- My fair value estimate of Amazon is $61.80 per share.
- Operating margins will replace decade-old revenue growth rhetoric in near future.
- Increased competition eroding away Amazon's edge.
"Is this price level offering future growth at a reasonable price?" It's an age-old question that bedevils growth investors all the time. Financial media is rife with advice on when to buy and when to sell, a mix of maxims that serves to confuse growth investors more than it enlightens them. Valuation bargains don't arise from trying to play the best time to buy, but are rooted in well-built understanding of the business, industry dynamics and knowing what makes up a good price.
For years, Amazon (NASDAQ:AMZN) has been one of America's bizarre success stories - a stock market darling whose revenues have grown from $610 million in 1998 to a whopping $74.5 billion in 2014. Exceptional revenue growth achieved by Amazon chimes well with the growth investors, beholding revenue growth as the first step in value creation. Over the last decade, the company has invested billions of dollars for achieving scale, efficiency, and urged the market to believe in its growth story. Investors rewarded the company for displaying meteoric revenue growth at the expense of profits, and held their focus on Amazon's potential to become world's digital mall.
To get a perspective on future revenue growth for Amazon and the size of the retail market in the US, I composed a list of twenty top retailers by revenue. Wal-Mart (NYSE:WMT) tops the list, followed by Costco (NASDAQ:COST) and Target (NYSE:TGT), but the mammoth revenue differential of $371 billion between Wal-Mart and Costco suggested to me the potential growth opportunity for Amazon. The top three retailers have increased their cumulative market share from 76.3 percent in 2008 to 80.7 percent at the end of 2013. Amazon's market share expanded from 2.7 percent in 2008 to 8.8 percent at the end of 2013. Applying a 3 percent growth rate to 2013 sales yields retail sales of $985 billion by 2019. Scale with the ability to buy items for inventory at low prices and order fulfillment capacity enabled Amazon to grow revenues and steal market share from competition. For the future, I will assume that Amazon will be able to achieve a 15 percent market share in the US by 2024.
The only thing which distinguishes Amazon from its competition is the better product access and low price offerings. As the company subsidizes cost to attract consumers, the entry of retailers like Wal-Mart into the online landscape will wield margin pressure on Amazon. However, the incremental investments which Amazon has made over the past several years will enable the company to restore its pricing power with customers.
As I progressed through my valuation analysis on Amazon, I noticed the marked sensitivity of price on operating margins. The table below highlights my valuation estimates for Amazon under varying revenue growth and operating margin assumptions. Even though Amazon has tremendous revenue growth potential, operating margins will be the key value driver for Amazon's stock in future. Current stock price levels (highlighted in red) imply revenue growth close to 20 percent over the next 5 years and at least a 430-basis point expansion in pre-tax operating margins.
Amazon's stock has handsomely rewarded the investors who have upheld their belief in Amazon's revenue growth story, but at the current price levels, the stock has gotten way ahead of itself. My fair value estimate of Amazon's stock based on revenue growth estimate of 15 percent and a 30-basis point expansion in margins is $61.80 a share.
After rebounding sharply from the losses of 2008's crisis, Amazon's stock has been on a miraculous run higher, defying gravity. The shift in investors' sentiment toward high-momentum stocks can punish high-beta names, sharply pushing them into undervalued to valued regimes. Price action in Amazon's stock during the last earnings announcement was clearly indicative of the shift in the management's focus - Raising the prices to achieve these margins.