Everyone has been talking about Amazon for years now. The stock has been one of the prime (pun intended) examples to show that making big losses in the beginning is not a bad thing, because they can turn into huge profits in the long-term. This narrative has been the key reason why small companies making huge losses currently trade at incredibly high valuations. Everything can become the next Amazon.
Amazon has also been mentioned as a threat to almost every other company that I know. Just like winter in Game of Thrones, the go-to sentence is “Amazon is coming”. For example, one of the largest web shops in the Netherlands (CoolBlue) had some operational issues at the start of the covid-19 induced crisis. Every single news channel went wild with rumors that they might had been acquired by Amazon. Spoiler alert: it turned out to be untrue. I personally also still believe that Ahold Delhaize, owner of the Dutch web shop Bol.com, would trade much higher if people would not have been saying that Amazon is also coming for them for over five years (if not longer already). Similarly, when Amazon starts a collaboration with any company (such as recently with Slack) rumors pop up that this is the start of another take-over.
Amazon rocked the news again this week, announcing incredible second quarter results due to covid-19. So I decided to put Amazon on my potential list for hot takes – and my Twitter followers voted in favor. The big question I aim to answer in this post is: is winter, in line with covid-19, finally here?
The most valuable company in history is, allegedly, the VOC – better known as the Dutch East India Company – at an inflation adjusted market capitalization of $8.28 Trillion (1637). Incidentally, the VOC was the company that pioneered the modern day stock market in Amsterdam in the early 1600s. The VOC used the stock market to finance its risky endeavors to conquer the world.
What did the VOC do? Today it is mostly known as a trade and shipping company with shipyards in Amsterdam, many warehouses and offices across Asia, and trading posts across the world. As history is told by the victors, people often forget that the VOC had a self-maintained monopoly on trade east of Cape Town. The activities of the VOC went far beyond simple trading and included managing an entire war fleet to protect its monopoly, controlling jurisdiction in its territories and even producing its own coinage.
What does this have to do with Amazon? Well, Amazon is not that different. Amazon is (i) using the stock market to finance its risky endeavors to conquer the world, (ii) is mostly known as an e-commerce (trading) platform, and (iii) its activities go far beyond simple e-commerce (trading). There are more similarities, like underpaying employees, but I intend to avoid such sensitive topics.
Amazon’s market capitalization currently stands at around $1.58 Trillion ($AMZN), so it still has a long way to go to surpass the VOC as the most valuable company in history. However, its 120+ P/E ratio implies that some people expect it may have a chance to grow a lot higher.
Introduction to Amazon
Amazon started selling stories as an online bookstore in 1994 (under the name Cadabra). Today, in 2020, Amazon is part of the big four tech companies in terms of market capitalization: Microsoft, Apple, Google, and Amazon. But then I hear you ask: how can an online bookstore (or e-commerce platform for that matter) be part of these global behemoths? The answer is that Amazon is doing much more than e-commerce. Amazon is actually doing almost everything.
It is hard to find a comprehensive overview of everything Amazon owns and does, so I tried my best to make my own visual to show what they all do and how it is supposed to connect with each other. But let’s first dive into Amazon’s culture.
Amazon has a very strong corporate culture, as becomes clear in Jeff Bezos’ shareholder letters. The main thing you will notice is that he is talking about ‘Amazonians’ when mentioning Amazon employees, a term I had never heard before and that honestly lacks some spark and creativity (I would personally vote for ‘Amazers’). Something else that stands out are the four principles of Amazon:
- Customer obsession rather than competitor focus
- Passion for invention
- Commitment to operational excellence
- Long-term thinking
When you realize this is the core of the company, then you understand why the logo has a (customer) smile in it, and why Amazon does so many different things.
As a reminder to the outside world that Amazon still perceives itself as a growing and starting company, Jeff Bezos always attaches a copy of the original 1997 shareholder letter and reminds the reader that today is ‘Day 1’.
Amazon Web Services (AWS)
Amazon’s main business is actually its Amazon Web Services (AWS). This is a cloud infrastructure business similar to that of Microsoft (Azure), Google (Google Cloud), Apple (iCloud), IBM, Alibaba in China and Nippon Telegraph and Telephone (NTT) in Japan, where businesses store their data in a centralized location instead of an on-premise location.
While many new businesses continue to enter the market and incumbents try to increase their market share, the market as a whole is growing at such a high pace that every player still has a lot to gain. Nevertheless, Amazon decreased its prices for AWS in 2019 and states that it will continuously try to reduce its prices for their customers.
Amazon also states that all of the industries it operates in are highly competitive, which at least to me means that even Amazon is aware that it is unclear how profitability in the cloud computing industry will turn out to be when growth starts to slow down. However, as the market leader with a market share of 33% and no sign of decreasing growth this may be a concern for later.
Everything Else and Other
Amazon leverages AWS to support all of its customer-oriented businesses. The main pillar of this business is not surprisingly e-commerce, which includes both the products that they buy and sell themselves as well as third-party services, where businesses use Amazon.com as a platform to sell their own products (and where Amazon in some cases also fulfills the orders). The physical stores (including WholeFoods) offer synergies with the e-commerce business through Amazon Fresh and other smart store concepts such as Amazon Go.
Amazon offers many adjacent services to enhance and support the e-commerce experience. The first are subscription services, which include Amazon Prime Video, Amazon Music, Audible and Twitch. These subscriptions lure in customers to the e-commerce platform and customers of the e-commerce platform can be referred to these subscription services for books, videos, music, games and other products.
Amazon Advertising is the advertising business through which Amazon can earn money by pushing ads on the e-commerce platform or on the subscription service platforms. Amazon Publishing and Amazon Studios (by which I mean both the video production and gaming studios) are the resources to more efficiently channel content to the subscription and e-commerce platforms. Finally, Amazon’s electronic devices are the physical counterpart for customers to enjoy the subscription services and to access the e-commerce platform. These electronic devices include the Kindle (e-books), Amazon Fire (phones, tablets, TVs), Echo and Alexa.
The other segment includes, in my opinion, everything Amazon does to further support its customer ecosystem. This includes the broadest variety of activities and aims to increase the ease of use of the services, reduce expenses, as well as improve corporate social responsibility. I perceive the following products and activities to fall in this category: Ring (conncected doorbell), investments in Rivian and other self-driving / mobility start-ups, Amazon’s own solar and wind farm projects, Amazon’s partner programs for payments (credit cards, etc), IMDb and Amazon Air and similar delivery systems it is setting up to increase its competitiveness.
P.S.: Forgive me if I forgot anything. As mentioned before, Amazon basically does everything. So if I missed any activity please let other readers know in the comments below this post.
The Threat of Competition
Amazon itself recognizes that it faces heavy competition. For every investor, cash flow and the risk of those cash flows determine the value of a stock. Yet, you cannot expect cash flows to be astronomically high in highly competitive industries. Amazon seems to combat this threat by focusing on customers, inventions and the long-term. However, by doing this Amazon is playing on a lot of different chess boards. Some of those chess games are just at the beginning, some are near their end.
Just think of the companies Amazon is competing with in all of its end-markets, aside form the earlier mentioned companies for AWS:
- Netflix, Apple, Disney, AT&T, Comcast, Spotify, Tencent, EA, Activision Blizzard (subscription services and studios)
- Alibaba, Google, eBay, Shopify, Facebook, company websites (e-commerce)
- Local stores, Walmart, Costco (physical stores)
- Apple, Microsoft, Google, Sony, Samsung, Huawei (electronic devices)
- Google, Facebook, ByteDance, Microsoft, Twitter (advertising)
As long as Amazon can reinvest enough cash and grow its top line in these sectors, hard questions will not be asked about its failures (such as the recent Crucible failure from Amazon’s Gaming Studios, or the Fire Phone). Amazon then just has to come up with enough ideas for new investments and growth stories to continue its world conquering trajectory (even if it means launching thousands of internet satellites, just like SpaceX – another competitor for the private sector space race).
Yet at some point, investors do want to see returns. So far the stock has been soaring, which has made investors enthusiastic and happy. The underlying numbers followed suit to keep the P/E multiple below 150x. The specific questions are (i) whether the growth will be sustainable and (ii) whether that growth is likely to produce sufficient cash flows to support the current valuation. To understand why this is so important, note that the share count of Amazon is still increasing and that the board approved a program to repurchase up to $5 Billion of common stock around three years ago (with no fixed expiration). To date, no stock has been repurchased under this plan (and Bezos is gradually selling his).
So, with all this in mind. Let’s dive into the financials.
Amazon’s Financials: Blurred Lines
Since Amazon heavily expanded the breadth of its business lines and competes on so many levels, it would be very nice to see how their Prime Video subscriptions and financial results would compare to Netflix, how their Fire Tablets and Kindle units sold would compare to Apple’s iPad, how fast Ring is growing, or at least what the actual operating margins of the e-commerce segment are.
I am going to honestly admit that I find the reporting of Amazon very disappointing. For a company of this size you would expect the annual report to be structured in a way that suits the underlying business. However, with Ernst & Young being their auditor since 1996 it seems more like the underlying business has just been shoved into the annual report structure of 1996. Fun fact: Amazon’s 2019 annual report has 87 pages compared to Unilever’s 2019 annual report of 183 pages. Probably that’s just a European thing. Still, here are five things I think are wrong with Amazon’s financial reporting.
The net sales are reported across different dimensions, of which the most insightful is (i) Online Stores, (ii) Physical Stores, (iii) Third-Party Seller Services, (iv) Subscription Services, (v) AWS, and (vi) Other. The annoying part then is that the operating income is only split into the primary net sales split of (i) North America, (ii) International, and (iii) AWS.
Then, if you wish to analyze the cost structure of the latter three segments there is no way to do it. The annual report mentions that the costs to operate AWS are primarily classified as ‘Technology and Content’ in the income statement. Yet the description of this cost items is as follows:
“Collectively, these costs reflect the investments we make in order to offer a wide variety of products and services to our customers”
In short, there is no clear-cut way to analyze Amazon’s underlying business lines in detail, which explains why its valuation is such a large topic of discussion and why so many people flock to competitors’ operating margins to estimate Amazon’s value. For now, I just need to have faith that their own reported margins are true and consistent over the years.
The Amazon Maze
This might be an issue I have in general with SEC filings and US reporting. The US is very confident that their reporting standards are superior, yet I have trouble to easily match something as simple as the accounts receivable number on the balance sheet to its underlying constituents. Any annual report in Europe or Asia would just show it to you in a simple table.
Then there is the US and in this specific case Amazon. You have to look for at least four paragraphs of text to find the constituents of the ‘accounts receivable, net and other’ position. Yet, when you have found them, it still does not add up to the number on the balance sheet. I will just assume I am missing another obscure paragraph and I will analyze the financials on a high-level basis from the overall financial statements, especially since that is all we can do given the lack of financial data for each operational unit.
Cash Cash Cash
Amazon knows how to inspire investors. Investors always say that profits are an opinion and cash flows are a fact. Amazon knows this and unlike other companies that start with the balance sheet or income statement in their reporting, Amazon starts with the cash flow statement. Amazon even goes as far as to state that their prime focus is on cash flows and they don’t really look at GAAP earnings:
“When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows”
Yet, while the cumulative cash flows are of course factual, the underlying allocation to operations, investing and financing activities is questionable. Amazon seems to admit this themselves and provides three(!) different free cash flow metrics. For 2019, the range of free cash flows provided is between $12.49 Billion and $25.83 Billion. The difference is explained by the way Amazon records its lease obligations as has already been covered by multiple journalists and bloggers.
The Tax Debate
Another remarkable issue is that Ernst & Young made mention of a ‘critical audit matter’ in their audit letter for the 2019 annual report, relating to the uncertainty of Amazon’s tax position. You would expect that a company that is earning so much cash, that is focused on society and the long-term, and that is very invested in corporate social responsibility, would take some efforts to resolve this matter. The most notable part is that allegations on tax evasion have been swirling around Amazon for years before this being pointed out by the auditor in the actual annual report.
Many companies always report like-for-like income statements and organic vs non-organic growth when they either make an acquisition or change accounting policies. Amazon doesn’t. It just adds the WholeFoods numbers in 2017 without providing like-for-like numbers, and it does not show adjusted financial statements for 2019 without the capitalization of operating leases.
To me all these shortcomings in the financial reporting seem to be a way to pull analysts away from the underlying margins of the business and towards the growth rates and sales numbers, to pull analysts into the growth story and to make them believe Amazon can continue to grow. Forever. This will enable Amazon to raise more cash from capital markets, reward more employees with favorable stock options and continuously gain a competitive cash advantage.
Amazon is no longer just a bookstore, but it never stopped selling stories.
The Actual Numbers
It is finally time to dive into the numbers. I am going to look at AWS, North America and International (just as Amazon wants me to). Keep in mind that I will use a very holistic 80/20 approach to get a sense of Amazon’s current valuation metrics and to see what needs to happen to justify its current valuation.
Financial Statements 2016-2019
Below you can find the financial statements for the period 2016-2019 that I pulled from the 2017 and 2019 Annual Reports.
Given the cash flow statement, you would expect the free cash flow to look something like this (similar to the initial way Amazon reports it). The current $1.58 Trillion market cap is (only) 61.1x the $25.8 Billion free cash flow number presented in this table for 2019.
Yet, when I look at it more carefully, I add back the stock-based compensation (as this would be a cash expense in the case of a mature business, or at least dilutive to current shareholders) and I also deduct the principal repayments of the finance leases, as these can be seen as a consequence of operational activities (I could also deduct the other principal repayments, but those are less material).
As a percentage of operating income, these cash flows seem to make much more sense. When looking at the $9.3 Billion free cash flow number, the 61.1x multiple increases to 169.1x.
Amazon Web Services
The key to Amazon’s current value is in Amazon Web Services (AWS). It is one of the pioneers and constantly innovating players in the cloud computing market, and while growth seems to be slowing, it is still well above 30% (the numbers for 2020 are the numbers for the first half year and the growth rate for 2020 is the growth compared to the first half year of 2019).
Operating margins even improved to above 30% in the first half of 2020, possibly driven by larger pricing power due to increased demand caused by covid-19. To see where AWS is going long-term, let’s see what we can derive from some market estimates.
According to Statista, Amazon currently owns 33% of the Cloud Market, which Statista values at $96 Billion. Some reports expect the market to grow to $832 Billion by 2025. As this specific report starts at a higher market estimate of $371 Billion in 2020, I would estimate Amazon’s current market share to be around 11%. This would mean revenues of around $91.5 Billion by 2025. For simplicity purposes let’s assume that Amazon can grow its AWS at the implied CAGR of 17.5%.
As the growth mainly comes from small and medium enterprises in the later stages of this development, operating margins are likely to decline for additional service loads, possible future pricing pressure or value going to more local intermediaries. On the other hand, operating margins may increase as a result of additional operating leverage. For now let’s assume that operating margins stabilize around 25% by 2025.
These growth rates and margins may seem low, but remember that growth rates have been sharply declining for AWS, and the higher than 30% growth rate in 2020 may just be a result of additional cloud investments as a result of covid-19. With all the additional players entering the market and the barriers to entry in Asian markets, we may have seen the highest growth for AWS. Yet, this is not necessarily a bad thing, as Amazon’s operating income has become less dependent on AWS over the past few years. The real growth in operating income may be hidden elsewhere.
North America and International
The North America and International segments consist of all the non-AWS business lines. Of these business lines around 79% of revenues originated from online stores and third-party seller services in 2019. Around 7% originated from physical stores, around 8% originated from subscription services, and around 5.7% came from the other segment.
Profitability has been volatile in the North America segment, with the highest operating margin in the past four years standing at 5.1% in 2018. The International segment slowly moves into profitable territory, with the second quarter of 2020 showing the first quarterly profits.
The e-commerce market is in my opinion the best proxy to estimate the future potential of the more shrouded segments of Amazon’s income statement. While Amazon’s $171 Billion net sales in North America and $75 Billion in net sales internationally in 2019 seem impressive, the market size for e-commerce was estimated at a whopping $9.1 Trillion.
This would imply that Amazon has a market share of only 2.7%. Logically, this is a result of many companies having their own e-commerce channels and the presence of other large e-commerce platforms. As a result of this industry dynamic, I would not expect Amazon to grow its revenues outside of AWS at a higher growth rate than the expected 14.7% for the entire market. Given that a lot of growth in this area may be taken forward due to covid-19, I think this estimate may even be optimistic, also given the developments in the growth rate in 2018 and 2019.
Concerning the operating margin I will be more optimistic again. As operating margins have already been 5.1% in 2018 and the revenue mix consists of some more profitable and scalable service and software components, I think the North America Segment and the International Segment can gradually grow towards operating margins of 13% over the next five years (twice the retail operating margin of 6.5%). We should also not forget that current margins in 2020 have been suppressed by operational covid-19 measures and could have been much higher in retrospect.
One could argue that the margins in the international market should actually be lower as operations in North America are set up more efficiently on a smaller geographical scale and with less diversity between cultures and geographies. However, as the other segments may be a little more profitable (most notably the ‘other’ segment), I choose to use equal operating margins.
I will use the aforementioned assumptions to calculate three scenarios (base, optimistic, worst) where I will assume that the full year revenues for 2020 will grow at the current growth rate of the first half year as compared to 2019 (I am giving Amazon a lot of slack – pun intended). My assumption will also be that by the end of 2025 Amazon’s current business lines will have matured so that it is a good measure of perpetual value.
The Base Case: AWS revenues grow at a CAGR of 17.5% to $105 Billion by 2025 with operating margins of 25%. The North America and International segments will grow at a CAGR of 14.7% to cumulative revenues of $653 Billion and operating margins of 13%. Together this results in a total of $757 Billion in revenues and $111 Billion in operating income. The EBIT x (1-t) formula would give us, at a tax rate of 21%, a free cash flow estimate of $87.7 Billion. The current $1.578 Trillion market cap is around 18x this 2025 net earnings / free cash flow number (5.6%).
The Optimistic Case: AWS revenues grow at a CAGR of 20% to $116 Billion by 2025 with operating margins of 30%. The North America and International segments will grow at a CAGR of 20% to cumulative revenues of $818 Billion and operating margins of 20%. Together this results in a total of $934 Billion in revenues and $199 Billion in operating income. The EBIT x (1-t) formula would give us, at a tax rate of 21%, a free cash flow estimate of $156.8 Billion. The current $1.578 Trillion market cap is around 10x this 2025 net earnings / free cash flow number (10%).
The Worst Case: AWS revenues grow at a CAGR of 15% to $94 Billion by 2025 with operating margins of 20%. The North America and International segments will grow at a CAGR of 10% to cumulative revenues of $530 Billion and operating margins of 6.5%. Together this results in a total of $624 Billion in revenues and $53 Billion in operating income. The EBIT x (1-t) formula would give us, at a tax rate of 21%, a free cash flow estimate of $42.1 Billion. The current $1.578 Trillion market cap is around 37.5x this 2025 net earnings / free cash flow number (2.7%).
Again, this approach is very holistic and does not take into account all other opportunities Amazon has at its disposal like shooting satellites into space for its own internet platform, other mergers and acquisitions, or price increases for (just as an example) its streaming business. It also leaves out all positive cash flows Amazon will earn in the rest of 2020 and the years 2021-2024. Likewise, it also leaves out all probable dilution.
The truth is, in my opinion, that the medium outcome implies a fair value for Amazon when looking five years into the future. Given the uncertainty and time span, this means to me that a lot of growth has already been priced in and for which the risk is hardly being rewarded (when strictly looking at fair value).
It is also not true to state that Amazon is grossly overvalued as some people may make you believe. There is a chance of outperforming expected market returns, but Amazon would have to continue to surprise all expectations for another five years. Personally, I would think the chance of Amazon underperforming the market and losing value (with some new failed investment initiatives here and there) is just as likely – especially considering the worst case scenario still assumes 10-15% annualized growth rates for a company already doing around $300 Billion in revenues.
Still, as long as Jeff Bezos can continue to tell his story, can continue to grow into emerging markets and can actually completely take over a multi-trillion dollar retail market, Amazon may actually be an interesting play if you want to be exposed to the market exuberance and if you would be satisfied to earn that worst case 2.7% yield if it just slightly underperforms industry expectations by 2025.
Hence, at a future market pull-back I might even myself consider to seriously look at Amazon. However, I would very much like them to improve their reporting standards first so that investors can make better decisions and are less led by the story and more by the actual numbers (which are honestly still impressive).
I started this post with a comparison between Amazon and the VOC, thinking that if Amazon looks like the VOC, talks like the VOC and walks like the VOC, it likely would be similar to the VOC. The only thing Amazon seems to lack is a monopoly and an army to gain or sustain it. Amazon does have a war chest of cash, but so do all the other tech giants. As everyone has to look out for Amazon, I believe Amazon also has to look out for what might be coming for them. If it were up to me, the VOC will remain the most valuable company in history for quite some time to come.
However uncertain the future may be, Amazon will remain an incredible story and one that will continue to dominate the markets for quite some time. I will personally sleep very well by passing up on the opportunity to invest in it, though I might slip a small speculative amount into a fractional share to see whether they will be able to beat my expectations.
As a bonus from this post I learned that Jeff Bezos is one of the best storytellers of our time, and one of the most influential persons in the world today. Amazon’s story is unlikely to come to a close, as he can always continue to tell stories at the Washington Post.
Jeff Bezos is the man that made Amazon King of the Story Stocks.