Amazon: Trading At A Bargain, AWS To Contribute To Margin Expansion
Summary
- Amazon Web Services is the industry leader in cloud computing.
- We believe AWS will be a major contributor to Amazon's expected margin expansion.
- Amazon is currently trading at bargain prices under current market conditions.
Recently, we wrote an article comparing the "FANGMA" stocks where we talked about why Facebook (FB) is currently the best, quantitatively speaking. However, we wouldn't recommend sleeping on Amazon (NASDAQ:AMZN) because its AWS segment has seen strong growth and seems likely to continue doing so. Its high margins will continue to boost Amazon's bottom line as it becomes a larger part of the revenue mix.
How Amazon Makes Money
Amazon breaks its revenue down into three segments:
- North America
- International
- AWS
As you can see, the North American segment is by far the largest with AWS making up only a fraction of total revenue. Amazon further breaks down its revenue into 6 smaller groups:
- Online stores
- Physical stores
- Retail third-party seller services
- Subscription services
- AWS
- Other
With this breakdown, AWS is the third-largest segment behind online stores and retail third-party seller services.
AWS Industry Analysis
Amazon Web Services operates in the cloud computing industry which is expected to grow at a CAGR of 17.9% from 2021 to 2028 and is estimated to be worth $791B. More specifically, AWS operates in the sub-industries of infrastructure-as-a-service, platform-as-a-service, and software-as-a-service.
The IaaS, PaaS, and SaaS industries are expected to grow at CAGRs of 27%, 13%, and 12.5%, respectively, from 2021 to 2025. The growth of cloud computing can be attributed to some key factors. To begin with, it has become more cost-effective to store data on cloud providers than to set up data storage on-premise. The upfront costs are quite significant along with the maintenance costs especially since it requires highly trained workers with high wages to maintain. It also helps that most cloud computing businesses are built on a pay-as-you-go model which allows companies to pay for only what they need.
In addition, compliance requirements and cyber threats are increasing. Thus, it makes more sense to outsource to platforms that specialize solely in data storage and cybersecurity. The last thing a business wants is to have to shut down operations because of a ransomware attack.
When it comes to market share, AWS has been the steady leader over the past years.
Although big competitors such as Microsoft (MSFT), Alphabet (GOOG) (GOOGL), and Alibaba (BABA), have increased their market share, it has not come at the expense of Amazon Web Services. International Business Machines (IBM), and smaller players classified as others are the ones who have been losing out to the giants. This suggests that AWS currently has a competitive advantage over the big players.
Currently, Microsoft Azure has a higher growth rate than AWS.
It's important to note that AWS has significantly higher revenues than Azure which is why, on a percentage basis, the growth is higher. Both platforms however, are seeing a deceleration in growth rates as their revenues continue to grow.
DuPont Analysis
Referencing the DuPont analysis from our Facebook article, there is an interesting pattern that is developing for Amazon.
Source: Finbox
Net profit margin measures the ability to make money, asset turnover measures the efficiency of operations, and equity multiplier measures leverage. In essence, an increase in ROE is favorable when driven by increases in net profit margin and asset turnover. It's much less desirable when primarily driven by leverage.
What is interesting about Amazon is that ROE has been increasing despite a decrease in asset turnover and leverage. It has been primarily driven by increasing profit margins. The decrease in leverage indicates that the return on equity metric is trending towards being an increasingly more accurate way of assessing Amazon's performance. The downside is that it's becoming slightly less efficient as it continues to grow and we would like to see the asset turnover ratio improve. In addition, although leverage is trending down, it still has much work to do to reach levels similar to Alphabet, Microsoft, and Facebook.
Valuation
To value Amazon, we will use a 5-year DCF with growth and margin estimates from analysts.
Our Assumptions:
- Risk-free rate: 1.43%
- Equity risk premium: 4.70%
- Beta: 1.15
- Equity cost: 6.84%
- Tax rate: 21.00%
- Cost of debt: 1.80%
- Cost of debt after-tax: 1.42%
- Weight of equity: 94.60%
- Weight of debt: 5.40%
- WACC: 6.54%
- Perpetual growth: 2.25%
Source: Data by Finbox
Therefore, based on what analysts are expecting to see from Amazon and under current market conditions, the DCF suggests that it is undervalued.
When taking a look at EBITDA in the image above, you can see that analysts are expecting margin expansion as the EBITDA margin starts off at 12.5% and gradually increases every year until it reaches 20.2% in 2025. We believe that the catalyst responsible for this expectation is the AWS segment as it has high margins and is continuing to expand (see below).
Source: Author using revenue and operating income data from Statista
When breaking down each segment into revenue, EBIT, and EBIT margin, we get a clearer picture of what has been driving Amazon's growing profitability margins that we saw in the DuPont analysis.
The North American segment has seen margins remain in the low to mid single digits with margins decreasing in the past 3 years despite revenue exploding. The international segment has had mostly negative margins in the past few years and has been a drag on earnings. Although it is finally positive, we expect it to perform similar to the North American segment as it offers the same products/services with the only difference being to different countries.
Amazon Web Services, on the other hand, has seen outstanding growth in both revenue and margins. Revenue has gone from $7.88 billion in 2015 to $45.37 billion in 2020. EBIT margin has increased quite a bit from 19.12% in 2015 to 29.82% in 2020. This demonstrates that AWS has significant operating leverage as revenues increase whereas the other segments require much more investment.
Risks
A risk that is commonly spoken about with regard to Amazon is the perceived regulatory risk. It is sometimes feared that regulators will step in and break up Amazon into smaller entities. So far, it has been a losing battle for regulators as they have been unable to successfully implement back-breaking changes. However, if Amazon was broken up, it would arguably become more valuable as the market better prices the spun-off entities. It's common for excellent companies with many different segments to be undervalued. The reason is that there is sometimes not enough data disclosed to fully analyze each business unit.
A second risk is that it may expand into new industries in which it will not have the ability to leverage its current resources to establish a competitive advantage. Such a move would be a drain on resources and could potentially compress margins. Nonetheless, Amazon has so far delivered a strong track record in being able to expand into new businesses, and we see little reason to believe it will enter a catastrophic industry.
In addition, Jeff Bezos recently stepping down from his CEO position adds some uncertainty since the new CEO, Andy Jassy, has a large role to fill. However, Bezos will still have lots of influence at the company as the executive chairman. Here's a recent quote from analyst Daniel Elman:
He'll likely still stay involved, though no longer focusing on the day-to-day and instead able to focus on company-wide initiatives and new products and services," said Daniel Elman, global technology analyst at market research firm Nucleus Research. "His skills for cutting through noise identifying high-value opportunities cannot be overstated ... so it would make sense for Amazon to free him from the operational grind to maximize those areas.
Based on the quote above, Bezos stepping down could potentially be a positive thing. We'll just have to wait and find out.
Also, we do think Andy Jassy has what it takes to replace Bezos since he built AWS from the ground up and has been with Amazon since 1997. We believe that he will continue to bring forth an innovative mindset that should keep Amazon's growth intact for at least another decade.
Conclusion
Amazon is a heavyweight with diversified revenue streams. It is currently an excellent business trading at a discount to intrinsic value based on the market's expectations. We believe that its AWS segment will be a major contributor to its expected margin expansion in the DCF as it continues to grow at a high rate.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of AMZN either through stock ownership, options, or other derivatives. 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.