Over time, large companies have appeared in the stock market revolutionizing what until then was understood as acquired. Many companies have evidenced innovative proposals including advanced forms of market behavior. However, I don't remember another company that - as Amazon.com (NASDAQ:AMZN) - has so radically achieved a paradigm shift of running a business, developing simple principles that modify so deeply what is the current strategy of a large investment worldwide.
Of course, all this has only a decisive importance because it has been successfully reached by a company showing how a completely different strategy can have merit if its bases are solid and the objectives are clear and valuable over a long period of time.
Obviously, I'm not going to tell you the Amazon story that everyone knows about. What I will study in this article is the degree of success the company has obtained, the risks of its strategy, the comparative advantage it has developed, and its value for investors. I may say that I don't have any bias because even now I'm still not sure about the conclusions I'm going to get - it's still early because the study is just about to begin.
Understanding that growth is given by the evolution of revenue, the following table gives a good picture of Amazon's expansion over the last ten years. However, it should be stressed that Amazon's strategy is far from being the traditional one. It is not about boosting sales and improving margins for increasing net income. Specifically, the company's strategy has to do with increasing revenue at all costs in order to maximize cash flow. This cash is invested in the growth of the company which in turn enables higher revenue and so on. Neither raising margins are an objective nor increasing net income is an important ambition in the medium term. Simply put, Amazon wants to grow strongly through the largest amount of cash flow it can generate.
With the table below, we may see how growth plays out. It's easy to see that net income has been marginal over the ten years considered. As I said above, Amazon has concentrated all its efforts on increasing sales and on obtaining free cash flow to finance the continued investment in its own growth. It is relevant to note that especially since 2014 the company has also invested under capital leases in its development and in additional acquisition of property and equipment - $4B in 2014, $4.72B in 2015, and $5.70B in 2016.
Sales growth has been very strong enabling a large progress of the company. Although there is a slight slowdown in its annual rate of increase, a rise at a CAGR of 27.90% in the last 10 years has to be considered as an extraordinary achievement.
Of the three segments that Amazon has defined for its business - North America, International and AWS, the latter is the most promising, not only in sales growth, but also in operating margin and income. In another perspective, AWS is also the segment with the largest potential market, and where Amazon has been the leader in cloud service, standing out now with about 31% market share.
The company's guidance for the next quarter is conservative, almost defensive, but the pattern hasn't changed. P/E is very high (~170) because share price is discounting future profits that are still far from being materialized. Therefore, it does not make much sense to analyze PEG because the strategy of the company is to maximize free cash flow, not EPS. Thus, it is obvious that the value of the PEG will always be high without implying a negative judgment on the price appreciation of AMZN shares. Let's take another route. We know that for this company working in a technology-based area, accelerated sales growth means that net income may not be decisive for a long time. Hence AMZN has shown an operating cash flow margin between 6.80% and 13.40% over the last 10 years. Currently, with sales slowing down a bit, the company is giving increasing importance to cash flow. The trend will be to take the sum of sales growth and operating cash flow margin to a high level, but at the same time keeping net income rising more than before.
Using these metrics, we conclude that AMZN continues to be efficient at turning sales into cash - promoting quality to its net income, which as I mentioned is currently growing somehow faster.
While sales show tremendous growth over the years, one gets the impression that the company could force businesses to accelerate and grow even more. The decisive importance given to customers and constant innovation provides this impression. It is understandable that this is not the case because we have seen an orderly growth, very strong, but never dependent on a specific product or service. Millions of products are sold by Amazon. Prime has tremendous value and Marketplace is a smart way to sell with the support of third-party sellers. But Amazon Web Services (AWS) is a "new Amazon" making its way even faster than Amazon itself. AWS offers dozens of services linked to IoT. Specifically, it has expanded to the most complete and advanced cloud service, a worldwide leader as mentioned above.
Putting as decisively crucial the focus on the customer together with the permanent innovation where can we find the risks of this company? Obviously, a strategy like this seems to have no flaws nor the need to solve growth problems. In fact, AMZN has increasingly more products and gets more customers in a qualitatively efficient way. But undoubtedly, there are risks which are more relevant to investors than to the company that keeps its business at a great pace with a strategy without dangerous missteps.
In my opinion, the growth rate is the biggest risk of the company. AMZN stock price is discounting continued high growth. In fact, its price tends to follow roughly the present value of probable future cash flows.
If sales start to grow at a slower pace than in the recent past, investors will expect net income to begin to pick up with greater intensity. This will be possible because the net income starts from a very low base considering that the company was not (and still is not) oriented to maximize profits. As AWS segment sales are rising sharply, it is the other segments that may experience a certain slowdown in sales. Net income may become one of the factors that measure Amazon's growth, but we have doubts that this will happen in the medium term. On the one hand, AMZN wants to continue to grow strongly because this is the culture of the company and will have to invest heavily as has happened so far. Such a strategy is the most natural and should increase operating cash flow. Net profits may continue to rise, but not with the strength that many expect because of growth-driven investment efforts. Nevertheless, AMZN share prices, as we may see in the chart below, may face drawdowns of some intensity if expected growth is not met or even if growth forecasts start to slow a bit. We have to take into account that AMZN's share price level has been implying the best situation in terms of sales and cash flow generation. Any slippage has repercussions on price behavior. We are also aware that AMZN share prices will revert to the mean, which is roughly an ascending trendline defined by the EMA(50). In other words, on doing so, we may say that share prices have returned countless times to its moving fair value.
Chart courtesy of StockCharts.com
Note: The chart above is in semi-logarithmic scale
Amazon's evaluation process is simple because I will not be doing a guessing scheme. My assumptions are clear and must be objective, not speculative. I'm dealing with a company that has invested heavily in its growth and that has always been and continues to be focused in the long run. I assume a conservative annual sales increase of 14% and take a free cash flow margin of 7.5%, which might also be higher. However, I think that cash flow will continue to be used on a relevant way on development spending and investment for growth. Using a basic DCF analysis I'm going to simplify terminal value considering that the expected free cash flow of Year 5 is multiplied by a price-to-free cash flow of 30.
- Adjusted FCF at a 14% CAGR reaching ~$19.64B in 5 years
- A 30x multiple against adjusted FCF in 5 years gives terminal value
- WACC (discount rate): 8%
- Net debt: -$18.3B
Thus, with a total market value of ~$479B, and supposing that there will be the same number of fully diluted shares outstanding (477M), we arrive at a value of $1,005 per share.
One very interesting aspect is fair value. When we make an evaluation process, we try to find fair value. Either way, the company has shown a very dynamic evolution over the years and we cannot be stuck at a certain level of value of the company. Indeed, we know that we deal with expectations and with a distant future that, especially in the areas where AMZN operates, may undergo unpredicted changes.
So far one thing is clear enough: AMZN's valuation is hugely dependent on its annual growth. In fact, if we consider annual sales growth of 20%, the value reaches $1,273 per share, but if we take 8% growth, the value is reduced to $787 per share.
As we have seen, the safety margin of the company's shares is very dependent on the growth rate. For this reason, whenever there are doubts about weaker quarterly results or important negative news, stocks may fall with some intensity. Although this has happened rarely, it will be the point to keep in mind in the evolution of the company and its stock price.
For a long-term investor, Amazon is the perfect challenge because, in my opinion, it is a company that works patiently to build its future based on a clear and successful strategy. While AMZN has grown tremendously, its positioning in the market has been sustained and based on very solid foundations. There was a time when investing in a company that showed irrelevant net income seemed crazy. Now everyone understands that Amazon invests on its own growth and has changed the paradigm of managing businesses. Its tremendous growth comes from customer focus, permanent innovation and the extraordinary multiplicity of products and services that it offers.
The company is heading in the right direction. In any case, there is an appreciable risk for investors in the company's stock: any slowdown in growth or any firmly negative news about the company's performance may cause the price of its shares to drop sharply. Let's say Amazon shares have a price that discounts continued strong growth in terms of long term. If there are some mishaps along the way, the stock price will suffer. It is up to the investor to assess if some potential setbacks are problematic while waiting that recovery will occur in due time as has hitherto been the case. In my opinion, I think Amazon is a great company to invest for the long term.
Source: Annual reports of Amazon.com
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
Additional disclosure: The author of this article is not an investment adviser and gives only his personal view and opinion, never making any investment advice or recommendation to buy or sell specific securities. Investors in financial assets must do so at their own responsibility and with due caution as they involve a significant degree of risk. Before investing in financial assets, investors should do their own research and consult a professional investment adviser.