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Amazon Gives More Than 110% And Still Offers Upside

|Includes: Amazon.com, Inc. (AMZN)

Amazon (NASDAQ:AMZN) shares returned more than 110% YTD. Despite being a long time customer, I didn't get interested in the stock until the sub $300 mark when the discounted value of future earnings made the valuation compelling. After more than doubling in less than a year, it's time to revisit the valuation.

Growth

Earnings per share (NYSEARCA:EPS) are expected to be $1.867 for FY15 which would mean shares are trading at 356x earnings. EPS for FY16 are expected to grow +196%. FY17 earnings are projected to rise +84%, and FY18 +45%. The projected compound annual growth is 99% per year.

Valuation (P/E)

The forward multiples (non-discounted) are 120x, 65x, and 45x based on the current stock price. Discounting earnings back at AMZN's cost of capital (9.29% equity WACC as provided by Bloomberg) and you find that AMZN shares are at 59x discounted projected future earnings (FY18). Not bad for a company expected to double earnings for the next several years.

A screen of the Russell 1000 and consensus estimates reveals that the only other company projected to grow earnings as quickly as AMZN is TerraForm Power, Inc. (NASDAQ:TERP). With projected earnings of just $0.135 in 2018 TERP has a discounted future PE of >120x.

Valuation (FCF Yield)

Since earnings are subject to one-time charges and easier to manipulate, I also like to look at cash flow metrics - in this case free-cash-flow yield (FCF/stock price).

Today Amazon looks expensive vs the benchmarks with a FCF yield of ~1.74% vs the S&P 500 5.61% and the Russell 1000 5.12%. However, AMZN has always had a discounted FCF yield (premium valuation). The premium was justified by investors looking at the underlying sales growth and drawn by the promise of 'eventually' when AMZN would reward loyalists.

Since 1998 the FCF yields for the S&P 500 and the Russell have been ~5.53% and 5.09% respectively. We saw overvaluations (low yields) before the bursting of the tech bubble, and very high yields (discounted valuations) during the global financial crisis. Generally FCF yields have ranged between ~3% and 7.5%.

During that time AMZN has consistently had a much lower (even negative) FCF yield. The historic average spread has been -4.2%.

As evidenced by the share price move this year, something has changed at AMZN. Free cash flow and earnings, once negative, are now positive and growing rapidly.

FCF projections in green are sell side consensus numbers as provided by Bloomberg. Shares are estimated by me based on average share growth over the past four years.

So what does this mean for the stock price?

I present several scenarios. In each case I assume AMZN meets consensus FCF projections and shares outstanding continue to grow by about 0.8%/year. In the bull case AMZN continues to command a premium valuation and trades at the current 1.76% FCF yield.

In the bear case I assume the spread between the benchmark FCF yield and AMZN closes rapidly. This equates to a FCF yield on AMZN shares of 3.375%, 3.73% in 2017, 4.37% in 2018, and 5.00% in 2019.

In the "Mkt Rate" case (which I consider an extreme case), Amazon immediately begins trading at the present S&P 500 FCF yield rate of 5.61% which is above historic averages for the market and seemingly inappropriate given AMZN's monster growth projections.

In my base case I assume the gap between AMZN's present premium and the market rate closes, but at a pace more consistent with normalization. AMZN's FCF is increase by more than 50% next year, but moderate to +30% in 2019. In my base case I have AMZN's FCF yield equaling 2.00% in 2016, 2.50% in 2017, 3.5% in 2018, and 3.75% in 2019. This still leaves AMZN shares at a healthy premium to the market but I believe if the company continues to execute as expected, the premium will continue to be warranted.

Note the convergence between the base and bear cases as my assumed FCF yield for AMZN rises (spread between market and Amazon shrinks).

If free cash flow matches consensus and my base case holds true, AMZN shareholders will be rewarded with compound annual returns of >20% for several more years.

With an AA- credit rating and ~$15B in cash and $9B in debt (down from $16B at the end of FY14) AMZN's balance sheet looks secure. AMZN continues to disrupt markets and drive innovation. The potential addressable market for AWS is staggering. Investments in warehouses and logistics are bearing fruit and more and more retailing is going online.

I continue to like AMZN shares for the long term.

Disclosure: I am/we are long AMZN.