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The Science of Hitting
The Science of Hitting
Articles (514) 

An Update on Amazon

My thoughts on the company following strong 2018 results

February 06, 2019 | About:

Amazon (AMZN) reported financial results for the fourth quarter of 2018 last week. Revenues in the quarter increased 20% to $72.4 billion, with revenues for the year up 31% to $233 billion. It’s worth noting that Whole Foods was only included in the 2017 results for the last four months of the fiscal year (if you remove Whole Foods from both periods, Amazon’s 2018 revenues increased by ~25%).

By segment, revenues for Amazon Web Services (AWS), North America, and International increased 47%, 33%, and 21%, respectively. Impressively, the growth rate for AWS accelerated in 2018 (lapping +43% in 2017), with revenues for the year to $25.7 billion. In addition, AWS has continued to show operating leverage, with segment margins climbing by 360 basis points to 28.4%. The combination of outsized revenue growth and margin expansion led AWS to $7.3 billion in operating income in 2018 – just $600 million short of what the segment reported in revenues in 2015.

Despite its continued growth, AWS still accounted for only 11% of Amazon’s revenues in 2018. This reflects the impact of the Whole Foods acquisition, as well as the fact that the North America and International businesses continue to grow as well (and started off a much larger base).

For Amazon as a whole, operating income tripled in 2018 to $12.4 billion (with EBIT margins up 300 basis points to 5.3%). Operating cash flow increased by nearly 70% to $31 billion. Net income exceeded $10 billion, which works out to roughly $20 per share of earnings. The company ended the year with $41 billion in cash on the balance sheet (and $18 billion of net cash).

Based on the financial results, it’s clear that Amazon continues to do a great job keeping its customers happy. As noted on the call, more people signed up for Prime this quarter than in any other quarter in the company’s history (with the number of customers that started a free trial or began a paid membership reaching “tens of millions” of people during the holiday season).

The company’s position as the preeminent e-commerce company (at least in the United States, where they are estimated to have 40-50% market share) is also leading to complementary opportunities for long-term growth. As an example, Amazon generated $3.4 billion in “Other” revenues this quarter, a 95% increase from the year ago period (adjusted for a change in accounting rules, the increase was closer to 40%). As noted in the quarterly release, the “Other” segment primarily includes sales of advertising services. If we assume advertising accounts for 60% of the segment, that’s a $6 billion business. This growth is expected to continue: Piper Jaffray analyst Michael Olson expects Amazon’s ad revenues to more than double over the next two years. This is just another example of how Amazon has produced significant value for shareholders by maintaining a willingness to take risks and focus on the long term (as noted in a recent Wall Street Journal article, Amazon has been selling ad space alongside product-search results on its marketplace for roughly a decade). This section from Jeff Bezos’ 2006 shareholder letter is worth thinking about:

“In some large companies, it might be difficult to grow new businesses from tiny seeds because of the patience and nurturing required. In my view, Amazon’s culture is unusually supportive of small businesses with big potential, and I believe that’s a source of competitive advantage. Like any company, we have a corporate culture formed not only by our intentions but also as a result of our history. For Amazon, that history is fairly fresh and, fortunately, it includes several examples of tiny seeds growing into big trees. We have many people at our company who have watched multiple $10 million seeds turn into billion dollar businesses. That first-hand experience and the culture that has grown up around those successes is, in my opinion, a big part of why we can start businesses from scratch. The culture demands that these new businesses be high potential and that they be innovative and differentiated, but it does not demand that they be large on the day that they are born.”

Conclusion

When it comes to valuing Amazon, I try to get to a reasonable estimate for intermediate-term revenue growth in the segments along with a normalized margin profile. Based on the assumptions in my model, I’m under the belief that normalized profitability could be around $110 per share in five years (to be clear, I am not saying Amazon will actually report $110 per share of earnings in 2023). Assuming a multiple of 15x to 25x on 2023 normalized profitabiliity and using a 9% discount rate, today’s fair value is in a range of $1,100 to $1,800 per share. With the stock at $1,660 per share, I think you can make the case that the current valuation for Amazon is reasonable.

That brings me back to what I said a moment ago: “Amazon has produced significant value for shareholders by maintaining a willingness to take risks and focus on the long-term.”

I’m not sure how to think about the value of an asset like Alexa, but I do know that the company responsible for nurturing it in the years to come has a proven track record of organic, long-term value creation (turning tiny seeds into big trees). I think it’s reasonable to assume they, if anyone, will find a way to do it again – whether it be with Alexa or some other emerging business we haven’t heard of yet. Again, I'm not sure how to think about quantifying that in a model but I do know it can be enormously important over the long run.

What does that mean in terms of the stock? I don’t own it currently, so that tells you something (actions speak louder than words). With that said, if it moved towards the lower end of the range discussed above, that might change. I have much respect for what this company and management team have built over the past 20 years – and if I get the chance to partner with them for the long-term at a price that seems reasonable, I’ll take it.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.7/5 (10 votes)

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Comments

Maximusliu
Maximusliu premium member - 2 months ago

Good analysis, thanks.

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Thanks for reading Maximusliu!

Ski Customer
Ski Customer - 1 month ago    Report SPAM

100% of the products I have recieved from Amazon have been counterfeit. Just two examples. I ordered $300 Danner boots, made in the USA. I recieved a knock off made in China worth $30. I orderd Canon camrea batteries and recieved fakes. I reported both and Amazon did not remove the products. You can still buy the fakes to this day.

I belive Amazon is knowingly selling counterfeit products and my story proves it.

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