Amazon's Next Potential Game Changer: Drone Deliveries

Summary

• On August 31, CNBC reported that Amazon has received federal approval to use drones for its delivery operations.
• The use of delivery drones could be a true game changer, not only for Amazon but also for delivery services, logistics and human life in general.
• In the following, I would like to discuss the opportunities and risks for Amazon and its shareholders in connection with the use of drones as delivery items.
• Additionally, I will evaluate why Amazon shares are still favorably valued and offer an attractive entry point.

1. Introduction

On August 31, CNBC reported that Amazon (NASDAQ:AMZN) has received federal approval to operate a fleet of delivery drones. With this move, the company follows UPS and Alphabet's (GOOGL, GOOG) Wing, which had already received FAA approval for their drone delivery operations.

When announcing the quarterly figures for Q2 2020, Alphabet's CEO Sundar Pichai mentioned that Alphabet-owned Wing has started delivering library books to students in Virginia.

In the context of the FAA approval for its Prime Air delivery drone fleet, David Carbon, vice president of Prime Air, stated the following:

“We will continue to develop and refine our technology to fully integrate delivery drones into the airspace, and work closely with the FAA and other regulators around the world to realize our vision of 30 minute delivery.”

Just recently, Amazon has invested several billion dollars to shift from two-day to one-day delivery. With the use of drones, the delivery time is targeted to be reduced to up to 30 minutes. At least, this is the company's vision.

As you can imagine, the FAA approval for Amazon's delivery drone fleet represents a true milestone, not only for Amazon but for delivery services, logistics and human life in general.

In this context, it is also noteworthy that Walmart (WMT) announced on September 9 that it will also test using drones for deliveries.

In general, drone deliveries are not a distant vision, but a reality in China, for example. Especially in rural areas of China, which are difficult to reach, orders are already being delivered via drones, according to several reports.

In the following, I would like to discuss the opportunities and risks for Amazon and its shareholders in connection with the use of drones as delivery items.

Furthermore, in the subsequent section, I will evaluate why the company's shares are still favorably valued and offer an attractive entry point.

(Amazon delivery drone. Source: Amazon)

2. Why delivery drones could be a game changer for Amazon and its shareholders

First, the increasing use of drones to deliver orders and as workforce in Amazon's warehouses could, in the long run, drastically reduce the personnel costs, the delivery costs as well as costs of hiring new employees.

In contrast to humans, drones and robots could work almost uninterruptedly except for their loading and maintenance times without taking vacation, sick days, fatigue or motivation problems. Once produced and ready for use, drones offer the possibility of rising economies of scale.

In this context, it is noteworthy that while Amazon is one of the world's largest companies in terms of sales and market capitalization and is rapidly growing, its profitability is comparatively low. In fiscal 2019, the operating margin was 5% and the net margin was 4%.

Among the largest cost categories are shipping (i.e., sorting and delivery centers, transportation costs) and fulfillment. According to Amazon's annual report, these items together amounted to approximately $78 billion (of which $40.2 billion were fulfillment and $37.9 billion shipping costs). This represents approximately 30% of total operating expenses in FY 2019 (see following figure).

(Amazon's operating expenses in FY 2019. Source: Annual Report 2019)

As of July 2020, Amazon already had over one million employees worldwide, according to CEO Jeff Bezos' prepared testimony for a House antitrust subcommittee hearing. The following figure illustrates the company's workforce growth over the past years.

(Amazon workforce growth over the past years. Source: Wikipedia)

At the same time, the company states that it has over 250k full-time employees in its fulfillment centers. The number of employees in this area is growing drastically, as is Amazon's number of global warehouses and fulfillment centers. Consequently, personnel costs are also growing at a rapid pace, which, in turn, reduces profitability, but could be dampened by using drones, for example.

Second, the use of drones could lead to increasing revenues for the company. On the one hand, Amazon could offer merchants and third-party sellers on its platform to use the drones for deliveries against payment of a fee. On the other hand, it is likely to attract more customers and Prime subscribers with the use of drones and the resulting faster deliveries. Especially for people from rural areas, hard-to-reach areas or physically challenged people, the delivery by drones might offer an advantage.

In particular, its combination of hardware (drones), software (AWS, Alexa) and the platform (marketplace) could offer Amazon a large competitive advantage due to the perfect compatibility and connectivity of these services. In this regard, customers could place orders, have them delivered immediately or process returns at any time.

As a consequence of the short delivery times and uncomplicated deliveries, customer satisfaction could, in turn, increase, which could lead to increased customer loyalty.

Furthermore, due to Amazon's wide fulfillment network combined with fast deliveries, merchants that are not currently connected to its network could decide to use Amazon as a delivery service instead of conventional delivery services, which, in turn, could increase Amazon's revenues and economies of scale.

Third, the use of drones could make Amazon a more environmentally friendly and sustainable company. Drones do not need gasoline, they are noiseless and they could help to reduce the traffic load on conventional transport infrastructure, especially in metropolitan areas. This, in turn, could attract environmentally conscious customers and investors.

Nevertheless, there are also risks and hurdles that must be taken into account when using drones as delivery items:

• The use of drones as a delivery service is technically limited, as they are currently only suitable for short distances and goods weighing up to 2.5 kilograms.
• The use of airspace for drone flights must first be regulated on an international level for global deployment.
• Potentially crashing drones represent a serious threat to humans, animals and other objects.
• Drones could be exploited by criminals, hackers or other interest groups for espionage purposes.
• Parcel delivery by drones jeopardizes jobs in conventional delivery services, which could lead to criticism by trade unions and scrutiny by governments.
• Drones could be susceptible to weather, especially to wind and rain.

3. Valuation: Still cheap considering Amazon's growth projections

Regardless of the use of drones as a future game changer, the valuation of Amazon shares based on my valuation criteria is still attractive.

First, in my last article about Amazon, I presented my fair value calculation on a very detailed basis, which is $4,762.53 and corresponds to a potential market cap of around $2.5 trillion. Based on the closing price of $3,294.62 on Friday, this represents a current upside potential of at least 45%.

Second, the last quarterly results of remote work or work from home stocks such as DocuSign (NASDAQ: DOCU) and Zoom (NASDAQ: ZM) could be an indicator that Amazon's growth is also unbroken or has even accelerated.

Compared to these two companies, Amazon not only earns almost exclusively from business customers, but also supplies consumers worldwide with physical and digital goods for everyday use.

While Zoom's Q1 2020 revenue growth was 169% year over year, and Q2 revenue growth was mind-blowing 355%. DocuSign also recorded a sequential growth spurt. Revenue growth in Q1 2020 was 39% year over year, whereas in Q2, revenue growth was 45%.

With regard to Amazon, there were numerous press releases of new hires at a global level (e.g., US, UK, Europe, Africa, India, Australia) in the last few months, i.e., immediately after the publication of the quarterly figures for the first quarter.

The following press releases and reports only refer to new hires reported on Seeking Alpha and most likely to meet the increased and unprecedented demand resulting from the pandemic. There may have been more new hires that we have not heard about:

• Amazon adds 7,000 more UK jobs as e-commerce booms due to pandemic
• Amazon adds 3,500 jobs across six cities
• Amazon roundup: PT raises before earnings, 1,000 Irish jobs added
• Amazon adding 3,000 workers in South Africa
• Amazon to give 125K newly hired temp workers option to stay full time
• Amazon to hire 50,000 temp workers in India

Consequently, there is a high probability that Amazon could also experience a sequential growth spurt and record accelerated growth compared to the previous quarter. This could also mean that analysts' expectations would once again be massively exceeded.

Third, from my own observations, I can say that in three major German cities, the number of pedestrians in the city centers has fallen massively since the outbreak of the pandemic. Based on media reports, the situation in other countries is similar. Even in direct contact with companies, I notice that an increasing number of employees work from home.

People who are hesitant to leave home will tend to prefer to place online orders or seek entertainment at home. In this context, Amazon could be one of the biggest beneficiaries as the best-known e-commerce company with its huge selection of physical and digital goods.

Fourth, as can be seen in the figure below, Amazon has the highest growth rate in terms of revenues among the so-called FAANG stocks.

(Amazon revenue growth in peer group comparison. Source: YCharts)

On the other hand, it offers the most favorable valuation among the FAANG stocks with regard to the forward EV/S ratio. As can be seen in the graph below, Netflix (NFLX) and Facebook (FB) have a valuation more than twice as high as Amazon on a forward EV/S ratio basis (see following chart).

(Amazon forward EV/S ratio in peer group comparison. Source: YCharts)

However, with $13 billion in free cash flows per last quarter, the company generated far more free cash flows than the other two companies (see following figure).

(Amazon quarterly free cash flow. Source: YCharts)

Additionally, as you can see in the following graph, Amazon generated about as much operating income in the last quarter as Facebook with around $6 billion.

(Amazon operating income. Source: YCharts)

At the same time, Amazon has been showing a stable upward trend in terms of operating income for the past five years, while Facebook's figure seems to be stagnating since 2018.

Furthermore, compared to Netflix and Facebook, Amazon has much more diversified business areas and income streams with, for example, e-commerce, subscription offerings, AWS, advertising, grocery stores and third-party sellers.

Going forward, I could imagine Amazon joining the stock split trend, which could create additional demand from investors.

In addition, I could imagine the company being included in the Dow Jones Industrial Average index after a potential stock split, which could become another stock price catalyst.

4. Conclusion

As already mentioned in the article, the use of delivery drones could become another major game changer for Amazon. On the one hand, the use of delivery drones could reduce personnel, warehouse and delivery costs, which are among the company's largest cost blocks. On the other hand, Amazon could use the delivery drones to develop new business areas and generate additional revenue by offering this service to merchants and third-party sellers.

Additionally, the company could further increase customer satisfaction and loyalty through the time-independent and fast deliveries by using drones. Amazon's self-proclaimed vision is to reduce the delivery time to up to 30 minutes.

Furthermore, delivery drones could help it become a more environmentally friendly and sustainable company due to decreasing pollutant emissions, which, in turn, could attract more environmentally conscious customers and investors.

With regard to valuation, the company is still attractively valued with a fair value of $4,762.53, corresponding to a current upside potential of around 45%, according to my calculation based on a DCF method.

Based on the last quarterly results of remote work or work from home stocks such as DocuSign and Zoom, it can be assumed that Amazon's growth may also have continued or even accelerated compared to the most recent quarter. At the same time, Amazon appears to be favorably valued compared to the peer group.

Furthermore, the company potentially joining the current stock split trend and a resulting inclusion in the Dow Jones Industrial Average index could be additional share price catalysts.

Nevertheless, even if the shares appear fundamentally undervalued, unexpected events are always to be expected on the stock market and there is no guarantee of rising share prices. Investors should always bear in mind that stock prices are volatile and should not be influenced by price movements alone, but rather, should pay attention to the underlying fundamentals. In this respect, investors should always pay attention to their individual risk tolerance.

Developments which could put pressure on the stock price are, for example, ongoing antitrust probes, digital tax disputes, investigations in the context of data collection and data security by public authorities all around the globe.

PS: If you liked my article and you want me to write more articles of this kind in the future, then like, comment and share this article. I intend to publish more about tech stocks in future. If you are interested in finding out my favorite technology stocks, just follow me on Seeking Alpha. Thank you for reading!

Analyst’s Disclosure: I am/we are long GOOG, GOOGL, ZM, AMZN, FB, NFLX, DOCU. 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.

Comments

[investor_newbie]

For fair value of $4762, what discount rate did you use?

[Hu Er Yu]

As it currently stands, it would be impractical to use drones. Currently the FAA requires an individual to have a license to operate a drone, the drone must be within physical view, you may only operate one drone at a time, battery lasts around 20-30 minutes. FAR part 103.

[Gary J is Rich on AMZN]

@Hu Er Yu

What are you not getting about this?

"On August 31, CNBC reported that Amazon has received federal approval to use drones for its delivery operations."

FAA approved Amazon's proposal. Period.

[Poteat]

Study up. There are several companies with FAA waivers allowing them to fly BVLOS.

[Marino Anderson]

I like Amazon, but my thesis does not currently consider drone delivery. The current consideration is using mall space for 1)warehouse, 2)whole foods, 3)warehouse showcase. The customer experience is: enter at the warehouse showcase, select items, shop whole foods, pay for everything, pick up from warehouse drop box.

With this model, drone delivery development/implementation can be deferred.

[Poteat]

Drone delivery is going to be essential in reducing last-mile delivery costs in rural areas. If there is a nearby mall, then you know drones aren't going to be implemented in that area.

[Skih20]

Thanks for your insights. I am curious to understand how much it would cost to ship an identical package via drone vs a conventional delivery service. Of course, depreciation, FAA compliance costs, and routine maintenance should be included in the equation. Drones sound “cool”, but the numbers will ultimately dictate how mainstream this becomes.

[Gary J is Rich on AMZN]

@Skih20

You can start with the cost per mile to put trucks on the road - usually a substantial number.

[exufficio]

@Skih20 I envisioned something like a mobile hub-and-spoke. A truck, loaded with drones, drives to a near- optimal, quasi-central point for a number of deliveries. Release the squadron of drones relevant to those deliveries. Drones return. Truck drives to the next quasi-central point for the next squadron and repeat until truck is empty and needs to return to the mother hive.

[Gary J is Rich on AMZN]

Just like I commented about the Delivery Robots they announced. A truck drops off the robot loaded with packages in my gated community and comes back later to retrieve or reload the bot.

[StockHarvestor]

Drone delivery is still and will be a science fiction in near term, how could it become a game changer for Amazon? Remember you are a long time bull for Wirecard - the Dax star from Germany, check how it has developed so far:))

[Güner Soysal]

Dear @StockHarvestor ,

thank you for your comment. I was bullish for Wirecard, but have pointed out in every article that this is only under the condition that the numbers are correct. You should know that if you have really read my articles.

Just like the German authorities and international secret services, I couldn't know that it was a fraudulent company until the moment of the release of the KPMG report.

In the sake of fairness you should also mention that I was also bullish for the following stocks: Apple, Amazon, Facebook, Qualcomm, Paypal, Zscaler etc. See my profile with all my articles: seekingalpha.com/... ;)

Have a nice day!

Best regards,

Güner

[cramerkim]

@StockHarvestor drone delivery is dramatic And practical in rural area.

[Gary J is Rich on AMZN]

@StockHarvestor

"Drone delivery is still and will be a science fiction in near term"

Newsflash: They are already doing it in the U.K.

[ssanghera187]

Anyone else worried about all the electromagnetic radiation we'd be exposed to from this? We already have cellphones and wifi... Now having remote controlled drones flying everywhere too is sure to give people health problems...

The body is electromagnetic, folks...

[Erin Snarkovich]

@ssanghera187 What's that saying about staying quiet and letting people assume you're a fool, instead of opining and removing all doubt?

[cramerkim]

@ssanghera187 I hate electromagnetic but now no choice. Only strong humans survive.

[whoisjohngaltmn]

@ssanghera187 ...I agree with you. I wear tinfoil hats and found it to be very beneficial.

[Michael Dolen]

The thing is, drone deliveries will require human control. Not autonomous. FAA won't change that anytime soon. So rather than pay a driver, you pay someone to fly it from a computer. I'm not sure on the rules of one person operating multiple drones simultaneously, or if that's even allowed yet.

In short, yes some day drone delivery will undercut cost of driver, but that is many years off. Plus, this will only work for the smallest/lightest deliveries.

In dense urban areas where you have door after door, each with an Amazon delivery, the current van method is actually very efficient and will remain so for the foreseeable future.

[It's a TOP]

@Michael Dolen

Drone delivery can be just like modern airplanes. Only landing and take off are under pilot control. The rest of the time it's autopilot. Drones can spend the majority of their flight time autonomous.

[Gary J is Rich on AMZN]

@Michael Dolen

"In short, yes some day drone delivery will undercut cost of driver"

Right, running trucks on the road is free. duh

[Poteat]

80% of Amazon's orders can be delivered via drone. This will be especially useful in rural areas where last-mile delivery costs are greatest.

[Hudson Investments]

I expect that $4,700 is a bit rich for the stock. I see $3,700 to $4K per share by the end of 2020

[Chart Rider]

Can't wait until the first ice storm. Amazon boxes be crashing through house and car windows like armageddon.

[It's a TOP]

@Laughing from the Links

Or they just won't fly during an ice storm just like UPS stops during extreme weather also.

[ssanghera187]

@It's a TOP don't you think it would be hard for a multi-trillion dollar company to just turn on a dime with a, "No drones today, folks! There's a storm about to happen in 2 hours!" type of action? Usually, these behemoth companies take weeks to decide what color drapes to hang on the front headquarters lobby... I don't see them side stepping, dodging and ducking storms on the fly...

[yogatech]

@Laughing from the Links It would make for a funny movie.

"Amazon drones in an Ice Storm"