A recent report from the prominent tech analyst Gene Munster, co-founder of the venture capital firm Loup Ventures, suggested that Amazon could buy Target in 2018. It’s a sensible prediction, citing comparable demographics and other good reasons for the combination. And of course there’s the appeal of real, terrestrial stores rather than just Amazon’s existing online business.
It’s also a less outlandish prediction than it might have been a short time ago because Amazon has bought Whole Foods, demonstrating that it wants to use real stores to build its business. It makes sense.
I still don’t believe it. To put it simply: It’s about the stock price. To put it less simply: Target is not as big as Amazon, but it is still big, very big. Its value today is $42 billion. It’s EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization, the earnings that come from the retailing business it does without regard to how it’s financed) was over $7 billion in the most recently reported 12-month period.
Of course, Amazon is much bigger. Its value today is over $450 billion, more than 10 times the value of Target. Target’s market value is less than 10% of Amazon’s; it would barely register on Amazon’s valuation.
But … is that right?
In the most recently reported 12 months, Amazon earned almost $14 billion in EBITDA, so Target’s figure was more than half as much. Stocks are often valued based on multiples of earnings, so one question is how the market would value the combined earnings of Target and Amazon. If Amazon buys Target, they’ll be hoping that the multiple of Target’s earnings will rise to the multiple of Amazon’s. That would make the acquisition a genius move. Target would be acquired for, let’s say, $50 billion or less, and it would add over $200 billion to Amazon’s value on the first day. After all, isn’t that what happened with Whole Foods? Doesn’t the market believe that if Amazon takes over a retailer, it’s instantly worth more?
I don’t think that would necessarily happen in the case of Target. The way Amazon is viewed today by investors is unique. There’s lots of reasons for that, but there’s certainly no company quite like Amazon. One of the ways that Amazon is unique that isn’t much talked about is its cost of capital, which is very low, nearly zero.
What does that mean? If your personal cost of capital were zero, you would act differently. If you could borrow or raise money with zero cost, you would likely find a second or third home where you could afford the real estate taxes and heating/cooling costs, and you’d buy it, use it, speculate on it and hopefully sell it for a greater value in the future. You would make investments in certain assets that you otherwise couldn’t afford. You’d buy securities and hold them for appreciation.
Companies would act the same way. They’d buy things they thought would appreciate, and they’d experiment in all kinds of ways because if the experiments failed and the capital they invested was lost, it would have zero cost, so — no problem. With a zero cost of capital, you can try any reasonable thing to build a business.
With such a low cost of capital, Amazon can experiment to grow. It can make acquisitions, it can try new technology, and if the ventures fail, the cost to Amazon is little or nothing. As long as investors will provide Amazon with a near-zero cost of capital, it can keep doing what it’s doing.
If Amazon buys Target, its earnings from those traditional, lower-growth retail stores will be more than one-third of the combined company’s earnings. The risk that investors will view Amazon differently will then be substantial. If investors start to view Amazon as another retailer, even a turbocharged retailer, its cost of capital will rise. When that happens, its stock price will drop. With so many of its senior and middle managers incentivized by the stock price, the risk of Amazon being viewed differently by the marketplace is enormous, existential and much too great to risk. Its entire management team could leave in a short time if the stock started to move in a different direction for a length of time because their compensation would be cut in a way they wouldn’t tolerate for long. The risk that Amazon could be viewed differently by the marketplace because a very substantial part of its earnings would be coming from a lower-growth business could very well impair or destroy the company.
You might say, “If that’s right, why didn’t it happen when Amazon bought Whole Foods?” Here’s why: What the market wants from Amazon is top-line growth. The people I talk to say that Amazon needs to have revenue growth of 20-25% per year to sustain its low cost of capital. As long as Amazon delivers substantial growth in revenues with the possibility of earnings coming later, the market will continue to provide Amazon with its low cost of capital, which allows Amazon to be what it is.
With Amazon taking by far the largest share of ecommerce revenues and Amazon Prime likely in a majority of households already, Amazon has to find new sources of expansion. It probably can’t double its share of ecommerce. It likely can’t double the number of Prime customers. It needs growth in revenues to sustain its low capital cost. For that, it has to find new categories of products to sell, and grocery is a juicy target because it’s so large.
Until the Whole Foods acquisitions, Amazon’s efforts in grocery were relatively small and unsuccessful. With the Whole Foods purchase, the market sees Amazon committed to finding a way to be impactful in grocery. That means more growth for Amazon in this largest of categories, and that’s what the market wants. With Amazon’s performance being measured in growth, the acquisition works.
Buying Target won’t put Amazon in any new categories. Sure, it will allow Amazon to have presence in many more locations and be in front of more consumers more often. But in terms of selling more things to more people than the combination of Amazon and Target do now, it’s incremental and not order-of-magnitude.
No one knows for sure; no one can predict how the market will react to things with certainty. But an acquisition of Target by Amazon might drag down Amazon because Target’s relative earnings are so substantial. It would be enormously risky for Amazon to buy Target, and I don’t think it will.
It’s a shame because the way the world works now, there is more combination needed between new commerce like Amazon and legacy retailers. And I do believe we’ll be seeing more combinations of old and new; I just don’t think 2018 will see this particular one. If I were running Amazon, I’d be thinking about where to invest to generate continued revenue growth and how to transition to greater profitability over time. I don’t think that buying Target in 2018 addresses those issues.