Why Amazon Is Undervalued

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About: Amazon.com, Inc. (AMZN)
by: Edward Ambrose
Summary

Amazon grew revenue 20% and operating income 78% in the fourth quarter. Full year revenue was $232.9 billion up 31% and net income more than tripled to $10.1 billion.

After the earnings were reported, the stock fell $92 or 5.4% to $1626.

Many were concerned about low revenue growth in the guidance, but the guidance is overly conservative. It is a strong buy.


AMZN stock price (add $1,000 to numbers).
Source:
Finbox.io.

Amazon (AMZN) stock fell after it met the high-end guidance for revenue and exceeded it by 5% for a 78% growth in operating income. The upper bound guidance projects 71% growth in operating income. This would take the current P/E from 80 to below 50, in a year. The lower bound of 19 % operating income growth would tank the stock. Amazon did the same thing in the previous quarter. The lower bound operating income was $1.5 billion below the upper bound. A realistic guidance would raise the stock. The lack of good guidance from Amazon reduces the price. Amazon is a strong buy.

The Fourth Quarter

The following table illustrates that Amazon grew revenue by 20% and operating income by 78% over prior year. North American revenue was up 18% and operating income up 33%. International grew revenue by 15 % and the loss in operating income dropped by 30%.

AWS is the high margin cloud computer services business, which grew 45% and operating income grew 61%. AWS is 10% of revenue but 58% of operating income in the fourth quarter. AWS growth and margins are unusually high.

Fourth Quarter Jump

As Amazon matures, more of the business is spread more evenly throughout the year so the fourth quarter jumps from third quarter declines. This rate of decline is very steady as can be seen by the trend line. The revenue jump in 2017 was high because Whole Foods was in the entire fourth quarter but only in part of the third.

Data source: Amazon; chart by author.

Analyst Concerns

The analysts focused on three issues: India, which is suffering from very unfavorable government action, advertising, which they expect might be offsetting operating income problems, and hiring.

In India, new rules issued with only thirty days’ notice forced Amazon to stop selling a large number of products with no time to react and an inventory of products that are illegal to sell to consumers. This law affects other e-commerce sites including one owned by Walmart (WMT). The law is a political move to win support among India’s 25 million small merchants ahead of the upcoming elections. At this point the merchants are more powerful than the online customers. That will change.

In the third quarter of 2018, Amazon launched a Hindi language web site and mobile app that enables people in rural areas who do not speak English to buy from Amazon. Amazon has a large infrastructure in place. They have spent $5 billion on India while Walmart spent $16 billion on buying majority control of an Indian website. The Indian on line market only has sales of $33 billion. Indian costs will be higher in this quarter, with lower revenue, but Amazon has the ability to adjust, probably better than the other on line sellers. It should not have a major impact on total Amazon results.

The advertising business is the majority of the other revenue. In the fourth quarter, other revenue was $3.2 billion up 96% from prior year. Amazon is spending to expand this business with tools that enable the advertisers to measure the result of their campaign. On an ongoing basis, the margins will be very high.

In 2018, Amazon increased employment by 14%, a number that is drastically lower than previous years. Management expects to increase employment by more than 2018 with more marketing and support people in AWS. Higher investment is also expected. In light of the sales and operating income growth, this is reasonable.

First Quarter Change

Sales and income declined in the first quarter from the high in the fourth quarter. This change for each segment is relatively consistent. The average decline in North America for 2017 and 2018 first quarters was 19%. The revenue drop in International was also 19%. AWS differed with revenue increasing 5%. Amazon revenue declined 17%. These changes are shown in the table below.

Do-It-Yourself Guidance (Hint: the Result is the Amazon Upper Bound)

In the fourth quarter, guidance was slightly above the upper bound. The lower bound was meaningless. The same pattern can be found in this quarter’s guidance. The percentage change for each segment was multiplied by the average change in the previous table. The results for the three segments were added together to arrive at the total.

This exercise produces revenue of $60,459 million vs the upper bound revenue of $60,000 million. The operating income is 2% lower. In the real world, all of these numbers will be different but the total should be relatively close.

Conclusions

Amazon is a quarter trillion dollar company. The results from quarter to quarter are relatively consistent. The question is, do you like the results? The revenue growth is smaller than in prior years but the operating income growth is high. The stock has a high beta, partly a product of poor guidance. The P/E is dropping rapidly as earnings grow. This stock is a strong buy.

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.