Amazon Stock: Conviction Buy Cheaper Than 2018 (NASDAQ:AMZN)

Christmas has come early, as mega-cap tech bargains are plenty. Amazon (NASDAQ:AMZN) has often traded at premium valuations relative to the market, but the stock is now curiously undervalued. The e-commerce powerhouse has been dominant for quite some time, but the market seems to have given up on the long term profit potential of the business. Even as Amazon Web Services continues to grow rapidly with high operating margins, the stock price continues to struggle. Given the company’s attractive secular growth story and value proposition, AMZN is one of my higher conviction ideas in the market today.

AMZN Stock Price

AMZN has fallen so much that it is now trading as low as it did 4 years ago.

I last covered AMZN in September when I rated the stock a buy on account of AWS being worth the entire market cap. The stock has since declined another 34% which has increased the margin of safety.

AMZN Stock Key Metrics

AMZN’s latest quarter showed a strong recovery in top-line growth, as sales grew 15% year over year (or 19% constant currency).

Revenues of $127 billion fell squarely between guidance of $125 billion to $130 billion. Operating income of $2.5 billion was lower than $4.9 billion in the prior year, but in the high end of guidance.

As has been usual over the past few quarters, operating margins were most negatively impacted by e-commerce operations, as AMZN has struggled to pass along inflationary cost pressures to consumers. In particular, while North America revenues were up 20% YOY, operating income was once again negative.

That said, management noted on the conference call that they generated over $1 billion in operations cost improvement, largely driven by improvements in their fulfillment and transportation networks. Over time, I expect margins to rebound significantly – I view the current operating losses as being representative of the company’s willingness to take market share amidst difficult conditions even if it means sustaining sacrificing on margins in the near term.

AWS has firmly become the company’s bright star. Revenues grew by 27% YOY and the segment generated $5.4 billion of operating income.

In this market, however, negative sentiment has shaped interpretation of the financial results. Wall Street seemed disappointed by the deceleration in growth rates as well as the forecast for “mid-20% growth” next quarter. AMZN noted that it was experiencing some volatility in growth in part due to it wanting to help reduce cost for customers amidst a difficult market environment.

While the company generated $2.5 billion in overall operating income, free cash flow was negative due to heavy investments in capital expenditures. Management expects to spend $60 billion in CapEx for the full year, with $10 billion less in fulfillment and transportation investments than last year but offset by $10 billion more in AWS-related costs.

Looking ahead, AMZN expects the fourth quarter to see revenues between $140.0 billion and $148.0 billion, representing growth of between 2% and 8% YOY. The guidance incorporates approximately 460 basis points from foreign exchange rates. AMZN expects operating income to remain pressured and end up in a range between $0 and $4.0 billion, compared with $3.5 billion in the prior year. On a side note, it appears that growth has remained resilient at the top tech companies though foreign exchange has ruined some of the luster.

Is AMZN Stock A Buy, Sell, or Hold?

It isn’t everyday that you get to say AMZN trades cheaply. Though that might not be so obvious as consensus estimates show strong earnings growth over the next decade.

That growth may look unbelievable, but it incorporates significant operating leverage.

AMZN’s business lends itself to operating leverage – especially the e-commerce segment. The e-commerce segment generated $425.7 billion in revenues and lost $10 billion in operating income over the last 12 months. In contrast, the business was generating positive 3% to 4% operating margins just a few quarters back. The struggles illustrate the headwinds from both inflation as well as the company needing to flush through excess inventory. While management was not sure about when exactly margins would rebound, I am of the view that the headwinds facing profitability are more near term in nature. Assuming a bounce-back to historical margins, the e-commerce segment might generate around $12 billion in annual operating income. Then considering AMZN’s extensive and still-improving fulfillment network, I expect further margin improvements. Assuming just 2% in margin expansion, the e-commerce business might generate $21 billion in annual operating income. I find 2% to be too conservative because of the numerous paths at the company’s disposal to drive margins higher (raising seller commission fees, raising Prime membership fees, streamlining fulfillment costs, etc). I also note that advertising may be an underestimated growth driver in the e-commerce business – that segment grew by 30% in the quarter. Based on 5% to 10% projected annual growth, I can see the e-commerce business being worth at least 15x earnings, or $315 billion. I can see AWS sustaining at least 25% growth and generating a 40% net margin over the long term. At a 1.5x price to earnings growth ratio (‘PEG ratio’), AWS might be worth around 15x sales or $1.23 trillion. Adding these together, we arrive at $1.55 trillion in value, or $150 per share.

What are key risks? The company has a neutral leverage position and wide access to capital, so liquidity should not be a serious risk. While there is the risk that e-commerce growth does not return even after lapping tough comps, I find it more likely that AMZN continues to win market share within the e-commerce segment due to its extensive fulfillment network. Perhaps the most serious risk worthy of consideration is that of regulatory intervention – there is always the risk that government agencies view AMZN as being a monopoly. AMZN may be forced to break up its business segments into separate entities, which may reduce the margin expansion potential. That might lead to value discovery as certain businesses may earn a higher multiple, but the uncertainty leading up to any such event may present a persistent overhang. Due to the lack of positive free cash flow and material share repurchases, there is reason to expect significant volatility in the stock price. As discussed with Best of Breed Growth Stocks subscribers, I view a basket of beaten-down tech stocks as the best way to take advantage of the tech crash. I continue to find AMZN to be one of my higher conviction ideas in the market today – this is one worth leaning into.