Why Amazon Is A Buy

| About: Amazon.com, Inc. (AMZN)

Summary

Delayed cash flows are now expected to arrive at a larger magnitude, fueled by Whole Food Market acquisition.

Operating profit margin is expected to increase, driven by growth in AWS and Third-Party Seller Services.

Amazon is undervalued by at least 23% with an intrinsic value of $1,183 that is expected to materialize by the year-end of 2017.

Investment Thesis

Due to its ability to expand operating profit margin, capitalize on online grocery market, and sustain revenue growth, I believe Amazon (NYSE: AMZN) is a company with good fundamentals and high growth potential. Upon reviewing the company’s business quality, growth catalysts, financial health, and momentum, my conclusion is positive. AMZN is undervalued by at least 23% with an intrinsic value of $1,183 that is expected to materialize by the year-end of 2017.

Good Business Quality

  1. AMZN’s fundamental competitive advantage is its adaptability, where its online retail dominance and increasing emphasis on physical presence jointly provide fertile soil for exploiting the online grocery market. Compared to major brick-and-mortar retailers such as Wal-Mart (NYSE: WMT), whose online sales account for merely 2.8% of its total revenue, AMZN knows more about its customers. Equipped with well-known machine learning, 58 Infrastructure Availability Zones, and customer data gathered through 2.65 billion of monthly online traffic, AMZN can use an algorithmic approach to position physical stores and distribution centers strategically. Furthermore, in the aspect of online retailing, eBay (NASDAQ: EBAY), whose strategic plan is subjected to its intermediary business model, does not have enough infrastructure investment to meet the increasing demand from the online fresh grocery market. Lastly, China’s decentralized transit network and urban structure, and consumer’s preference towards local food markets restricts Alibaba (NYSE: BABA) to exploit the Chinese online grocery market. In comparison with its peers, AMZN is well positioned for the e-commerce trend. With warehouses and fulfillment centers strategically dotted around the nation, the company can leverage its infrastructure to handle fresh products just right.
  2. AMZN’s focus on its investments in Fulfillment by Amazon (FBA) and warehouse technologies allows the firm to establish a high entry barrier for other Third-Party Seller Services (TPSS) providers. (Exhibit 1) Launched in 2006, FBA’s 100-plus fulfillment centers not only speed up transactions, but also serve as inspection centers to eliminate unqualified sellers. Since inception, FBA has significantly improved customer service, grown third-party sale to total revenue from zero to 17%, and reduced COGS to total revenue from 77% to 59%. In contrast, other online retailers are unable to compete on scale, thus unable to sustain their maker shares. Besides benefiting from economies of scale, Amazon has developed warehouse robotics solutions, allowing both human and robots to specialize the tasks they are good at, leaving tedious activities such as picking and shipping to robots. As a result, warehouse efficiency has been constantly improving, with orders up as much as 30% and fill rate up to 99.8%, without adding more pickers.
  3. The 90% of independent directors and 16.7% of insider ownership set a benchmark for its competitors.

Exhibit 1. Fulfillment and Warehouse Operations (Square Footage), AMZN vs Peers

Source: Bloomberg

Historical Growth

  1. Amazon has achieved a CAGR of 24.8% over the past 10 years, and has delivered segment growth rate of 55%, 43% and 43% for AWS, Retail Subscription Services and Third-Party Seller Services, respectively as of December 2016. (Exhibit 2)
  2. Amazon’s revenue growth rate surpassed that of its competitors 7 out 10 times during the past decade. (Exhibit 3)
  3. Top line growth is expected to increase to 30% and sustained at 30% for the next five years driven by the following catalysts.

Exhibit 2. Annual Growth Rate (%) by Segments, 2014-2016

Source: Factset

Exhibit 3. Revenue Growth Rate (%) Comparison, AMZN vs Peers

Source: Factset

Growth Catalysts

  1. Currently, e-commerce only represents 12% of the US retail sales market, indicating plenty of room for the e-commerce industry to grow. As AMZN accounts for 41% of the global online retail market share, the company’s online retail business is well positioned to be the future leader in the retail industry. The e-commerce giant’s online retail segment currently represents 67% of its total revenue. (Exhibit 4) With a fast-growing annual growth rate reaching as high as 19% in 2016, AMZN’s online retail business continues to serve as the company’s top-line growth driver.
  2. Luxurious investment in fulfillment centers and the recent acquisition of Whole Foods Market allows AMZN to establish a firmer foothold in physical distribution channel and a stronger presence in the online fresh grocery market.
  3. Public cloud infrastructure service is one of the fastest growing markets. While the industry remains in its early stages with a projected CAGR of 19% for the next three years (2017-2020), AWS not only occupies 75% of US market share but also has 90% of infrastructure workload unused. (Exhibit 5) Additionally, more than 70% of CFOs say cloud investments deliver the greatest measurable impact on their business in 2017.

Exhibit 4. AMZN's Revenue Growth Rate and Revenue Proportion, 2008-2016

Source: Factset

Exhibit 5. Cloud Infrastructure Services Value Comparison, Q1 2017

Source: Forbes

Good Financial Health

  1. Operating margin is expected to increase, driven by growth in AWS and Third-Party Seller Services. AWS is AMZN’s fastest-growing business segment, generating 70% and 55% annual growth rates in 2015 and 2016, respectively. This rapidly growing segment, with its relatively high margins, gives AMZN’s overall profitability a boost. To illustrate, in 2016, AWS’s operating margin was 25.4%, while other segments jointly contributed 0.87%. In addition, AWS generated 9% of consolidated revenue and 96.69% of consolidated operating income in the same year. (Exhibit 6) AWS is expected to continuously serve as AMZN’s profit margin explorer because none of its competitors have 75% of US public cloud market share, and few of them have a well-established technology infrastructure and a 30% of CAGR in R&D since 2007. In Third-Party respect, although the segment currently has a low operating margin, its bottom line is expected to expand as investment rates gradually slow down and economies of scale start to exert influence on operating efficiency.
  2. Return on equity (ROE) is expected to recover. AMZN’s ROE has decreased from 58.48% to -1.27% from 2007 to 2014. This underperformance was caused by decreasing financial leverage (Equity Multiplier) and profit margin (EBIT/Revenue). That said, ROE’s underperformance did not put much pressure on the stock price since the market understood the short-term impact of FBA and Research and Development investments on margins. Shareholders accepted the pain and expected a richer payoff, while the payoff came at just the right time. In 2016, ROE increased to 14.55% primarily driven by AWS. Looking ahead, short-term ROE is expected to decrease due to the Whole Foods Market (NASDAQ: WFM) acquisition, but in the long-term ROE should pick up. (Exhibit 7, Exhibit 8)
  3. Investment in FBA and AWS is a positive economic value added (EVA) activity. For simplicity, the WACC in 2016 is used as a rough hurdle rate for the past 10 years to illustrate the performance trend. As can be observed, AMZN experienced four negative EVA fiscal years caused by heavy investment in FBA and AWS. However, ROIC finally picked up in 2016, fueled by an improved NOPAT from the AWS segment. (Exhibit 9) In the long run, NOPAT from Third-Party and online grocery retail segments are also expected to catch up.
  4. Conservative financing strategy and lower risk profile. Although AMZN’s leverage has gone up and coverage ratio has declined, I expect this to give no trouble to the firm since debt ratio and coverage ratio still hover near industry averages and Amazon’s 2.87% cost of debt is considerably lower than that of other online retailers. (Exhibit 10) Besides, the company’s enormous future growth potential and profitability also can be considered as collateral to these debts. Additionally, AMZN’s higher-than-average debt ratio allows it to enjoy competitive tax advantages and ultimately brings the WACC down to 5.8%, which is lower than the average WACC of the online retail industry (8.8%).

Exhibit 6. AWS Gives AMZN’s Overall Profitability a Boost

Source: RevenuesAndProfits

Exhibit 7. Dupont Analysis on AMZN

Source: Bloomberg

Exhibit 8. ROE Comparison, AMZN vs Peers

Source: Factset

Exhibit 9. EVA Analysis on AMZN

Source: Factset

Exhibit 10. Leverage and Liquidity Analysis on AMZN

Debt to Asset Ratio

Interest Coverage Ratio

WACC by Industry

Industry Name Beta Ke E/(D+E)

Kd

Tax D/(D+E) WACC
Retail (Online) 1.2 9.4% 91% 3.7% 8% 9% 8.8%
Restaurant/Dining 0.8 6.8% 74% 3.5% 16% 26% 5.6%
Retail (Automotive) 0.9 7.6% 63% 3.5% 23% 37% 5.6%
Retail (BuildingSupply) 1.3 9.8% 82% 3.5% 20% 18% 8.4%
Retail (Distributors) 1.1 8.7% 64% 3.7% 17% 36% 6.4%
Retail (General) 1.0 8.4% 72% 3.7% 22% 28% 6.7%
Retail (OTC:FOOD) 0.7 6.4% 60% 3.5% 24% 40% 4.7%
Retail (Special Lines) 1.0 8.3% 66% 3.7% 21% 34% 6.2%
Average 1.0 8.2% 71% 3.6% 19% 29% 6.5%

Source: Factset, NYU Stern School of Business

Strong Earnings and Price Momentum

  1. AMZN has strong earnings momentum based on the number of earnings surprises generated and the increasing trend of analysts’ consensus estimates. Interestingly, analysts’ opinion on the annual EPS this year is the most divergent since its IPO. This is mostly due to the company’s recent acquisition of WFM, which lowered the market’s expectations on AMZN’s 2017 EPS. (Exhibit 11) That said, a positive surprise and long-term synergies will have a material impact on the stock price.
  2. Strong earnings momentum produces strong price momentum. (Exhibit 12) AMZN’s three-year price momentum appears to be stronger than most of its competitors, despite two major dips over the years. The first drop was caused by a downgrade from Monness Crespi Hardt, who is concerned about “AMZN’s investments in growth may yield less degrees of upside than delivered throughout 2015." The second decline was caused by missed earnings in October 2016. Like previous price declines, the recent price depression will mostly likely be temporary since it merely reflects lower EPS estimations due to the WFM Acquisition. Looking forward, AMZN’s strong price momentum is expected to persist, a result driven by expected growth in both its bottom line and top line.

Exhibit 11. EPS Surprise History and Earning Momentum

Source: Factset

Exhibit 12. Three-Year Price Momentum, AMZN vs Peers

Source: Factset

Valuation

  1. Based on a DCF valuation model (Exhibit 13), Amazon’s target price for year end of 2017 is set to be $1,421. Please click AMZN DCF MODEL to view details.
  2. Amazon is currently trading at a discount based on price-to-sales. The company’s P/S ratio is slightly lower than industry average and lower than most of its peers. (Exhibit 13) The lower-than-average P/S ratio indicates that investors are less concerned about top-line results but more excited about bottom-line growth. AMZN’s 247.6 forward P/E indicates that investors are willing to pay a significant premium for its future growth. In AMZN’s case, a high forward P/E does not mean that the stock is overvalued, since most of its gross income is reinvested to fuel future growth. For this reason, investors should not punish AMZN’s stock price as long as its growth story can be sustained. Because P/E ratio is misleading, an average industry forward P/S is used to multiply the estimated revenue in 2017, arriving at a target price of $ 953 per share for year end of 2017.
  3. Based on the sum of the parts analysis, AMZN’s target price for year-end 2017 is set to be $1,175. The company can be split into two segments: retail and AWS. For its retail segment, a 0.75x multiple is applied on 2018E GMV of $474B, justified by WMT’s 0.5x GMV and AMZN’s higher growth profile. For the AWS segment, a 14.5x multiple, lower than industry average 20x, is applied on 2019E AWS EBITDA of 14.4B.
  • A simple average of the three prices above is used to set up a target price of $1,183.

Exhibit 13. DCF Valuation Model (AMZN DCF MODEL)

Source: Factset, Assumptions

Exhibit 14. Price to Sale Ratio, AMZN vs Peers

Source: Factset

Downside Risks

The following risks may have an impact on the magnitude and timing of cash flows.

  1. AWS price-cutting may create further margin pressure.
  2. Heavy investment in AWS and infrastructure may create margin pressure. (Exhibit 15)
  3. Slower than expected integration with Whole Foods Market will delay cash flow.

Exhibit 15. Investment in AWS and Infrastructure Created Pressure on Operating Profit Margin

Source: Factset

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.

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