Amazon (US:AMZN) is one of the strongest consumer brands in the world. It divides opinion among consumers and investors alike as to whether it is a force for good or bad. From an investor’s point of view, it is either a transformative company that will go on to create masses of future value and is worth every dollar of its current share price, or its shares are very overvalued and cannot deliver the expectations of profits growth that are currently priced in.
There can be no denying that Amazon’s growth rate has been exceptional, and the valuation of its shares clearly implies that it is expected to keep on growing strongly. The risk of overpaying for future growth is one of the biggest that investors face. Sometimes, though, despite this risk, paying a high price for an exceptional company pays off as the growth comes through.
Long-term investors in Amazon shares have been rewarded so far for taking on this risk. Is it a risk that is still worth taking?
The business
Many readers will be very familiar with what Amazon does as they are or have been customers of it. Amazon has been in business since 1994. It started out by selling books to customers and has evolved into a retail colossus and much more. It now sells millions of different products through its website and some bricks and mortar stores. Through its Amazon Prime subscription service, it gives customers free delivery on goods, as well as access to video media, ebooks and music. It also has a publishing business and has moved into the selling and delivery of food.
It also helps other businesses sell their products through Amazon Marketplace in return for a percentage of the sales made.
In recent years the company has made a big push into selling devices such as the Kindle e-reader, Fire tablet computers and media devices and the Echo smart speaker with its Alexa cloud-based voice service. These are sold with the aim of creating more loyal Amazon customers – rather than a source of profit in themselves – but have also allowed Amazon to gather huge amounts of customer data and create a rapidly growing source of advertising revenues.
Most attention is placed on Amazon as a retailer, but its cloud-based computer services business – Amazon Web Services (AWS) – for businesses and developers has been growing rapidly and is much more profitable than its retail business. It offers customers cloud storage services as well as database and analytical services.
Amazon’s strategy in its own words is to grow its business with a relentless focus on customers, constant innovation, operational excellence and long-term thinking. In simpler terms, and in the eyes of its customers, it means selling more products at lower prices and delivering them faster than anyone else.
The business is seasonal, with just over 30 per cent of its sales coming in the September-December quarter.
Financial performance
For a long time Amazon’s financial performance has been summed up as lots of revenue growth at very thin profit margins. Its results for 2018 suggest that this might be changing.
AMZN ($bn) | 2014 | 2015 | 2016 | 2017 | 2018 |
Sales | |||||
North America | 50.8 | 63.7 | 79.8 | 106.1 | 141.4 |
International | 33.5 | 35.4 | 44 | 54.3 | 65.9 |
AWS | 4.6 | 7.9 | 12.2 | 17.5 | 25.7 |
Total | 88.9 | 107 | 136 | 177.9 | 233 |
change | 20.4% | 27.1% | 30.8% | 31.0% | |
Op profit | |||||
North America | 1.3 | 2.8 | 2.4 | 2.8 | 7.3 |
International | -0.1 | -0.1 | -1.3 | -3.1 | -2.1 |
AWS | 0.7 | 1.9 | 3.1 | 4.3 | 7.3 |
Total | 1.9 | 4.6 | 4.2 | 4 | 12.5 |
change | 142.1% | -8.7% | -4.8% | 212.5% | |
Margins | |||||
North America | 2.6% | 4.4% | 3.0% | 2.6% | 5.2% |
International | -0.3% | -0.3% | -3.0% | -5.7% | -3.2% |
AWS | 15.2% | 24.1% | 25.4% | 24.6% | 28.4% |
Total | 2.1% | 4.3% | 3.1% | 2.2% | 5.4% |
Source: Company reports
Revenues are still growing strongly, but profit margins are beginning to verge on the respectable. The North American retail business saw a step change in profitability in 2018 as previous investments started to bear fruit, while costs in staff and warehousing costs grew more slowly than sales. There was also growth in higher-margin advertising, which fed through to profits.
Amazon’s international operations are dominated by businesses in the UK, Germany and Japan, with a big push on growing in markets such as India, and in China where it has struggled to gain a foothold and make money. The international business is still losing a significant amount of money.
AWS has been growing rapidly in recent years as it has taken on more business customers while investing in more services. This business is now Amazon’s biggest source of profit, along with its North American business, and is making very high profit margins, which are driving the improvement in operating margins for the company as a whole.
The main focus of the business is on delivering sustainable growth in free cash flows. We can see that free cash flow has been quite volatile, but increased significantly in 2018 due to very strong growth in operating cash flows.
Amazon $bn | Net op CF | Capex | FCF | Net income | FCF conversion | Stock compensation | WCAP CF |
2014 | 6.84 | -4.89 | 1.95 | -0.24 | -809% | 1.50 | 0.97 |
2015 | 11.92 | -4.59 | 7.33 | 0.60 | 1230% | 2.12 | 2.56 |
2016 | 17.20 | -7.80 | 9.40 | 2.37 | 396% | 2.98 | 3.85 |
2017 | 18.37 | -11.96 | 6.41 | 3.03 | 211% | 4.22 | -0.24 |
2018 | 30.72 | -13.43 | 17.30 | 10.07 | 172% | 5.42 | -1.04 |
Source: Company reports
Amazon’s free cash flow is significantly more than its net income. The main reason for this is that it has a very big non-cash share-based compensation expense ($5.4bn in 2018), which reduces profits, and that capex is less than the depreciation and amortisation expense.
Stock compensation should be seen as the same as paying workers in cash in my opinion, but it is a big source of cash flow for Amazon. Investors looking at future cash flows should view these big payments as signs of potential increases in the number of shares in issue in future years. It is therefore better to look at the impact on future free cash flow per share than looking at free cash flow in isolation.
Amazon | Sales | Op Profit | Cap Employed | Cap Turnover | Op margin | ROCE |
2014 | 88.988 | 0.178 | 26.4 | 3.37 | 0.2% | 0.7% |
2015 | 107.006 | 2.233 | 30.9 | 3.47 | 2.1% | 7.2% |
2016 | 135.987 | 4.186 | 39.6 | 3.44 | 3.1% | 10.6% |
2017 | 177.866 | 4.106 | 73.4 | 2.42 | 2.3% | 5.6% |
2018 | 232.897 | 12.421 | 94.3 | 2.47 | 5.3% | 13.2% |
Source: Company reports
As profits have grown, so has the amount of money invested in the business (capital employed).The amount of sales per capital employed has come down (shown in a lower capital turnover ratio), but the improving operating margin has driven a big improvement in ROCE. ROCE is getting towards a very healthy level (I see a ROCE of more than 15 per cent as the beginning of being categorised as a very profitable business), and could keep on increasing.
If analysts’ forecasts are believable and are delivered, then Amazon is expected to be making nearly 10 per cent operating margins by 2021. Assuming capital turnover stays over two times, this could push ROCE to over 20 per cent by then. This is something to bear in mind when thinking about the valuation of the shares, which I will discuss shortly.
The company’s financial position is very healthy, with net cash balances of over $8bn. It can fund its growth investments very easily from its own cash flows and should not have to ask shareholders for fresh money.
Can it keep on growing?
According to current analysts’ forecasts, the outlook for future sales, profit and cash flow growth looks very bullish. But where is it going to come from?
Broker forecasts
Year | 2019 | % change | 2020 | % change | 2021 | % change |
Turnover | 275,087.90 | +18.1% | 324,997.40 | +18.1% | 374,859.20 | +15.3% |
Ebitda | 42,393.80 | +50.3% | 54,512.40 | +28.6% | 67,905.00 | +24.6% |
Ebit | 17,666.50 | +37.4% | 25,630.00 | +45.1% | 36,143.70 | +41.0% |
Pre-tax profit | 16,668.60 | +45.7% | 24,349.20 | +46.1% | 34,995.10 | +43.7% |
Post-tax profit | 13,805.40 | +34.9% | 20,344.00 | +47.4% | 28,482.80 | +40.0% |
EPS (¢) | 2,719.00 | +32.8% | 3,930.70 | +44.6% | 5,665.90 | +44.1% |
Dividend (¢) | - | - | - | |||
CAPEX | 14,729.40 | +9.7% | 17,036.90 | +15.7% | 19,112.20 | +12.2% |
Free cash flow | 27,366.10 | +58.2% | 37,768.80 | +38.0% | 47,124.20 | +24.8% |
Net borrowing | -38,970.10 | -68,550.10 | -91,828.10 |
Source: SharePad
It’s not unreasonable to think that Amazon can keep on taking market share from existing competitors and by targeting new market sectors and geographies. There’s no doubt in my mind that Amazon’s constant focus on innovation and investing in delivering stuff to customers at a lower cost makes it a very difficult business to compete against. This is its economic moat.
Some analysts and commentators took a cautious line on Amazon’s 2018 fourth-quarter results. They pointed to a slowdown in sales growth in its retail business, but if the results of Wholefoods (bought in the third quarter of 2017) are taken into account then the slowdown is not a big one.
The fourth-quarter results also gave cause for optimism that the growth potential of the retail business is still very good. It saw the biggest rate of sign-ups for Amazon Prime ever. This means more sticky customers, who are likely to buy a large proportion of their goods through Amazon in the future.
Further margin improvements – before any savings are reinvested in lowering prices – are likely to come from significant further investment in logistics, such as the leasing of aircraft. Amazon is confident that it can drive down the cost of getting goods to customers and deliver them faster by investing in its own logistics compared with third-party suppliers. This should not only help profits, but will further enhance its competitive advantage.
AWS is investing heavily in new capacity and new services to woo more customers. It is also taking the business into new geographies. The business has a similar strategy to the retail business in that the growth is driven to some extent by cutting prices and growing volumes.
It’s not unreasonable to think that cloud-based computing services are something of a commodity. However, Amazon is offering extra services such as databases, analytics and learning technologies that create a point of difference with the competition, probably at a lower price. The outlook for growth from AWS still looks good for the next few years at least.
That’s not to say that there aren’t considerable threats to Amazon. The guidance the company gave for 2019 first-quarter profits is not very clear and this has spooked investors. The range for expected operating profits is very wide at $2.3m-$3.3m, compared with $1.9m made in 2018.
The big uncertainty is India where the government has recently changed the rules for e-commerce businesses. The new rules have forced Amazon to remove its products from its website and forced it to only sell third-party products. This is not helpful to the business and the impact on profitability is not yet known.
Then there are the regulatory and political threats. Companies as successful as Amazon will always attract the attention of detractors. Some of it will be reasonable, some unfounded.
I think there is a tax risk facing the company as governments look to level the playing field in countries such as the UK between high-street retailers and those selling online. Sales taxes based on the sales location could eat into Amazon’s profits.
The other growing risk is the rising concern over individual privacy coming from companies that have strong positions in advertising. This is an issue for Amazon as its devices – particularly the Alexa Echo – have the potential to collect lots of customer data.
Amazon’s Marketplace service for third-party sellers is also being looked at by the EU to see if there is a conflict of interest where Amazon competes with its third-party sellers and whether its website favours Amazon’s own products over those of Marketplace sellers. The EU is also scrutinising whether Amazon uses Marketplace data to help its own retail business.
The valuation of Amazon shares
There’s no getting away from the fact that they remain very expensive. At $1,633 per share, they trade on nearly 80 times trailing earnings and have a trailing free cash flow yield of just 2.2 per cent.
Amazon valuation at current share price
Share price $ | 1633 | |||
Current mkt cap $m | 802,134 | |||
2018 | 2019 | 2020 | 2021 | |
Net income | 10073 | 13,805 | 20,344 | 28,483 |
Free cash flow | 17296 | 27,366 | 37,769 | 47,124 |
Free cash flow per share($) | 34.6 | 53.9 | 73.0 | 93.7 |
PE | 79.6 | 60.1 | 41.5 | 28.8 |
Earnings yield | 1.3% | 1.7% | 2.4% | 3.5% |
FCF yield | 2.1% | 3.3% | 4.5% | 5.7% |
Source: SharePad/My calculations
If analysts’ forecasts are broadly right – they could be very wrong – then someone buying the shares at $1,633 would have a free cash flow yield on cost of over 5 per cent in three years’ time. On that scenario and assuming interest rates do not rise, I would say that the chances of losing money on Amazon shares over three years would be quite low.
Of course, analysts’ forecasts should be treated with large pinches of salt. That said, the quality of Amazon’s profits is getting better – read higher margins and ROCE – and with decent growth, I have some sympathies with the bulls of the shares that they could still offer some upside from here. That said, they are only suitable for those happy to take on the risks of overpaying.
