Amazon: What Most Investors Get Wrong About AMZN’s Long-Term Potential

This article was first posted in Outperforming the Market on February 9, 2023.

I think that Amazon (NASDAQ:AMZN) is one of the mega-cap companies that many investors often misunderstand.

Since releasing its fourth quarter results, Amazon has been down 12%. While I think that most of the earnings were largely in line with market expectations, I think that investors are missing the long-term opportunity they have before them with Amazon.

Investment thesis

While sentiment for Amazon remains poor, I think that the company is actually headed in the right direction.

Firstly, the company is looking to identify and invest in a fourth growth pillar that will bring Amazon forward. Secondly, the operating efficiency improvements in the quarter were evident and operating income would have beaten expectations if not for one-off charges. Lastly, AWS has near-term headwinds but the business fundamentals for AWS remain solid. Optimization of cloud spend today is the short-term pain necessary for long-term gain.

I have written an earlier Amazon article detailing why I think Amazon’s stock price is disconnected from its intrinsic value, that will help provide better context for this article.

The fourth growth pillar

This was the first time Amazon’s CEO Andy Jassy joined the earnings call in his almost 18 months as the company’s CEO.

Andy Jassy highlighted what I thought was one of the most under-rated statements in the earnings call.

He was focused on finding Amazon’s fourth pillar.

Amazon currently has three core pillars, namely AWS, Retail Marketplace, and Prime. CEO Andy Jassy highlighted his criteria when deciding to identify and invest in this next fourth pillar.

He listed four criteria to meet when evaluating whether to invest in any particular new business.

These four criteria are:

1. Could it move the needle at Amazon?
2. Do they think it’s being well served today?
3. Does Amazon have a differentiated approach?
4. Does Amazon have some competence in those areas? If it does not, can it acquire this competence quickly?

Ultimately, I think that this growth mindset is a very valuable one for Amazon and while there are no guarantees that any of the company’s investments will be successful, the only thing Amazon can do now is to try and get the most out of the opportunities they have today.

There were some examples of potential fourth pillars listed, some of which include Project Kuiper satellites, streaming, healthcare (Amazon launched RxPass in January), the connected home, and Buy with Prime.

These are likely the areas in which Amazon is looking to invest in given that they probably fit the four criteria listed above.

I particularly like this line that CEO Andy Jassy said in the earnings call:

And do I think every one of our new investments will be successful? History would say that would be a long shot. However, it only takes one or two of them becoming the fourth pillar for Amazon for us to be a very different company over time.

The bottom line is that Amazon is looking to invest to develop its next fourth pillar in the long term, but that investment will not be affected by the near-term streamlining of costs at the company.

Costs streamlining

In terms of streamlining costs, I think that Amazon is heading the right way although it is not always crystal clear.

Removal of one-off charges leads to an operating income beat

Amazon’s operating income of $2.7 billion in the fourth quarter was in-line with market consensus of $2.65 billion. That said, it included three large one-off charges. Excluding these three large one-off charges, Amazon’s operating income would have come in at $5.4 billion, way above consensus and exceeding its guidance of $0 to $4 billion.

So, what are these three large one-off charges?

The first was $640 million in severance costs in the quarter as a result of the elimination of 18,000 jobs in the fourth quarter. The second charge was $720 million in impairment charges on property and equipment and operating leases for its Amazon Fresh and Amazon Go physical stores. This was done to recalibrate its format of stores to the ones that best fit customers’ needs and help the grocery business scale over time. Amazon continues to see grocery as a significant opportunity moving forward and this was just an exercise of rationalization to eliminate stores with poor performance. Lastly, there was a $1.3 billion expense in self-insurance liabilities as Amazon increased its reserves for general product and automobile self-insurance liabilities, as a result of changes in its estimates of the cost of asserted and unasserted claims.

The beat in operating income excluding these one-off charges implies an upside to the guidance for Amazon’s operating income for 2023.

Operating efficiency improvement

As most of the charges listed above relate to the North America retail segment, I think that Amazon started to see efficiency gains in the fourth quarter. What this implies is that I think that the market consensus for Amazon’s 2023 operating income and operating margin is somewhat too low and too conservative.

Where are the improvements in efficiency coming from?

These improvements in efficiency came across the board for its North America business. This includes improvements in efficiency across its transportation network and fulfillment centers. The company made improvements to the technology and process that resulted in higher Amazon Logistics productivity. and better line haul fill rates.

In addition to a better macro picture with lower inflation, reduced freight and fuel costs, and lower headcount costs as a result of the 18,000-headcount cut, I think we will be seeing sizeable efficiency gains in 2023.

AWS facing macro headwinds while secular growth tailwinds remain in the long term

Those panicking over Amazon’s near-term deceleration in AWS should look at the big picture. If you look at Microsoft’s (MSFT) Azure and Alphabet’s (GOOG) Google Cloud, they are all also facing the same deceleration in growth.

This near-term AWS pressure is a macro-driven one and when the macro condition improves, the long-term secular growth tailwinds in the cloud will drive an acceleration in AWS growth once more.

Why do I think that this situation at AWS is good?

First, the deceleration in growth of AWS was due to the optimization of cloud spend by Amazon’s customers. Again, these are what Microsoft and Alphabet are seeing with their own cloud businesses. These optimization efforts are necessary for AWS to continue to bring a strong value proposition and good value for money to customers. In short, optimization of cloud spend is not good for the short term, but benefits the business in the long-term as loyalty improves given better customer experience and service.

Second, AWS states that its new customer pipeline remains healthy and robust. Management continues to see many customers continuing to plan to migrate to the cloud and commit to AWS in the long term.

Lastly, and this is the one that no one seems to be talking about, this slowdown and deceleration in AWS also imply lower capital expenditures on AWS in the near term. I think that this is an opportunity for Amazon to rationalize capital expenditures in AWS in the near term given that they have already been making heavy investments in technology infrastructure and data center investments, as well as the near-term headwinds surrounding AWS growth.

Valuation

On a relative valuation basis, Amazon stock is trading at 12x 2023 EV/EBITDA and 10x 2024 EV/EBITDA. This EV/EBITDA multiple for Amazon looks attractive despite what might seem to be a difficult operating environment for Amazon.

I would argue that the worst is actually over for Amazon. The deceleration of AWS has been priced in, the impact of a slowdown in e-commerce has been priced in and even the impact of cost headwinds has already been priced in. When so many negatives are priced into the stock, I think that this implies the risk-reward skews more towards the positive end of the spectrum.

What matters is the outlook for the business, and I think that the North America e-commerce business looks poised to re-accelerate on an improved cost structure, implying strong growth in profitability going forward. Furthermore, the weakness in AWS is likely near-term, with the near-term pressures helping improve base effects for the next year.

I have a 1-year price target of $159 for Amazon. I used an equal weight of both the EV/EBITDA method and the DCF method. I assumed 17x EV/EBITDA for the relative valuation method and a 15x terminal multiple and cost of equity of 8% for the DCF. My 1-year price target implies a 62% upside potential from the current stock price.

Risks

Weakening macroeconomic environment

Amazon is vulnerable to a weakening of the macroeconomic environment. Its e-commerce business will be affected badly by worsening consumer sentiment if the global macro backdrop worsens. Furthermore, its AWS segment will see further deceleration if the business environment continues to be weak, leading to more prudent and conservative spending by its AWS customers.

Competition

Amazon has traditionally been known as the disruptor. That said, with its leadership positions in both e-commerce and the cloud space, I think this leaves Amazon in a vulnerable position if it does not innovate and improve on its products and services. At the end of the day, Amazon needs to provide the best value proposition it can to its e-commerce and cloud customers. There are other competitors like Microsoft and Alphabet in the cloud space and Walmart (WMT) and eBay (EBAY) in the e-commerce space that could intensify competitive pressures.

Conclusion

All in all, I think that Amazon is heading and trending in the right direction. Operating income would have beaten market consensus and guidance if not for the three one-off charges, while the North America e-commerce business continues to see significant operating efficiency gains across the business. AWS weakness near-term is expected, but that has been priced in, in my view, while the long-term thesis for AWS remains solid. As explained I think that the worst is likely over for Amazon and that the negatives have been more than priced in. As such, I think that Amazon stock’s risk/reward opportunity skews more towards the positive end of the spectrum. In the long-term, I am positive about CEO Andy Jassy’s focus on identifying and investing in its fourth pillar of growth and look forward to the day when this investment bears fruit.

I have a 1-year price target of $159 for Amazon, which implies a 62% upside potential from the current stock price.