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

This is a shared post with understandingamazon.com, re-posted here because of its obvious ties to the Shleifer Effect, Mr. Market, profitability bias, and other investing concepts we discuss. 

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. 

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.

Understanding Amazon...A Spin Off

First, a housekeeping note. I've been experimenting with the mysterious world of twitter. I'll confess it baffles me, but it also intrigues. If you're interested in my occasional twitter musings, feel free to connect with me at this handle: @pauldryden. 

I've also put a box of tweet updates on the blog. 

This is a brave new world for me, folks. Be patient!

Now, as many of you have noticed, my interest in the business of Amazon.com has turned into an obsession. But it's a healthy one. I think. 

I don't want that to suck all the oxygen out of my other ideas and research exercises here on Adjacent Progression. Amazon-related posts now account for about a quarter of the content of this blog, and - for better or worse - there's a lot more coming. 

So it's time for a spin off. New musings about Amazon will appear at this site, www.understandingamazon.com. I've also put a link to it at the top right hand corner of the side navigation bar. 

My goal is to continue posting at Adjacent Progression two or three times a week on average. There remains plenty of material to wrap my brain around. And while the cardinal purpose of the blog continues to be about helping me develop my own thoughts (especially around investments), I hope the readers who have stumbled upon it will still find it useful, entertaining, frustrating, confounding...whatever those reasons are that keep you reading.

Why all the thinking about Amazon? In brief, it's a remarkable business (which I mean less in the adoring fan sense and more from the perspective of a - somewhat - neutral researcher willing to be impressed by the performance of his specimen). It's poised to do some transformational things in its various spheres of influence. I see it taking those models refined in its web retailing ventures, and applying them to a long string of new initiatives. And I think its likelihood of success in the new businesses is unusually high. I'll explore those concepts more on the new blog.

From an investment perspective, I remain on the sidelines. The price is not right. Though I suspect it will be in the not so distant future. What is the right price? I have no idea the amount. The opportunity to buy will come less from a precise price and more from Mr. Market's attitude about the company. Today he is optimistic and excited. But because Amazon is investing so heavily in its growth opportunities - to a point where it could very well post a loss at some point in the next few quarters - and because those growth opportunities are hard to understand, I anticipate the current attitude will give way to overreaction on the downside. The sort of pessimism that, when attached to an outstanding business, gets my heart pumping.

I'll revert back to this Warren Buffett quote previously posted under No Extra Credit for Being a Contrarian:

The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.

I hold out great hope for calamity. My optimism in the market's eventual pessimism knows no bounds! And in the meantime I wait.

I hope you'll continue indulging my obsession by following the series at Understanding Amazon.

Re: Google vs. Your Boys (but really about amazon)

We had a very pleasant lunch, as we always do. He is an old and good friend. He was amused by my unhealthy fixation with Amazon. And so he sends me this gentle barb a few days later:  Google is coming! [Links to WSJ article.] 

Uh-oh, a threat to Amazon's AWS cloud computing service. I get these challenges with some frequency from people that have learned of my obsession. I love them. Not so much because it offers a chance for debate and I consider myself the superior debater. I'm not. It's more because the challenges keeps me honest. 

It reminds me of the verse from Rudyard Kipling's "If": 

...If you can trust yourself when all men doubt you,

But make allowance for their doubting, too...

It's the only way to keep a kernel of intellectual integrity in his game of investing...look for challenges to your theses. Not to fight back and counterpoint the opposing argument, but for the strength and the wisdom the challenge could bring, giving you the opportunity to improve your models, test your reasoning. It's possible to find something nearing sublime in approaching the debate with philosophical detachment, shunning dogma as best as our bloated egos allow.

Unfortunately, our tendency is to seek out those of like-minded opinions, forming echo chambers for our views and doubling down on the risk of our wrongness being compounded in a confirmation marketplace.

Below is my reply to my good lunch friend:

Thanks for passing this on, T. I'm fascinated by this impending convergence of the major tech giants. They're all sitting on these enormous and valuable assets, mainly large customer bases and some combination of tech gear, tech infrastructure, and customer captivity. As a sort of manifest destiny, they are all compelled to extend and expand the use of their infrastructure...those assets. It's inevitable, as if the combination of management ego and economic drive for higher profits, creates a siren's song for the businesses to expand. I've started calling it the growth imperative, a set of behaviors I've noted in other industries, too.

So it becomes interesting with Amazon, Apple, Facebook, and Google. [See The Great Tech War of 2012 by Farhad Manjoo in Fast Company back in October 2012.] Their markets, as they expand, are overlapping more and more. They must compete, not only to grow, but also to make sure one of the competitors doesn't gain some advantage that allows them to attack their core markets....sort of like offense is the best defense.

A theory I've considering works something like this: cloud computing is a huge market that Amazon entered early and has pretty much controlled. Amazon is taking great pains to commoditize the industry - making the services non-branded - so it will be defined by who can offer computing at the cheapest price to customers. Amazon has demonstrated its willingness to make AWS (its cloud computing) cheaper and cheaper, having lowered prices 20 times since launching. Jeff Bezos has thrown down a gauntlet and dared others - IBM, Microsoft, a slew of tiny players, and now Google - to follow. Amazon has said it will make it all about price.

That creates a fascinating dynamic, and this is where the theory part kicks in. What company can afford to offer cloud computing the cheapest? Both Amazon and Google have deep cash reserves, so they can duke it out on low price there while subsidizing any losses with their own cash. That could be a painful war, and we must ask who would win.

My bet would be with Amazon, and for a simple reason...Amazon has demonstrated both an indifference to how the stock market perceives it as it pursues long-term dominance of an industry, and it has demonstrated a capacity to suffer while its stock price is getting killed because it is losing money in pursuit of dominance. Jeff Bezos frequently says he's comfortable being misunderstood for long periods of time.

So let's consider this like a game theory scenario...you have two giants pressing on the gas, hurling their dragsters at each other in a business that one of them (amazon) is willing to define by price. They will both take losses. The more they fight, the deeper those losses will be, and the more likely their stocks will tank as long as the war persists.

Jeff Bezos is fond of saying something to the effect of ..we want to sell the same thing as everyone else, but because we run more efficiently than they do, we can sell it cheaper. So if they want to have a price war, they'll go broke 5 percent before we do.

He's signaled to the world his intentions and his willingness to be a fanatic in pursuit of them. Now, how crazy is google willing to be as it enters the cloud computing market? How deep is its capacity to suffer? And remember, there's a lot of catching up to do since Amazon has been in the market since 2006.

In this game theory game of chicken, my vote is with crazy Jeff Bezos. That dude's a fanatic!

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.