- David Einhorn is wrong. Amazon does not defy laws of value investing.
- In fact, Amazon is the only FANG stock in the opportunity portfolio.
- After a big 2017 run, the stock seems fairly valued now under my assumptions which I think are more than reasonable and may prove conservative.
David Einhorn, an investor whom I respect, recently talked about Amazon (NASDAQ:AMZN) and Tesla (TSLA) as "defying the laws of value investing," putting each into his “bubble basket.” While I may agree about Tesla (although I admittedly haven’t done nearly the amount of work on it to have a judgment), I think he’s dead wrong about Amazon - and as I wrote about before, Netflix (NFLX), for that matter (also in his "bubble basket").
Amazon, however, is a part of my opportunity strategy’s portfolio - in fact, this year it was the only FANG stock in it (unfortunately). I happen to think Einhorn is dead wrong about Amazon, and Bill Miller, who is a big Amazon bull, is more correct.
Amazon is in the portfolio because: a) its total addressable markets (ecommerce, cloud computing, and streaming video) are far bigger than those of the other FANG stocks. Moreover, Amazon seems to have a policy of spending all of its profits on experimental research and development, as well as new data centers for AWS and fulfillment centers for speedier Prime delivery. Therefore, the company spends all it can on future growth and to further cement its deep competitive advantages, which makes valuing Amazon trickier than simply taking a multiple of GAAP net earnings.
Earlier this year, I attempted to value Amazon using a discounted cash flow analysis, and found it undervalued. After a 40% gain and recent blockbuster earnings, I revalued the company. And while there are obviously a lot of assumptions that go into it, it is better to get things approximately right than precisely wrong. So let’s dig in.
Capitalizing Research and Leases
One of the first things that I did was capitalize both leases as well as research & development. Amazon is, of course, in large part a tech company, and often a tech company’s (as well as a pharmaceutical company’s) biggest asset is its research & development asset. Normally one might capitalize the asset and depreciate it over a few years, but in Amazon’s case, I think one can make a case for capitalizing over a longer period.
For instance, here is an interview with Jeff Bezos on Charlie Rose from 2013:
That long view, Bezos believes, gives Amazon a distinct edge.
Jeff Bezos: The long term approach is rare enough that it means you're not competing against very many companies. 'Cause most companies wanna see a return on investment in, you know, one, two, three years.
Charlie Rose: You don't care about that?
Jeff Bezos: I care, but I'm willing for it to be five, six, seven years. So just that change in timeline can be a very big competitive advantage.
As you can see, amortizing the R&D expense this way is consequential, increasing operating income by $12.8 billion, from a mere $3.2 billion in GAAP recorded over the past 12 months to over $16 billion.
I also capitalized operating leases over the next 10 years, and this made a modest improvement in operating income as well.
As you can see, while Amazon has recorded $3.2 billion in EBIT over the trailing twelve months, these adjustments increase the “true” operating income to about $16.25 billion, or a 10% operating margin. Interestingly, this is very close to the company’s recorded operating cash flow, which was $17.1 billion for the past 12 months.
In addition, the company also capitalizes its capital leases and financial leases for us on its balance sheet, with the total $18.8 billion this quarter augmenting its debt load. I took a shortcut here and didn't adjust the financial and capital leases, but merely added these long-time liabilities (given to us by the company) to debt.
This is also a tricky calculation. Since I am going to be adjusting margins as the DCF goes on, I’ll be using a stable sales-to-capital ratio. Going through Amazon’s financials since 2010, I calculated invested capital based on book equity, book debt, capitalized operating leases, and other long-term liabilities (which includes capital and financial leases, and is a significant number - $18.8 billion in the latest 10-Q, since Amazon uses lots of leased capital equipment in its operations).
I was a bit lazy and didn’t precisely calculate capitalized operating leases, but estimated them. Still, one can see a clear trend of the sales-to-capital ratio getting lower as time goes on.
It should be noted that the company only took ownership of Whole Foods Market in late August, but the debt used to acquire the company is fully recorded in this number. Therefore, I think the true sales-to-capital ratio is really in the mid-4's range. I use a 4.5 ratio for my model.
It is quite possible that with the robust build-out the company has done in the past few years with Prime Now and building its data centers for AWS, it will achieve operating leverage in the future and the sales-to-capital ratio will start to tick up in the other direction. Still, for my DCF, I will use 4.5x. Certainly, it would difficult for any retailer to match these capital investments, and only giants such as Microsoft (MSFT) and Google (GOOG, GOOGL) can hope to compete in cloud infrastructure.
For my DCF, I used a 10-year model, with revenues growing at a 25% CAGR for five years before decelerating over the next 5 years to 2.5%, which is roughly where the 10-year Treasury bond is. In the recent quarter, Amazon’s sales remarkably accelerated 34%, or 29% excluding the addition of Whole Foods. While a 25% growth rate may seem high for such a large company, the sheer size of the markets it is playing in, and the fact that it has been able to accelerate sales this year to 29%, makes me feel as though this is a realistic figure.
Amazon accounts for about 34% of ecommerce, and ecommerce makes up only about 8% of overall retail, so that means the company has only about 3% of retail sales overall. That’s a lot of room to grow, even from this incredibly large base. Moreover, Amazon is combining its Prime offering with Alexa to become a true dominant platform for the connected modern household. In addition, the company is building out its private brands, which Alexa will no doubt suggest over other products, meaning the competitive moat is depending and Amazon could further achieve greater profitability in the future.
For cloud computing, Amazon is the dominant first mover in the infrastructure-as-a-service space. That vertical is projected to grow almost 40% in 2017 as businesses of all kinds eventually make the transition to the cloud. Cloud still makes up a minority of overall IT spend, but it really is a better model, and Amazon’s lead will make it able to offer lower prices and more features than most other companies. In fact, the sheer capital investments required to become a competitor are so large that only a few companies, such as Microsoft, Google, and perhaps IBM, will be able to compete. The growth opportunity will be big over the next few years and really is an open-ended opportunity. Despite this being a $20 billion run rate business for Amazon, the segment grew 42% year over year.
Finally, the company participates in streaming video, not only competing with Netflix for premium content, but also buying the rights to live events such as Thursday Night Football. Streaming is rapidly supplanting the cable bundle as the way people consume video, and Amazon is a big player. According to Market Research Future, the streaming video market is expected to grow 17% per year through 2021.
So, again, 25% growth seems more than realistic.
For operating margins, I have them expanding from roughly 10% to 12.5% in year ten. This is mostly due to the fact that Amazon Web Services, which earns a 26.6% operating margin last quarter (and that is on a GAAP basis), will become a larger part of the business, up from the 10% of revenues it is now.
Using CAPM, my rough calculation is roughly an 8% cost of capital. After year ten, I expect Amazon to retain a return on capital slightly higher at 12%.
The valuation I get is $1,131, which is strikingly close to the current value of $1,110.66 as of this Nov. 5 writing.
Here is the sensitivity table based upon growth rate ranges and operating margins:
I happen to think Amazon can beat these expectations, especially on the margin front; however, it appears that under reasonable margin expansion, the stock is fairly valued at its all-time highs. Bill Miller thinks the company can go up four to five times over the next ten years. That would mean the company can greatly expand its current markets and open new business lines (as it has done in the past) or make its existing business much more profitable. I wouldn’t necessarily count that out. In fact, I think it’s more likely than the alternate scenario where the company doesn’t grow and/or margins contract. However, to be reasonable, I think these estimates are reasonable without getting too carried away. (Note: This was done before tax reform, so considering I used a 36% tax rate and used after-tax EBIT as the basis for valuation, the value of Amazon is higher than this current model, making Einhorn even more wrong.)
Despite all that is going on in Amazon’s financials, it appears as though Einhorn is wrong, and the market has the company fairly pretty much fairly valued after this year’s 40% run.
On the Fat Pitch Expedition, I plan to keep re-valuing high-quality companies on my watchlist (and portfolio) over time, in addition to searching for less-known hidden gems. I also plan take requests for intrinsic valuations from subscribers. I hope you give it a try!
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This idea was discussed in more depth with members of my private investing community, "The Fat Pitch Expedition.' on Nov. 5
This article was written by
Analyst’s Disclosure: I am/we are long AMZN, NFLX. 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.
Amazon is in the Opportunity portfolio, whereas I own both Amazon and Netflix personally. Netflix is currently on my watchlist, which I also update every month or so on the Fat Pitch Expedition.
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