August 04, 2016 - 12:03am EST by
2016 2017
Price: 754.64 EPS 0 0
Shares Out. (in M): 474 P/E 0 0
Market Cap (in $M): 357,755 P/FCF 0 0
Net Debt (in $M): 5,959 EBIT 0 0
TEV ($): 363 TEV/EBIT 0 0

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I believe that the stock of Amazon is one of the most attractive risk/rewards in the market today.  Over the long run, Amazon equity is likely to a) preserve value, b) deliver an attractive relative return over the market, and c) deliver a positive absolute real return in excess of inflation.  As a result, this is one of my core holdings.

Many VIC readers will be familiar with the business given its steadily growing market cap and media coverage, as well as some excellent prior discussion on VIC, particularly the 2011 write-up by trev62.  So I will jump right into the meat of my thesis, Q&A style.
It feels odd to invest in Amazon at a time when the market's bullishness and acceptance of Amazon has never been higher. Why now? 
I concur that the sell-side is generally positive.  The company is covered by over 40 sell-side analysts, the majority of whom rate the stock a 'Buy'.  I am not aware of any notable 'Sell' recommendations or sell-side bears that have been vocal recently.  Having said all that, I modestly propose my view that the buy-side is much more sceptical.  Several high-profile investors are short (or were recently short) the stock.  And in my own life, I have experienced more negative reactions from the revelation that I own the stock of Amazon than positive ones, in my interactions with other investors.  So if one is focused purely on sentiment, it feels that sentiment has further to run.
Given Amazon's failure to produce meaningful net income, is the valuation not bubbletastic? Why not short Amazon instead?
Since its founding, the business has produced a grand total of $4b cumulative GAAP net income.  Yes, this looks bad on the surface.  At this juncture in our conversation, I could follow the classic 'I like Amazon' line of thought and extol the virtue of growth and how the business is aggressively reinvesting to maximise long-run free cash flow.  I will not do that just now, even though I buy that argument.  Instead, I would like to propose the following thought experiment.  Call it a Munger-style inversion, if you will.
Imagine that tomorrow you woke up to a crazy new state of the world where Jeff Bezos has a sudden change of heart and decides that from now on, his #1 priority is to achieve sales growth broadly in line with GDP and no faster, and that he values near-term GAAP net profits and near-term free cash flow much more than he does distant GAAP net profits and distant free cash flow.  Before we do that, here are the actual LTM Jun'16 numbers:
  • Sales $120.6b
  • Gross profit $41.5b (34.4% margin)
  • EBITDA $10.3b (8.5% margin)
  • GAAP EBIT $3.9b (3.2% margin)
  • GAAP net income $1.9b (1.6% margin)  
So once Bezos has this change of heart, suspend your disbelief for a moment and simply imagine that Bezos now does the following:
 - he cuts the marketing expense to about $2b annualized from $6b annualized today, so the incremental Prime members and platform sellers are expected to come via mainly word-of-mouth.  The Kindle adverts that you see on the metro or the Fire Stick adverts that you see alongside Coca-Cola promo clips next time you go to the movies?  Gone.  All the outreach that Amazon is doing in India, criss-crossing the country to sign up new vendors?  Poof, gone.
 - he cuts content (mainly Amazon Video) and technology (mainly AWS, possibly also some drone R&D and the like) spending from $15b annualized to $8b.  No aggressive additions of AWS availability zones, and no longer an ambition to sharply increase Amazon's hours of original content to better feed the Amazon Prime flywheel of customer loyalty.  Of course, this also means a curtailment of Amazon's ambition to compete with Netflix.
 - he begins to exploit the company's strong e-commerce market share and the associated network effects, and unilaterally ups Amazon's take rate on both 1P and 3P relationships.  On a very simple basis, we can imagine that the company's ex-AWS gross margin increases from 30% today to 34%.  On an annualized basis, that's an extra $5b of income to Amazon
Netting all of this off, annualized GAAP net income jumps from $2b today to a $18b pro-forma figure, which roughly makes this a 20x P/E LTM stock.  Of course, future transaction and user growth will tail off somewhat.  This imaginary valuation would look like a 'bargain' to me relative to, say, Home Depot (24x P/E LTM) or Costco (31x P/E LTM).  And even if Bezos did all these moves, can you really imagine Amazon growing at merely 'with-GDP' rates?  If this hypothetical, alternative-universe Amazon was freely tradeable in the market tomorrow at that price, would I pay that price? You bet. It's not 10x trailing earnings, but still, I would be buying all day long. 
The aim of this exercise that we just walked through together is self-evident: it is to highlight the powerful economics of the business and to reiterate that contrary to what you may hear from most folks, the valuation is not bubbletastic.  At least, not yet. At some point, the market will swing the pendulum too far into ridiculously optimistic territory, but my humble assertion is that we are still rather far from that.
(Consider also the fact that since 2000, Amazon's number of shares outstanding only grew by 1.8% p.a., a rate that recently slowed to 1.2%. Amazon occasionally repurchases some stock, too).
Can't businesses with meaningful logistics and warehousing assets catch up to or put pressure on Amazon's growth or margins in the e-commerce division? For instance, what about Wal-Mart?
I fully expect players such as Wal-Mart to act in their own long-term rational self-interest and therefore aggressively invest in their e-commerce and online delivery capabilities.  If we take the US for example, I expect Wal-Mart to become an increasing competitive force to Amazon.  I say Wal-Mart because I perceive Wal-Mart's brand, store locations and logistics network as the most formidable among the large brick & mortar retail groups.
For instance, research from MWPVL pegs Amazon's US logistics network at 180 facilities with a square footage of somewhere between 71.5 and 112 million.  Wal-Mart (including Sam's Club) has 166 facilities with 124.2 million square feet, in addition to 5,280 retail units (779 million square feet).  If Wal-Mart decided that e-commerce is its #1 priority, it is hard to deny that it has the real estate and raw logistical base to seriously compete with Amazon.  But I do not perceive this coming competitive tussle as sufficient to form a compelling Amazon bear case.  Why?  First, less than 10% of US retail sales are Internet-based (per US Department of Commerce data for FY15).  If we assume for a second that the aggregate amount of physical stuff that US households consume stays relatively constant, then it feels that there is still significant room for growth in the entire e-commerce market simply from substitution to e-commerce.  If we look at it another way, the share of total population that shops online in the US is consistently 5-10 percentage points behind UK and developed European markets such as Germany and Sweden.  And, there is no shortage of statistics for individual consumer spending segments suggesting huge upside, e.g. a recent Goldman note estimated that only 2% of consumer essentials are purchased online.  So, in general, I expect that the growth of the total e-commerce market will somewhat relieve the competitive pressures that Amazon will come under as players such as Wal-Mart get up to speed. 
We live in rather unprecedented times.  Where is the limit to US share of retail sales from the Internet?  Is it 20%?  30%?  It is difficult to say.  But it is hard to deny that secular growth from here is powerful, and this is certainly a market you want to be in if you can build scale.  On a fundamental level, the advantages that e-commerce confers to the customer are robust.  There's choice and ease of comparison, but one really under-discussed element is time.  Buying online saves you time.  In a world of increasing distractions (Facebook, Twitter, Instagram, email, etc) and increased social competition, time is becoming more valuable.  And the squeezed working- and middle-classes who increasingly have to supplement their main jobs with earnings from freelance gigs (from selling homemade goods on Etsy to proofing CVs on Fiverr and coding websites on Odesk, all the way to Uber) are valuing time ever more.  And for those fortunate enough to have better-paying jobs, at the margin the deluge of leisure time options at their disposal (explosion of compelling TV and Netflix/Amazon shows being a good example) further increases a person's subjective assessment of time's worth.  All this will continue to act in favour of online retail.
And if we peel the onion one layer further, I find it difficult to believe that players such as Wal-Mart will be able to quickly replicate the increasingly compelling deal that Amazon offers US customers via Prime.  Not only do you get fast shipping, but you get original video content, music, and the Kindle book lending.  You also get very good customer service.  So I expect that Amazon will continue to occupy a decent share of the market.  And all of the above paints also directionally apply to the other major markets where Amazon is a force, such as Germany and the UK.
AWS has fuelled much of the market's recent excitement over Amazon. Shouldn't one be worried about increasing competition from Microsoft, Google, IBM and others? What is Amazon's moat in AWS?
First, I will lay out some numbers.
AWS annualized sales run-rate: $11.5b
Microsoft cloud annualized sales run-rate: around $10b
Google cloud annualized sales run-rate: around $1-2b
IBM cloud annualized sales run-rate: around $12b
Global commercial software spending (from Gartner): $3,536b, of which $940b is from IT Services (including cloud)
I concur that AWS will run into increasingly intense competition.  From a sales, technical and pricing perspective, the gap between the main offerings on the market is not that big, in my understanding.  But I believe that the total market opportunity is tremendous.  For instance, just the disaster recovery segment of IT spend clocks at $90-100b, only 10% of which is currently in the cloud.  The general number of in-house and outsourced IT consultants employed by big corporations tends to be needlessly high.  On the back of this, prior to the advent of the cloud, countless tech entrepreneurs and dozens of tech corporations extracted enormous economic rent and built vast personal fortunes.  AWS is now rapidly building scale and disrupting that market, transferring a portion of the economic rent previously captured by the IT vendors & consultants back to the CIO.  A new player (such as AWS) eventually emerging and starting to do this was inevitable.  That the incumbents and others would notice and gradually adapt was also inevitable. 
Similar to the argument that I have made with e-commerce, I expect AWS to hold a decent share of this attractive and growing market, though I do expect margin growth here to find a plateau somewhat faster than in e-commerce due to the cloud market's greater competitive dynamism.  In any case, from speaking to start-up founders and venture capitalists, it is clear that AWS is executing tremendously well and does not have notable gaps or weaknesses versus competitors that they cannot address.  The fact that Amazon incubated AWS from scratch will also continue to help it in moving faster vs competitors such as IBM or Oracle, who psychology dictates are much more beholden to the human self-preservation instinct to avoid destroying their legacy revenue lines too quickly.  The moat is not huge, but in a market growing so quickly, it is not a thesis-killer.
OK, then what about Amazon's accounting? Doesn't Amazon's use of leasing overstate its cash-flow generativeness? What is the true operating ROCE of Amazon?
It is true that Amazon makes extensive use of capital leasing, principally in acquiring property and equipment.  The rule of thumb is that for every $1 of capex that Amazon spends itself via cash, Amazon also executes $1 of capex via capital leases; this latter capex does not flow through the Cash Flow From Investing Activities (CFI) section of the financials; instead, an asset and a liability are simultaneously created on the balance sheet.  Amazon is effectively levering up its business and accelerating its investment programme.  Whether or not this is a good idea depends on whether the underlying operating returns from the business exceed the implied cost of financing.  For its ordinary long-term debt (of which Amazon has about $8b outstanding), the weighted effective interest rate is around 3.4%.  Note that this is unsecured debt.  What is the effective interest rate on the capital leases? See Amazon's capital lease contingency schedule as of Dec'15, below.
Inline image 1
Given Amazon's FY15 interest expense of $459m and a 3.4% effective rate on the unsecured debt, I estimate that Amazon spent about $175m on capital lease interest payments in FY15. Given that Amazon started Jan 2015 with $2,060m of capital lease obligations (incl interest) for that year, repaid $2,462m during the year and made new PPE capital lease acquisitions of $4,717m during the year, the effective interest rate on the capital leases likely ranges somewhere between 2.6% and 5.2% (depending on intra-year timings), but likely towards the higher end.  Even if it is 5%, this is not too bad.  If you trust that the operating investments into core PPE such as warehouse space or AWS data-centres will continue to pan out, I believe this use of capital leasing is reasonable.  Of course, past examples such as SunEdison (or maybe even currently developing examples such as Tesla) demonstrate the danger in levering up too quickly and investing too aggressively in pursuit of long-term projects with pie-in-the-sky long-term IRRs.  In the case of Amazon, you are making the bet that management will continue to allocate capital in a reasonably rational manner.  A quick check of the balance sheet suggests that the situation is under control.  Below, I show the ratio of total assets to equity.
  • 2008: 3.1x
  • 2009: 2.6x
  • 2010: 2.7x
  • 2011: 3.3x
  • 2012: 4.0x
  • 2013: 4.1x
  • 2014: 5.1x
  • 2015: 4.9x
  • 2016H1: 3.9x (going back down again, which is a welcome sign)
And now onto ROCE.  To calculate a 'normalized' ROCE, I return to the example of the "hypothetical, near-term profit-maximizing Bezos"; that would inflate the LTM EBIT from $4b to $20b.  Now, let's also treat all capital lease capex as cash instead; there's about $6b of such capital lease capex on an annualized basis, at present. Let's say Bezos' newfound frugality cuts that down to $4b. So the new, normalized 'cash EBIT' would now be around $16b ($20b less another $4b of lease capex).  Now let's fiddle with capital employed.  A simple figure for that is about $36b (total assets less current liabilities).  That would result in a ROCE of 44%.  To add a dollop of conservatism, one can penalise Amazon for its current negative NWC of $16b and set that to zero.  Then, dividing $16b of cash EBIT by a harsher measure of capital employed ($52b), you get a ROCE of 30%. Still pretty good. The market appears to be absolutely missing this.
What else could the market be missing? And what are the biggest risks here?
I believe that one thing that the market is not too focused on is the potential for Amazon to gradually top-up the platform with improving capabilities.  For instance, in education, Amazon has a long-run opportunity to eat away at the market caps of incumbents such as Houghton-Mifflin, Wiley and Pearson (combined market cap of $15b).  The market is also not paying attention to the fact that in video, Amazon's content is rapidly improving in scope and quality.  Jeff Bezos personally attended the recent Golden Globes (where Mozart In The Jungle, an Amazon show, took key accolades), and Amazon is aggressively growing content spend; this is absolutely a significant focus of the company going forward.  I have come across anecdotes of people cancelling their Netflix subscriptions but keeping their Amazon Prime ones, and unless you view House of Cards or Marvel superhero-shows as absolute must-have kind of content in your house, I can understand why you would do this.  The relative all-in value proposition of Amazon Prime is becoming simply too compelling ($10.99 per month or $99 per year vs $9.99 per month for Netflix).  Several intangible factors are helping people skew towards Amazon Prime vs Netflix, and I have yet to see the sell-side (or the buy-side) focus on them: 1) Amazon's integration of IMDB has long-term potential to deliver a strong recommendation engine and is already yielding some results via the X-Ray functionality that tells you which actors or songs are in a scene, and also feeds you goofs;  2) Amazon has an offline viewing functionality, and Netflix does not;  3) Netflix content quality lately appears to have taken a hit (see Adam Sandler and similar content);  4) Amazon fundamentally benefits from its ability to up-sell subscribers content to rent or buy.  If you are in the mood to consume content, you are much more likely to ultimately find something to your liking when you log onto Amazon Video vs Netflix (once you count Amazon's Rent Or Buy section, which is prominently highlighted in the interface, but not too intrusively). 
Because of all these factors, I believe that Amazon is having an impact on Netflix churn figures and future growth (though this is difficult to prove as we will not have a counterfactual).  I have a positive long-run fundamental view on OTT video in general (for many of the same reasons that others, notably WinBrun, raise in the recent NFLX discussions on VIC), and I expect Amazon to play a significant, almost central role in the development of that sector and area of consumer habit as time progresses.
And in the midst of all that, Amazon also continues to sit on a certifiable gold-mine of a unique asset thanks to its huge databank of consumer data (names, addresses, card details, wide-ranging consumption preferences) that can be utilized to up-sell and rapidly roll-out entirely new categories of goods/services.  If those products have a physical aspect to them, the market is missing the fact that Amazon's broad logistical capabilities here have a decent chance to gradually approach those of much larger, more established logistics players.  In the next few years, Amazon will have an operational fleet of close to 50 jumbo jets moving cargo; UPS has around 250, meaning that Amazon could soon approach 20% of UPS's aircraft capacity.  This was almost unimaginable to the market just a few years ago.  The more Amazon's logistical moat grows (combined with the e-commerce network effect), the stronger the rationale for the business to command an increasingly lower earnings yield. 
With regards to key risks, I can note a couple:
 - Poor capital allocation.   Management may decide to waste capital on overpriced, ill-conceived acquisitions; think Softbank buying 80% of Sprint a few years back.  This can also take the form of overly aggressive, overly hasty expansion moves on projects with negative or low ultimate IRR; think Uber's efforts in China.
 - Too much success for its own good.  Amazon has been described by Stan Druckenmiller as 'a serial monopolist'.  Hard to disagree with where Mr Druckenmiller was going with that line of thought.  Though I recognize that it was a compliment, I also see a risk there.  Overall, businesses that are too successful for their own good end up getting taxed, fined or regulated; US tech corporations' repeated travails with the EU Competition Commission are an example.  Those kinds of run-ins are probably just a matter of time.
 - Macro.   Any macro shock that has a negative impact on households' disposable income or consumer confidence will constrain Amazon's top-line growth, slow the ramp of operating leverage, and also impact the overall market multiple.  But there is also the flip-side: if governments ever end up instituting a direct version of helicopter money (whereby money is magically dropped into people's bank accounts in an effort to spur inflation), Amazon would be a prime beneficiary.
 - Key man risk.   I have a friend who had a leveraged long call option position in Apple just prior to a dramatic turn in Steve Jobs' health situation, so I can say with confidence that this is not a risk to be underestimated.  An expected negative event impacting Jeff Bezos' focus on the business or long-term involvement with the company would meaningfully impact Amazon's intrinsic value.
 - Market patience.   Every couple of quarters Amazon surprises the market to the upside, mainly via a faster-than-expected operating leverage ramp.  And then just a few months later Amazon puts a downer on the analysts again, by doubling capex here and there (e.g. HBO content spend in the past or the planned doubling of content spend in the near future), giving wide guidance ranges or plain not answering the analysts questions.  The stock is likely to continue to jump around; that is just how this stock trades, even though that is not how the intrinsic value is progressing.  Those periods of contained volatility are likely opportunities to add to the position (should capital become available from elsewhere).
Amazon is an absolute gem of a business that continues to be undervalued by the market.  Reversion-to-the-mean works most of the time, but I believe that this is not one of those times.  The quality of the business results in it having the best attributes of a bond-like downside (low-risk due to a massive moat) with significant upside for all the reasons described above.  In its current configuration, I believe Amazon's FY21 revenues can cross $320b, with a GAAP operating margin in excess of 8%.  That would result in $26b of EBIT and $20b of net income.  In my view, the growth profile of the business combined with the market's eventual realization of Amazon's potential to generate meaningfully higher near-term cash-flows if it's stewards decided to do so will likely result in Amazon maintaining an optically expensive multiple, and 35x P/E in 2021 is probable, resulting in 90% upside. 
1. There is an interesting paper prepared by Josh Tarasoff and John McCormack on Amazon's operating returns, available online here.  It is behind a password wall but I was able to access it from a library.  The methodology pursued by the authors of that paper is somewhat different to what I present here in assessing the profitability and ROCE of the business, but the directional conclusions are similar.  
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Successive quarters of continued evidence that management is taking steps to maximize long-run absolute free cash flow, with no unreasonable acquisitions or uses of liquidity, and no overly aggressive capital expansion plans. Continued improvements in operating margin, with operating leverage effects continuing to come to the fore (although not in a straight line). Market realization of some of the specifics of the story as outlined in this memo.

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