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In the past week I published an earnings model for Amazon.com's (NASDAQ:AMZN) Q1 2013 earnings. This same model can be used to estimate Amazon.com's earnings over the long-term future - which is usually given as the reason why Amazon.com manages to trade at a huge present valuation.

Street estimates

Amazon.com's value is clearly pegged on how it will do over the long term. The estimates below, from Morgan Stanley, are typical of what the Street presents, both for revenues and for EPS (Source: Morgan Stanley, truncated to show only revenue and EPS estimates).

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It's important to understand that while the Street has always had this hockey stick shape for Amazon.com's revenue and earnings estimates, even in the face of 8 consecutive quarters of massive guide-downs by the company.

What my model will show, is simply that the guide-downs were not the exception - they are the rule. The earnings which Amazon.com is producing flow directly from quite stable relationships between what Amazon.com sells and how much it earns. To believe that Amazon.com will turn into an earnings machine requires it to actually change its business model whereas the Street seems to think that it just needs to keep on growing and to realize operating leverage.

The Model assumptions

My model is based on the relationship between Amazon.com's gross margins and operating costs, and GMV (Gross Merchandise Value). GMV is the value of goods sold by Amazon.com or third parties (3P). For instance, if Amazon.com sells something from a 3P for a 10% commission and charges $10, then the GMV of that transaction would be $100. As for a good or service sold by Amazon.com itself, if it charges $100, then its GMV is also $100.

In my model, I used 11.5% as the average commission charged by Amazon.com to third parties. This is consistent with Ebay (NASDAQ:EBAY) and many different research reports on Amazon.com, even though it's a bit subjective given Amazon.com's lack of transparency.

Now, when we observe how Amazon.com's gross margin and operating costs behave, we quickly notice that while they fluctuate when compared to reported revenues, they are actually very stable when compared to GMV. What this means is that we can use this stable relationship to predict how gross margins and costs will evolve in the future as revenues grow. On the other hand, for Amazon.com's costs or revenues to deviate meaningfully from these predictions, something structural needs to change at Amazon.com. Just selling more, as we've seen, is not enough (thus implying no operating leverage at least when taking into account GMV).

This said, here are the model assumptions:

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A brief explanation of each of these assumptions:

Growth 1P. This is the growth rate, year-over-year, that Amazon.com product sales are predicted to exhibit. This growth rate has been on a steep deceleration curve and that is expected to continue, given the effect of sales taxes' collection and scale. The chart below reproduces how this parameter has fared in the last 6 quarters (in blue) and how it's expected to behave from 2013 to 2020. Historical growth rates are TTM, the drop seems somewhat severe towards 2013 because growth decelerated strongly during 2012, so the present rates are already much closer to those considered for 2013.

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Growth 3P. This is the growth rate, year-over-year, that third party sales are predicted to exhibit. This growth rate has been on a steep deceleration curve that's expected to continue given Amazon.com's scale, Ebay competition and commission increases. The chart below reproduces how this parameter has fared in the last 6 quarters (in blue) and how it's expected to behave from 2013 to 2020. Historical growth rates are TTM, the drop seems somewhat severe towards 2013 because growth decelerated strongly during 2012, so the present rates are already much closer to those considered for 2013.

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Growth Other. This is the growth rate, year-over-year, that Amazon.com's other initiatives, like AWS and advertising, are predicted to show. The chart below reproduces how this parameter has fared in the last 6 quarters (in blue) and how it's expected to behave from 2013 to 2020. Given the ongoing price war between Amazon.com and Google (NASDAQ:GOOG) in the AWS segment, this might turn out to be too optimistic;

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Product Margins. This is an estimate of the gross margins Amazon.com has in its product sales. Amazon.com's reported COGS (Cost of Goods Sold) reflects just the costs sustained in selling its own products. AWS and 3P are carried at 100% gross margin. When we take this into account we notice that Amazon.com's product margins are actually very stable (and not growing strongly, as is usually implied). The chart below reproduces how this parameter has fared in the last 6 quarters (in blue) and how it's expected to behave from 2013 to 2020.

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Gross Margin on GMV. This is an alternate way to compute Amazon.com's gross margins. It takes into account the fact that Amazon.com's gross margins exhibit a rather stable behavior when compared to its GMV (Gross Merchandise Value), that is, the value of everything Amazon.com sells, be it in its own name or the name of third parties. GMV is estimated by dividing 3P revenues by 11.5% (an estimate of the average commission Amazon.com gets) and then adding the result to 1P revenues plus other revenues. This way of calculating Amazon.com's gross margins has exhibited great stability over the more than 2 years where it's possible to calculate it. The chart below reproduces how this parameter has fared in the last 6 quarters (in blue) and how it's expected to behave from 2013 to 2020.

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Marketing/GMV. This is used to calculate the "marketing" operating cost line. Amazon.com's marketing costs have been very stable when compared to GMV. Amazon.com pays for web traffic both for 1P and 3P sales, so this is no great surprise. The chart below reproduces how this parameter has fared in the last 6 quarters (in blue) and how it's expected to behave from 2013 to 2020.

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Fulfillment/GMV. This is used to calculate the "fulfillment" operating cost line. Amazon.com's fulfillment costs have been very stable when compared to GMV. The chart below reproduces how this parameter has fared in the last 6 quarters (in blue) and how it's expected to behave from 2013 to 2020.

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Technology/Other. This is used to calculate the "technology" cost line. A careful analysis of Amazon.com's past cost structure shows that technology costs are not linked to GMV. Indeed, they're linked to "Other" revenues, which are overwhelmingly AWS revenues. This is no surprise - AWS's costs are mostly all in this operating cost line. This line is a bit more variable than others. The chart below reproduces how this parameter has fared in the last 6 quarters (in blue) and how it's expected to behave from 2013 to 2020.

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G&A/GMV. This is used to calculate the "G&A" cost line. An analysis of Amazon.com's past shows this cost to be rather stable when compared to Amazon.com's GMV. The chart below reproduces how this parameter has fared in the last 6 quarters (in blue) and how it's expected to behave from 2013 to 2020.

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As we can see, the cost relationships are very stable. With these inputs we can then run the earnings model and produce a simulated Amazon.com P&L for 2013 to 2020.

The Model output

Using the assumptions I described, we get the following results (notice that all the estimates were derived using the product margins. If we used the gross margins derived from GMV earnings would be substantially worse - indeed, Amazon.com might show up as unsustainable since the difference between the two measures exceeds operating earnings by a wide margin in the out years):

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As we can see, this model deviates strongly from Morgan Stanley's estimates, especially in what regards EPS. Morgan Stanley sees as much as $24.64 in GAAP EPS in 2020, whereas here the model points towards $4.47. This difference appears early, as well, with Morgan Stanley seeing $2.38 and $3.24 in EPS for 2013 and 2014, whereas the model predicts $0.33 and $0.17.

This has several implications:

  • One is that there is still downside to the consensus estimates, both in the short and long term;
  • Another is that estimates such as Morgan Stanley's require a change in Amazon.com's business model. They require that several stable relationships between revenues and gross margins as well as costs would need to break in the future, and break in Amazon.com's favor. There is little if any reason to believe such will happen;
  • The model also confirms that Amazon.com's gross margin, given its present accounting policies, will continue to expand strongly, from 24.8% to as high as 39% in 2020. Yet, as we've seen, this happening doesn't mean that Amazon.com will get incredibly profitable. This is so because the same optical effect which drives gross margin higher also drives almost every operating cost line higher versus revenues, as well.

In short, this earnings model for Amazon.com stands as more realist that the Street consensus, in that it respects the stable relationships between GMV and costs, as well as between GMV/product revenues and gross margins. Such realism calls into question the rosy Street scenarios for Amazon.com's future earnings.

Potential upside

Amazon.com has increased 3P (Third Party) commissions on some products during Q1 2013 and Q2 2013. There's also anecdotal evidence of higher pricing and less-liberal shipping options. These changes might lead to higher gross margins (against GMV). This could lead to increased earnings over time. It should be noted that this is different from gross margins increasing versus revenues - such is a mechanical effect without much impact on earnings, because several operating costs also increase mechanically against revenues.

Potential downside

Any of the segments (1P, 3P, AWS) might end up slowing down more than assumed. Margins might be hit by further price matching initiatives from retailers such as Best Buy (NYSE:BBY) as well as the need to collect sales taxes in more States.

Conclusion

The most important conclusion is that if Amazon.com's overall business model stays the same, it's very likely that Amazon.com won't live up to the market's lofty earnings expectations over time. Contrary to the market's perception, Amazon.com's gross margins have remained stable (versus GMV): There's an optical illusion in the growth of gross margin versus revenues which then does not lead to higher earnings.

Amazon.com needs either margins to increase versus the gross merchandise value or costs somehow get reduced against that same gross merchandise value. If this doesn't happen Amazon.com will not meet future expectations. Since neither has happened over several years, there's little reason to believe that this will happen in the future, other than through Amazon.com pricing its wares higher and losing its "low-cost destination" image. Amazon.com has not shown the presence of any operational leverage.

Source: Amazon.com Long-Term Earnings Model And Estimates