Why Carl Icahn's $216 Fair Value for Apple is Unrealistic

You may have read Carl Icahn's letter published yesterday in which he outlines why he believes Apple stock is worth $216 per share today. With the stock currently fetching an all-time high of $127, making it the most valuable company ever, you might be wondering if a company already worth nearly $750 billion can really still be 70% undervalued. Quite simply, I do not believe so. Let me explain why.

First, I think it is helpful to look at a snapshot of the last five years, to give you an idea of where Apple stock has traded relative to its business fundamentals. Below is a chart I constructed that shows Apple's revenue, earnings per share, ending stock price, and ending P/E ratio since fiscal 2010, along with consensus forecasts for the current 2015 fiscal year and Carl Icahn's above-consensus estimates.

From this chart you should be able to see how Icahn is getting such a sky-high fair value estimate for Apple; he's using an extremely optimistic P/E ratio assumption. There are many reasons why Apple shares are unlikely to fetch a P/E ratio of 20+ ever again. Some that come to mind are:

1) Apple's current size - With annual sales of over $200 billion, investors are unlikely to assume dramatic growth rates from here, which limits the multiple of earnings they are willing to pay.

2) Apple's industry - Though it may be hard to fathom right now, the tech sector has a decades-long history of musical chairs when it comes to market dominant companies, so investors often will discount their valuations if it seems as though things can't get much better and a technological shift in consumer preferences is likely at some point in the future.

3) Apple's poor capital allocation - When you are keeping $141.6 billion of net cash on your balance sheet investors will not always give you full credit for it since it is not generating an adequate return. When the cash pile reached $100 billion people were miffed and the hoard is more than 40% higher. For comparison's sake, Apple's total cash outlay for capital expenditures and acquisitions was $13.5 billion in fiscal 2014, making their cash "buffer" equal to more than 10 years' worth of growth investment.

4) Apple's historical valuation - Over the last five years Apple's average P/E ratio at the end of its fiscal year has been 15. Carl Icahn's insistence that Apple is worth 50% more than that does not make much sense. Over that five-year period Apple's sales have tripled. A higher P/E ratio usually implies the expectation of higher growth. It will be very difficult for Apple to triple its business over the next five years, which would mean that the average P/E ratio during that time could very well be less than 15 (not over 20).

So what do I think Apple stock is worth? Well, first off let me point out that I am far from an Apple bear. I have been long the stock for many years and some of my clients have an average cost basis in the single digits per share. I just think investors' expectations should be more muted than Carl Icahn's. Consistent with the points outlined above, I think Apple shares will trade at a P/E ratio between 10 and 15 going forward. Using a $9 EPS figure for fiscal 2015 and giving the company full credit for its cash position, that gets you to a range of $114-$159 with the midpoint being $136 per share. Relative to today's price of $127 Apple stock is neither dramatically overvalued nor undervalued.

"Profitless" Amazon Myth Lives On Thanks To Lazy Financial Media

Last night CNBC premiered their newest documentary entitled Amazon Rising. I tuned in, as I have thoroughly enjoyed most of their previous productions. I found this one to have a noticeably anti-Amazon vibe, but none of the revelations about the company's business practices should have surprised many people, or struck them as having "crossed the line." For me, by far the most annoying aspect of the one-hour show was the continued insistence that Amazon "barely makes any money" and "trades profits for success." It's a shame that the media continues to run with this theme (or at least not correct it), even when the numbers don't support it.

Most savvy business reporters understand the difference between accounting earnings and cash flow, the latter being the more relevent metric for profitability, as it measures the amount of actual cash you have made running your business. There are numerous accounting rules that can increase or decrease the income you report on your tax return, but have no impact on the cash you have collected from your customers. A good example would be your own personal tax return. Did the taxable income you reported on your 2013 tax return exactly match the dollar amount of compensation that was deposited into your bank account during the year? Almost by definition the answer is "no" given that various tax deductions impact the income you report and therefore the taxes you pay. But for you personally, the cash you received (either on a net or gross basis) is really all that matters. One can try to minimize their tax bill (legally, of course) by learning about every single deduction that may apply to them, but it doesn't change the amount of pre-tax cash they actually collected.

As a result, the relevent metric for Amazon (or any other company) when measuring profitability should be operating cash flow. It's fancy term that simply means the amount of actual net cash generated (in this case "generated" means inflows less outflows, not simply inflows) by your business operations. In the chart below I have calculated operating cash flow margins (actual net cash profit divided by revenue) for five large retailing companies -- Costco, Walgreen, Target, Wal-Mart, and Amazon -- during the past 12 months. The media would have you belive that Amazon would lag on this metric, despite the cognitive dissonance that would result if you stopped to think about how Amazon has been able to grow as fast as they have and enter new product areas so aggressively. After all, if they don't make any money, where have the billions of dollars required for these ventures come from? The answer, of course, is that Amazon is actually quite profitable.

As you can see, if we measure "profitability" by actual cash collected from customers, over and above actual cash expenses, as opposed to the accounting figure shown on their corporate tax return or audited income statement, Amazon's profit margins are actually higher than each of those other four companies. Shame on the media for giving everyone a pass when they insist Amazon doesn't make money, or at least "barely" does so. They make more money, on a cash basis anyway, than many other large, well-known retailers whose profit margins are rarely questioned.

Full Disclosure: Long Amazon and Target at the time of writing, but positions may change at any time.

Zuckerberg, Facebook Move To Mimic Amazon & Google's "Go Anywhere" Strategy

My last post about Facebook (FB) back in February speculated that its 15% valuation premium to Amazon was not justified (the spread has since narrowed and I continue to feel the same way today) but this post is more general in nature. Perhaps Mark Zuckerberg's biggest challenge is figuring out what's next for Facebook. He would likely admit privately that overall Facebook usage is likely to decline over time. Calling the site/app a fad is too harsh, but Facebook has already lost some of its cool factor (once your parents and grandparents are using the service, kids are likely to move on to something else) and it is entirely reasonable to expect that the average user today will spend less time on Facebook on a daily basis five years from now than they do now. So how does the company evolve?

I find this an interesting question because technology companies did not always move this fast. It used to be rare (and still is, to a large degree) that tech companies were much more focused. They rarely made 180-degree turns and ventured into completely unchartered territory, and those that did often failed (Microsoft, for instance, has maintained its lead in enterprise software, but has had numerous duds trying to gain traction in the hardware market --- think Zune, Surface, Windows-based phones, etc).

In recent years, however, two companies in particular have challenged this focused strategy; Amazon (AMZN) and Google (GOOG). Jeff Bezos started out selling books online and now he will gladly sell you physical books, digital books, as well as Amazon-branded digital book readers, tablets, and streaming television devices. But it doesn't end there. Amazon has cut out the middleman and now has its own book publishing unit, television production company, and game development studio. If something makes it more likely and/or easier for you to use Amazon, they are going to consider making it. It might seem like a disorganized strategy, but most of these products and services fit together in some way, if you take the time to think it through.

Google is very much doing the same thing, but it's various special projects are less obvious in terms of cohesiveness. When you have hundreds of millions of people using your email service, file storing service, and search engine, it makes sense to sell your own tablets and phones (to make it easier to access those services and therefore less likely you will switch to a competitor). Self-driving cars and internet-connected eyeware do not exactly fit that mold, but when you have the money, desire, and brainpower to venture into new and exciting areas, why not? If not Google, then who?

With its IPO behind it, I think Facebook finds itself in a similar position. They have a bilion users, billions of dollars in the bank, and thousands of excellent engineers. As Mark Zuckerberg has stated publicly, the future of Facebook is not about the blue app on your phone (another indication he knows the original Facebook service will fade over time). Facebook's future success depends on its ability to move into new areas and succeed in doing so. With a hugely valuable stock and plenty of cash, Zuckerberg has placed two big bets in recent months; $19 billion to acquire the WhatsApp messaging service, and $2 billion to acquire virtual reality goggle maker Oculus. Are these the right moves? Will the next five moves he makes be largely successful when we look back five or ten years from now? These are open questions.

Right now Wall Street is giving Facebook the benefit of the doubt. As an investor, I am more skeptical. While Facebook could certainly be the next Google or the next Amazon, I think it might be a tougher task for Facebook to succeed with the "go anywhere" tech strategy. Google will bring in over $65 billion in sales this year. Amazon will come close to $90 billion. Facebook is projected to be around $11 billion. And yet Facebook is worth more than Amazon and about 40% of Google, based on current equity market values. Of the three, I like Amazon most from a stock perspective as of today. Of the three, I think Facebook has the most risk, the most to prove, and the shortest track record from which to predict success.

It will be fascinating to see where Zuckerberg takes the company over the next few years, and whether he can come to dominate multiple domains like Amazon and Google have. These three companies have changed what technology business models look like, and for their efforts now sport a combined stock market value of two-thirds of a trillion dollars. Not bad considering that none of the three companies even existed in 1993.

Full Disclosure: Long Amazon at the time of writing, but positions may change at any time.

Amazon ($AMZN) Sales Growth Projections for Next Two Years Appear Overly Optimistic

Investors have been reallocating capital out of Amazon ($AMZN) shares fairly heavily since the company reported a lackluster fourth quarter earnings report. After peaking over $400 in January the stock has dropped about 75 points to the low 300's. In fact, I actually think the stock is beginning to look compelling for long term investors, if you believe Amazon will continue to successfully enter new markets, as the shares now fetch only about 1.5 times 2014 revenue (after deducting net cash). While profit margins remain low (cash flow of $5.5 billion in 2013 equated to only 7.4% of sales), those that claim Amazon makes no money don't seem to dig into the company's financial statements very deeply.

All of that said, after looking at Amazon's sales trends over the last 15 years, I believe that Wall Street is currently overly optimistic about sales growth at Amazon for the next two years. If you believe that investors will be focused on sales growth, in lieu of material profit margin gains in the intermediate term, it would imply that Amazon bulls can take their time building long-term investments in the stock over coming quarters.

So why do I think Amazon will be hard-pressed to achieve the current consensus estimates for sales in 2014 (up 21% to $89.9 billion) and 2015 (up another 20% to $107.6 billion). First, let's look at Amazon's annual sales since 1998:

Simply looking at this data may cause you to feel pretty upbeat about Amazon's business. Over the past 15 years sales have grown an astounding 41% per year, rising from under $1 billion in 1998 to nearly $75 billion in 2013. Is it really a stretch to asssume that two more years of 20%+ growth could be in the cards?

The problem Amazon is going to begin to face is the fact that once you reach a certain size, it becomes nearly impossible to continue to grow at 40%, 30%, or even 20% per year. Finding an additional $15.4 billion of revenue in a single year (the incremental figure analysts estimate Amazon will book in 2014) is no easy feat. In fact, Amazon's total revenue in 2007 was just $14.8 billion, so "2014 Amazon" must equal "2013 Amazon" plus "2007 Amazon." With annual revenue approaching the $100 billion level, the company's growth rate is likely to begin to slow soon.

Is there any way to know when exactly growth will decline significantly? Not really, but one of the numbers I like to focus on is incremental revenue growth, in dollars, from one year to the next. As a company gets larger and larger, the amount of incremental sales growth needed simply to maintain its growth rate rises fairly sharply. In fact, if we chart out Amazon's incremental annual sales growth since 1999, we can see patterns emerge:

For instance, between 1999 and 2006 Amazon was able to grow sales by between $1-2 billion a year (roughly). That figure rose to $4-5 billion from 2007-2009, and accelerated to $10 billion in 2010 after the recession ended. Interestingly, over the last three years Amazon has hit a wall. In both 2012 and 2013, incremental sales growth at Amazon failed to eclipse 2011 levels. I believe this could be the beginning of a period where we see Amazon's sales growth slow materially.

Perhaps problematic, the current Wall Street consensus forecast calls for Amazon's incremental revenue growth in dollars to reaccelerate to more than $15 billion this year, and again to nearly $18 billion in 2015 (look at the orange bars in the above chart). While there is no assurance that this figure cannot continue to climb, there will be a time when Amazon simply cannot continue to find that much new revenue each and every year (without making large acquisitions anyway, not something they have typically done). Given that a disappointment in merchandise sales growth has been a key driver of Amazon's recent stock market weakness, I believe it is entirely possible that both 2014 and 2015 sales forecasts are too high. Maintaining annual sales growth of 20% for much longer seems unlikely, perhaps even starting this year.

As I mentioned at the outset of this article, however, I don't necessarily think this would spell the end of Amazon's stock market stardom, at least not long term. If Jeff Bezos is willing to show investors that he is willing to demonstrate that profit margins can be susteained at levels above those currently being attained, investors would likely be very pleased and any short term stock decline would quickly be reversed. After all, annual sales approaching $100 billion offer Amazon the ability to generate some very impressive free cash flow, which would make the stock's current market value of $150 billion seem not so unreasonable.

In coming quarters, I will be focused on Amazon's sales trends and if I am correct and the current consensus forecasts are too aggressive, any continued short-term weakness in Amazon shares could present investors with an excellent opportunity to continue building a long-term position in the stock.

Full Disclosure: Long AMZN at the time of writing, but positions may change at any time

Is Facebook ($FB) Really Worth 15% More Than Amazon ($AMZN)?

If you needed more proof that there is another bubble forming in Silicon Valley 15 years after the last one ended badly, how about this headline:

"Facebook to acquire WhatsApp for $19 billion"

This announcement makes the Facebook ($FB) deal to buy Instagram for $1 billion in 2012 look like the biggest bargain in U.S. corporate merger and acquisition history. Maybe the Snapchat guys were smart to turn down the $3 billion Mark Zuckerberg offered them. Their asking price is probably $10 billion now and they just may get it now. All of the sudden the debate over whether Twitter ($TWTR) is worth $40 billion with only $1 billion in annual revenue takes a back seat. Now WhatsApp, a company many people have never heard of, is in some eyes worth half that price without a penny of revenue(Correction at 5:05pm PT: The WhatsApp app is free for the first year, then users pay $0.99 per year, so they technically do have revenue, although 8 cents per month is not material in my mind).

Rather than debate whether startups without fully formed business models are worth tens of billions of dollars, the more interesting thing to me is that Facebook's current market value is now $185 billion after you add in the $15 billion of new stock they are giving WhatsApp (along with $4 billion in cash). Amazon ($AMZN), after its recent post-earnings report decline, has an market value of just $160 billion.

I might be completely wrong about this, but if I had to pick one of those stocks at those prices for the next 5 years, I'd take Amazon over Facebook in a heartbeat, even ignoring the fact that I would be getting it at a discount. I just don't think Facebook usage five years from now will be as high as it is today. They seem to share this view, based on their recent buying spree, which has resulted in them targeting competing apps that they intend to operate completely separately from the Facebook platform.

Essentially, it's an "app grab" and they have plenty of money and equity-raising ability to pay huge amounts in order to place bets on which apps will dominate in the future. Given how fast consumers' technology preferences change (if you looked at the top 10 most visited web sites from 10 years ago you would giggle), I think it will be really hard to know which apps will be long-term winners. And paying $19 billion for one seems truly remarkable to me.

Along those lines, for investors looking for a way to play their opinions on how these kinds of things play out longer term, I think you can make some interesting bets using paired trades to reduce your market risk. For instance, getting Amazon for a 15% discount to Facebook looks intriguing to me, and I am putting a little money on that paired trade; short Facebook, long Amazon. It's a market-neutral bet that simply is a play on Amazon narrowing that valuation gap, and quite possibly overtaking Facebook, in the next, say, 3 to 5 years.

Now, I could be completely wrong here (and in technology it's easier to be wrong than in other industries), but right now I just think the sentiment has shifted so much lately (to Facebook and away from Amazon, though not for the same reasons), that I'm willing to put a little money on the line. It wasn't that long ago that Faecbook was written off shortly after its disasterous IPO and after a mediocre holiday quarter (in the eyes of some anyway), Amazon shares have dropped 60 points in short order.

From hero, to goat, to hero again, in less than 2 years...

Concerns about Amazon's low profit margins seem to be moot after the WhatsApp deal...

Full Disclosure: Long Amazon and short Facebook at the time of writing, but positions may change at any time

Here's What Not To Say If Carl Icahn Is Breathing Down Your Neck

Ben Reitzes, Analyst, Barclays: "And I guess there’s been a lot of things in the media about your potential to buy back more stock, and shares are around $500 tonight. I was wondering if you thought this was a good level, and whether it was time to accelerate the buyback from current levels. You obviously generated a ton of cash in the quarter, and what are your latest thoughts there?"

Tim Cook, CEO, Apple: "We’ve been buying back stock. As you know, last year we increased the program overall, our cash return, doubling it to $100 billion. And $60 billion of that is buyback, and we’ve been progressing on that. Luca can give you the precise numbers of it. So we’re a big believer in buying back the stock, and that doesn’t change today, whether the stock goes up or down [emphasis added]."

Apple now has $159 billion of cash. That is $177 per share, versus a share price of $510 per share, so more than 1/3 of the value is in the bank, not within its corporate offices, inventory, retail stores, or supply chain. The core operations are trading at around 9 times earnings, nearly a 50% discount to the S&P 500. We know Carl Icahn is begging for an accelerated buyback and is completely justified in asking for one. I'd bet he is buying more stock today. And yet, despite knowing all of this, Tim Cook casually states on the conference call that his willingness to do stock buybacks does not change at all depending on where the stock is trading. I can't wait to read Carl's next letter to the board. And you thought the first one was unapologetically critical.

Full Disclosure: Long shares of Apple, but positions may change at any time.

Amazon Holiday Fun Facts 2013 ($AMZN)

They never give specific numbers, but Amazon (AMZN) always takes plenty of time in crafting their holiday press releases. Here's an excerpt from today's:

Holiday Fun Facts:

• Amazon shipped to 185 countries this holiday.
• The last Prime One-Day Shipping order that was delivered in time for Christmas was placed on Dec. 23 at 10:22 p.m. PST and shipped to Carlsbad, California. The item was a Beautyrest Cotton Top Mattress Pad.
• The last Local Express Delivery order that was delivered in time for Christmas went to Everett, Washington. It was a Plantronics Audio 655 USB Multimedia Headset in Frustration Free Packaging ordered at 12:26 p.m. PST on Christmas Eve and delivered at 3:56 p.m. PST that same day.
• Amazon.com shipped enough items with Prime this holiday to deliver at least one gift to every household in America.
• Prime was so popular this holiday, that Amazon limited new Prime membership signups during peak periods to ensure service to current members was not impacted by the surge in new membership.
• On Cyber Monday, customers ordered more than 36.8 million items worldwide, which is a record-breaking 426 items per second.
• More than half of Amazon customers shopped using a mobile device this holiday.
• Between Thanksgiving and Cyber Monday, Amazon customers ordered more than five toys per second from a mobile device.
• Amazon customers purchased enough Crayola Marker Makers to be able to draw a line around the world four times.
• The new Xbox One and PlayStation 4 gaming consoles were so popular that at the peak of sales for each console, customers bought more than 1,000 units per minute.
• Amazon customers purchased enough Rainbow Looms from third-party sellers that the bands can stretch around the circumference of the Earth.
• Amazon customers purchased enough Hot Wheels from third-party sellers to stretch around the Daytona International Speedway racetrack.
• Amazon customers purchased enough miniature flashlights to satisfactorily light four collegiate football fields in accordance with NCAA standards.
• Amazon customers purchased enough running shoes to provide a pair to every participant in the top 10 largest marathons in the world.
• Amazon customers purchased enough winter boots to keep everyone living in three of the coldest cities in America – Duluth, Minnesota, Butte, Montana, and Watertown, South Dakota – warm for the winter.
• Amazon customers purchased enough cross-body purses to outfit every attendee at a typical Taylor Swift concert.
• If you stacked every Himalayan Crystal Lamp purchased by Amazon customers this holiday season, the height would reach the top of Himalaya’s highest peak - Mt. Everest.
• Amazon customers bought enough books in the Divergent Series – “Divergent,” “Insurgent,” “Allegiant,” and the complete box set – to wrap around Chicago’s Pier Park Ferris Wheel 263 times.
• If you placed every upright vacuum purchased by Amazon customers end-to-end, they would reach 15 times the depth of the Marianas Trench, the deepest point in Earth's oceans.
• If the Nylabone Dinosaur Chew Toys purchased during this holiday season were stacked on top of each other, they would be the height of more than 950 T-Rex dinosaurs.
• The number of “Star Trek Into Darkness” Blu-ray combo packs purchased would span the distance of 25 Star Trek Enterprise space ships.
• If you had a single plain M&M for each Eminem album purchased on the Amazon MP3 Store over the holidays, you’d have nearly 100 lbs. of candy-coated chocolate.
• Amazon customers purchased enough youth archery kits to outfit every resident of Katniss Everdeen's hometown, District 12, four times over.
• Amazon customers purchased enough Tovolo Sphere Ice Molds to fill Don Draper’s (of “Mad Men”) whiskey glasses for 251 years.
• Amazon customers purchased enough Cuisinart Griddlers to place one in every McDonald’s restaurant in the world.

Biggest Challenge for Social Media Stocks: 24-Hour Days

Many of us remember Napster, Friendster, and MySpace. Services that we used quite a bit for a while, only to see them fade away into obscurity as we moved on to the next cool thing. A more recent example is Zynga (ZNGA) and the FarmVille frenzy that took over Facebook (FB) for a while a couple of years ago. FarmVille users have fallen off by millions since then. Today Candy Crush is the hot game (and its creator, King, is rumored to be considering an IPO) but that too is likely to fade over time. Zynga timed its IPO well just as its user base had exploded, but now (as the stock chart below shows) that honeymoon is over. King would be smart to avoid the public spotlight and simply focus intently on not becoming an afterthought a year or two from now. 

I think the biggest issue social media companies are going to have, especially the ones that go public and see their initial valuations soar to the moon, is that there are only 24 hours in a day. And by that I mean, we can't possibly use every single app, or visit every web site, or play every game, on a regular basis. There is simply not enough time. And as a result, when something new and cool comes out, we are forced to abandon the last cool thing in order to try it out.

There was a teenager interviewed on CNBC a couple weeks back and the anchors asked her what social media apps she uses most with her friends. She declared that her Facebook (FB) usage was declining (which jives with recent reports that teenage usage is stagnant or even beginning to drop) and that Twitter (TWTR) and Snapchat were hot right now. Within days we learned through media reports that Facebook offered to buy Snapchat for $3 billion. That is how fast these things move. It was once thought to be foolish to buy a company with no profits, but now Facebook feels like it has to fork over billions for a company that doesn't even have sales, let alone profits. It seemed like a desperate move by Facebook to try and remain relevant with teens. But what if Snapchat goes the way of Friendster, MySpace, and FarmVille?

The huge increase in the number of online choices consumers have is going to be a big problem for investors, I believe. There is simply no way that we can devote enough time to fully engage all of these different services. Maybe for a short time, but not over the long term. How long can you keep up religiously checking your Groupon (GRPN) and LivingSocial daily deal emails, Facebook wall, LinkedIn (LNKD) profile? Don't forget to listen to your Pandora (P) music play list, play some rounds of Candy Crush, tweet to all of your followers, share photos with Instagram and Snapchat, check out the flash deals at Gilt and Zulily (ZU), and review the restaurant you just tried on Yelp (YELP). Eventually you have little choice but to weed out some of these services. Maybe you try a new one for a few months, but your technological schedule has its limits.

I point this out because right now there is a huge bull market/bubble in internet-related start-ups, especially social media apps. If you use the stock market as a barometer you would conclude that they will all be wildly successful; continuing to maintain and grow their user base and figure out how to monetize all of that customer engagement, to the tune of tens of billions of dollars. The problem? They can't all be successful. There are only 24 hours in a day and we can't possibly integrate all of these services into our daily life over the long term. Sure, there will be some winners, but I suspect far more will fade into oblivion over time and the newest hot app will just keep replacing the slightly less hot app and so on and so forth. We've seen this game before and it does not end like Wall Street and the Silicon Valley-based venture capital world seems to be suggesting right now. They all can't be winners. For every Google there will be duds like Excite and Lycos.

The 2013 IPO Bubble Is Here, And Companies Are Lining Up Quickly Before The Window Closes

From Yahoo! Finance:

"Zulily, Inc. operates as an online flash sale retailer in the United States, Canada, the United Kingdom, and internationally. It provides various merchandise products to moms purchasing for their children, themselves, and their homes, including children’s apparel; women’s apparel; children’s apparel products comprising infant gear, sports equipment, toys, and books; and other merchandise, such as kitchen accessories, home decor, entertainment, electronics, and pet accessories."

Yes, Zulily (ZU). One of the latest hot initial public offerings. The company description above might sound fancy, but it's a shopping site targeted at moms. Think of it as a specialty boutique store, with just an online presence. I don't mean to minimize it, but there is no special sauce here. It's a retailer, plain and simple. And a very popular one at that. For the first nine months of 2013, the company's sales totaled $439 million, which generated $29 million of positive cash flow (7% cash flow margins).

So, how much is Zulily worth? $5 billion. And I'm not joking. The company went public last Friday at $22 per share and now trades at around $37. The initial expected price range for the IPO was set at $16-$18 but investors were willing to pay more than 35% above that before the stock even began trading. After it opened, the price was bid up another 70% on the first day.

Zulily is the perfect example of why the current IPO frenzy has gotten out of hand (and likely won't last too much longer). The company is targeting what is likely an under-served niche within specialty retail (moms), and it has been very successful thus far. In fact, they are based here in Seattle and I hope they continue to make their customers happy. But the price of the stock makes no sense. And that's where the IPO market, and many retail investors who are gobbling up any newly issued stock they can, will wind up having a problem.

There is nothing new here in terms of Zulily's business model (at least with Twitter (TWTR) you can argue they created something new and were a first-mover, so perhaps they will be a unique case). They are a retailer. We have a good idea of how that business works and what kind of profit margins one can expect. Accordingly, we should be able to determine what kind of market valuation makes sense. We might not be able to pinpoint it exactly, because Zulily is growing very fast (2013 sales are running double those recorded in 2012) and its exact growth trajectory is difficult to predict, but at this point they are simply taking market share from existing retailers, both online and off. Moms across the country aren't all of the sudden dramatically spending more on their children. There is not a retailing renaissance more generally throughout the U.S. The consumer economy has not suddenly taken off. Zulily, if they continue to execute well in the marketplace, will see its growth rate slow over the next few years and then find itself just like any other retailer vying for consumers' discretionary dollars.

And that is why the company should not trade at 150 times cash flow. The business model at it currently stands does not justify a $5 billion valuation. Heck, even Amazon (AMZN) trades at 34 times cash flow and it is one of the few companies that can barely turn a profit (7% profit margins on a cash flow basis -- same as Zulily's interestingly enough) and not face any objections by investors. Is every dollar of sales generated by Amazon really worth 75% less than a dollar of sales booked by Zulily? That is what the market is saying right now.

And because of that other internet start-ups are preparing to test the IPO waters. Just in the e-commerce space we have heard rumblings that Gilt.com, Wayfair.com, and Fab.com are itching to cash in, and I don't blame them. So I would caution everyone to stick to a valuation discipline when you pick stocks for your portfolio. The last time we had companies being valued based on a multiple of sales (not profits), or saw P/E ratios reach triple digits, or saw analysts justifying prices by using financial projections five years into the future, was the late 1990's. And we all know how that turned out.

Full Disclosure: No positions in the stocks mentioned, but positions may change at any time

Thoughts on the Twitter IPO

I confess; when Twitter (TWTR) launched I thought it was stupid. When every single television commercial and print advertisement started saying "like us on Facebook, follow us on Twitter, etc I felt like it was social media overload. Now I can hardly watch any TV program without having random hashtag phrases pop up on the screen. Like enough people are really dying to tweet about the Survivor episode they are watching. #redemption island? Please. Stop. And no, I don't care what most celebrities have to say in 140 characters. And how many times do we need to hear about a professional athlete who tweeted something insensitive and then had to issue a public apology? We have better things to do with our time. As a result, I never thought I would really "get" Twitter.

But I am slowly coming around. Not because I find Paris Hilton interesting, but because I have actually found myself searching twitter several times lately for other reasons in my daily life. I was traveling on the day of the Potbelly (PBPB) IPO but one of my clients was interested in the shares, if the price was right after it came public (it wasn't). So I am sitting in an airport terminal waiting for my flight and wanted to know how PBPB opened. Since IPOs typically don't open until an hour or so after the opening bell in New York, I had no idea when that first trade would print. But a quick search on Twitter provided that information. I no longer had to be in front of a TV tuned to CNBC to find out.

Not only that, but I also wanted to know at what price it opened. Many stock quote apps are 15-20 minutes delayed and it would take 30-60 minutes for major news outlets to write and publish a story about it. Once again, Twitter was the only way I could find out the opening price in real-time. Within minutes after that I was boarding my flight and powered down my phone. But I knew that the price was above what I felt was reasonable and I could forget about it for the rest of the day.

It turns out Twitter is very useful for non-investing information as well. Now that I have lived in the Pacific Northwest for almost 18 months, I have grown to be a huge fan of food trucks. They were everywhere in Portland (part of the culture really) and here in Seattle there aren't as many but still quite a few. In fact, there are two that serve the parking lot outside my office a few times a month. The schedules can be variable and sporadic (the food truck business is tough from a proprietor standpoint so unless you have a "can't miss" location reserved, you are likely to mix it up day-to-day or week-to-week to try and get by financially). It turns out the only way to really find out where and when a particular truck will be in a given location is through Twitter. Web site listings become quickly out of date given how much these trucks relocate and how little advance notice is typically given.

So, I am warming up to Twitter. I don't actively tweet (although links to each of my blog posts are set up to automatically go out to followers of @peridotcapital) and I don't plan to, but the service clearly has value. And as I have found, not only to celebrity junkies or tech heads. Now, does the fact that I can get Potbelly quotes and food truck location updates mean that Twitter is a sure-fire business that is worthy of your consideration at a $20 per share IPO price/$14 billion initial valuation (and likely to go higher than that even before it begins trading)? Maybe, maybe not.

I don't think there is any way to know that without a crystal ball. After all, the company will bring in about $700 million in revenue this year so investors who buy the stock are buying it for future revenue and profits, not what they are earning today (which is only about $3 per year for each of the 230 million monthly active users they have right now).

It is entirely possible the stock opens at $40 next month (I would not be surprised if the IPO price gets bumped up to $25-$28 before it is all said and done as well) and comes with a nearly $30 billion valuation. It is hard to justify that, but I am beginning to see that Twitter could play a large role in social media going forward with a larger slice of the population than I would have guessed and is likely to figure out a way to make several billion dollars monetizing the platform over time. Whether investors are willing to pay $10 billion, $20 billion, or $30 billion for that business remains to be seen.

Full Disclosure: No positions in any of the companies mentioned at the time of writing, but positions may change at any time.