB's neglect has increased their odds considerably.