Stock Analysis of Amazon and J.C. Penney
- The two stocks selected are Amazon (AMZN) and J.C. Penney (JCP). Amazon is an American e-commerce company (online retailer) with a market capitalization of $171B, and J.C.Penney is an American clothes retailer with a market capitalization of $2.64B. These two stocks are of particular interest for our study period. Amazon is interesting because it is a strong growth internet company who is trying to innovate and convince its investors of its ability to sustain high growth rates. J.C. Penney is interesting because it is considered as a “fallen angel”, a previously highly profitable company which encountered profitability and competitiveness issues and is now struggling to turn its situation around. Moreover, both companies were very present in the news recently, Amazon among others related to its project to deliver packages with drones and J.C. Penney related to the involvement of famous investor B. Ackman. We study the behavior of these two stocks as well as the NASDAQ and Dow Jones indexes from January 30 to March 6, 2014. Over the assignment period, only Amazon is the only company whose share price declined. It had a negative return of -3.13%. J.C. Penney had a +37.35% return. The two stock indexes also had positive performance, +4.33% for the Dow Jones and +7.41% for the NASDAQ (see charts in the Appendix).
- We shall now analyze each stock and index and determine their performance drivers.Amazon’s negative return of -3.43% was subpar and not in line with the returns of the NASDAQ (+7.41%), which can be considered a “technology-heavy” index. As such, the NASDAQ is an appropriate benchmark for the expected performance of technology stocks. Thus, we would say that Amazon performed poorly during our study period. Amazon’s share price drop is mostly due to internal company news: while the overall market climbs due to historically low interest-rates, Amazon’s stock fell. The stock price decline was triggered among others by 2 analysts’ downgrades from Buy to Hold/Neutral (by UBS and TheStreet Ratings). The downgrades can be explained by the company’s very low margins, as well as the company’s high debt relative to its industry. The debt/equity ratio of the company is only 0.71, which would be considered conservative for the average business because the company has more equity than debt. However, this debt level is considered high for Amazon (and is worrying investors) because it is lower than its peers. Since Amazon has low profit margins, having relatively high levels of debt is risky as it makes debt repayment sensitive to sales and revenues. This means than a sudden drop in sales or customer involvement could harm free cash flows and potentially create debt repayment problems. While leverage magnifies returns, it also magnifies risks! Moreover, the low margins are of particular concern because they tend to be constrained by Amazon’s low pricing power. Amazon has a cost leadership strategy, and thus must keep very attractive prices to keep its customer base loyal. Furthermore, the nature of online e-commerce makes rising prices hard. Indeed, if Amazon raises its prices by an unreasonable amount, customers will switch to another website (this is dangerous because online customers have no costs and constraints associated with changing the website on which they order their products; it does not make a difference whether a book is bought on Amazon or on Ebay because it still is the same book). Online customers will use price comparative websites to spot the new lowest prices on the internet. If Amazon has a low pricing power, increasing margins becomes difficult to accomplish, thus the company needs to increase revenues in order to increase net income. The net profit margin is .93%, which means that amazon generates $.93 profit for every $100 in sales, which is very low and below its industry average. Amazon’s stock saw tremendous growth in the last decade and the fall in the stock price may also be due to investors’ skepticism regarding the sustainability of this growth.
J.C. Penney, on the other hand, saw a staggering return of +37.35%, outperforming U.S. indexes by a large margin. To understand this performance, we need to analyze the historical context first: J.C. Penney was a famous US clothes retailer that encountered many problems and was sub-competitive (it had among. The stock has been declining for more than a year due to the competitiveness problems and the restructuring that the company has to undergo. During our study period, much news affected the stock price and the trading volume. Firstly, the company was due to report earnings on February the 26th, which sparked investor’s optimism. While still turning a loss, the expected loss for the 4th quarter was $.88 compared to $2.51 loss a year earlier (with revenues staying the same).These expectations reflected a belief that the company can cut its losses and turnaround its situation. These beliefs are backed up by various facts. Firstly, the expected $.88 loss per share turned out to be a $.11 earnings per share. Secondly, online sales also increased during the last quarter. This is a good sign at it shows (at least to the investors’ opinion) that J.C. Penney may be returning to generating profits in the next year. This is actually part of the company’s forecasts, which expects higher sales and gross profit this year.Finally, the firm’s liquidity problems do not worry investors in the near-term since the firm has enough funding to operate for a whole year without the need for external financing. Most of the returns happened on February 26th when the stock price surged +25.34% due to the positive earnings release beating estimates (comparing with a total return over our study period of +37.35%). Such a large one-day return can be explained by the fact that financial markets were expecting a loss while J.C. Penney ended up turning a profit. The subsequent days also showed positive returns, while the period before earnings release saw the stock price stagnating. We can conclude that the surge in the stock price was thus mostly a one-day event caused by the earnings release.
Both indexes had a positive performance. The Dow Jones increased by +4.33% and the NASDAQ increased by +7.41%. These are strong increases relative to the historical returns of the stock market. The primary factor leading to increasingly high valuations is the quantitative easing policy followed by the Federal Reserve (FED). “Quantitative easing” refers to the accommodative policy where the FED buys back bonds every month to lower interest rates. Thus the Federal Reserve has been artificially maintaining interest rates very low, making money cheaper and thus fostering investments and corporate growth. Because of this, companies are able to fund more projects and have better future prospects than in a world with higher interest rates, leading the stock price of the indexes up. Moreover, people can borrow money cheaper than before, and thus get to spend more, generating more profits for the companies. Another reason the current low interest rates drive the stock prices up has to do with the role of interest rates in valuing future prospects. The discounted cash flow (DCF) model is widely used among analysts to determine the value of a company. According to the discounted cash flow model, the present value of a company is equal to the present value of the future cash flow to equity discounted at the cost of equity. Investors use the risk-free rate to compute the cost of equity, thus the discount rate is sensitive to interest rate changes. The artificially low risk-free interest rates set by the Federal Reserve yields abnormally low discount rates (with regards to historical average), which in turns yield valuation models to generate higher valuations (because the discount rate is the denominator of the formula, a lower number increases the final results). This factor is also a driver in the positive performance of the indexes, and was discussed by super-investor Don Yacktman among others. The newly appointed chairman of the Federal Reserve, Janet Yellen, did not lower the interest rates and did not announce her intention to do so, giving confidence to the financial markets. Finally, macroeconomic conditions play an important role when it comes to stock indexes performance. An important factor that contributed to the positive performance of both indexes is the fact that the US unemployment rate decreased to a 3-year low, at 6.60%. This reflects improving economic conditions nationwide and thus represent good news for companies. While both indexes showed a strong performance, the NASDAQ still outpaced the Dow Jones by 308 basis points. This can be explained by the fact that the Dow Jones is composed of industrial companies (“blue chip stocks”), while the NASDAQ is heavily weighted towards technology stocks having higher volatility. Therefore, the components of the indexes must be taken into account while comparing them. The NASDAQ will have a higher standard deviation due to its technology stocks, while the Dow Jones and its industrial companies will have a smaller standard deviation.
- The total performance of stocks and stock market indexes can be attributed to three main factors, being business performance, macroeconomic conditions, and investors’ sentiment. Business performance is obviously influencing the price an investor will pay for the business: the larger the earnings generated by the company, the higher the price investors will be willing to pay. Business performance drivers include company earnings, company growth, profitability, return on equity, revenues, margins They include among others the profit margin warnings for Amazon, as well as a change in net income for J.C. Penney. The second driver of performance is macroeconomic condition, with indicators such as GDP growth, the unemployment rate, interest rates, inflation During our study period, macroeconomic indicators were all very positive: the unemployment rate was decreasing (to 6.6%, a 3-year low) and the interest rates were maintained at very low levels. For reasons explained above, these positive macroeconomic conditions allow companies to generate higher profits and thus warrant higher valuations: their stock price increase. A third driver of performance can be categorized as investors’ sentiment and involves all psychological factors associated with investing, such as investors’ optimism versus pessimism, fear, greed, herding Investors’ sentiment was overall high during our study period, as can be demonstrated by the high amount of money increasingly invested in U.S. equities. As more and more capital is allocated to equities, their price goes up and generates performance. Our study timeframe happens in a period where investors regain trust in the financial markets, which can be explained by the good performance of the stock markets in 2013, a few years after the financial crisis.
- This stock analysis taught me a number of interesting points. Firstly, we notice that stock price performance is more affected by changes and expectations than by absolute values. This fact is apparent when looking at J.C. Penney: even though the company is making a loss and is still expected to make a loss during its 4th quarter, the stock price strongly increased because the expected loss was reduced compared to the previous years. We also note that these figures are not actual losses but rather expected losses, reflecting the fact that investors’ sentiment and expectations are crucial in determining stock performance. The fact that expectations seem to matter more than actual results is surprising. Amazon is an example of this finding. Even though the company is now turning a profit ($.58 earnings versus -$.10 year-on-year), the stock price fell because investors expect higher margins, among others. Moreover, I noticed that macroeconomic indicators are critical for stock returns. During our study period, macroeconomic indicators were very positive for stocks. The interest rates were extremely low, with 1-year Treasury bills having a yield of 0.11%, and the unemployment rate decreasing to 6.6%, a 3-year low figure. This positive macroeconomic context led both stock indexes to show substantial gains, which is truly representative of the economy, as the Dow Jones represents 30 stocks and the NASDAQ represents 3000+ stocks. We can thus conclude that positive macroeconomic factors are critical for global positive stock returns.
Appendix
AMZN Stock Chart
JCP Stock Chart
Dow Jones Stock Chart
NASDAQ Stock Chart
AMZN, JCP, Dow Jones & NASDAQ Stock Chart Comparison
