Amazon (AMZN) earnings day has come and gone and it was more of the same. The Internet retail giant missed low Wall Street expectations rather badly, yet the stock rose rapidly after hours. This pattern was a repeat of what happened over the past three or four quarters. Predictably, bears went crazy. On the other hand professional analysts seemed more than satisfied, raising expectations for the future.
The claim I make and believe in strongly is simply this. In disruptive, complex companies like Apple, Amazon and Tesla Motors (TSLA), whose futures hinge on the absurdly complicated potential unfolding of a large number of inter-connected variables, one needs to look at a variety of future scenarios. Single events like earnings release give some data but are not very important. Evaluations based on single extrapolations of past trends, wonky drilling down into arcane accounting details, or championing of one possible future over another, are entirely futile in terms of valuing the company in the present.
What we need are multiple narratives. Diverse stories about what may happen in a future no one can foretell accurately. I daresay not even Jeff Bezos himself could predict, with any degree of certainty, what Amazon might look like in 2021.
As in my previous article, I will describe five different scenarios for Amazon, each extending eight years into the future. Then I will use these scenarios to determine a rough approximation of the expected value of the company in the first quarter of 2021, which will enable me, using a 10% per year discounted cash model, to determine a rough approximate value right now.
Of course the final company value determined is dependent on the subjective weight I assign to each scenario. But if you don't like my weights, you can use the table provided to fill in your own, seeing how the changes effect the final determination of value in the present.
Here are the five scenarios, laid out from worst to best, for Amazon eight years in the future. Note that each scenario is not a lone data point, but rather the weighted average of all points in that scenario's segment of the future pie.
Scenario I The River Runs Dry.
2012 is Amazon's reality. Growth is slowing. Profits are minuscule. Keeping top-line growth even in the middling teens requires Amazon to continually sacrifice profit margin by investing more and more in fulfillment centers so delivery times remain competitive, eating much of the cost of shipping, possibly eating some or all of the new sales taxes they are gradually being forced to collect and distributing electronic media at or near cost.
By 2015 top-line growth is down to 12% and net, after-tax margins are still below 2%. Competition is everywhere and fierce. From Apple, Google (GOOG) and Netflix (NFLX) for the high-margin electronic media business in books, software, streaming movies, TV shows and music, to eBay (EBAY), Walmart (WMT), Target (TGT) and ten thousand other retailers with beautiful, effective websites as well as, in some cases, profitable brick and mortar presences. The huge lead Amazon has in 2013 in terms of customer satisfaction, website design and overall customer friendliness has erodes. By 2017 growth is down to 10% with margins still under immense pressure, and by 2020 growth is only 8%. Revenue is $150 billion in 2020. With net after tax profit margin at just over 1% earnings are a total of 1.7 billion or $3.70/share (450 million outstanding shares). The market no longer gives the company any premium whatsoever. At a PE of 8 the share price is under $30.
Scenario II Harder From Here
2012 is somewhat of an aberration. Net margins grow in 2013 and 2014 to a more reasonable 2% as building out of fulfillment centers slows and various efficiencies take hold. Competition is fierce on all sides, but the great customer relationships Amazon has built continue to keep folks loyal. Top line growth is not quite what it had been in earlier years, due to the ending of Amazon's sales tax advantage among other things, but holds at a very respectable 15%. Revenue for 2020 is around $180 billion. With net margin at 2% Amazon earns a profit of 3.6 billion dollars which is an EPS of $8. With growth still strong the PE is still a generous 20, giving Amazon a market capitalization of 72 billion, and a share price of $160.
Scenario III Consensus
2012 is definitely an aberration. Net margins return to 2.5% by 2014, helped by the slowing growth of capital spending and expanding high margin electronic media sales. Growth in renting out of server rack space, third party partner sales, and the continued addition of new categories of items to Amazon's vast online store keeps top line growth at or slightly above the background growth in e-commerce -- holding steady at around 20%. Total revenue in 2020 is $260 billion. At 2.5% margin net profit is $6.5 billion EPS 14.40. With no foreseeable end to growth PE is 25, yielding a market cap a $162 billion or $360 per share.
Scenario IV Getting Better All The Time.
Amazon continues to disrupt larger and larger segments of the retailing space. Best Buy (BBY), Barnes and Noble (BKS) and numerous other brick and mortar retailers go belly up. Even the mighty Walmart struggles to compete with the even mightier Amazon. Sales grow 25% per year on average and, helped by increasing economies of scale and incredible marketplace clout, margins grow until in 2020 they have reached a more than respectable 3.5%. Revenue is $360 billion in 2020, profits $12.6 billion. Eps is $28, PE is 30 and market cap is $378 billion or $840 per share.
Scenario V Total Domination
Selling everything from automobiles to apparel to furniture, books, electronic devices and hardware, Amazon becomes the monster of retailing. By 2018 Malls are deserted. Walmart is struggling to survive, its weaker brick and mortar brethren like Target and Best Buy out of business entirely. Neither Google nor Apple, not to mention the flash-in-the-pan Netflix can slow Amazon's total domination of electronic media sales. Amazon's huge size, insane customer loyalty and global reach keep growth accelerating through 2020 at which time it is close to 40% per year. Total revenue in 2020 is $700 billion. Margin is a juicy 5%. Profits $35 billion, EPS $78. At a still nosebleed PE of 50 the market cap is 1.75 trillion dollars or a share value of around $3900.
And yes it could happen. I think the odds are low. But it is certainly possible for Amazon to grow that large and profitable by 2020. I think it is the possibility of this kind of accelerating growth and total market dominance that gives Amazon its real value, that makes the stock so much the darling of Wall Street. And makes the more extreme bear cases rather silly.
Amazon in 2021. Five possible scenarios.
Share Value (SV = EPS * P/E
Probability (P) Sum =1.0
0.20 (i.e. 20%)
Scenario Value (SV * P)
To get the expected value (given all the many assumptions) in 2021, we simply sum the numbers in the bottom row getting $517 per share. We now have to discount the price in 2021 by our required 10% per year growth which means we must divide $517 by 2.15 giving us a present fair value of $240/share. That is, assuming my numbers are reasonable, if you bought Amazon for $240/share you could expect, on average, over the possible future scenarios, a compound return of 10% over the next eight years. Of course you might make a lot more. Or a lot less. That is how it is with these innovative, disruptive companies.
What this basically means, given the large measure of uncertainty in these numbers, is that Amazon's present value of $265/share is reasonable, certainly within my margin of error. One point to make is that my method, being inexact at best, is useful in uncovering stocks that are tremendously undervalued or tremendously overvalued. If a stock currently trades at $265/share and my method says fair value is $240/share; well, the best thing to do is move on. There are plenty of stocks.