Ten Grand Chicago Portfolio

Symbol	Company	Date Acquired	Qty	Purchase Price	Market Price (Q2 2011)	Market Value (Q2 2011)
Total						11,922.08
XLF	Financial Select SPDR	Feb.29.2008	20	25.94	15.95	319.00
XLF	Financial Select SPDR	Sep.17.2008	27	18.59	15.95	430.65
XHB	SPDR S&P Homebuilders	June.26.2008	28	17.39	17.39	486.92
HOG	Harley Davidson	July.2.2008	15	35.48	34.67	520.05
SPY	SPDR S&P500 ETF	Mar.5.2009	8	69.42	125.75	1006.00
NE	Noble Corporation	Mar.30.2010	25	40.98	35.77	894.25
DIS	Walt Disney Company	Aug.10.2011	50	32.04		1602.00
Cash*						$6,425.76

*Cash position includes dividends and closed positions (gains/losses). The value of the portfolio will be calculated every quarter.

Closed Positions
DST , DST Systems Inc.
Acquired: Jan/18/2008, 7 shares @ $73.60
Sold: Feb/05/2008, 7 shares @ $73.80
Gain(Loss): $1.40

TRMS , Trimeris Inc.
Acquired: Jan/18/2008, 70 shares @ $7.01
Sold: Apr/22/2008, 70 shares @ $5.85
Gain(Loss): ($81.20)

ING CD, ING Direct 6-month CD @ 3.65%
Acquired: Jan/28/2008, @ $2500
Closed: Jul/28/2008, @ $2544.96
Gain(Loss): $44.96

NTRI, NutriSystem
Acquired: Jan/18/2008, 21 shares @ $23.65
Sold: Sep/26/2008, 21 shares @ $19.88
Gain(Loss): ($79.17)

NTRI, NutriSystem
Acquired: Jun/30/2008, 36 shares @ $13.78
Sold: Sep/26/2008, 36 shares @ $19.88
Gain(Loss): $219.60

DV, DeVry
Acquired: Oct/24/2008, 12 shares @ $42.15
Sold: Feb/3/2009, 12 shares @ $57.94
Gain(Loss): $189.48

DV, DeVry
Acquired: Mar/16/2009, 25 shares @ $41.39
Sold: Mar/17/2009, 25 shares @ $46.30
Gain(Loss): $122.75

ING, ING Groep NV
Acquired: Oct/17/2008, 100 shares @ $10.29
Sold: Aug/24/2009, 100 shares @ $14.23
Gain(Loss): $394.00

IVAC, Intevac
Acquired: Jan/18/2009, 43 shares @ $11.37
Sold: Aug/24/2009, 43 shares @ $11.69
Gain(Loss): $13.76

DV, DeVry
Acquired: Mar/16/2009, 15 shares @ $41.39
Sold: Mar/17/2009, 15 shares @ $52.22
Gain(Loss): $162.45

PCU, Southern Copper
Acquired: Jan/18/2008, 18 shares @ $29.66
Sold: Aug/24/2009,18 shares @ $29.08
Gain(Loss):($10.44)

RIMM, Research in Motion
Acquired: July/07/2008, 5 shares @ $110.45
Sold: November/18/2009, 5 shares @ $66.06
Gain(Loss):($248.95)

PCU, Southern Copper
Acquired: Sept/16/2008, 25 shares @ $20.64
Sold: Nov/18/2009,18 shares @ $35.94
Gain(Loss):$382.50

SPY, SPDR S&P500 ETF
Acquired: Oct/06/2008, 5 shares @ $103.34
Sold: Nov/19/2009, 5 shares @ $109.58
Gain(Loss):$31.20

EWC, iShares Canada ETF
Acquired: Jan/06/2009, 5 shares @ $18.62
Sold: Feb/08/2010, 5 shares @ $24.44
Gain(Loss):$145.50

PCU, Southern Copper
Acquired: Feb/04/2010, 100 shares @ $27.13
Sold: Feb/16/2010, 100 shares @ $30.68
Gain(Loss): $355.00

AMX, America Movil
Acquired: Mar/30/2010, 20 shares @ $45.76
Sold: Jun/29/2010, 20 shares @ $48.50
Gain(Loss): $54.80

MLHR, Herman Miller
Acquired: Apr/30/2008, 20 shares @ $23.67
Sold: Jul/09/2010, 20 shares @ $19.17
Gain(Loss): ($90.00)

JOEZ, Joe's Jeans
Acquired: Mar/30/2010, 250 shares @ $1.92
Sold: Jul/09/2010, 250 shares @ $2.18
Gain(Loss): $65.00

JOEZ, Joe's Jeans
Acquired: Jul/20/2010, 250 shares @ $1.83
Sold: Oct/07/2010, 250 shares @ $2.08
Gain(Loss): $62.50

TKC, TurkCell Iletisim Hizmetleri
Acquired: Jul/7/2008, 35 shares @ $14.47
Acquired: May/21/2010, 40 shares @ $12.54
Sold: Nov/29/2010, 75 shares @ $17.41
Gain(Loss): $297.70

MYTAY.PK, Magyar Telekom
Acquired: Jul/7/2008, 20 shares @ $25.57
Sold: Nov/29/2010, 20 shares @ $13.18
Gain(Loss): $297.70

Dividend History

2008 Dividends $93.03
2009 Dividends $135.28
2010 Dividends $87.67
2011 Dividends $17.49 (YTD Q2)

Low Yield CD's and Discipline

Staying disciplined with investing is one of the hardest things to do, especially now. On one side, it's very easy to sell and limit your losses, and sometimes that is the best thing to do. On the other side, it's very tempting to jump back in because a lot of good companies have been beaten down the last few weeks. It doesn't help as an individual investor when you read the papers, watch CNBC, or listen to the business lunch hour programs on the radio (WBBM in Chicago runs a good hour show by the way). There are so many differing opinions that can influence you one way or the other.

I made sure my first 5 buys used up only 25% of my capital ($2500). It's very tempting to use the remaining 75% to open up long and short positions now, but in order to remove that temptation, I decided to move $2500 into one of the 6 month low yield CD's at 3.65%. That leaves me about $5000 to put into play if more quality company's get punished further. Somewhat disciplined, but somewhat flexible. The Fed is looking to lower rates again, so it made sense to me to lock in some of the current rates, and put some discipline to control my emotions.

Speaking of CD's, I will put in a plug for ING Direct. I've used them for a number of years and they have usually offered some of the highest Savings and CD rates. But that's not their real secret of their success. They have one impressive customer service line up. There have been a few instances where I have called them up at 9pm on a Sunday evening, and within two phone rings, someone actually picks up the phone. Whether I need information about CD's, investment funds, or mortgages the same person is able to answer all of my questions and take care of business. Not too many banks can do this. As simple as that sounds, it is very hard to achieve.

I did some comaprison shopping of other 6 month CD rates on bankrate.com. Some banks were able to offer 4.7% which was rather impressive. However, I feel comforatble with ING. I never heard of giantbank.com, or Uncle Joe's Super Bank before.

The Ten Grand portfolio page will be up shortly.

Gorging on NutriSystem (NTRI)

Disclosure: I own NTRI.

It’s the New Year, time to follow up on those New Year resolution promises. Every year my local gym is packed during the first 3 to 5 weeks of operation. I call it the “resolution wave”. By the time February and March rolls around the gym is back to normal operating levels, half the crowd disappearing. How can you blame them though?There’s this great Chicago restaurant chain called Portillos, just five minutes from my gym that serves up some nice Italian Beef, Chicago style hot dogs, BBQ Ribs, etc. This isn’t something I can easily give up. However there is something I can gorge on without adding the pounds, and that’s NutriSystem’s stock (NTRI). A week ago they turned up on the screen I discussed in my last post. I decided to dig further and see if they had some promise for my ten grand portfolio.

What is NutriSystem?

First off, I am not a dietician or an expert in healthy eating. NutriSystem provides a meal based program geared towards busy individuals who don’t have the time to actively select healthy meals, or don’t feel like thinking about what they should and shouldn’t eat. Based on a monthly subscription fee of $293.72 for women or $319.95 for men (at the time of this writing) you get 28 days of meals automatically delivered to you. This includes breakfast, lunch, snack, dinner, and dessert. That comes out to about $11.42 per day for a full day of food. The company wants you to follow up with exercise, and water consumption in order to achieve those weight loss goals, in addition to providing you counselors to help with the program.

Why NutriSystem stock?

What really caught my eye when I dug into their financials was the massive revenue and profit growth they have experienced in the past 2 to 3 years. Their profit margins have grown from a low 2.68% in 2004 to 14.98% in 2006. For the first 3 quarters of 2007, they are running at 14.63%.

Quite simply they have gown revenues faster than their costs to grow the business. You can clearly see this during course over the last few years.

Even with this type of impressive growth, they are still only trading at 7.5x trailing twelve months earnings. They are able to generate impressive returns on their assets at 62.8%. NutriSystem competes in a very competitive landscape with South Beach Diets, Weight Watchers, Seattle Sutton, Slim Fast, and all the other fad diet programs that come and go. Their biggest competition at the moment comes from Glaxo SmithKline’s new diet pill drug called “Alli”. It has softened the company’s outlook for the 4Q of 2007. Even with the competition, they have still been able to grow their business. So what is their secret sauce?

I don’t believe NutriSystem is really a food or product based business. Sure they focus on creating healthy meal programs that people may actually want to eat, but I think their core strength is that they are really a social based business or will become one in the future. Weight loss, image perception, how your legs and abs look, and taking control of your health is really a personal and social matter. The support of family and friends can help people stick to their healthy eating programs. I think NutriSystem’s opportunities exist in trying to be an extension of that support network. The frontline folks at NutriSystem who work the phones and cover the online community play an especially important role. Specific focus on customer service has been the CEO’s mantra (Michael Hagan), which has paved the way for a much improved profit margins over the past 3 years.

Their weight loss counselors are the ones who forge the relationships with the customers and provide the social support for customers. At the same time they are the company’s sales force to suggest, offer, and sell new food and service programs the company has baking in product development. Since I consider this to be the foundation for the company’s future success, I decided to head over to the company’s career section to see what type of people they were looking for to help grow the business further. One of the listings was none other than the “Weight Loss Counselor”.

The opening snippet reads:

“This position receives and initiates weight loss counseling calls and emails to and from the weight loss clients. Listens to and probes for progress indicators. Motivates and counsels clients to continue with the program, answers food and weight loss questions. Documents correspondences as required. We are currently looking for only 3:30pm to 12:00am shifts, including 1 weekend day”

If you read the rest of the job description you’ll come across important criteria they use such as the ability to listen and motivate customers to stick with their program. Keep in mind that some of these counselors deal with some very emotional customers; we’re talking about weight loss, image, and health after all. They are currently looking for the night shift, and weekends, the times when customers come home from work and have nothing else better to do than watch TV. It is an important time slot to fill, and if they can fill these positions with motivated and qualified personnel, it will help retain and increase their customer base. Some may attribute the majority of their past success on new meal programs or a better marketing strategy, but it may often be overlooked that a sizeable portion of their revenue increase has come from reactivation revenue. These are revenues generated from customers who were once on NutriSystem’s meal plan, but have since left. Sticking to a controlled diet and exercise program was never easy, but the company’s front line has managed to reactivate a number of these customers.

Focus on the Social Community

If you listen in on the 3^rd quarter conference call the their Chief Marketing Officer , Thomas Connerty made some brief mention about the company leveraging their online community to find out what their customers are talking about². This allows the company to shape new products based on a treasure trove of information, as well as help educate their weight loss counselors on what customers need. If they continue to put investments into their online community and provide tools for their customers to communicate with each other, this social base will help folks stick to their goals, as well as increase sales of NutriSystem products and services. The only complaint I have is that their online community area is buried deep inside the main NutriSystem web site. They need to bring more awareness to this to increase customer registration and community involvement.

Alli: The path of least resistance

The surprise new competitor which has come forth is the new diet pill called “Alli” from Glaxo Smith Kline¹. The new diet pill has had 2 million customers sign up since it was introduced. The company knew about the new drug, but the CEO even mentioned they were a bit surprised at the number of new diet starts on this drug². This shouldn’t come as a surprise as most folks battling weight loss want the results fast. They will take the path of least resistance. The new drug isn’t for everyone. I dug a little bit further and found a brief write up from the Mayo Clinic about using Alli. Taking this drug will result in approximately 3lbs loss after a low calorie diet and exercise. The drug is not recommended for folks who use blood thinners, have thyroid disease or diabetes. What the drug does is block fat break down³. So the fat has to go somewhere. Please bear with me. If you read the Mayo Clinic’s write up further, you will see a break down of the following side effects:

• Gas with an oily anal discharge
• Loose stools or diarrhea
• More frequent bowel movements
• Hard-to-control bowel movements

I can’t judge what other people will do with this drug, but I would surmise that some of those 2 million Alli customers will not appreciate these side effects, and that they will eventually realize that they still need to eat a low calorie diet and exercise. It is not a magic pill. You still need to work to lose those pounds and maintain a healthy lifestyle. NutriSystem doesn’t have a magic pill, but if they continue to move on their vision of building a community of customers, provide easy and good access to their weight loss counseling support, they will be able to drive their profits further. NutriSystem will probably face 2 to 3 quarters of competition from Alli, but I believe some of those customers will turn. The company is expecting flat revenue growth in Q4 of 2007 compared to the same period last year due to the new drug. Given NutriSystem’s track record and investments into their social aspects of their business (increased recruitment of weight loss counselors and continued development of their online community) will put them in a good position when some of the customers turn from Alli.

What is the business worth?

As always calculating forward looking growth rates is never black and white, the following assumptions were used in determining NutriSystem’s value:

• The company has been in operation for the past 35 years with a strong brand presence. I foresee this company continuing operations for the next 10 years and beyond. Cash flow available to the firm was estimated for each of these 10 years going forward, starting in 2007.

• Based on the 3rd quarter conference call, the company estimates 4th quarter 2007 revenues to come in flat with the same period a year ago. This estimates to about $701million in revenues for 2007. Although this amounts to 107% continuous annual growth rate (CAGR) since 2004 when the company jump started its business, the following growth rates were used for the upcoming years:

1. 2007 to 2011 at 20% CAGR
2. 2012 to 2016 at 5% CAGR (due to new entrants and existing competition)
3. 2017 and beyond at 5% CAGR

• The company has done an excellent job at reducing their cost of good sold (COGS) as well as their selling, general, and administrative expenses (SG&A) over the past 5 years. I believe the company will be able to hold these costs relative to their revenues constant.

• The company has no debt, and has been using their operating cash flow to reinvest back into the business. I have estimated the cost of equity to be at 16.29% (what the shareholders required rate of return is for investing in their business). This rate is used to determine the present value of all the cash generated in the future.

This results in a positive cash flow growth several years going forward:

The estimated value of the business today is $1.16 billion when you discount all future cash flows back to today. This roughly equates to $32.40 a share and represents my best case scenario.

Let us consider the worst case scenario if new entrants enter the market and the current subprime mess results in a full scale recession. Those $300/month meal plans maybe the first things to go for the every day NutriSystem customer. Let’s assume the company’s revenues shrink 5% for 2008 and 2009, but then turns back to a moderate 5% growth rate year over year from 2010 going forward. This equates to roughly $19.79 a share. At the time of this writing the market has almost priced in this worst case scenario at $23.45/share.

Given the company’s focus and investment on building a social support business for weight loss and wellness, I think they are poised for good growth going forward. They are nicely valued at the moment and I currently hold them in my ten grand portfolio. It’s getting late. Time to get some good old Chicago style hot dogs.

Full commentary on NTRI

A detailed valuation analysis can be found here.

References:

1. "NutriSystem Warns, Blames Glaxo's New Diet Pill", SmartMoney. October.4.2007., http://www.smartmoney.com/onedaywonder/index.cfm?story=20071004

2. 3rd Quarter 2007 NutriSystem Conference Call, October.24.2007., http://phx.corporate-ir.net/phoenix.zhtml?c=66836&p=irol-EventDetails&EventId=1669479

3. "Alli weight-loss pill: Does it work?", Mayo Clinic., June.11.2007., http://www.mayoclinic.com/health/alli/WT00030

BOGOF

“Jewel-Osco is running BOGOF today… got to hit the supermarket”, my wife proclaims from time to time. Other times I will be sent off on a grocery shopping run with the following list:

• Crest Toothpaste (BOGOF)
• Oranges (BOGOF)
• Oreo Cookies $2.99 / pack.

So what exactly is “BOGOF”? It basically stands for buy one get one free. That is my lovely wife’s definition, as she goes out on a mission to save money for the household. What I define BOGOF as, is basically opening up of my fridge to a Florida orange farm, or opening up my freezer to about 100 lbs of chicken breast packs sliding away and landing on my feet at 6am.

What does this have to do with the stock market? Well, let’s take my wife’s true definition of BOGOF. With the Dow Industrials taking a massive plunge of more than 5% since the start of the year, a lot of stocks have been taken down like a typical UFC fight. Some stocks are now entering the BOGOF territory from their highs of just a few months ago. With ten grand sitting around, I have to take advantage of this opportunity and wade in. The recent sell off has also brought to mind a recent book I read from Joel Greenblatt titled, “The Little Book that Beats the Stock Market”. It is quite an easy and interesting read, and I highly recommend it. Mr.Greenblatt’s system is very simple and I decided to try this out. His system is to buy stocks with high earnings yield (a company’s earnings relative to the share price) and a high return on capital (how much a company earns based on its investments in capital, stuff like machines, delivery trucks, robots, and such). I am somewhat simplifying his formula, as he uses a slightly different formula for earnings yield and return on capital to level out differences in taxation between companies. You can read more about the details of his approach in the appendix section of the book. The system requires an investor to buy sets of 5 to 7 stocks every quarter until you have about 20 to 30 stocks after one year. As each stock matures to the one year mark, you need to dump that set, and buy a new set of stocks based on the same set of criteria. He has made it easier for the average investor by creating a site which returns a set of stocks which pass these criteria daily (http://www.magicformulainvesting.com/).

He back tested this formula over the last 17 years with great success, earning returns of over 30%. That is quite impressive. So impressive I decided to give it a shot with my portfolio. The problem with the magic formula web site list is that it is not ranked in the order in which the book describes, and his return on capital data values are aggregated into quartile buckets. His list is ranked in alphabetical order so I can’t really tell which stock ranks at the top. So I decided to run similar criteria by doing the leg work myself and see how many companies overlapped the list from the magic formula site. Using a stock screener, I set it up using the following set of criteria:

• 5 to 15X P/E (trailing twelve months). Picking the stocks with the lowest P/E ratio is pretty much the high earnings yield definition Mr.Greenblatt speaks about in his book.
• Return on Assets (ROA) > 20%. This is similar to the high return on capital criteria the book describes.
• Removed all international companies (ADR’s) and ETF’s

You can download to see the complete list. To get the ranking as the book described, I sorted by P/E ratio from smallest to largest and assigned the rank to each stock starting with 1. I then sorted the same list but this time by return on assets from largest to smallest and assigned the rank to each stock starting with 1. I summed up both columns to get the final score for each stock and sorted the list again by this new summed up column.

As I cruised down my list there were a few names I recognized (Coach, Moody’s, Herman Miller, etc.). I then cruised over to Mr.Greenblatt’s list to find some overlap, but not all. The differences exist because of the slight variations in the formulas we used for earnings yield and return on capital. That’s ok though because the concept is relatively the same and I needed to see that ranking. It was time to make my first set of picks for my portfolio. I walked down the list looking into each company’s story, what their business was, and how strong it was especially in light of the worsening economic picture in the US. Following the system, I had $2500 to spend ($10,000 divided by 4 quarters) in the first quarter of 2008. I decided to pick 5 companies so I would end up with 20 stocks by year end. The following is my first set of buys that I made on Jan.16.2008:

Symbol	Company	Quantity Purchased	Purchase Price
NTRI	NutriSystem Inc.	21	23.65
DST	DST Systems Inc.	7	73.60
TRMS	Trimeris Inc.	70	7.01
IVAC	Intevac Inc.	43	11.37
PCU	Southern Copper Corporation	6	88.98

We’ll see how this set performs a year from now. The proposed benefit of Mr.Greenblatt’s system is that you don’t really have to think, because the “magic formula” he describes does the work for you. The two screens he uses, makes good business sense. I’m a bit weary of anything termed “magic”, so I’ll be walking through each of these 5 stocks in the next set of posts to explain their story and do a good discounted cash flow valuation on each. One of my goals when I started this site was to keep things as simple as possible and try to make common every day sense out of all the financial jargon. I can’t explain discounted cash flow in a few sentences, so I’ll try to explain the process using some simple examples and apply them to my stock picks. I’ll also refer some books that I think explain such financial topics very well.

Not everyone is a fan of Mr.Greenblatt’s system. A review from the guys at Motley Fool labeled him in 2006 article as one of “Wall Street’s worst stock pickers”. Ouch. In any case, I’m going to test Mr.Greenblatt’s approach anyways. NPR covered an interview of Mr.Greenblatt a few years ago which is pretty good.

Each bit of analysis takes some time, so I’m already behind. As my wife proclaims, it’s BOGOF time! I need to start making my shopping list for the 2nd quarter. Happy trails… you’ll need it in this punishing environment.

Dangers of the Amazon (AMZN)

Time to start doing, and stop thinking. A number of my friends and family have been subjected to my stock analysis rants over the past year, and have urged me to do something about it. Well after doing OK this past year with my investment picks, and drawing bits and pieces of investment strategies from the books I've been reading, it's about time I start tracking this.

I spent the last few months on and off thinking of my approach, drafting up ideas upon ideas, of how I could best write about my analysis without dangling into heavy financial jargon. What is the purpose of this other than finding the capital to satisfy my salivating desire to race a 911 GT2 on the Sea to Sky highway? Kidding aside, it's simply to document my results testing investment strategies that I have picked up from the vast amount of investing advice there is out there. Most glossy investment paraphernalia you get from your investment adviser usually pit their performance against the S&P 500 index, based on $10,000 invested so many years ago. What they fail to mention to you is all the other costs you incur along the way, but I'll talk about that another time.

So I start today, with a clean slate, and a hypothetical $10,000 to invest. My portfolio has no stocks at the moment, so it's time to start hunting. Time to see where this goes. Let's not waste any more time, as my first stock to cover for the year is none other than Amazon. I've been buying stuff from them for years now and thought I'd check them out.

Recommendation: Avoid!

Every time the Amazon smiley face box arrives at my door, it is like Santa showing up again. Unlike that special day that only comes once a year, I know exactly what I am getting but still have those same happy feelings as I rip on yet another book, gadget, or toy. In order for this company to continue to deliver the same feelings to its shareholders it will need to make some big adjustments to their operations. Amazon does a great job making their customers happy, from a broad array of products, competitive pricing, free shipping, to their website experience. However, this comes at a significant cost to their business. What remains is a business that runs profit margins of just under 3% year to date. The company was moving in the right direction as it continues to cut costs, but in the 3rd quarter of 2007 they started to pick up the spending activity compared to last year.

I listened into the 3rd quarter conference call but could not pull out why there was a sudden increase in fixed assets spending in the most recent quarter compared to last year. It wasn’t only until the recent news about the launch of their Kindle initiative (iPods, but for reading aficionados) did I understand where some of the increased expenditure could possibly be coming from. Kindle was introduced with much publicity, but didn’t receive a good review from the Wall Street Journal. Similar to their Unbox initiative they launched a while back, you will be hard pressed to find this part of their business broken out on the financial statements and investor calls. It’s still early for Kindle, but Unbox has had more than a year to demonstrate its effects on the bottom line.

Amazon still needs to do more to cut costs, specifically their selling, general, and administrative expenses (SG&A) in order to justify their lofty share price. The reason why I am focusing on SG&A is that this is the only likely aspect of their business that they can control. As commodity prices move up higher, their cost of goods sold will continue to have upward pressure. Unless they increase their prices, their ability to sustain current gross margins will be under pressure.

One of Amazon’s goals is to increase customer value through a broad offering of products online. Consumers however still have a multitude of offerings to purchase products from traditional brick and mortar retailers like Barnes and Nobles , Best Buy, Walmart, and Target. The switching costs for a customer to move from one retailer to the next is pretty much non-existent. Amazon is just one of many places to buy things. What does set Amazon apart is their continuous focus on the shopping experience through:

1. Broad based product offering by incorporating other retailers into their e-commerce site
2. Seamless purchasing process from 1-click checkout, free shipping, good product recommendations, and a host of other online promotions. These are great things for Amazon’s customers, but they come at a cost to the company.

What does this cost?

At the moment Amazon’s current business runs at about 23% Gross Margins year to date. What this means is that after subtracting out the cost for Amazon to acquire their products from suppliers, they are left with 23 cents for every dollar of sales to pay off their selling, general, and administrative expenses (marketing costs, employee salaries, depreciation expenses from all those heavy duty servers, etc.). Let’s start setting up the variables for a more detailed analysis. There are three important factors to note here:

1. Higher commodity prices. At some point manufacturers will need to pass on the effects of high oil prices down the chain. In the best case scenario, let’s assume Amazon’s purchasing department can work wonders and keep COGS as a percentage of revenues leveled at 75% for the next 10 years. This is based on their past track record. I am essentially giving Amazon the benefit of the doubt, such that they have a rock solid purchasing department. This leaves the company 25% gross margins to work with in running the rest of their business.
2. The company operates several a large scale IT infrastructure operation with web sites across several countries in addition to key distribution centers to keep products in stock. The countries in which they operate are Japan, Canada, US, UK, Germany, France, China. Although this helps stabilize the company’s revenue stream when one country’s economy suffers, the expenses required to run this operation total 19.6% of total revenues. After subtracting out COGS, and SG&A, the company is only left with just 3 cents on every dollar of sales for the bottom line. The capital investment in technology, operations, and the costs to acquire and retain software engineers to run this operation will continue to grow. Let’s give Amazon another advantage and they somehow reduce SG&A down to 19% of Revenues.
3. Free shipping hurts. Although Amazon can lock you in for that 79$ free shipping Amazon Prime membership deal, it can not lock in shipping costs that UPS, and USPS charge. Can Amazon continue to offer free shipping forever and eat these costs year after year? As a customer I already equate Amazon to free shipping. What happens when Amazon decides to charge more for Amazon prime to cover these costs, offers free shipping only on a limited number of products, or drops free shipping all together? That will adversely affect consumer behavior, ultimately affecting revenue growth. The company ran total shipping costs in 2006 of $317 million, and this is after collecting all those Amazon prime revenues. Outbound shipping costs will continue to rise with oil prices hovering above $90/barrel.

Cash Flow Analysis

We now come to the meat of my argument. How much cash is available to the firm each and every year for the next 10 years?

Let’s assume the following highly optimistic inputs:

1. The company has a strong brand as the destination for online shopping and will continue to do so for many years to come, beyond 10 years. We will estimate all future cash available to the firm from year 11 onwards (2017 onwards), assuming competitors will eventually give Amazon a run for its money and reduce revenue growth rate to 5% year over year
2. The company continues to see payback from its investment in 3rd party sellers, technology, marketing promotions, AWS, and Unbox, and capture more consumer spending for the next 10 years, resulting in 30% growth year over year .
3. Let’s assume Amazon’s purchasing department can hold COGS down resulting in 23% gross margins for the next 10 years.

The present value of all that cash today is $23.5 billion, after you pay for the company’s long term debt position. This roughly equates to $60/share. Even with the company’s recent stock slide, the current share price of $81 is still too high. Mark Manahey of Citigroup recently upgraded this stock to a buy rating citing improving operating margins of a full 2% points in 2008. Mr. Manahey obviously has a lot more confidence in the company’s ability to squeeze out those margins than I do. We’ll have to see the next few quarters. I love Amazon’s service, but I’m definitely not adding this to my portfolio until the company drastically improves its margins.

My portfolio still has 10 grand in cash sitting around. Not good. Time to keep hunting.

--- Detailed valuation analysis can be found here