Bureaucracy defends the status quo long past the time when the quo has lost its status." - Laurence J. Peter
Today we give our take on the online retailing behemoth Amazon (AMZN). The stock has quadrupled over the past five years, but the shares have spent the past 16 months marking time. We take a shot at a ‘sum of the parts’ analysis and valuation in the paragraphs below.
Amazon.com, Inc. is the self-acclaimed “consumer-centric” behemoth that, amongst many descriptors, is both the world’s largest online retailer and the world’s largest provider of cloud infrastructure. One of the greatest business success stories in history, a $1,500 investment on the (then) online bookstore’s IPO in May 1997 is now worth ~$1.9 million. With ~750,000 full and part-time employees, Amazon’s workforce has eclipsed the population of Seattle, home to its worldwide headquarters. The company’s 2019E sales would make it the 43rd largest economy in the world, slightly ahead of Finland. Thanks in large part to its burgeoning digital advertising and cloud offerings businesses, shares of AMZN ascended more than six fold in 45 months to became the second company after Apple (OTC:APPL) to achieve a market cap of $1 trillion in September 2018. Since then, its stock has pulled back, trading in a narrow range for most of 2019, and currently valued at ~$940 billion.
Central to its revolution of the marketplace for purchasing consumer goods, Amazon has developed a loyal following of ~110 million Prime members, who enjoy free next day (or in some instances same day) shipping for online purchases, unlimited reading on any device, and significant discounts at Whole Foods, amongst other amenities in exchange for a $12.99 a month or $119 annual fee. It has sold over 100 million devices housing personal AI assistant Alexa, who can control 85,000 smart home products from over 9,500 unique brands. Despite her many talents, Alexa has not rendered an opinion as to whether Amazon’s stock is merely consolidating its gains for its next move higher or forming a top.
Amazon disaggregates revenue into North America, International, and Amazon Web Services (AWS). North America and International encompass ecommerce, brick-and-mortar retail stores, third-party ecommerce services, consumer electronics, media content, advertising, and unparalleled distribution and logistics services amongst many other offerings. AWS comprises sales of compute, storage, and database services in the cloud for start-ups, enterprises, government agencies, and academic institutions.
North America was responsible for operating income of $7.4 billion on revenue of $161.2 billion in the last twelve months ending September 30, 2019 (TTM3Q19) versus operating income of $6.7 billion on revenue of $134.5 billion in TTM3Q18, representing 10% and 20% increases, respectively. Operating margins have contracted over the same periods from 5.0% (TTM3Q18) to 4.6% (TTM3Q19) as the company has built out its one-day shipping infrastructure.
International accounted for an operating loss of $1.7 billion on a 14% increase of revenue to $71.7 billion in TTM3Q19 as compared to a loss of $2.4 billion on revenue of $63.1 billion in the prior year period.
AWS, although the smallest contributor to the top line at $32.5 billion TTM3Q19, is the largest contributor to the bottom line with operating income of $8.8 billion. This segment is also Amazon’s fastest grower with revenue up 39% and operating income improving 36% versus TTM3Q18.
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It is easy to infer from the segment breakout that cloud computing services will be one of the most important drivers of growth for the company in the new decade. Fortunately for Amazon, the public cloud system infrastructure services market – a relevant segment of the public cloud market – is supposed to grow by 22.5% per annum through 2023 to $74.1 billion, according to Gartner. AWS was the first mover and is still by far and away the biggest vendor in the cloud, but Microsoft (MSFT) and others are making notable inroads. For example, Amazon’s market share of renting out cloud infrastructure has declined from 53.7% in 2016 to 47.8% in 2018 while Microsoft captured 15.5% of the market in 2018, up from 8.7% in 2016. These trends continued in 2019 (see chart above). Part of Microsoft’s strategy has been to tell customers that if they use AWS’s cloud services, they will be placing vital consumer and product information in the hands of a competitor.
Also, in October 2019, Microsoft won the Pentagon’s Joint Enterprise Defense Infrastructure (JEDI) cloud computing contract valued at ~$10 billion that many analysts assumed was earmarked for AWS. The JEDI award puts Microsoft in a prime position for future government and enterprise contracts linked to government agencies, as it will host the cloud on which the AI will work. The additional government contracts alone are worth ~$40 billion over the next several years, according to the New York Times.
The final decision was rendered after President Trump made disparaging remarks, both publicly and privately, about Amazon potentially being awarded the job. It is no secret that Trump is no fan of the coverage/criticism he has received from Amazon CEO Jeff Bezos’s The Washington Post. Amazon has responded to the contract loss by filing a claim against the Pentagon, alleging Trump exerted “improper pressure”. Irrespective of its final adjudication, the entire episode illustrates AWS’s vulnerability, or a perception of vulnerability in the federal government sector while Trump is in the White House. More importantly, it exemplifies the changing dynamics in the cloud computing marketplace.
Microsoft is not the only deep-pocketed competitor in cloud computing. In 2018, Oracle (ORCL) announced plans to increase to size of its cloud-computing workforce. Then in July 2019, IBM shook up the cloud market with its $34 billion acquisition of Red Hat Inc., the largest provider of open source cloud software, to bolster its cloud offering. Alphabet’s (GOOG, GOOGL) Google has also dedicated additional resources to this area, purchasing data-analytics firm Looker for $2.6 billion in June 2019. These competitive advances suggest that in the 2020s, AWS will command a diminishing share of an expanding pie.
On the other side of the political aisle, Amazon’s grip on the retail and cloud markets has elicited calls for the company to be broken up by Democratic presidential hopefuls Bernie Sanders and Elizabeth Warren. While this can be brushed aside as the rhetoric of socialists pandering to their far left base by using Amazon as a ready-made punching bag, the words of Amazon’s third employee Paul Davis cannot. He recently suggested that Amazon Marketplace should be broken out of the company stating that it’s not good when “the company that operates the marketplace is also a retailer. [Amazon has] complete access to every single piece of data and can use that to shape their own retail marketplace.” The company’s practices are the subject of investigations by the EU’s Competition Commission, the U.S. House of Representatives, and the Federal Trade Commission.
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Sum of the Parts Valuation:
With these monopolistic issues not only the focus of congressional and regulatory authorities, but also a sales pitch of Microsoft, it may be instructive and relevant to see what Amazon would look like broken up. Even though Amazon splits its business up into three segments, it essentially provides results on five business units (or six, depending on one’s perspective) in its supplemental data: AWS; Advertising; Physical Stores; Third-Party Services, as well as Domestic and International ecommerce.
AWS is clearly the company’s most valuable segment, although it will only account for 2019 revenue of ~$36 billion, or 13% of the $279 billion consensus total. Since Amazon’s biggest competitors (Microsoft, IBM, Oracle) are not pure-play cloud companies, a basket of larger cap, “purer” cloud companies – not necessarily direct competitors – such as Service Now (NOW), Atlassian (TEAM), Twilio (TWLO), Salesforce.com (CRM), Shopify (SHOP), and Zendesk (ZEN) can provide a more accurate valuation for AWS. These cloud companies are trading (on average) at ~16.6x’s 2019E revenue. Applying that metric to AWS produces a ~$600 billion market cap, approximately the same size as Facebook (FB), only smaller than Saudi Aramco (ARMCO), Microsoft, Apple, and Google. However, removing outlier Shopify (31x’s) from the comps results in a 13.8x’s 2019E revenue valuation, or ~$500 billion. This assessment seems more reasonable considering the fierce competitive environment in which AWS is likely to lose meaningful market share and experience margin compression in the coming years.
Advertising is another significant growth driver. Digital ad revenues are expected to reach ~$14 billion in 2019, representing a ~40% increase over 2018, decelerating from 117% growth in the prior year. This business deserves a premium multiple not only because of its fast top-line growth, but also due to its solid (likely mid-20%) operating margins. Facebook and Google are the proper comps and currently trade at ~8.5x’s 2019E sales of ~$70 billion and 5.9x’s 2019E revenue of $163 billion, respectively. Facebook’s higher multiple is more appropriate (and possibly a bit low) as Amazon is still poised to gain meaningful market share as increasingly more product searches are conducted on its site. Applying Facebook’s multiple to Amazon’s Advertising unit provides a market cap of ~$120 billion.
The other area of strong growth with solid margins for Amazon is the aforementioned marketplace (Third-Party Services), which generated 2019E revenue of ~$52 billion, up 22% from 2018, which gained 35% over 2017. Third-party sellers account for ~60% of sales in the company’s stores, so it’s not surprising to see Amazon pivot towards this lower top line, higher-margin business to compensate for some of its other initiatives such as one-day shipping and incremental content investments. Using eBay (EBAY) as a guide, Amazon’s Third-Party Services unit would be worth ~$140 billion as a standalone at 2.7x’s 2019E revenue. This valuation is too low for the simple reason that Amazon is growing revenue in the mid-20s, much faster than eBay’s typical mid-single digits performance that flatlined in 3Q19. Etsy (ETSY) and Mercari (OTCPK:MCARY), although smaller, are a better measure of value, owing to their relatively similar growth rates. Their average price to sales of ~5.8x’s 2019E revenue bestows Third-Party Services’ with a more accurate ~$300 billion price tag.
By contrast, Physical Stores – mostly the result of the company’s $13.7 billion purchase of Whole Foods in 2017 – is a low-margin, no-growth business for Amazon that will provide the company with revenue of ~$17 billion in 2019. Using Walmart (WMT) and Target (TGT) as comps, the Physical Stores unit is worth ~$12 billion, or roughly .7x’s 2019E sales.
That leaves Amazon’s online retail operations, which include the sale of its books, music, videos, games, software, and for the sake of this exercise, subscription services. When factoring out already covered contributions from advertising, third-party services, and physical stores, online retail is slated to account for 2019E revenue of ~$160 million, of which ~$105 billion is North America with ~$55 billion* International. The company’s North America and International online segments are in different phases of the business lifecycle with North America migrating from Prime member acquisition to engagement, whereas Europe and Japan are still in the Prime member acquisition phase. Either way, once high-margin advertising and third-party marketplace revenues are stripped out, North America online retail becomes a perpetual money loser as does the less-developed International unit, which lost $1.7 billion in the TTM3Q19 with the contribution from advertising and the marketplace.
Buying into a stream of negative operating margins – not net income, but operating income – would imply a negative value. The real value of Amazon’s online retail operations (when combined with its third-party marketplace) is the platform it provides to generate high-margin digital ad revenues. Assigning a Walmart-esque valuation of .64x’s 2019E revenue would imply a ~$102 billion valuation.
These (admittedly) crude valuations (AWS $500 billion; Advertising $120 billion; Third-Party Services $300 billion; Physical Stores $12 billion; Online Retail and Subscription Services $102 billion add to a total of $1.034 trillion, or ~$2,085 per share.
Other Attempts at Valuing Amazon:
It should be noted that Morningstar conducted a similar exercise in October 2019, breaking out Amazon into five business units but arranging them slightly differently. Similar to the analysis above, Morningstar calculated valuations for AWS ($554 billion), Advertising ($126 billion), and Physical Stores ($19 billion), but elected not to assign a specific valuation to Amazon Marketplace, instead combining the company’s Third-Party Services with its Online and Subscription units and splitting that into North America ($299 billion) and International ($147 billion), stating (correctly) that “those functions all work together to enhance Amazon’s network effect with margin profiles that depend on one another.” The rationale in this report behind splitting out the third-party marketplace is that is a current target of politicians, ex-employees, and possibly the regulators. Either way, Morningstar’s sum-of-the-parts arithmetic arrived at $1.145 trillion, or ~$2,300 per share.
Possibly the most telling narrative originates from the Street analysts who follow Amazon. Currently, ~44 analysts render opinions on the company and only one (China Renaissance Securities) has a hold rating, with 27 buys and 16 outperforms comprising the balance of recommendations. Given the overwhelming admiration from the Street, one would expect some nosebleed price targets; but that is not the case. Their median twelve-month price target is $2,150. That’s like saying a stock currently trading at $19 is a buy with a price target of $21.50. Thirteen percent upside for a stock that pays no dividend is not typically appealing to investors or worthy of a “buy” rating. Further reinforcing the groupthink mentality of Street analysts: despite all the positive ratings, only four have a twelve-month price target north of Morningstar’s $2,300, representing approximately 20% upside.
Make no mistake, Amazon is an extraordinary company and one that is very difficult to appropriately value. Its stock currently trades at ~2.8x’s 2020E Sales and 70x’s 2020E EPS. Supporters will counter that because of its incessant reinvestment in its businesses, P/E ratios need not apply as Amazon’s proper valuation metric. On what many consider a fairer measure of its true value, Amazon trades at ~27x’s TTM cash flow and 40x’s TTM free cash flow. Those valuations do not appear cheap considering the company’s most profitable and fastest growing reporting segment is going to experience increased and intense competition from many of the largest companies on the planet, portending reduced market share and likely lower operating margins, never mind the political and regulatory uncertainty.
To be sure, Amazon has a very strong foothold in the cloud and a growing presence in another business that will also experience significant growth over the 2020s: digital advertising. And it certainly has the wherewithal from technical and financial standpoints to become a major player in the B2B market. However, with each one of its current business units experiencing decelerating revenue growth, to-the-moon valuations are no longer in order. And to a large extent, the market and analysts have recognized this, based on their uninspiring price targets. This report’s exercise also produced a tepid valuation, demonstrating that because its digital advertising, third-party services, and ecommerce platform are all dependent upon each other for success, the sum of the parts at Amazon is not greater than the whole.
As such, the it has entered the realm of outstanding company, not so exciting investment proposition. This is not to say that Amazon is going to lose 25% of its value tomorrow; it’s just to say there are better places to park your money in my opinion.
I do wish 'mini-options' were available on Amazon as I think the stock would make a solid buy-write candidate at current levels. This strategy would allow one to create a 'synthetic' income stream even if the shares continue to trade level. However, given the stock's approximate $1,900 a share level, one would have to shell out over $175,000 to complete one order using the July $1900 call strikes; more than rich for the average investor.
Bureaucracy gives birth to itself and then expects maternity benefits."-Dale Dauten
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Thank You & Happy Hunting