Amazon (NASDAQ:AMZN) likely reports earnings in late January. Until then, many, if not most, investors will be focused on the consumer environment and the potential retail results. That said, we think the financial make-up of Amazon is changing drastically to one focused much more on cloud computing services. We think analysts need to shift a great deal of attention and understanding to AWS (Amazon Web Services, the company's cloud offering) instead of spending time solely understanding retail.
Cloud Becoming Meaningful To Amazon
Last quarter, cloud made up less than 10% of revenues, but more than 50% of profits. Top-line growth was 78% versus the rest of the businesses, excluding AWS, at 20%. The margins at AWS are tracking at 25% (as of last quarter). The entire business, excluding AWS, this year is expected show roughly 3% segment operating margins.
The nice thing is that the core retail business seems to be hitting the operating leverage, driving flow through to earnings. Even if the top line is growing much slower, the profits could actually keep pace with the cloud business as Amazon is finally seeing leverage on the fixed-cost expense.
But, as for valuation, the cloud business is deserving of a much greater piece of the company's overall valuation given the current statistics and potential market size. The company thinks that the business can grow 50-70%, but it is running faster than that.
Barriers To Entry And Amazon Scale
To be a player in cloud, a company needs a lot of money to invest in technology, architecture, software, people, etc. AMZN already needed to do it itself by building out its one-of-a-kind online retail business. From that investment, the company realized that the scale and know-how can be offered to other players.
There are many other players in this field including Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Oracle (NYSE:ORCL), Microsoft (NASDAQ:MSFT), etc. The one issue is that Amazon claims to already have over 10x the computing capacity of its next 14 competitors combined. If you are a GE or Cap One or any bank or business with mission-critical applications, you need reliability, security and scale. Based on its size and first-mover positioning, AMZN is winning this business.
$200B Potential Cloud Market
Forrester Research says this business could be $180B by 2020 (4-5 years from now). Amazon thinks ultimately there are only going to be a few main players capturing the major customers due to their reliability and security. A customer's number one issue is security. Amazon needs to deal with that for its online business every day and so has been seen as a reliable source so far.
If Amazon ends up getting a position as one of the lead players in this industry, we're adding another $50B to revenues in five years at 25% EBIT margins.
How Is The Market Putting A Value On The Businesses? Our Guess: 50X AWS A Few Years Out, 30x17 For Retail
Here's some math to think about how to get to the Amazon's value and what the market is pricing for its businesses. As a caveat, all of these numbers are malleable, and you can do the math yourself to see where the valuation can go with your own inputs. As another important comment, we do not think that growth companies can be shorted based on valuation, so if you happen to get to a lower valuation, unless something goes wrong with the company, most growth companies grow into their valuation. To be short on a high-valuation company, one needs to expect something to go wrong.
Let's do a walk through.
Currently, there are scale advantages and a limited number of companies with capital to enter, and with Amazon's large lead, we gave it a nice market share of 25% (all of these figures we can't know for sure, we are just estimating and modeling).
Our profit margins of 20% are based on the company's current 25% recently, but understanding that just like Q1 of '14, it may drop at any time to take another huge jump in market share. AMZN may also have to invest heavily in the business, like it's done with Amazon. The company is no longer only growing one business on AWS, it is growing all of its customers and new customers, which will require investment. Our bias, though, is that margins go up from 25% over time. But, again, there is no way to know yet.
We gave the company a 50 multiple on that business five years out and discounted it four years at 10%. All these numbers can be played with. We think in actuality how markets work is, if these numbers prove correct, then the multiple will be higher as they grow into the multiple. Here again, there is no way to know, so we chose 50.
You can then see the value should be $410 for AWS today in that $647 Amazon stock price. The rest we give to retail/online. Taking our (which aren't far from the Street) estimates, we get about 60x earnings for the retail/online business for the next year. If we look out to '17 and assume another EPS growth of 2.5x, then the multiple becomes a more normal 30x. But, if Amazon keeps the growth rate, and now profit leverage, the multiple could likely end up being higher than that.
Valuation Not Unfair
As we went through this process, our price did not end up far from the current price when plugging in our own numbers. Given the growth rates of the company, we feel the price of Amazon does not seem unfair. We think the price has been decided by sizable investors who have done a similar run-through and made an extra decision that Amazon is a market leader that will unlikely get moved from its position for many years.
Shorter Term, We Have Upside In Q4. In line for Q1. We are Higher For '16
When trying to figure out what Q4, Q1 and '16 can be, we used the recent trends and seasonality and broke it down by business.
For retail, there is a big jump sequentially in the fourth quarter, and Q1 comes back down. That said, the retail/online Q4 growth rate should slow as it did last year from Q3. Most of the drivers for top line have been "all-year" drivers, smoothing out the quarterly revenue trajectory. They have been driven by Prime (which is an all-year sales subscription), clothes and food which are more all year and less giftable than their one-time core business of music and books. We allow for this in our non-AWS (retail growth rate) estimates. The growth rate should pick back up in Q1 (although we kept the growth rate the same).
For margins, in Q4, we assumed an average of the jump in sequential margins from Q3 to Q4 last year as well as figuring the margin improvement year over year from the recent Q3'15. We get about $.20 upside for Q4 versus the last couple of quarters' upside of $.30.
North American retail margin has grown by 300-500bp this year. The Street is assuming some continuation next year. We have a 250bp improvement in Q4 (which may be conservative) and are still higher than the Street. We say this may be conservative because Q4 is the company's core quarter with the most margin potential, where its distribution centers run at the highest utilization which should drive the highest margins.
For next year, you can see in the model, there is upside potential versus the Street estimates. We have, on average, 10ct upside surprise per quarter.
The Risks To Numbers
We like that Amazon has focused its communication around cash flow. We think that is an important message; that means we are in a period of growth and profits flowing through.
We know AMZN has been notorious for spending back upside, which we thoroughly respect. We also saw that after Q1 of '14, the margins of AWS dropped from 23% to 7.7% Q1 to Q2 because the company decided to drop price and invest more.
The company has said that it expects the AWS business to be "lumpy." Lumpy means it can drop the price again or ramp up spending to maintain its lead.
This was part of Amazon's strategy for many years with distribution centers, then content, Fire, phones, etc. It's worked, and we expect it to constantly push to find new investments.
That said, AMZN's investments seem to be driven based on the greater good of the overall company and customer offering. AWS was a little different that it realized it already built, something so special that the company might as well make a business out of it. There are other high-multiple companies that saw multiple depression from non-strategic investments. That has not been the case with Amazon because its investments have been on point with its overall strategy.
Conclusion, The Bulls Win
Overall, we are obviously impressed with Amazon. We think, because of the markets, there could be a bull and bear tug of war here. Ultimately, we think the bulls win as this is a one-of-a-kind company in a rare premium position, both in retail and cloud.
We believe that AMZN is a longer-term buy and can be bought after the "bad news" has cleared, whenever that happens. Whenever investors are disappointed that they decided to increase spending or drop price, and the stock takes a hit, there is a strong value support, story, and positioning to step in.
Our Valuation Take
50 x '17 Retail = $372
50x Ultimate AWS five years out discounted three years = $450
372 + 450 = $823
That said, we would look for "bad news" entries to manage through the longer term. If one doesn't use scary dips to buy, he could get shaken out on those scary dips, making this a losing investment.
So far, Amazon has proven to push its business model to discover new opportunities. AWS fell into its lap based on the company's online build-out need, and it made sense to resell the capacity and turn it into a business. AMZN is getting accolades for its content. That said, a lot of its new endeavors don't automatically have a great ROI or are profitable at all, especially at first.
When the company invested heavily in distribution centers, the typical flow through visibility was initially missing to the Street on how it would play out. In the end, we see it's working, but the process took years.
That said, AMZN can find something else to invest in that investors don't get. As we mentioned before, it could take huge swaths out of its price in AWS or do a massive distribution build-out in a new region. These moves would slow operating leverage and potentially hold back or lower earnings expectations.
This is the biggest and real risk. The other clear risk is the market. Going into a rising rate environment, the potentially biggest hit stocks are those with high multiples. That said, often times a market advance thins out to only the best players, causing a thin dichotomy between a few great ones (like Amazon) performing and the rest weak.
In any case, investing in a high-multiple stock when everything is already pretty clearly working can't have the ranch bet. Investors always need to be humble, and that's why we say to use weakness to find opportunities to enter.
Chaim specializes in earnings and predicts, analyzes and reacts to earnings and earnings events as well as developing current company and macro stories with a hedge fund perspective.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.