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The world's hottest shares, part 2: Amazon

Amazon keeps on making new highs – but can it continue to do so? Neil Wilson weighs up the investment case
The world's hottest shares, part 2: Amazon

Back in January  it was announced that Moderna, a US biotech company with a market capitalisation of about $7bn that few people outside of US biotech would have known much about, was using Amazon’s (US:AMZN) cloud technology to develope a class of medicines that apply messenger RNA. The Amazon Web Services (AWS) cloud platform is central to analysing the data and making the whole process faster, reducing the time it takes to go from research to trials. Moderna (US:MRNA) was working with AWS on a range of drug candidates at the time; now it’s using this same approach to fast track a potential Covid-19 vaccine. In no small part thanks to Amazon, Moderna is leading the race for a coronavirus vaccine. The implications need hardly be explained, albeit some of the shine has since come off the initial announcement by Moderna that phase 1 trials were going well.

Using AWS is a powerful tool that didn’t exist for drug companies before. It eliminates wrong pathways, blind alleys and wild goose chases in super-quick time. It’s rather like playing chess against a computer that can analyse every potential move in a nanosecond while I try to remember how castling works – it's going to win.

But we’re not talking about Moderna in this article; the above only serves to illustrate just what a powerful and important platform AWS has become. Not only can we find applications in just about every setting imaginable, it has become a behemoth that accounts for a third of the global cloud market and can count Apple as one of its biggest customers. 

Amazon's cloud platform is a key reason behind the ongoing investment thesis for the stock. AWS revenues exceeded $10bn for the first time in Q1 this year, generating 13.5 per cent of total revenue, but 77 per cent of operating income. It’s a high-margin business, generating more profit than any other division.

 

Deceleration

But AWS is not growing as fast as it was. Back in January Deutsche Bank warned that competition and some top-level personnel changes underscored the “increased risk of further deceleration at AWS”.

Compared with Microsoft (US:MSFT), AWS growth is heading in the wrong direction. This may not be as big a worry as it may seem given AWS is just so big in the first place – Amazon accounts for around a third of cloud spending, versus about a fifth of sales being generated by Microsoft. But Goldman Sachs’ biannual survey of IT spending at large companies suggests Microsoft’s Azure is becoming a lot more popular. By 2023, the bank expects Azure to be the most-utilised cloud vendor. Overreliance on AWS for operating income growth could weigh on Amazon stock in the coming two to three years, although this looks to be fairly well appreciated by the market already.

 

Covid-proof

RBC Capital Markets analyst Mark Mahaney is one of the leading watchers of Amazon. He sees the company as a long-term pick partly because of the pandemic. “We view AMZN as a structural winner as the Covid-crisis accelerates the shift to online retail and businesses deepen their transformation to digital, benefiting AWS,” he wrote in a recent note.

The e-commerce story needs little introduction. The pandemic and subsequent response by governments only makes consumers shop online a lot more. 

RBC research shows, in the key US market at least, that consumers prefer Amazon to all others for their online shopping, followed by Walmart. Being popular matters when you want to add more products to your virtual shelves. 

Mahaney highlights the potential for Amazon online grocery to further expand – currently it’s just a tenth the size of Walmart in terms of sales. He expects growth of 24 per cent in this segment over the next three years. In the UK, Amazon has a partnership with Morrisons, although lately there has been some chatter about a tie-up with Marks and Spencer.

Stifel analyst Scott Devitt agrees, saying: “We believe Amazon will be better positioned following Covid-19 given the upcoming substantial dislocation in traditional retail and long-term benefit in cloud services as digital transformation accelerates.”

Both analysts cite AWS, of course, as the shift to remote working is powering incremental demand for cloud hosting. 

Arguably what’s more relevant – and instructive – is the amount Amazon is spending to make its business Covid-proof. After its Q1 results – which barely reflected the lockdown in the US – Amazon said it would spend $4bn to make sure workers were safe and ensure that deliveries, – which couldn’t keep pace with an intense uptick in demand initially – can resume normal service. This means the company could swing to an operating loss of $1.5bn in the second quarter. 

About $600m in cleaning supplies and $300m in testing was not forecast, but it’s better than shutting fulfilment centres and handing much of the increase in demand to competitors. Only three months earlier the market chatter was on the cost of implementing one-day delivery for Prime members – an investment that investors have been happy to shrug off.

As ever with Amazon, the company is not looking to the next quarter earnings per share (EPS) but 5-10 years out, continually reinvesting profits when required. It was this attitude that took Amazon to where it is today and so long as the leadership doesn’t change, there is little chance of this culture changing.

The return on investment from this $4bn will become abundantly clear towards the end of 2020 and into 2021 as we see increased demand for Amazon services. 

In January – albeit before the Covid spending splurge was disclosed – Jefferies analysts explained: “We continue to view valuation as supporting further outperformance and believe near-term spending has no bearing on AMZN’s ability to drive long-term profit upside from faster revenue growth at higher-margin businesses (AWS & advertising).” In short, don’t worry about Amazon's spending, look at the top-line growth.

 

Advertising: Amazon's best kept secret

Often overlooked by stockpickers dazzled by the online retail and AWS footprints, Amazon is also increasingly a major advertising player. The company is rather quiet on its ad business and doesn’t break out the numbers fully. But we know advertising makes up the vast bulk of its ‘other’ segment. 

 

 

Amazon's original headquarters

 

In January the company said the division grew 40 per cent in the final quarter of 2019 to $4.8bn, while this momentum followed through into the first quarter 2020 as revenues for the division rose 44 per cent from a year before to $3.9bn. This was well ahead of growth in online sales (24 per cent), subscription services (28 per cent) and Amazon Web Services (33 per cent).

Advertising is important because it’s high-margin and the growth underlines the way Amazon is disrupting Facebook (US:FB) and Google's (US:GOOGL) dominance. Increasingly Amazon will gain market share, albeit it won’t overtake either. According to data from eMarketer, Amazon could account for 14 per cent of US digital ad revenues in 2023, up from 9 per cent last year. The more people shop on Amazon, the more traffic, the more ads. It’s a virtuous circle that looks tough to break.

In advertising, as in everything else, Amazon is capable of disruption wherever it decides to go, and this is one of its great attributes.

 

Anti-trust angst

Disruption and dominance do not come without drawbacks, notably the attention of regulators and politicians with an eye for re-election. One US senator recently called for a criminal antitrust investigation, just to add more legal trouble on top of the many civil cases the company is already answering.

In a letter to Attorney General William Barr, Republican senator Josh Hawley said the company "has engaged in predatory and exclusionary data practices to build and maintain a monopoly”. 

Jeff Bezos, Amazon chief executive and the world’s richest man, is an easy target for populists. And he owns The Washington Post, which has come under fire from Donald Trump for, well, just about everything. Of course, antitrust concerns have been circling Amazon for a while. Amazon’s relationship with its third-party sellers is increasingly a source of concern. And, ever since the Facebook-Cambridge Analytica scandal, big tech has been an increasingly easy target for Washington and Brussels. 

Amazon is facing multiple antitrust probes in the US and Europe relating to various parts of the business. The US Congress recently called on Mr Bezos to testify in an investigation into whether Amazon unfairly used data on third-party sellers to boost its own products – the source of Senator Hawley’s concerns, which were reported after a Wall Street Journal investigation. If true, it would put Amazon in hot water as it would directly contradict its previous Congressional testimony. Thus far, Mr Bezos has demurred. Meanwhile, the US Federal Trade Commission has widened its anti-trust investigation beyond the company’s retail business to include AWS.

Most think that break-up risks are relatively low, but greater regulatory scrutiny of its business is a potential problem and increased regulation in both e-commerce and advertising are both risks. EU fines can sting – Google has been slapped with more than $9bn in fines by zealous former European Competition Commissioner Margrethe Vestager in the past three years. 

Meanwhile, while battles with unions and worries about working conditions are also a perennial bugbear and source of more political virtue-signalling, they have so far failed to handicap the fastest horse in the race.

 

Spinning top

Trying to call the top on Amazon stock has always been a mug’s game; it achieved escape velocity long ago. Whatever else happens, it seems Amazon keeps on making new highs – but can it continue to do so?

Firstly, true it’s very well priced. But it always has been. Trading at about 115 times on a trailing 12-month basis, it’s more expensive than it was last year, but cheaper than the +200 times levels in 2016-17 and about where it was in the autumn of 2018. EPS is often lumpy: in growth stocks that plough free cash straight back into the business, price/earnings (PE) multiples can vary significantly from quarter to quarter, but the point is that Amazon is not much pricier than it was last year and is far less pricey than it has been historically. Earnings multiples have never really told the story about Amazon.

From a technical perspective, there is evidence that AMZN is now a bit overbought and the rally has become overextended. On each of the last four big tops for the stock, it has extended well above its 200-day simple moving average (SMA) and been forced back to – and under – this SMA support level before resuming the broader uptrend. We now see a potential double formation too and we are way too far extended at the top end of the Bollinger bands. The subsequent narrowing of this envelope combined with the double top and the extension above the 200-day SMA suggests we may see quite a strong pullback to within the longer-term average. 

So, should we be looking to short Amazon from here? There may be a potential short-term trade on this extension. But longer-term you would tend to see Amazon as – in the words of Mr Mahaney from RBC – a “structural winner”. Funnily enough, it could be AWS, through Moderna, that helps get us back in the bars, high-street shops and cinemas quicker, and means we use Amazon a little less than we do now.

 

Click here to read The world's hottest shares part 1: Tesla