By Soundview Technology Group :
Amazon ( AMZN )
is a paradox in the stock market right now. In the last year,
revenue growth has substantially decelerated and operating margins
have declined. That dynamic typically spells disaster for a stock,
especially those owned by "momentum investors." Yet the shares of
Amazon have traded up from $182 at the start of 2012 to $254 in a
volatile but strong fashion (higher highs, lower lows). Amazon is a
mightily successful company investors may ask "successful for
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There is always a steady march of "Here is why Amazon is going
to collapse" articles and notes on retail sites like Seeking Alpha
but so far none have offered much insight beyond "look how
expensive the stock is?!" Perhaps on the principle that even a
"broken clock is right twice a day" some authors crank out an
article every other day or so.
This is just noise if and until there is something fundamental
to derail the long-term investment case for the stock and cause
holders to abandon the shares. As some other notable high-flying
stocks like Apple ( AAPL ) have changed
course in the last few months, it has made more institutions ask us
Before we get to the valuation question at hand, it's worth
noting a few reasons some think of Amazon as a "one decision stock"
or at least have done so in the past. [I have no position long or
short in AMZN.]
High Level Bull Case
- The market opportunity for Amazon is virtually unlimited. It's
basically "stuff people buy" which is measured in the trillions.
Not many companies can use the word trillion with any
- Amazon is an important player in digital goods (books and
video) which helps them preserve or gain share as the market
becomes more digital. In terms of books, they are the
innovator/leader in the category.
- Cloud computing has been and will be a major trend for years or
decades and again Amazon has been the innovator/leader in the
space. There is competition now from Google ( GOOG ), Microsoft ( MSFT ), Rackspace ( RAX ) and hundreds of
hosting companies but Amazon continues to have the most serious
- Competition has yet to really materialize. There are many niche
competitors but we have yet to see anyone really threaten the
Amazon business. For a brief period, a small company called GSI
Commerce was planning to enable every online retailer to replicate
the Amazon Prime experience, at least in terms of shipping, but
they were acquired by eBay before this strategy could play
- Bezos is an asset. Investors trust him like a geek version of
Warren Buffett. He can talk about the very long term and get the
benefit of the doubt. His leadership to ensure Amazon technology
would be best-of-breed by far has been a singular triumph.
High Level Bear Case
- Competition hasn't given up. More importantly, Google is
experimenting with a same day delivery service, large retailers
like Wal-Mart (WMT) and Target (TGT) are trying to improve their
delivery service. eBay (EBAY) is doing the same and trying to also
use lower seller fees to attract business. Considering Amazon
margins (next point) this unrelenting competition may force Amazon
to keep getting leaner.
- Margins have collapsed. Operating margins have deteriorated
from 4.4% to 1.4% in the past two years.
- Collecting sales tax will put Amazon more on par with local
retail establishments which changes the comparison equation for
consumers. This is certain to be the case with some purchase use
cases (high priced, light weight items that are in stock close to
home.) So far we haven't seen any quantification over how much
revenue this might be. Since sales tax will be neutralized, it will
come down to price, selection and free delivery which are typical
- A slower economy will have a direct impact on Amazon, and their
high fixed-cost business model will mean more suffering for the
company and shareholders than they may be prepared to live
Who is right?
We had to stick to "high level" arguments because getting into
specifics around areas like Amazon Prime Video, changing
third-party seller economics and the additional revenue streams
like advertising is interesting but tends to cloud the big
Amazon management gives the "the street" little to go on. For
example, most every question on their recent quarterly earnings
call was answered with something along the lines of "we don't
disclose or talk about that" or "we're very pleased with the great
results we are getting in that area." There are few if any direct
answers, let alone metrics and hard numbers. A further deceleration
of growth for the 2013 fiscal year (to 22% YoY) is already factored
into consensus estimates.
Based on the operating margins of Wal-Mart, Target and Dell
(DELL), our base case IV outlined below is probably the most
"right" model for the moment. The foundation of the case is an
eventual return to a 4% operating margin which is the steady-state
for these large retail-oriented players.
In terms of understanding where improved margins might come from
we can look at what is already known about Amazon's expansion
trajectory and see what the established players generate:
Streaming Video : This an exciting but so far
not very economically attractive story. Netflix is the leader in
the space with gross margins of only 27% and a barely profitable
operating margin of 0.6%. Existing Amazon Prime customers get many
of these videos for free. There is no data as to the propensity of
these customers to purchase other videos nor any figures for this
benefit driving growth in Prime memberships. It seems safe to say
that video isn't going to be the ticket to higher margins at Amazon
Hosting : Amazon is powering much of the
commercial cloud applications being developed and deployed. Their
pricing has tended to be fairly aggressive, so they may be keeping
margins there lower than they have to. Pure hosting company
Rackspace generates relatively attractive operating margins of 8%.
Continued growth of Amazon services should be mildly to slightly
additive to operating margins.
Third-Party Selling : This is the commercial
side of the eBay business. Rather than one-off items, these are
small business that can use Amazon to handle their listings,
delivery and customer service. Unfortunately, eBay is really two
different businesses, online selling and PayPal. Margins at eBay
are juicy at 70% gross and 18.7% operating. Amazon has a payments
service but thus far it has very limited traction and there isn't
anything suggesting a major push is coming. So far it is another
"me too" offering alongside a dominant PayPal. Amazon has ramped up
third-party products which add to margins. Third-party selling and
related services like payments are one of the most compelling
opportunities for Amazon to expand operating margins above 4%.
Advertising : This is a small but intriguing
opportunity for Amazon mainly because the incremental margin is
very high. Provided they can do it without an adverse effect on
customer experience, this is additive but probably not in huge
amounts. A relatively small amount of organic advertising revenue
of $2B will add 1 point to operating margins over time.
If there is one area that cries out loudly and strongly as
worthy of acquisitions it's in the third-party selling segment. For
example, consider the latest hot "instant online store" company Tictail . They are
fine for what they are but with strong hooks into Amazon services
like fulfillment would make the technology far more important and
potentially drive accelerating growth in sellers for Amazon. There
are plenty of things Amazon could do in this segment and they offer
opportunities to expand margins while adding to growth.
Most of Amazon's acquisitions have been related to the core
business (Kiva Systems, GoodReads) and line expansions (Zappos).
There are certainly be more of these but they probably won't have a
major impact on long-term operating margins.
Based on how Netflix is doing heavy investments or acquisitions
in this space might be bad for the stock as it's yet to be seen
what level of operating margins are achievable in this
And now for our raison d'être for this note, which is to look
more closely at valuation for Amazon if investors decided to focus
on it. It's not a simple answer because there are different classes
of investors besides "momentum" and "value." In the middle are a
heterogeneous group of "growth at the right price" or GARP
We'll use our standard intrinsic value (IV) model as the
starting point. Our base case model generates a share price of $182
for 2013 and $212 for 2014. The first figure is about 30% lower
than the current stock price of $254. Given the long-term nature of
the Amazon story and the fact that it will soon be mid-year 2013,
I'd use the $205 as a more reliable "fundamental value" for the
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Amazon is a somewhat complex beast though it makes sense to go a
few more steps beyond a straight ahead IV model. Amazon makes large
investments and reported earnings are certainly not the only
measure that investors care about. Cash flow matters, even though
for a non-dividend paying stock like Amazon, it's a little
For example, Amazon made capital expenditures of just over $4B
in the TTM period which works out to $8.80 per share. Before
considering what portion of these investments were discretionary,
it's worth pointing out that if they had not made those
investments, the shares would be trading at 27x operating cash
flow. Not cheap but not outrageous.
We've included two additional IV cases as an appendix showing a
"bear case" in which margins simply don't recover through 2018.
This would put the shares between $80 and $100 depending on the
multiple investors ascribed to it.
The other additional IV case incorporates more than a
replication of what other large retailers have achieved and affords
an additional 2% of operating margin from expanded success in
third-party selling, hosting and some advertising. Without
increasing the multiple, this would suggest an IV of $280-300 in
Considering where Amazon stock is right now and the IV suggested
in base, optimistic and pessimistic cases, the shares are not very
Using very round numbers of $300 for the upper bound, $100 on
the lower and $200 as what we would call fair value, the stock
would begin to be interesting at $200 and well-justified on an IV
basis at or around $150.
Like all investors, we will need to watch what moves Amazon
makes to get a better handle on how long-term operating margins
will develop. If they make some of the right moves, we might be
able to put a higher probability on the $300 case. Right now, we
have to stock with $205.
We've included both a more pessimistic and more optimistic IV
case that were prepared to support our analysis and conclusion.
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Disclosure: I have no positions in any stocks
mentioned, and no plans to initiate any positions within the next
72 hours. 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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