Free cash flow is important
Jeff Bezos, CEO of Amazon.com (AMZN), said earlier this year that it is the free cash flow (FCF) per share that he wants to maximize, not margins. More important yet, he states that if he has to achieve that by lowering margins, it is exactly what he will do.
There are very significant things to consider here. Amazon has always focused on the long-term and has invested heavily in product development and market expansion.
Currently, the company continues to put all the emphasis on investment activity on a very long-term basis. Regardless of the recent drop in margins and lack of profitability, its shareholders and analysts are backing this strategy. In fact, share price has remained remarkably high even after more than 4 years of a very strong uptrend. In February 2013, Amazon reached a record market value of $284.72 and is now trading at $266 as can be seen in the chart below.
Chart courtesy of StockCharts.com
A Business Plan for the long term
Amazon's goal is to expand to new markets and to grow its worldwide customer base, keeping prices low enough to maximize enterprise potential over the long term.
This business plan has risks, but it is supposed to boost shareholder value. As free cash flow should provide a signal of true earnings power of a company, it is imperative that, in due time, profits will appear. Shareholders have been paying a premium for this situation as share prices reflect this high expectation. As a result, profits must match this level of optimism and these large investments must earn an exceptionally high return in the long run.
Let's look at the true market potential of the company and assess how it can develop in the future. FCF is calculated as operating cash flow minus capital expenditures. Free cash flow represents the cash that the company is able to produce after investing the money required to expand to new markets, develop new products, make acquisitions and pursue marketing campaigns. I will use levered free cash flow (LFCF) per share (ttm) which is FCF minus interest payments on debt. At the end of 2012, Amazon's LFCF was $1.19B, and it had 455M shares outstanding.
Levered Free Cash Flow per share was: $1190/455 = $2.62 per share
If we take Amazon's 28/03/2013 closing price of $266.49 and divide that by $2.62, we get 101.71. It means that Amazon is trading at 102 times its Levered Free Cash Flow. The first conclusion is that Amazon's stock price seems remarkably overvalued. But that specific high multiple is not bad in itself. In fact, it reflects that the company is making substantial investments. If these investments generate a high return, there will be confirmation that this strategy will be correct in the long run.
Therefore, it is crucial to study the development project of the company and the assumptions on which it bases its activity. Thus, I can present my estimation on what the company could be worth in 7 years, which is the minimum period to be considered for a company that operates on the very long term. Assessments made by several authors on Seeking Alpha, with the current data, arrive at values that are in a range between $60 and $100 per share. It is interesting to note that analysts who follow Amazon give a median target of $325 per share. For me, what is at stake is the long-term sustainable value. Indeed, what will be the value of the company at the end of 2019? Based on this, what should be the appropriate level for Amazon's current market price? These are the key questions that I intend to address in this article.
Amazon's Global Market
Amazon is a giant ongoing investment project. I will move to another level of analysis in order to take into account the potential for increased market share and customer base.
In early January, a Morgan Stanley report predicted that the global e-commerce market will hit $1 trillion by 2016, with Amazon poised to capture nearly a quarter of that amount. As seen in the table below, Amazon's sales have been growing at quite a high rate. I believe there is a good probability that online commerce presents a geometric growth that can come close to the amount mentioned. In addition, I see Amazon with the competence to take advantage of a market opportunity of this magnitude, but I seriously doubt the validity of the above projected market share.
Amazon continues to invest heavily in expanding the market for its current products and also extending its activity to new products. The competition is extremely strong in the United States and around the world. Amazon is a leader of e-commerce, including online bookstore and DVD, CDs and MP3 downloads. Amazon also sells video games and toys directly or from third parties' software. With a retailing strategy that can include any type of products, the company also sells food, furniture, apparel and jewelry. The company also produces consumer electronics such as the Kindle e-book reader and tablet Kindler Fire with multiple devices and applications. Amazon is a leading global provider of public cloud computing services and is in an excellent position to be a hybrid cloud player as well. In addition, the company is exploiting its good potential in online advertising.
The capability that Amazon has to sell ads is promising, and I think that, in the coming years, Amazon will begin to cause problems for Google (GOOG) itself. The reason is simple: Amazon has the right data to know what customers just bought and what they are trying to buy at the moment. Amazon's newly developed "DSP" technology probably will have the potential to be a turnaround in online advertising.
The biggest problem is that Amazon faces stiff competition. Regarding Wal-Mart (WMT), Target (TGT), Costco (COST) and eBay (EBAY), Amazon had to significantly lower margins to get a satisfactory market share. In electronic products such as the Kindle, Amazon has tapped a clear comparative advantage. In new products such as cloud and online advertising, it has serious competitors. Lately, eBay is adopting a policy of lower prices than Amazon, which can be a serious operating margin problem. In addition, Amazon has other problems besides competition. One is the tax that will affect online sales and this is another factor reducing the already very small margin that Amazon enjoys. Moreover, there is the problem of the increasing cost of gasoline-related shipping costs. However, Amazon assumes the increase on the cost of shipping as it reduces shipping rates, uses more expensive shipping methods, and offers additional services to clients. Amazon seeks to mitigate costs of shipping over time in part through achieving higher sales volumes, optimizing placement of fulfillment centers, negotiating better terms with suppliers, and achieving better operating efficiencies. In short, the company believes that offering low prices to customers is fundamental to future success, and one way to achieve this is through shipping offers.
However, though market share is very valuable, returns are far more decisive when many years from now the massive investments will be required to generate adequate profits. In 7 years, the current business plan focused on the long term will still be in the execution phase, and the company will have to report high results.
To this end, I'll make an approach to the probable value of Amazon's stock at the end of 2019. It is a long enough period to validate or not its current market price. The table below shows the sales growth since 2000 until now, which represents a CAGR of 32%.
Net Sales ($Million)
As sales growth rates have been declining throughout 2012, note that it is extremely difficult that Amazon hold on the average level of growth recorded in recent years. Thus, my forecast will reflect this issue: I will consider 18% growth in 2013 and 2014, 16% in 2015 and 2016, 14% in 2017 and 2018 and 12% in 2019. These are still strong growth rates which are increasingly difficult to achieve as the size of Amazon's sales becomes considerable.
With selling prices quite crushed, larger quantity sold increasingly has less influence on reducing unit costs. Therefore, Amazon will have serious difficulty in achieving a net margin of over 1% in e-commerce. The new products mentioned above provide a higher margin, but their market share is not expected to reach 10% of total sales by 2019. For this, I consider that net margin may reach 2% at best.
Net Sales Mix
Electronic & General Merch.
Since Amazon's international sales accounted for 43% of total in 2012, it is necessary to note that competition is extraordinarily high in certain countries. This is the case of China which has a vast potential for online market expansion, which is estimated at more than $500 billion in 2020. Competitors are tough in an e-tailing marketplace where companies sell directly to the public and enable members of the public to sell to each other. Total transactions processed last year reached $170 billion. Amazon's difficulties in China will be growing, and market share will probably suffer.
My Price Target for Amazon
Following what has been stated above, with net sales at a 15.4% CAGR, we arrive at $166.6B in the end of 2019. Using a net margin of 2%, the company will get a net profit of $3.33B and an EPS of $7.34. I'll take an adequate multiple of 20x earnings because Amazon, in all likelihood, will continue a growth strategy focused on investing in new products after 2019. Moreover, this multiple is above the average of its current competitors.
MSFT PE Ratio TTM data by YCharts
Then, at a 20x multiple against $7.34/share, we arrive at $147/share by 2019.
What is the price an investor should pay now for a stock that could be worth $147 at the end of 2019? First, I am going to choose a low rate of 5% as the minimum annual return an investor will require. The purchase price of an Amazon's share today only makes sense if, at a 5% CAGR, it equals the price target of $147 in the end of 2019. Then the purchase price should be $105.
Amazon has an exciting business plan based on technical innovation, ongoing investment in product development and expansion of its global market. The competition is unusually strong, and the company has a policy of lowering the prices of its products to break through new markets and to maintain leadership in others. Although the company is focused on long-term development of its business, the return on invested capital must begin to materialize at the appropriate level.
My study was based on balanced assumptions as well as the expectation that Amazon will assert its leadership and will turn profitable within a not too distant future. There are two conflicting premises here that merit the attention of investors. On one hand, there is a substantial risk of investing in Amazon considering that future solid returns are uncertain and may take much longer than expected.
In contrast, if Amazon takes control of market share without lowering prices systematically, it will extend margins and may start to become fairly profitable over time. However, I think it is more likely that an intermediate situation will happen as I have introduced in this article. In this case, I think Amazon shares are overvalued even considering a long-term horizon of 7 years. I think the company has a serious margin problem and will need much more time to develop properly its global project than investors anticipated. Investors will have to wait too long, and to buy its shares will be too risky at current prices.
Disclaimer: The author of this article gives only his personal view and opinion, never making any investment advice to buy or sell specific securities. The information presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Before investing in financial assets, investors should do their own research and consult a professional investment adviser.