Amazon: The Market Is Overlooking This Fundamental Trend
Summary
- Amazon's post-earnings sell-off was an overreaction.
- Amazon has dramatically increased its capital expenditures.
- The company is trading at a discount to its intrinsic value.
Amazon (NASDAQ:AMZN) has seen a hefty pullback recently after guiding for slower growth in the third quarter. The market seems to be focusing on the e-commerce slowdown despite having another potential trillion-dollar business hiding within the company. We are referring to Amazon's real money maker, AWS which we covered recently in a previous article. We suggest taking a look if you're interested in learning more about AWS and why we think it's a major growth catalyst for the company. In addition, we cover the main risks involved in holding Amazon's stock.
However, today's article will not be focusing on AWS. Instead, we want to talk about what the market is potentially missing from the recent earnings call. In addition, we will take a look at Amazon's new plan to open up department stores and provide an updated valuation with recent numbers.
What the Market Overlooked
This is all part of a multiyear investment cycle for us. Unit volumes, while obviously growing at lower rates off last year's large comp, continue to remain high, and we see strong demand for FBA [fulfilled by Amazon] and third-party sellers.
These are the words of CFO Brian Olsavsky. The company has drastically increased its Capex spending in recent quarters.
Source: Finbox
As you can see from the image above, spending in the last 6 months has almost doubled compared to the same period last year. When comparing the most recent 4 quarters to the earlier 4 quarters pictured above, we can see that capital expenditures more than doubled.
An interesting trend emerges when we compare the increase in capital expenditures and the revenue growth rate.
We can see that Amazon's revenue growth tends to accelerate when capital expenditures are increased. Both metrics move almost in tandem with the exception of the period around 2006 where the benefits from the capital expenditures lagged a little. This makes sense because sometimes the benefits from investments might take a little longer to be realized.
This trend also appears when comparing revenue growth to increases in SG&A:
Source: Finbox
Obviously, as spending increases on facilities, the company also needs to hire new employees to operate the facilities.
Therefore, while growth is expected to "slow" because of difficult comps, it's very reasonable to assume it will once again accelerate as the company invests to improve its fulfillment centers and logistics:
First, we are adding a lot of capacity. If you step back, the Amazon fulfilled unit volume, so that's the units coming out of our fulfillment centers both retail and FBA have doubled in the past 2 years. And the AMZL, the delivery arm of our business, has more than doubled in that time period. So, you can see there's been very strong multiyear demand here that we're still catching up with from last year.
As the CFO stated in the quote above, Amazon is still trying to catch up with the demand that it is experiencing. This also boosts our belief that revenue will accelerate after the tough comps pass. Once Amazon catches up to the demand, it'll be able to meet it more efficiently and deliver more packages resulting in higher revenues.
Amazon to Open Department Stores
After disrupting the retail industry for decades and driving some once-prominent brick-and-mortar department stores to bankruptcy, Amazon has now decided to open up its own. The company already has some physical locations which include Whole Foods and other small stores for books and groceries.
The new retail spaces will be around 30,000 square feet, smaller than most department stores, which typically occupy about 100,000 square feet, and will offer items from top consumer brands. The stores will have a footprint similar to scaled-down formats that Nordstrom (JWN), and other department-store chains have begun opening.
Some might be wondering whether or not venturing into physical locations makes sense for Amazon. We believe it does because most shopping is still done in person.
In fact, over 80% of Americans still shop in person as per the image above. E-commerce has made things much more convenient and is still expected to see strong growth in the long term. However, it's unlikely to outright kill brick-and-mortar altogether. Instead, e-commerce has raised the bar for physical stores where customer experience is now a crucial part of success. In addition, e-commerce still does have some limitations. There are times where people want or need a product right away and can't wait for it to be shipped.
Moreover, Amazon is sitting on a huge pile of data that gives it a great insight into what customers want at different locations. This obviously increases the chances that the stores will be successful. Although it likely won't make a significant impact on revenue anytime soon, it makes sense for Amazon to venture into this space in order to complement its online marketplace.
Valuation
To value Amazon, we will use a 5-year DCF with growth and margin estimates from analysts.
Our Assumptions:
- Risk-free rate: 1.26%
- Equity risk premium: 4.7%
- Beta: 1.14
- Equity cost: 6.67%
- Tax rate: 21.00%
- Cost of debt: 1.60%
- Cost of debt after-tax: 1.26%
- Weight of equity: 93%
- Weight of debt: 7%
- WACC: 6.29%
- Perpetual growth: 2.25%
Source: Data by Finbox
As you can see, analysts expect its revenue growth rate to continue declining over the next 5 years. However, Amazon would still have a 22.8% upside in this scenario under the current low-interest-rate market conditions. Therefore, if history is any indication, and revenue does in fact accelerate, then the upside should be even higher.
Final Thoughts
Although we believe the market is overlooking the impact that Amazon's increased capital expenditures tend to have, the company is still trading at a discount to its intrinsic value based on what analysts are expecting. Therefore, we remain bullish on Amazon.
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.