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The juggernaut, challenged: Why Amazon investors are making a very risky bet

If you're searching for the perfect symbol of this frothy, tech-loving, disruption-applauding era, look no further than Amazon.com Inc.

The online retailer changes hands for around $1,000 (U.S.) a share, a price that has quadrupled since 2012 despite the company's conspicuous lack of profits. The Seattle-based e-commerce giant has lost money in two of the past five fiscal years. Only once in its two-decade history has it managed to squeeze out annual earnings of more than $5 a share.

Notwithstanding that threadbare bottom line, Amazon's galloping increases in revenue have made it an irresistible buy for many investors. In the eyes of most people, it's an unstoppable force, one destined to conquer huge swaths of the retailing sector and force many brick-and-mortar stores over the brink. Profits will eventually take care of themselves – or so goes the prevailing opinion.

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But here's a contrarian thought: What if Amazon isn't quite as intimidating as it looks? What if today's investors are buying into a dream that will never be fully realized?

One worry is whether the company's prowess at eviscerating traditional retailers will elicit a political backlash, especially outside of the United States. Another concern is growing competition, as giant rivals from Wal-Mart to Chinese e-commerce giant Alibaba bring their guns to bear on the same territory that Amazon now dominate.

Even a modest hiccup in growth could blow a hole in Amazon's stock price. Most analysts assume the retailer's sales will continue to leap ahead by more than 20 per cent a year until some time well into the 2020s.

Given the retailer's weed-like spread over the past two decades, and its history of stellar execution, assuming such an expansion rate is not outlandish. But the high hopes around the stock leave no room for setbacks. Miss those double-digit targets and the company's remarkably high valuation could plummet.

To be sure, professing pessimism on Amazon is today considered only slightly less outlandish than arguing Donald Trump is a closet Muslim. Out of 49 analysts that cover the stock, 43 consider it a "buy," according to Bloomberg. Five label the retailer a "hold", and only one lonely soul calls it a "sell."

Allen Gillespie, an analyst with FinTrust Brokerage Services of Greenville, S.C., is the lone skeptic. He reasons that Amazon is worth only about $640 a share, or about two-thirds of its present value, because of the U.S. Federal Reserve's determination to raise interest rates.

Today's ultralow rates distort valuations for high-growth companies such as Amazon that have yet to produce much in the way of a profit, he argues. The rock-bottom rates exaggerate the present value of earnings that are expected to materialize only years in the future.

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"In a negative to near-zero interest rate environment [the valuation models] return nearly infinite prices for the value of an equity that invests cash today and promises cash tomorrow because cash today has nearly no value, while cash later, if it materializes, has potentially large value," he says.

While a move up in rates would hit many stocks, Amazon is particularly vulnerable because of the near-religious level of adoration that has grown up around its business model. A typical fan is R.J. Hottovy, an analyst at Morningstar, who proclaims "Amazon is the most disruptive force to emerge in retail in several decades."

By Mr. Hottovy's calculations, fair value for Amazon is around $1,200 a share. He lauds the company's operational efficiency and its sterling reputation for customer service and low prices. Those are "sustainable competitive advantages that few, if any, traditional retailers can match," he says.

Perhaps so. But the history of retailing juggernauts, from Sears Roebuck to Wal-Mart, suggests that any dominant seller inevitably sees its supremacy challenged by newer, more nimble competitors. The question is how long Amazon's golden age will last.

Investors are valuing the e-commerce giant at levels that suggest it will continue to expand sales at a double-digit pace for another decade at least. As a result, the stock trades for 250 times earnings and three times sales – stratospheric figures, to say the least.

To put those numbers into perspective, consider Wal-Mart, which has nearly three times Amazon's revenue. Its shares change hands for a mere 20 times earnings and a scant 0.5 times sales. People who prefer to buy Amazon at today's prices are paying a tremendous premium for its supposed growth potential.

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Investors' high hopes rest on the assumption that Amazon is as much a technology company as a retailer. There are good reasons for that characterization. Amazon Web Services offers customers access to a suite of software, database and data storage offerings that reside in the cloud. The division accounts for only about a 10th of Amazon's overall revenue but has been growing at more than 40 per cent annually and already accounts for the bulk of the company's operating income.

Retailing is no slouch either, but it is growing at less than 30 per cent a year and generates decidedly unimpressive returns. Retailing outside of North America – a segment that encompasses about a third of Amazon's total revenue – actually loses money.

More worrisome, the company is being forced to invest heavily to keep its retail sales booming. The most dramatic evidence of that came in June when Amazon announced it would pay $13.7-billion to acquire Whole Foods, the underperforming purveyor of pricey gourmet fare. The deal – which took place at a 27-per-cent premium to Whole Food's preacquisition share price – underlined Amazon's determination to muscle into the food business, no matter what the cost. But it also highlighted an intriguing question: Why does the world's most successful e-commerce retailer need a bricks-and-mortar retailer anyway? Is it possible that Amazon's usual online model doesn't work in some sectors?

Grocery shopping is one example. Fashion retailing may be another. This summer, Amazon unveiled Prime Wardrobe, a program that lets members of its Prime program order three to 15 articles of clothing at a time, without actually buying them. Customers have seven days to return the items they don't want and pay only for what they keep. That's a nifty deal for shoppers – but it also seems cumbersome and expensive for Amazon to implement.

Also expensive is the company's devotion to producing video programming for a Netflix-like service aimed at its most loyal customers. The company is expected to spend roughly $4-billion this year to create shows and series aimed at members of its Prime program. However, as Shira Ovide of Bloomberg recently noted, it's not clear if that massive investment actually lures more people to Prime or if it results in more sales.

If nothing else, the move into physical Whole Food locations, the introduction of programs such as Prime Wardrobe and the splurge on video content suggests that Amazon's original e-commerce model is undergoing heavy revision as the company pulls out all stops to maintain growth. The problem for prospective investors is that all the new enhancements are likely to add costs and reduce efficiency.

One measure of those creeping inefficiencies is the surging number of Amazon employees. Between 2010 and 2016, the company's revenue roughly quadrupled, but its work force shot up much, much faster, growing 10 times. As a result, revenue generated for every employee fell by roughly 60 per cent. If the trend continues, Amazon will have to employ more and more people to generate the same increment of sales increases, a trend that doesn't bode well for its already meagre profits.

And that's just one threat to the company's future returns. Right now, analysts are projecting Amazon's earnings will jump in coming months as the need for massive capital expenditures ease. It's entirely plausible, though, that those high hopes will be deferred.

Instead of easing back on capital expenditures, Amazon could choose to keep spending at full tilt to stay ahead of the most ferocious competition it has ever faced. The company that initially prospered by putting corner bookstores and small retailers out of business is now confronting myriad challenges from some of the world's biggest companies.

Microsoft, Alphabet and IBM are all intent on wrestling away chunks of the business now dominated by Amazon Web Services. Wal-Mart is attempting to make up for its late start in online sales by pouring billions into its own e-business initiatives. Alibaba is expanding its own online e-commerce platform and is hugely popular in Asia. Even IKEA Group, the world's largest furniture company, is getting into online business with its recent purchase of TaskRabbit, a website geared to hiring people for odd jobs.

"Based on our research, the consumables market is currently undergoing a dramatic change as too many assets chase too little demand," says Scott Mushkin, senior retail analyst at Wolfe Research LLC in New York. "Competition from … traditional staples retailers, new business models, hard discounters and e-commerce operators is leading to a growing competitive climate."

Fans of Amazon argue the company has always been able to find new ways to expand sales. The company's web-services division is the prime example. Alexa, its voice-operated personal assistant product, may turn into another. So may a rumoured expansion into online prescriptions.

But it's hard not to be awed by the challenge in front of the retailer. To meet analysts' projections, Amazon would have to double its sales over the next four years.

The challenge only grows larger as resistance builds to Amazon's near monopoly on many sectors of e-commerce. The European Commission recently ordered the company to pay €250-million ($371-million Canadian) to Luxembourg to compensate for what the commission deemed to be illegal tax benefits. Meanwhile, more and more U.S. states are cracking down on third-party merchants who sell goods through Amazon's marketplace. The states are forcing those sellers to pay sales tax, a levy they had previously escaped.

Governments' willingness to tangle with Amazon is likely to grow as the retailer's clout increases. In Europe and Asia, policy makers could easily decide to get tougher with a U.S. giant that is putting local players out of business. "How government entities respond to [Amazon's] market power may be the greatest risk to the equity in the longer term," Mr. Mushkin says.

For now, investors are ignoring such risks. They're right to admire Amazon's dazzling progress, relentless ambition and impressive execution. But even a modest backlash could turn this contemporary retailing icon into a symbol of a completely different phenomenon – how investors' hopes can sometimes run ahead of reality.

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About the Author

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More

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