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Investment Conclusion
Amazon (NASDAQ:AMZN) is moving rapidly towards achieving its overarching objective of turning into a company with a razor-razor-blade business model, with the low margin online business fueling sales of the high margin segments, specifically marketplace, advertisements, and subscriptions. In order to dominate the retail landscape in markets it participates, which is necessary to attain the razor-razor-blade business model goal, AMZN appears prepared to operate its online business as a loss leader, with minimum to zero margins, for an extended time horizon.
Through price leadership and excellent customer service, it hopes to create sufficient brand value in its markets to attract third-party sellers and ensure their success. In addition, it seeks to utilize its market leader role to encourage third-party merchants to avail of its advertisement services. Further, using price, product selection, and convenience, it hopes to convert customer loyalty into memberships to Prime, its flagship subscription service. Moreover, as the AMZN ecosystem expands and succeeds, it expects to eventually improve margins associated with the online business.
However, that is AMZN’s future growth story. The business that is currently delivering almost all of the company’s earnings and keeping AMZN profitable is Amazon Web Services (AWS), the firm’s cloud computing segment, that continues to grow rapidly, in an industry that appears to be in the nascent stage of its evolution. There is significant growth ahead for AWS.
Overall, AMZN is a win-win situation for all stake holders, including customers. Therefore, the long-term outlook for the company is highly favorable. We are initiating on AMZN with a Buy Rating and a 1-year Price Target of $140/share, based on our 10-year Discounted Cash Flow model, which includes a perpetual growth driven terminal value.
Investment Thesis
AMZN was founded in 1994 in Bellevue, near Seattle, Washington. The corporation has headquarters in Puget Sound, Washington, and Arlington, Virginia. AMZN’s online business is conducted in 22 countries, including the U.S., the U.K., Germany, Japan, Australia, and India. In addition, the firm has 672 physical stores in North America, and seven in foreign countries.
AMZN operates in three segments, North America, International, and AWS. The company’s revenues are derived from: online services, physical stores, third-party seller services, advertisement services, subscription services, and AWS. Over nine months ended September, 2022, online services accounted for 42.6% of total revenues, physical stores for 3.8%, third-party seller services for 22.3 %, advertisement services for 7.2%, subscription services for 7.1%, and AWS for 16.2%.
There are two primary issues surrounding the AMZN story. The first is whether the firm’s recent weak financial performance underpins more serious business challenges? The secondary issue garnering investor interest is what is the long-term financial outlook for AMZN? We analyze the elements below.
Current Financial Challenges Abnormal, Business Poised For Significant Growth
It appears that AMZN’s financial underperformance over the previous three quarters is based on short-term factors and is not systemic in nature. On a long-term basis, fundamentals associated with the company’s segments appear strong and on track to deliver on profit targets.
In regard to the e-commerce business, AMZN currently markets its products in 22 countries through dedicated websites and ships merchandize to numerous foreign regions. The firm expects to expand into South Africa, Chile, Nigeria, and Colombia, by April 2023.
However, it is noteworthy that the predominant objective of the online business is to ignite revenues associated with third-party seller services, subscription services, and advertisement services. Therefore, AMZN is not overly concerned with near-term profitability of the e-commerce segment, instead preferring to develop the business for the long-term through reinvestment. It values revenues, market share, number of orders fulfilled, and repeat orders, ahead of earnings. AMZN is not focused on the category’s margins, and accordingly seeks to compete on price, driving prices as low as the anti-competitive laws of the land permit, even selling at a loss to engender retail dominance in countries it operates in. To encourage customer loyalty, it combines low prices with convenience and an excellent selection of a large number of products.
In addition, the goal is to keep customers in the Amazon ecosystem driving additional sales. With that objective in view, the firm launched Fresh, it grocery delivery platform which provides same day delivery. Further, in order to add to its share of the grocery market, it is in process of expanding its footprint of brick-and-mortar Fresh stores, which combined with its base of ~550 Whole Foods outlets, would comprise some semblance of exposure to the 71% of U.S. customers that prefer to shop for groceries off-line. The objective is to rapidly open Fresh physical stores across its key global markets.
However, the roll-out of these establishments is encountering challenges, and new unit development has been slower than expected, due to struggles related to the high costs associated with building and operating outlets, dysfunctional internal culture, and problems related to the integration of Whole Foods with AMZN’s retail business. Nevertheless, given that the corporation provides its emerging businesses ample time horizons to develop, we anticipate that AMZN will eventually establish itself as a key provider, in the off-line grocery business. Considering, these elements, the global grocery channel could develop into the next leg of long-term growth for the firm’s retail business, in our assessment.
Cumulatively, given the scale and scope of AMZN’s operations and the resources available to it, we view the whole world as possible addressable population for its e-commerce business. Considering that AMZN’s current operations are largely limited to 22 countries, which underpin further penetration opportunities, and the significant global white space it could expand into, the online business remains in the development stage, with sufficient growth ahead of it, in our judgment.
In regard to the third-party seller services business, AMZN launches marketplaces (through which vendors market products), once it has secured sufficient brand value to ensure the success of a majority of third-party merchants. In that context, it is noteworthy that, over nine-months ended September 2022, third-party seller units accounted for 58% of total units sold through AMZN’s on-line enterprise, versus 56% experienced over the same period last year. Given the potential for growth in existing marketplaces combined with the potential large number of marketplaces, AMZN will likely open, as it continues to extend its e-commerce business across the world, third-party seller services revenues are well-positioned to advance substantially, over an elongated time period.
AMZN advertising becomes available to third-party vendors, soon after the marketplace is added to the firm’s dedicated website for the country. It is noteworthy that the company’s advertisement services business is booming as awareness continues to develop among advertisers that 74% of U.S. customers begin their purchase journey by searching for products on AMZN, and that they would select AMZN if they could shop at only one online store. In addition, other factors driving the popularity of AMZN’s advertisement services among third-party sellers include that: the customers searching on AMZN are engaged and ready to buy; that the advertisements are targeted, displaying the right product in the right category; and that advertisers can evaluate the performance of their promotions, through the attribution feature. It is notable, that in addition to the e-commerce business, advertisement services revenues are derived from Prime Video and proprietary products.
During CY2021, AMZN accounted for 11.3% of the digital advertisement market, Google (GOOG) 28.6%, and Meta (META) 23.8%. Although global digital advertisement spending appears likely to decline over upcoming years due to over saturation, based on elements described above, we believe that AMZN’s advertisement services sales are well-positioned to escalate, as the company captures market share from Google and particularly Meta, as the group’s advertisement business has been unfavorably impacted by regulatory changes associated with Apple’s (AAPL) in-app tracking, which now permits customers to decline cookies. An additional factor driving our conviction on the issue is that customers are increasingly realizing that they can skip a step if they begin their search on AMZN, as Google and Facebook provide links to product websites, whereas AMZN’s websites actually carry the products. Further, the firm’s marketing which promotes AMZN as the store that has everything, is an additional element that is reflecting in large numbers of customers migrating to its website to perform product searches.
On the whole, we expect the company’s advertisement services revenues to advance as the population of its third-party sellers expands due to further penetration in existing markets and AMZN’s entry into new markets.
The corporation’s flagship subscription service is centered around Amazon Prime which offers monthly/annual fee based free one-day delivery of products, and Prime Video which features movies, shows, and live events. Other subscriptions offered to customers include: Kindle Unlimited, which provides consumers the opportunity to download and read one million e-books; Audible, a platform for purchasing and downloading audio books; and Amazon Music which features 60 million songs and playlists.
Prime Video competes with Netflix, Hulu, and Apple TV, among others. However, the content, aside from live events is somewhat substandard compared to other streaming services. Nevertheless, it is important to note that Prime Video is not an individual subscription service (as that associated with other providers of streaming entertainment), but rather a feature bundled as part of the Amazon Prime subscription. It serves as a marketing tool for Amazon Prime, in our opinion.
In addition, the price-point, which for an additional $12/year over the annual price of a basic Netflix subscription, offers customers free one-day delivery on products, Prime Video, and other perks, appears to offer excellent value for subscribers. Therefore, considering the benefits offered by Amazon Prime, sales associated with AMZN’s subscription services are well-positioned to expand as customer awareness surrounding Amazon Prime escalates in existing markets, and AMZN extends its business across the globe.
AWS is Amazon’s cloud computing business which provides enterprises the option of accessing cloud based resources for computing, networking, and data storage, on demand, with pay-as-you-go pricing, instead of owning, buying, and maintaining physical data centers and servers. The greatest benefit of the infrastructure as a service segment of cloud computing (which is AWS’s specialty) is the ability to scale-up or scale-down quickly in response to an enterprise’s requirements.
At the end of the third quarter, AWS lead the infrastructure as a service segment of the cloud computing market with a share of 34%, followed by Microsoft’s (MSFT) Azure with 21%, and Alphabet’s (GOOG) Google Cloud with 11%. Gartner, awarded AWS the top spot among a group of cloud infrastructure as a service and cloud platform as service providers for the 12th consecutive year, based on its ability to execute.
Factors that drive AWS’s industry leadership include, the platform’s first mover advantage, that relative to other providers it has a larger footprint of data centers, and offers a significantly higher number of services. Comparatively, Azure is more popular among corporations whose computer networks are powered by Microsoft’s Windows operating system, and/or that utilize other services provided by the company. Google Cloud is typically considered a secondary platform selected by Amazon competitors, and firm’s that prefer an open cloud architecture. During the previous three quarters, AWS generated $58.7 billion in revenues, Azure $56.7, and Google Cloud $18.9 billion.
AWS has operations in 30 regions across the globe with 90 availability zones. It is expected to add five regions (in Australia, Canada, Israel. New Zealand, and Thailand) and 15 availability zones to its infrastructure footprint, over the near-term. With respect to future growth, it is noteworthy that although the developed world is significantly penetrated with respect to cloud computing, emerging countries are barely represented, and present a considerable growth opportunity, as a majority of large and medium sized companies are likely to eventually migrate their IT infrastructure to the cloud. Based on dynamics associated with its industry and its business, we view AWS as a major long-term growth driver for Amazon, and believe the service is likely to maintain its industry leadership, although its market share might moderate, given the law of large numbers.
Overall, all of AMZN’s segments are still penetrating its existing markets and business dynamics support expansion into numerous new markets, ensuring accelerated growth in all categories, over a substantial time horizon. Therefore, it appears that FY2022 is a throwaway year for AMZN, and FY2023 financial performance is likely to see a significant improvement. In addition, once global economies rebound from a possible economic downturn, we expect AMZN to revert to rapid growth.
In addition, AMZN has a 17% equity interest in Rivian Automotive (RIVN), an electric vehicle company located in California. Based on our analysis, RIVN appears to be a credible enterprise in the emerging growth stage, well-positioned to expand over the next decade. Therefore, AMZN’s RIVN investment represents a significant growth opportunity, as the market value of the group’s shares appreciate. In addition to AMZN, Ford Motor Company (F) owns 13% of the brand, and T. Rowe Price (TROW), Cox Enterprises, and Third Point are also investors.
Long-Term Financial Outlook Appears Strong On Solid Fundamentals
Although FY2022 is shaping up as a disappointing year in terms of earnings and free cash flows, we remain upbeat on future prospects, as the shortfall was a function of events that are unlikely to impact AMZN’s business over the long-term. Factors that drove the company’s recent underperformance were: a $10.4 billion loss associated with its investment in RIVN, significant growth in spending associated with infrastructure development and employee hiring, considerable increase in the value of the U.S. dollar that reflected unfavorably on revenues and earnings, and substantial growth in global inflation which resulted in a pullback in spending by low-income groups.
To be specific, for nine months ended September 2022, total revenues were ~$365 billion, representing a growth of 9.7% on a year-over-year basis. In addition, net loss was ~$3 billion, compared to a net income of ~$19.3 billion, over the same period last year. Loss per share was $0.29 versus earnings per share of $1.85 during nine months ended September 2021. During the same time period, North America and International generated operating losses of ~$2.6 billion and ~$5.5 billion, while AWS recorded operating income of ~$17.6 billion, representing a year-over-year growth of 33.2%.
Further, revenues associated with North America were 61% of total revenues, representing a year-over-year growth of 13%, that linked to International were 23% of total sales, reflecting a decline of 8% over the prior year’s same period, and that related to AWS were 16% of total revenues, representing a growth of 32% over nine months ended September 2021. Moreover, for the same period compared to nine months ended September 2021, sales growth associated with online services was 0.04%, physical stores was 13%, third party seller services was 11.4%, advertisement services was 22%, subscription services was 10% and AWS was 32%.
Furthermore, as a percent of sales, cost of revenues decreased by 130 bps to 55.7%, fulfillment expanded 100 bps to 16.8%, technology and content increased 200 bps to 14.4%, sales and marketing advanced 160 bps to 8%, and general and administration escalated 40 bps to 2.3%. In addition, over nine months ended September 2022, gross margins increased by 130 bps to 44.3%, operating margins decreased 380 bps to 2.6%, and profit margins declined 570 bps to negative ~1%. At the end of F3Q2022, AMZN had cash and cash equivalents of ~$135 billion and long-term debt of ~$159 billion on its balance sheet.
Overall, although AMZN’s financial performance over the previous three quarters has been abnormally weak, we don’t anticipate any repercussions on the long-term outlook for the company. The previous three years have been outliers in regard to AMZN’s financial outcomes, as FY2020 and FY2021 were heavily impacted by a once-in-a-lifetime increase in customer demand, as the world population migrated towards online shopping due to pandemic induced lockdowns, and FY2022 appears headed for a relatively light finish, based on factors discussed above. As the global macroeconomic environment stabilizes over the next couple of years, we anticipate that AMZN’s financial growth will revert strongly.
We expect the rebound to be driven by the return of sales growth associated with online services to pre-pandemic levels, and a major increase in sales growth related to third-party seller services, advertisement services, subscription services, and AWS. In addition, gross margins are likely to expand as cost of sales decline propelled by decrease in commodity costs, including gas prices. Further, we expect selling and marketing, and general and administrative expenses to return to historic levels, as spending on infrastructure and hiring eases.
Importantly, we believe operating margins are likely to advance significantly as higher margin businesses such as third-party seller services, advertisement services, subscription services, and AWS develop into a larger fraction of AMZN’s total sales. In addition, RIVN shares are likely to rally significantly over time, leading to gains in the firm’s non-operating business category. Overall, given these elements, we expect considerable boosts in earnings and free cash flows, over the medium to long-term.
Incorporating these inputs into our 10-year Discounted Cash Flow model, we arrive at a 1-year Price Target of $140/share for AMZN. We assume a normalized 10-year revenue growth rate of 18%, (vs. the nine-months ended September 2022 revenue growth rate of 9.7%). Based on our analysis of AMZN’s historic financial reports, we model normalized 10-year operating cash flows as 15% of revenues/year and straight line 10-year capital expenditure as 8.5% of revenue/year. Furthermore, we deploy a perpetual growth rate of 3% and a weighted average cost of capital of 7% to reach our terminal value and present value of free cash flow figures. We utilize the current diluted outstanding share count of 10,331 million to arrive at our 1-year Price Target.
Risks
New Leadership Might Not Deliver. Following the departure of Jeff Bezos as CEO in July 2021, Andy Jassy, AWS’s CEO took the helm at AMZN. However, since his ascension to the top spot, the firm’s business has been underperforming. Although extraneous circumstances are responsible, prudent leadership is required to lead AMZN out of the rough patch. We cannot prognosticate about the CEO’s abilities to return the corporation to its glory days. However, he has served in varying capacities at AMZN for 25 years and has been Jeff Bezos’ shadow for a while. Nevertheless, we believe that in case the firm continues to struggle for an extended period of time, Jeff Bezos is likely to return as AMZN’s CEO, to alleviate the situation.
Bottom Line
What’s not to like about the AMZN business? It includes a growing online segment, well-positioned to continue to dominate global retail. Satellite high margin businesses on path to becoming a larger fraction of total revenues. Barely penetrated existing large foreign markets with significant white space to expand into numerous new markets. AMZN has no shortage of growth prospects and the wherewithal to deliver on them. The retail behemoth appears well prepared to generate growth and profits for a very long time. AMZN is truly a ‘One For The Ages’ company.
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