Debate over Amazon (AMZN) can be quite frustrating. Bears supply detailed quantitative arguments as to how overvalued Amazon is. Bulls? They tend to boast about how much the stock has gone up since they've bought it. Even if they don't, the reasons they provide are entirely qualitative: how you should view Amazon as a technology company not a low margin retailer, how Jeff Bezos is the new Steve Jobs etc. Unfortunately, none of these reasons will tell you why Amazon is a buy at $300 rather than $30 or $3000. So in this article I'm going to try and justify the bull case for Amazon with actual numbers.
I'm going to imagine how much profit Amazon could make were it to try and maximize its earnings rather than its growth rate. This doesn't mean I think Amazon will do this or in fact should do it now.
You should think of Amazon being made up of four pieces
· Amazon classic, which is Amazon's own products sold directly to the customer.
· An eBay (EBAY) like marketplace platform for the sale of physical goods.
· An ecosystem play similar to iTunes and Netflix (NFLX), for the sale of content and apps.
· AWS and Amazon's embryonic ad exchange network.
Taking the second of these first, Amazon's third party (3P) marketplace platform has roughly the same gross merchandise value (GMV) as Amazon's direct sales, or about $60 billion. What's interesting about that number? It's very nearly the same as eBay's GMV (ex autos). Since the only difference between how these two platforms operate is Amazon's fulfillment service (FBA), which either operates as a cost center or at least can do one has to assume 3P has the same earnings generating power as eBay does.
So how much does eBay earn? $3 billion a year, when you include PayPal. That's nearly 5% of its GMV. Let's think about that number for a minute. If Amazon were to operate all its other platforms at breakeven - or close them down, that's the minimum amount of profit it would make.
Now Amazon isn't currently making $3 billion profit, because it subsidizes shipping on its own goods and those FBA, as well as other expenses. What happens if it stops doing that? Will its customers desert Amazon and go to eBay or someplace else?
The important thing to note is that Amazon's success in third party sales compared to eBay over the last several years hasn't been built on price. Amazon's prices are roughly similar to eBay's yet for most of the last few years its growth rate for 3P has been 2-3X eBay's. Actually, at the beginning of the year Amazon's 1Q 2013 had 60% growth compared to just 13% for eBay.
If not price then what?
Consumers find Amazon delivers a far superior service as far as search, convenience of paying, standardized shipping, returns, trust and so on. In addition, FBA allows Amazon to combine purchases from different sellers in one order and delivery, a big cost advantage. Indeed eBay has recently adopted many of these measures and has seen its growth rate pick up after a long period of stagnation.
What about 1P sales? First of all, though we don't know how profitable they currently are, there's no reason why they shouldn't be as profitable as 3P GMV. After all, what are the main elements of retailing?
· There's the sales channel. This is the same for both 1P and 3P, in this case Amazon's own website.
· There's the logistics. Well, Amazon has a logistics operation second to none that many 3P sellers use themselves.
· Sourcing/Selection of product. Amazon has the advantage of bigger economies of scale as well as insight into what consumers are buying via its huge database of information provided by its customers.
Check. Check. Check.
Furthermore, it enjoys a dominant position in high margin media sales that's unlikely to erode anytime soon.
A 5% margin on $60 billion of sales yields $3 billion in profits. The actual percentage doesn't matter a great deal because over time 3P will grow faster than Amazon's own product sales and end up constituting most of Amazon's value. Indeed the main factor behind Amazon's top line growth slowdown is that 3P sales are increasingly cannibalizing Amazon's own sales.
Room for a third ecosystem?
The best way of thinking about Amazon's ecosystem play is it's essentially binary: either it will succeed in carving out a third place ecosystem - and perhaps second place, in which case it should reap some sizeable profits, or it will fail: in which case it can then cut out various expenses such as Kindle R&D, discounts on the tablets themselves, the content acquisition costs for new films and TV shows, all the things Amazon is spending on to try and build its ecosystem up.
One massive advantage Amazon has over Google (GOOG) is Amazon has over 200 million credit card details on file. Lack of payment options is the main reason Google's Play store has lagged behind Apple's (AAPL) iTunes in paid apps. In fact Amazon's App store has higher revenue per user than even iTunes does.
How much profit can Amazon make from app and content sales? Gartner forecasts gross app sales to be $58 billion in 2016. Net revenue should be roughly $20 billion. Operating margin on that is hard to estimate (see below) but perhaps up to $2-3 billion. A 20% market share isn't unreasonable, so $.5 billion in profit.
Now some have questioned whether there really is much margin in content and app sales and have cited Tim Cook's statement that iTunes is aimed to be run at slightly above breakeven point. I think that's somewhat disingenuous. I also believe Amazon will have some inherent cost advantages in running its own app platform over Apple, but those details will have wait for another article.
One possible weakness
I don't have any special insight into AWS, so I'm simply going to go on what others have valued it, which is around $25 billion. That's about 6 X 2013 sales estimates. This seems to be aggressive valuation as cloud computing seems to be a commodity business with some very deep pocketed competitors playing in this space.
This one's a wildcard
Lastly there is Amazon's ad exchange. It serves ads on third party websites and shows products based on customers' purchase and search history. It's hard to say how successful it will end up being, but promises to be a lot more useful to merchants than Google's contextual Adsense network, which generates $10 billion in annual revenue for Google.
No profits are good
Why does Amazon even bother to subsidize the price of its products? Doesn't that contradict what I said earlier about price being irrelevant to its success? While that is generally true, Amazon deploys that cash flow in a highly targeted way that is designed to drive revenue growth.
Firstly it invests in its Kindle line of tablets and readers that are responsible for a large chunk of incremental revenue growth just due to the actual tablet sales, not including any content or app sales.
Secondly, the free shipping subsidy: this is clever on Amazon's part because customers value free shipping more than it is actually worth: i.e. they prefer to pay $20 and no shipping charge, rather than $15 and $4 shipping on an item.
Finally, by bringing Amazon's annual profitability down to zero from say $6 billion it saves Amazon over $1 billion in taxes - yielding even more money for Amazon to invest in its business.
The bottom line
Now, how much is all this potential earnings power worth? Excluding AWS and content sales, we have $6 billion in annual profit from the 1P and 3P business lines. Growth in GMV is likely to be around 30% per year after Europe's economy starts recovering. Even after raising prices by a 3-4 percent that growth shouldn't drop below 25%, say. How much would you be willing to pay for that growth? A multiple that equals that growth sounds reasonable, so 25 X $6 billion = $150 billion. Add AWS at $25 billion and you're up to $175 billion.
This leaves content sales as well as Amazon's ad exchange. I think content sales have a high chance of generating $.5 billion in incremental profits, while the ad exchange has a smaller chance of earning a lot more than that. A further $25 billion in value would fairly reflect that speculative upside in my opinion.
This all adds up to $200 billion in market cap, or about $450 per share.
Finally, if we were to apply eBay's PEG multiple of 1.5, instead of 1.0 to Amazon's growth rate, it would value Amazon 1P and 3P businesses alone at $225 billion, therefore $275 billion cap in total or around $600 per share.
This isn't at all unreasonable given that FBA allows Amazon to become the platform for the entire ecommerce sector in a similar manner to Google being the de facto advertiser for the online sector.