Amazon (AMZN) is still considered to be a growth stock, which is a commonly used argument to justify lofty valuations. In fact Amazon did a pretty good job with a revenue increase at CAGR of about 31.2% from 2008 to 2013 (estimated) and about 24.4% from 2011 to 2013 (estimated).
Table: Revenue growth
At the same time Amazon has broadened its business scope from an e-retail company to a media/technology/service company with publishing and video content, tablets, e-readers and cloud services. To achieve these goals, Amazon continues to invest significant amounts of money into warehouses, digital content and related infrastructure. Consequently Amazon currently operates with razor-thin profit margins of 0.5% (2013, estimated) and 1.4% (2014, estimated). At current price levels, PE ratio on estimated 2013 earnings is above 300, while 2014 estimated PE ratio is about 100.
Table: Earnings estimates
That said, it needs to be acknowledged that investors are willing to pay for the future vision and strategy, pushing shares up about 21% p.a. since January 2008 or up about 43% p.a. since January 2009.
While the potential long-term success of Amazon's strategy has been discussed for a long time, as an investor I require the achievement of a reasonable valuation level within a limited timeline. The question is: what does Amazon need to deliver in the future in order to justify current share price. As Amazon is still in a growth mode, typical measures like PE ratio will not work properly. Thus I will refer to "return on revenue margin" as a profit margin measure of future profitability. I will model scenarios for 3 time frames: a 3-year scenario, a 5-year scenario and a quite long-term 10-year scenario.
I acknowledge that the following calculations are far from a "scientific" business case, however I think these figures will give a good hint on what items Amazon has to deliver with regard to growth and profitability in order to qualify as a sound, long-term investment.
A first scenario which I have calculated investigates which CAGR on revenue will be necessary over the next 3/5/10 years to achieve a target PE ratio of 15, which sounds reasonable for an established value company. Results are shown dependent on different future return on revenue margins.
Table: Model assumptions
Table: Necessary CAGR on revenue
Given the current share price and a target PE of 15, Amazon needs to earn about 8.7bn USD over the applicable time period (3/5/10 years). If Amazon can maintain the indicated pace of revenue growth of the last 3 years (marked yellow) for the future, then target revenue and return on revenue can be derived: if CAGR is around 24% (25%/28%) over the next 5 (3/10) years, then required return on revenue margin has to be 3% (5%/1%) to achieve a PE of 15.
Let's check these figures against historic figures:
Table: Historic figures
While all figures between 2008 and 2011 have been quite stable, gross margins improved since 2011, while expenses for Technology & Content rose from 5.1% in 2010 to 8.2% in TTM. Net income declined from about 3.4% to a red zero. One could argue that investments have eroded profit margin. As outlined above, Amazon currently focuses on investing in future growth at the cost of profit margin. If we assume lower investment expenses in the future, in the amount of about 4-5% of revenue, then a future profit margin of 4.5-5% looks reasonable. This level of profit margin also seems to be realistic as Amazon is going on to shift its business towards more profitability, with digital content business, cloud services and as marketplace for third-party sellers. On the other hand, there is the risk that revenue growth will suffer from lower investments. Maintaining high revenue growth rates may prevent Amazon from achieving higher returns on revenue.
Having said this, we need to take into consideration that the scenarios above have been calculated assuming current share price. In considering an investment, I would expect some share price appreciation over time, especially as Amazon currently does not distribute dividends. Thus, under the same assumptions as outlined above, how do the figures look like if we expect a moderate 10% p.a. share price appreciation?
Table: Necessary CAGR on revenue when share price return assumption is 10% p.a.
Amazon needs to achieve growth rates at the 22-26% level over the next 5 years and needs to deliver about 6-7% margin on revenue to be a worthwhile investment providing an annual 10% share price return. If we look at the 3-year period, Amazon needs to achieve 25% annual growth and a 8% profit margin; if we look at the long-term, 10-year period, Amazon needs to achieve 20-26% annual growth and a profit margin of about 3-5%. High hurdles, considering that both high growth rates and high net margins are difficult to achieve at the same time. As shown in the table, a growth rate of 20-26% p.a. over the next 10-year period would result in revenues in 2023 of about 450-750bn USD. While the profit margin of 3-5% sounds achievable, the necessary revenue growth rate does not look achievable for me. On a 3-year investment horizon, the necessary growth of 25% p.a. looks achievable, while an 8% margin would seem to be very ambitious. Even higher growth rates and/or margins will be necessary if the investor expects more that the 10% p.a. share price appreciation.
In summary, Amazon needs to deliver steady, high growth rates and a significantly higher profit margin in order to justify an investment at current prices for an investor who expects a 10% p.a. share price appreciation and a target PE of 15. As both targets, revenue growth and higher profit margin, are to some extent mutually exclusive, I would argue that at current prices, buying Amazon shares represents a bet on extremely optimistic future scenarios for Amazon.
Finally, what could instead be a valid entry point for buying Amazon shares? Let's look at the 5-year period and a target PE ratio of 15, and additionally of 20, for those who are willing to pay a premium in expectation of an ongoing growth story beyond the 5-year period. And again we will expect a 10% p.a. share price appreciation.
Table: Amazon share price entry point
Select an expected future profit margin and an expected growth rate and the table will return a reasonable entry price for shares in Amazon. The higher the expected future net margin and/or the growth rates are, the higher the price which I am willing to pay for Amazon today.
The model assumes a 10% p.a. price appreciation, which is not too impressive in my view. This 10% p.a. price appreciation implies a comparably higher acceptable share prices today, whereas a higher assumption regarding share price return results in a lower price which I would be willing to pay for Amazon today. Additionally I would prefer to have a certain margin of safety, as I am not inclined to risk overpaying my investment. Therefore, I prefer to select values for profit margin and growth rates at the lower end of expectations.
Thus I would look into reasonable figures of 4-5% profit margin and 20% p.a. growth rate, which both still are ambitious from my view. That results in a price of 150-180 USD/share which I am willing to pay today, if I accept a PE ratio of 15 in 5 years, or a price of 200-250 USD/share, if I accept a PE ratio of 20 in 5 years. In these cases a 1% point change in profit margin equals a change of 37.7 USD/share (target PE of 15) and of 50.3 USD/share (target PE of 20), respectively. If I expect a higher than the 10% p.a. share price return then I would be willing to pay even less for Amazon today, e.g. a 15% p.a. share price return assumption results in a 20% lower "justified share price" today.
Amazon is a great company and moving in the right direction from a strategic point of view. It has a trusted brand which can hardly be overrated as competitive edge, and it has a dominant market position with impressive growth rates. On the other hand, Amazon has a lack of profitability as retail margins are limited and higher margin businesses like technology, content and cloud services are facing competition from other major players like Google (GOOG), Apple (AAPL), Netflix (NFLX), eBay (EBAY).
Thus, based on the considerations above I do not see a rationale for taking a long position in Amazon at current prices, which have run too far in the last years and are above a reasonable entry point. I recommend staying on the sidelines until the market offers a bargain price for Amazon shares, which from today's point of view should be significantly below 200 USD.