Amazon: Looking At The Long Term
Summary
- Highly complex situation in terms of logistical disruption, price increases in materials and wage inflation. Opportunity to expand competitive advantage in the long term.
- Fall in margins due to investment mix, inflation and disruption.
- Doubling the annual capex, a very important opportunity in the long term.
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Summary
Amazon's (NASDAQ:AMZN) results have been very interesting, and no doubt, reading between the lines and doing second-level thinking, we can find very striking points.
The guidance shows a very wide range; this is due to supply chain disruption, material and wage inflationary pressures, and COVID cost overruns. In the conference call, we were told that this guidance includes 2b due to inflationary pressures on wages, 2b due to operational disruption and higher transportation costs.
There are numerous quotes about the situation, but among them we can see:
"The demand for labor has recently coincided with the shortage of available workers, particularly in the United States. This began in Q2, but it really started to impact our operations and cost structure in Q3. It has led to wage increases and sign-on incentives as companies compete for workers as well as inconsistent staffing levels in our operations."
"In addition, disruption to the global supply chains and inflation in the cost of materials such as steel and services such as trucking have also raised our cost of operations. We estimate the cost of labor, labor-related productivity losses and cost inflation to have added approximately $2 billion in operating cost in Q3, particularly in August and September. Our Q4 guidance range anticipates that these costs will approach $4 billion in Q4 as we see a full quarter's impact of these effects and a higher seasonal unit volume. "
This and other paragraphs quoted in the conference call give us a context for the drop in margins in the guidance and, above all, the breadth of the range.
This context, a priori should be a cause for concern, since it implies a drop in margins as long as the current situation is maintained. That said, my reading is very different, I believe that this situation can create a very important opportunity to expand Amazon's strength in the sector, which is already very important. From the following sentence we can draw conclusions that lead me to think what I indicate:
"Certainly, the cost of fulfillment in the last few months and what we've forecast into the next quarter are not what we're happy about. But we see ourselves as the shock absorber absorbing a lot of the costs so that the customer is not impacted and sellers are not impacted.
And again, there's just quite limited options in the short run to impact your cost structure. Most companies would delay shipment or add fees or something. We don't think that is customer-centric nor productive. And we will get through this period and then we are committed to getting our cost structure down."
Amazon will not pass these cost increases on to customers, while maintaining the customer experience. The competition will not be able to replicate Amazon's strategy, since it does not have the capabilities of Amazon. This will mean that the difference in quality of service will widen even more, and above all, that many of the more regional competitors will not be able to withstand this situation if it continues over time. Therefore, we have a situation that a priori could seem worrying, but in which, if we think in the long term, Amazon's position should be strengthened, even if the situation becomes even more complicated.
As for Q3, the market was concerned about the drop in margins, although analyzing the situation and putting it in context, it is temporary and not structural. We must understand that in 2020 Amazon benefited from operating leverage on the fulfilment side, as the centers were running at 100% at all times. With normalization this is not the case, and operating leverage reduced its positive impact.
Undoubtedly, the strongest investments have been made for years in the fulfilment area.
Source: Annual Reports and Own Research
Note how the capex on sales has gone from 5% to reach the last quarters above 10%, it has doubled. This clearly reflects Amazon's intentions and that it obviously still sees an important long-term opportunity, doubling its capex over sales, after so many years of investment, clearly reflects that there is still room to grow and compound in the long term.
Regarding the effort in fulfilment, there is a very interesting sentence in the conference call of the third quarter, where they tell us:
"To put this in perspective, we are on track to double our fulfillment network over the 2-year period since the pandemic's early days."
We are talking about doubling the network, a monster with capabilities that are already within the reach of very few. The 3rd party sellers are an increasingly important part, representing 56% of all units sold, a metric that is increasing quarter after quarter.
The investment is not only aimed at further increasing the number of 3rd party sellers, but also at Amazon's shipments increasingly relying on its own transport, with 50% of shipments already being sent through its own network.
All these points give us a very interesting reading on Amazon's current situation, which we can summarize in the following points:
- Very complicated situation in terms of logistical disruption, price increases in materials, wage inflation. Opportunity to expand competitive advantage in the long term.
- Fall in margins due to investment mix, inflation and disruption.
- Doubling the annual capex, a very important opportunity in the long term.
Valuation
Amazon's margins are clearly benefiting from stronger growth in higher margin divisions:
- AWS
- Advertising
- Fulfillment
Undoubtedly, positive news for the long term. In the model, we do not include the positive optionality of Amazon's multiple initiatives: Pharmacy, Health, Gaming, etc...
To build the valuation model, we start from segment sales, which can be constructed from Amazon's memories.
The tricky part is to obtain the margins of these divisions, as Amazon does not provide this information. Through the analysis of comparables and other research sources, we arrive at the margins that you can see in 2020 and use them to project into the future.
Amazon's fastest growing segments are the ones with the best margins, so in year 10 the operating margins double compared to today, and the normalized FCF margin triples.
These do not seem to us to be overly optimistic assumptions, given the current state of the capex cycle and segment projections.
Source: Annual Reports and Own Research
It may seem surprising to see such a high upside for a company so closely followed, but I drew precisely the same conclusion at the beginning of the year with Alphabet, which seemed absurdly cheap.
Amazon, given its growth prospects and competitive position, is trading at an attractive price that offers a double-digit compounding opportunity over the long term.
Risks
- A company like amazon will always have regulatory risk, since its position is so dominant that it will always be under scrutiny.
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Another important point is the Amazon wheel, where all segments have powerful synergies with each other.
A deterioration of the core business (e-commerce) would undoubtedly affect the growth of segments such as advertising, where it clearly benefits from being the most powerful commercial platform in the world. It would also affect subscriptions and even Fulfilment, three key pillars for the expansion of margins and evolution of Amazon over the next 10 years.
- The cloud currently has high barriers to entry, as scale is critical (just look at the fact that Google Cloud has yet to generate a profit). With the technological evolution this advantage can be lost, barriers to entry based on technology and scale are dangerous, as they can be subject to disruption. Much of the attractiveness of the thesis lies in AWS, given its expected growth and very accretive margins for Amazon.
- Optionality is always positive, but it is also resource-intensive. Amazon Pharmacy, Amazon Health, Amazon Music, may be segments that do not end up fitting and consume considerable capex for years.
Conclusion
As new quarterly reports come out, I see Amazon's position getting stronger, benefiting from strong growth in the more profitable divisions, while investing heavily to strengthen its moat. In the long run, the combination of the two is certainly a winner.
The price at which it is currently trading is reasonable for Amazon's competitive position in its segments, yielding an interesting upside as long as our time horizon is long term (given that there may be volatility due to the aforementioned reasons).
This article was written by
Analyst’s 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.
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