Amazon: Valuing Maturity

Amazon faces maturity: With 10% of the US retail market, sales growth in 1P and 3P as well as its prime, media and advertising segments should slow. Amazon has become the market.

AWS also slows: Amazon Web Services is 33% of the market with heavy weight competition (Microsoft, Oracle, Google) . Growth rates of 30% do not seem sustainable and should decline to 20%.

Margin gains: Post pandemic capacity expansion and fixed cost in fulfillment should be diluted and EBITDA margins can expand from 10% to 14% through YE25.

Free Cash Flow acceleration: Slower growth has a big advantage, lower capex as well as working capital plus EBITDA margin gains can produce US$30bn in FCF for 3% yield in YE23 and growing.

Valuation: At 15x EV/EBITDA, a significant discount to consensus (24x) provides 30% upside with a YE22 price target of US$2,858.

Risk: Short term analyst downgrades and a still weak 2Q22 plus market dynamic, can keep the share around US$2000 (pre split).

Amazon’s growth story is not over but faces a slowdown with a shift toward maturity and significant free cash flow generation. The key question is: Can Amazon keep its premium valuation as it moves into slower growth and dare I say begins to pay dividends? 

Amazon’s core ecommerce sales are slowing on maturity. With an estimated 10% market share of all retail sales in the US (11% Walmart) Amazon could see better than market growth for a few years on further ecommerce penetration but sooner rather than later retail sales should slow and grow on a multiple of GDP i.e. 5%+. That leaves the cloud service business (AWS) to carry growth, and this has an estimated 33% share (Microsoft 22%) and unlikely to be able to maintain a 20%+ growth rate past YE25.

Slower revenue growth: 1- ecommerce (1P) retail sales via its website are decelerating 2- marketplace (3P) products it sells on its website for third parties should continue to grow at 2x GDP (nominal), 3- Entertainment and Marketing in line with 1P and 3P traffic generation, and prime service (Prime accounts are an estimates 125m same as US Households). 4- Cloud service, Amazon Web Service (AWS) is the key driver. Thus, on a consolidated bases Amazon looks more like a 12% top line grower medium term with a gradual decline as 1P and 3P decelerate simply due to size, Amazon is the market.

Amazon retail is a bigger than one may think. Reported marketplace (3P) revenue is the fee it charges the third-party retailers to list and deliver products and at a 20% take rate this backs into over US$400bn in gross merchandise volume (GMV), about the size of Walmart. Add its direct sales (1P) and this adds up to US$600bn and with 70% sales in the US, this is over US$400bn vs total US retail sales of US$4.5trillion.

What is AWS? It’s made up of many different cloud computing products and services such as storage, networking, remote computing, email, mobile development, and security. It’s the backbone of the digital business world. AWS can be broken into three main products: EC2, Amazon’s virtual machine service, Glacier, a low-cost cloud storage service, and S3, Amazon’s storage system. At the heart of this business is infrastructure i.e., computer servers and software engineers, IT development and service. 

Web infrastructure is a US$350bn market that should continue to growth 20%+ year, it’s akin to an electricity grid or a cable/telecom network, but at some point, infrastructure needs are met, and growth slows. They compete with Google, Microsoft, Oracle, and others.

Consensus Forecast too positive? There are 48 analyst covering Amazon with consensus estimates that point to a still high 14% revenue growth, 25% earnings growth, FCF of US$40bn and a YE22 price target of $3700 or an implied PE of 66x and EV/EBITDA of 25x. EBITDA margins are forecast to increase to 19% and cash to build up to over US$150bn by YE25 a very positive scenario.

The low end of estimates does not change much, which prompts me to believe the market could be enthralled with Amazon and perhaps not applying a potential slowdown risk that, in my view, is a very real possibility.

I believe Amazon shares may continue to trade sideways until at least 3Q22. This is partly due to market dynamics, Fed rate hikes, inflation, and slower GDP growth. Partly due comparative valuations, there are a lot of very beaten down stocks with solid growth to look out for. And finally, the possibility of analyst downgrades. However, post 3Q22 and prime day, Amazon results could begin to reflect the new slower growth and higher FCF dynamics.

Negative triggers – Consensus downgrades i.e., price target cuts, reduced guidance of course and missing estimates.

Positive triggers – M&A that enhances cost structure, expands away from US or expands and creates new vertical i.e., logistics, fintech or software.

Would share buy backs and a dividend add value to the stock? Theoretically yes but many would view this as a sign of maturity, slower growth, and an inability to find new ideas. This could backfire and lead to lower valuation.

On more conservative estimate, one that assumes Amazon’s core ecommerce platform slows revenue growth to 12% and margins expand to 13.6%, EBITDA grows 20% and cash build up to US$100bn. Still very good results for a company the size of many nations. At a 15x EV/EBITDA target multiple, Amazon has 30% upside, in my view.

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