Amazon (AMZN) has successfully diversified its core business from selling online books to a web service provider. Currently, Amazon is fighting to win the contract to develop first-ever private cloud for the Central Intelligence Agency, or CIA. In this article, we have analyzed the impact of this contract on its business, if the company wins the contract. It is also enhancing its core book selling business, which will act as a long-term catalyst for its earnings growth. Let's discuss these developments in detail.
CIA contract - A game changer
Last year, the CIA asked for open bidding to provide the agency web-based infrastructure, which is a four-year contract to build a private cloud. In January, Amazon won that contract. International Business Machines (IBM), the long-term government contractor protested this and in July, the CIA called for rebidding. In addition to submitting a new bid for the contract, Amazon filed a case with the U.S. Federal Court of Claims, arguing that IBM's protest over the $600 million contract was flawed.
Amazon's web services, or AWS, segment rents data storage and computer servers to organizations to run business processes. We strongly believe that Amazon is more likely to win this contract for the following reasons,
- Amazon launched its web services in 2006, and since then, the company has launched over 150 new web services on its AWS platform.
- According to Gartner, "AWS had five times the compute capacity then the combined total of 14 other providers." And, "No other company is really close to Amazon in terms of its offerings." These statements imply that Amazon has a huge capacity to provide web services. The company has attained this capacity by launching numerous new services in this segment.
- The company has introduced over 30 price cuts. We believe its low cost infrastructure and immense services will help Amazon fetch the CIA contract.
Further, In the second quarter of 2013, Amazon web services witnessed a robust growth of 52% year-over-year. Its revenue from web service reported 63% of the combined revenue of its three competitors providing similar web services, which are Microsoft (MSFT), Google (GOOG), and IBM.
Why is this contract important for Amazon?
Amazon is undoubtedly the largest computing vendor, but this contract posses a huge opportunity for the company for the following reasons,
- This deal has potential to be much more than $600 million, as winning the first cloud contract from government will open the gate for more government contracts.
- Various technologists consider this online book seller incapable of handling the CIA's demand requirement as the CIA is one of the U.S.'s intelligence gathering agencies, and its data requires the utmost protection. Winning a contract from this agency will increase the goodwill of its services, leading towards more contracts.
- This deal will have significant impact on the company's revenue per share.
Considering that the $600 million will be received equally over four years, we have calculated the impact of $150 million on the company's revenue per share. Amazon has total outstanding shares of 456.88 million and assuming that these will remain constant, it will impact the revenue per share by $0.32 every year till 2016.
Core business updates
Amazon is facing tough competition from Overstock.com (OSTK), an American website popular for retail products other than books. To beat Amazon, Overstock.com is providing heavy discounts on books and both companies have entered into a price war. In late July, Overstock.com offered prices 10% lower than Amazon's prices on its 360,000 book titles. Amazon countered by offering discounted prices for many books. Analysts estimated this price war to cost Amazon between $500 million to $1 billion annually due to its discounts. Henceforth, it poses a significant risk to Amazon's core book business. This situation is having a significant impact on the company's earnings, but now Amazon is focusing more on e-books.
With growing adoption of Kindles, iPads, and other devices, the book business is changing rapidly towards e-books rather than hard copies. According to research by PWC, the e-books market will reach $8.2 billion sales by 2017 from $3.04 billion last year. Amazon is a market leader with 60% market share in the e-book business, and to gain from this trend shift, Amazon announced on Sept 3, 2013 that it will offer discounted digital copies to customers globally. This will include more than 10,000 books. We feel this strategy will attract more customers to its e-book business, increasing its revenue from this segment. We consider this the right move to capitalize on this trend shift. With the assumption of maintaining 60% market share in the future and the e-book market reaching $8.2 billion, we estimate Amazon's e-book revenue to reach $4.92 billion by 2017, which will upsurge its earnings.
With its various strategies, Amazon's EPS is expected to upsurge from $0.85 this year to $2.81 by the end of 2014. Over the past three quarters, the company estimated EPS of $0.41 in accumulation and reported an EPS of $0.37. This gives us an earnings downside of approximately 9%. Factoring this downside to the earnings estimates for 2014, we get an EPS estimate of $2.55, which is a huge upsurge from last year.
Its P/E ratio is expected to decline drastically from 1114 last year to 362.83 this year. With this 67% decline, we assume that this will continue to decline to approximately 116 next year, supporting the EPS increment.
With its attractive valuation, its fundamentals are also strong, as depicted above. Both the valuation and fundamentals lead us believe this is an unquestionable investment.
Additional disclosure: Fusion Research is a team of equity analysts. This article was written by Shweta Dubey, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.