I rate Amazon (NASDAQ: AMZN) a buy due to the robust growth of their service businesses, wide EBIT margins of the services segment, and highly-valued media and cloud-computing assets. During 4Q21, Amazon incurred $ 4 billion in extra costs attributed to labor shortages, supply-chain disruptions, and the highest annual inflation rate since 1981. These macroeconomic headwinds have especially impacted Amazon’s e-commerce division, illustrated by e-commerce revenues only growing by 1% year over year in 4Q21.
The current headwinds that have plagued Amazon’s e-commerce division are short-term problems. These issues are not attributed to a lack of demand, mismanagement, or poor execution of strategy. They are attributed to the current macroeconomic climate, which has been especially difficult for e-commerce given the supply chain disruptions that have impacted global business.
Diversification In An Uncertain Economy
Despite the stagnation in e-commerce, Amazon has flawlessly executed on the diversification of their product and service offerings. Because of this diversification, Amazon is a reliable investment that can endure times of economic hardship. If one segment doesn’t perform well, the company can rely on another segment. For example, cloud spending is more insulated from inflation, illustrating an added benefit of their AWS segment. In recent years, Amazon has relied on revenue from their advertising and AWS divisions to offset the stagnation in e-commerce. They have transitioned in the past 5 years from purely an e-commerce company to a services company as well, illustrated by the accounting segment for 48% of their total revenue in 4Q21.
Robust Growth In Key Segments
Amazon’s services business is growing significantly faster than their e-commerce segment. In 4Q21, service revenue grew 21% year over year and e-commerce revenue grew by only 1%. More specifically, Amazon has continued to experience robust growth in both advertising and AWS (see below). Advertising revenues for 4Q21 were $ 9.7 billion, up 33% year over year and up 60% year over year in 2021. Amazon reported 4Q21 revenue of $ 17.8 Billion for their AWS division, up 40% year over year. In addition, Amazon’s AWS will continue to see growth for the foreseeable future due to a rapidly expanding cloud computing market.
Market research firms forecast that the cloud computing market will grow from its current size of $ 483 Billion to $ 1554.94 Billion by 2030, representing a CAGR of 15.7% (see below). This rapid growth will give Amazon ample opportunity to acquire additional market share. Despite the intense competition within cloud-computing, significant growth of the cloud services market will aid Amazon’s growth for the foreseeable future within their AWS division.
Wide Margins In AWS And Advertising
In addition to robust growth, Amazon’s service businesses have significantly wider margins than their e-commerce division. Their service business had 13% EBIT margins in 4Q21, while EBIT margins for e-commerce were a mere 5%. Because of the wider margins within the services business, this segment is a more powerful upside driver than their e-commerce segment. This bodes well for Amazon given the significant forecasted growth of the cloud-computing market. Continued growth in services revenue will increase Amazon’s profitability, free cash flow, and return on invested capital.
Investors Are Currently Not Paying For Amazon’s E-Commerce Revenue
Currently, I believe that Amazon investors are receiving free revenue from their e-commerce segment. In order to illustrate the free revenue being generated, I built a valuation model for Amazon’s assets (see below). In order to value Amazon’s assets, I took the 2022 consensus estimated revenue of each asset and multiplied it by the EV / Revenue multiple of a company that has similar operating assets. After multiplying each asset by the corresponding EV / Revenue multiple, I added the values of the assets together by business segment, arriving at each segments valuation (see below).
After calculation, my model indicates that Amazon’s media assets (including advertising) are worth $ 796 billion and the AWS segment’s assets are worth $ 791 billion (see above). After adding these two valuations together, I arrived at a combined total of $ 1.58 trillion. When compared to the enterprise value of $ 1.49 trillion, my model indicates that these two segments combined are worth more than Amazon’s EV. This implies that investors are paying nothing for Amazon’s e-commerce business and therefore, receiving the segment’s revenue for free.
Discounted Cash Flow Analysis
For my discounted cash flow model, I made assumptions of a 18% CAGR in revenue for Amazon over the next 4 years (see above). My DCF analysis arrived at an intrinsic value of $ 3508.23 per share (21.52% upside from current price of $ 2887). Regarding the assumptions of costs and expenses, I used 3-year historical averages as a% of sales.
Over the past three years, Amazon’s average cost of revenue was 59.14% of sales. Their 3-year average operating expenses were 35.37% of sales. Non-operating expenses were 0.46% of sales. Capital expenditures were 8.46% of sales. And finally, changes in net working capital were 3.25% of sales. Regarding terminal value, I used the 10 Yr Treasury Note as the perpetuity growth rate. After placing these assumptions into my DCF model, I arrived at the following cash flows for FY22 through FY25:
For my discount rate, I calculated Amazon’s WACC to be 7% using their current market capitalization and current market value of debt (illustrated below). To calculate Amazon’s Cost of Equity, I arrived at market risk premium of 3.95% for their cost of equity by taking the difference between an expected market return of 6.87% and risk-free rate of 2.92% (US Treasury 10Y). To calculate the market value of debt, I used the interest expense from 2021, total debt (book value) from YE21, and a period of 4 years.
After applying a discount rate of 7% to my forecasted future cash flows for Ford, I arrived at an intrinsic value of $ 3508.23 per share (pictured below). This represents an upside of 21.52% from the current share price of $ 2887. My price-target falls below the median of Wall Street 12-month price targets, which range from $ 2800 to $ 5000 per share.
There are a number of risks to consider before investing in Amazon. The risk of recession is steadily increasing and may come sooner rather than later. Despite healthy consumer balance sheets among the US population, Goldman Sachs sees the risk of recession in the next year as high as 35%. This is very much a possibility in the near future given the geopolitical turmoil, inflationary environment, high oil prices, and potential corporate tax hikes. Given the healthy state of the consumer balance sheet, the next recession will hopefully not be as bad as the dot com bubble or sub-prime mortgage crisis.
Another risk is the supply-chain disruptions that continue to plague global business. These disruptions have been driven by the current geopolitical discord, high costs of raw materials, and Brent crude over $ 100 a barrel. Companies throughout the United States are having to deal with a lack of inventory due to rising costs of materials, while others are lacking the capacity to meet demand.
A third headwind is the labor shortage. Amazon is very reliant on employees for their e-commerce segment. This growing disparity between employees and jobs could further decelerate the e-commerce segment’s growth. Additionally, the labor shortage has given potential employees leverage over employers in terms of compensation. In order to make these jobs at their new facilities attractive, Amazon is going to have to offer competitive compensation. This increase in payroll expenses could be costly to Amazon’s bottom line.
A fourth and final risk is the growing threat of unionization among Amazon employees. Widespread unionization among workers is probably the greatest long-term threat to Amazon. The labor shortage could force Amazon to concede to a union’s demands. Unions will demand significant pay raises and expensive benefits, which could significantly hinder Amazon’s long-term growth.
Amazon is one of those stocks that you buy and hold for 40 years. The growth in their services division looks promising, bolstered by wider profit margins in their e-commerce segment. The wide margins of their services division will increase profitability and future cash flows, allowing Amazon to reward shareholders (e.g. stock buybacks). Additionally, the total addressable market for AWS is expected to expand rapidly, which bodes well for the future growth of Amazon’s AWS segment and their profitability. The unionization of employees is my one major area of concern, especially during a labor shortage. However, I am confident in Amazon’s leadership to successfully navigate through their unionization problem. Long AMZN.