Have you ever been to an art auction? In this auction, a piece never seen before by Picasso will be auctioned, the painting is called Amazonia. Everyone is going to the auction to either bid or have a pique on that amazing piece of art. The appraised value of Amazonia is 50m and the bidding would start at 5m. Fernando Valor, an expert art investor, realizes the value of Amazonia and bids 10m. David Gruth, an investor that just made his fortune betting on the 2024 student-debt crisis, wants a piece of art and bids 20m for Amazonia. The bidding goes back and forth and David’s latest bid is 49m, Fernando decides to bid 55m, 5m over the appraised value, as his experience suggests that such a rare piece will increase in price. David fires with 60m...after a couple of rounds Fernando wins the bidding war for 100m.
This is a very common situation not just in art auctions, but in M&A wars and even when purchasing “growth” companies. Why would I include growth companies in this basket? If you are a rational investor, you purchase a growth company only if you believe that the growth assumed by the market is lower than what you expect. In this article, I will illustrate the growth implied by the market and try to challenge those assumptions.
Having said that, Amazon is a great company. I have been a loyal customer of Amazon in New York, Toronto and even now in Santiago, Chile! Believe it or not, even including the shipping and customs fees, importing some items are cheaper if I buy them from Amazon rather than buying them here. But a great company doesn’t always translate to a great investment. I believe that Amazon’s shares are pricing lots of growth.
Revenue growth of 16%-22% based on DCF
If we keep all the costs and margins constant, what revenue growth would justify the current stock price? AMZN’s revenues would need to grow 22% for the next ten years. However, if EBIT margin improves to 9%, revenues would need to grow 16%. If margins improve to 30%, growth would only need to be 3.5%.
Source: Author estimates
The margins of the e-commerce business could improve but not significantly mainly due to shipping costs. It is no secret that AMZN is subsidizing the shipping cost. Their bet is that by gaining more market share there will be so many deliveries close-by that delivery per destination will decrease. Also, by offering free shipping to Prime members, AMZN is betting that the convenience of free shipping would trigger customers to buy more items from AMZN even when there is a better deal on other websites. However, I am skeptical about this. First of all, Prime membership is a fixed annual fee but shipping is a variable cost. Secondly, the benefits of Prime membership is not only free shipping but also PrimeVideo, PrimeMusic...etc, all those benefits have to be financed with a portion of the membership fee.
What if we ignore e-commerce and try to achieve the margin improvements from AWS? In order to improve margins closer to 30% only counting on AWS, AWS revenues would need to compose ~75% of AMZN revenues, by the end of 2018, AWS represented 11% of AMZN total revenues.
High implied growth for the next 10 years
The second approach was to take 2018’s FCF (operational cash flow minus capex) and calculated the implied growth rate in the current stock price. The implied growth of free cash flow for the next 10 years should be 16-19% to justify the current stock price...I see this as very optimistic.
Source: Author estimates
A double-click on growth
Any way you see it, AMZN needs to grow high double digits in the foreseeable future. For a company to maintain that growth rate, it either has to increase the pie or cut a larger slice. The pie can grow if the industry grows at that high rate or if the company expands its industry. The only way to cut a larger slice is by taking market share from competitors.
I hope we can all agree that a larger industry is more desirable than taking market share from the competition. In the latter, the competition will not stay quiet and will defend its share costing you money.
So how fast in the pie growing?
E-commerce represented 14.1% of total retail sales in 2019 and is expected to increase to 22% by 2023, by which time, growth of e-commerce would have decelerated to 14.9%.
Thus, AMZN could maintain a high growth just by defending its turf and maintaining its market share. However, the competition is moving. Walmart (WMT), Best Buy (BBY), and Home Depot (HD) are demonstrating significant growth in their online operations.
What about AWS?
According to Gartner, by 2022, the growth of the cloud would slow down to 14.5% leading to the same conclusion as for e-commerce. But the competition in cloud is even fiercer, all the big guys are ready to fight such as Alphabet (GOOG), Oracle (ORCL), IBM (IBM) and Microsoft (MSFT).
I wish I could predict the future but I cannot, however, taking market share from the competition will be costly as those players have big financial backs as well. Gaining market share may translate to higher revenues BUT at a lower margin and once a player triggers the price war, it is a nasty trip down the rabbit hole.
Bezos realized this and opted to try the first option we have discussed, increase the size of the pie. AMZN started that by entering the grocery industry with the acquisition of Whole Foods. The online grocery business could easily grow at a 30% click for the next 5 years, however, I struggle to see how that could compensate the other operations growing at 14%. Furthermore, while you could always purchase peanut butter from AMZN, grocery delivery is more complicated as you need to take into account the expiration of perishable products and keeping the cold chain for proteins such as meat and fish. Other players in the grocery delivery business such as Walmart (WMT) have decades of experience dealing with these issues so have a head start to AMZN.
The risk of regulation
AMZN is already among the largest companies in the world and it is already making noise with politicians. Do you think that regulatory pressure would decrease or increase if AMZN grows above 20% annually for the next 10 years? If that growth projection occurs, AMZN would have taken significant market share from other big players who would pressure the government to do something. I believe that this is the single largest risk AMZN faces nowadays. One potential regulatory solution would be to force AMZN to spin-off AWS and have a Chinese wall between AWS and the e-commerce segment. While that would not solve everything, it would calm the waters.