Amazon.com (AMZN) stock has had quite a run. Investors have bid up the stock tremendously, focusing on strong revenue growth and significant market share gains. In this article, I seek to show why enthusiasm for the stock is completely unfounded and why Amazon may present a good short opportunity.
As one of the largest, most successful Internet retailers, Amazon generates revenue from many products and services. Merchandise and content is purchased for resale from vendors and third-party sellers. In addition, Amazon manufactures and sells the Kindle e-reader.
One side note before I project Amazon's future revenues: The firm's financial health is extremely solid. Amazon's pristine balance sheet carries a tangible book value of $5.856 billion as of June 30, 2011, very little debt, and cash and marketable securities totaling $6.355 billion. Off-balance sheet operating and capital commitments are negligible, amounting to under $900 million per year, an extremely small percentage of Amazon's costs. The firm is equipped to handle a difficult economic environment due to its strong financial position.
Amazon divides revenue into two segments, North America and International, and further into three sub-segments: media, electronics and other general merchandise, and "other." The "other" segment represents insignificant non-retail activity plus Amazon Web Services (AWS).
The majority of revenue is derived from the media and electronics segments. The media segment consists primarily of book sales, but also other items such as music and DVDs. The electronics segment consists of many items such as computers, tablets and televisions, as well as non-electronics items. Amazon's future revenue will be determined primarily by their share of the global books and electronics markets. I will first project media segment revenues by examining the U.S. market for book sales.
As data from the U.S. Census Bureau shows, this is a slow-growth market (click to enlarge charts):
Since this is a mature market, future growth within Amazon's domestic media segment must come from gaining market share. Below shows Amazon's strong revenue and market share gains since 2006:
While still impressive, the growth rate within Amazon's domestic media segment has slowed because there is only so much revenue that can be generated from a mature market once a certain level of penetration is achieved. Amazon has shown the ability to increase market share 5-6% per year, to the point where they may control 75% of the market by 2016. Assuming a 1% growth rate in U.S. book sales the next five years, I project Amazon's domestic media segment revenues through 2016 below:
Amazon's international media segment has also grown revenues significantly as shown below:
I project Amazon's international media revenues to grow slightly more than its domestic segment, due to significant opportunity within emerging markets:
The U.S. electronics market is also a slow-growth market. However, it has grown faster than the market for book sales as shown below:If Amazon's electronics sales are added, the CAGR increases to nearly 3%. In an article dated July 5, 2011 by Steven Smith and Alan Wolf, it is estimated Amazon had $7.9 billion of electronics sales in 2010 within the U.S., representing approximately 72% of segment revenue in "electronics and other general merchandise." (click here)
Below U.S. electronics sales are shown including sales from Amazon:
Amazon has begun to take significant market share within electronics since 2005 as shown below:
According to a recent NPD study (click here): "For example, only 19% of people surveyed by NPD said they would be 'extremely' or 'very likely' to buy a new television online, even though 56% of them research which TV they want to buy online.Other products that people are reluctant to buy on a web site include a Blu-Ray player (21%), a camcorder (also 21%) and oddly enough a mobile phone or smart phone (23%). The products with the highest percentage of people willing to pay for them online include computers and computer software (both 34%), an eReader (32%) and a digital camera (30%)."
Although Amazon has grown revenues significantly, it may be difficult to capture more than 20% market share due to the reluctance of many consumers to purchase expensive durables online. For many people there is comfort in testing an item at a store, walking out with their purchase, as well as the value and convenience of customer service when buying and returning.
I project Amazon's market share to slow when it reaches 20% as shown below:
Due to potential from emerging markets and the slow growth of the U.S. electronics market, I project Amazon's international segment to grow revenues faster than the domestic segment. Amazon's international segment's electronics revenues since 2006 and my future projections are below:
My projections:
My total projected revenues for Amazon are as follows, which include "other" segment revenues reaching nearly $5 billion domestically within five years due to growth of Amazon Web Services (AWS):
Amazon not only faces the challenge of a mature domestic market within its core products but also a challenge improving margins. Amazon's past gross margins are below:
While many companies such as Google (GOOG) and Intel (INTC) have had success increasing gross margins as revenues have grown, Amazon has had trouble doing so. Its gross margin year after year has been remarkably similar. Why? Google and Intel offer products which are vitally important and hard to replicate, while Amazon sells commodities and competes mostly on price. Below are gross margins from competitors:
Competitors have remarkably similar gross margins. From Amazon's past execution and the performance of its competitors, it seems unlikely Amazon will be able to improve gross margins much above 25%. Investors are making a mistake by treating Amazon as a unique internet firm. Although Amazon's top line growth needs to be recognized, investors will soon realize Amazon is just another retailer unable to improve gross margins because it is in the business of selling commodities and competing on price.Below I will examine Amazon's other costs and show why they will also have difficulty increasing their operating margins, which not only has to do with the difficulty of improving gross margins, but also increasing fulfillment, shipping and technology costs.
A description of fulfillment costs from the most recent 10-K:
"Fulfillment costs represent those costs incurred by operating and staffing our fulfillment and customer service centers, including costs attributable to buying, receiving, inspecting, and warehousing inventories; picking, packaging, and preparing customer orders for shipment; payment processing and related transaction costs, including costs associated with our guarantee for certain seller transactions; and responding to inquiries from customers. Fulfillment costs also include amounts paid to third parties that assist us in fulfillment and customer service operations."
Fulfillment costs ranged from 8.4%-8.7% of sales from 2006-10. However, in 2011 they have increased to 9.1% of sales. It appears it is costing Amazon more to prepare and process orders. This may not seem like a big deal, as these costs for the first six months of 2011 have only increased 90 basis points compared to the first six months of 2010. But when your operating margins are below 5%, 90 basis points is a big deal.
Net shipping costs are part of "costs of sales." From 2006-09 net shipping costs as a percent of revenue ranged from 3%-3.5%. In 2010 they increased to 4.1% of revenue. In 2011, they are up to 4.8% of revenue, an increase of one full percentage point over the first six months of 2010. As Amazon enters the more expensive electronics market and is forced to compete on price, it appears they have no choice but to eat more shipping costs.
A description of Technology and Content expenses from the 10-K:
"Technology and content expenses consists primarily of payroll and related expenses for employees involved in application development, category expansion, editorial content, buying, merchandising selection, and systems support, as well as costs associated with the compute, storage, and telecommunications infrastructure used internally and supporting AWS."
Since 2007, technology and content costs ranged between 5.1% and 5.5% of sales. They have increased to 6.5% of sales the first six months of 2011, a 90 basis point increase from the first six months of 2010. Again, a big deal when operating margins are below 5%. There is no sign of these costs decreasing as a % of revenues, as Amazon states in the latest 10Q, "We expect these trends to continue over time."
The factors above explain why Amazon's operating margin the first six months of 2011 was almost chopped in half compared with the first six months of 2010.
Now that we have an idea of Amazon's future revenue growth and costs, we need to determine the best way to value Amazon.
An EV/EBITDA valuation will not work because Amazon's closest competitors are much slower growth retailers. Currently, Amazon carries a ridiculous EV/EBITDA multiple over 40, nearly 4x e-Bay's multiple.
Free cash flow will also not work because Amazon has been spending aggressively on capital expenditures the past 18 months as they expand rapidly. Shown below:
Amazon has some work to do if they seek to achieve their ultimate goal stated in the 10-K as follows:"Our financial focus is on long-term, sustainable growth in free cash flow per share."
Both of the above measures would underestimate the value of Amazon. I believe a discounted earnings model is more appropriate, which measures the future earnings power of the underlying business. Below is my discounted earnings model on Amazon. The assumptions are derived from my explanations above. I assume slightly lower tax rates each year due to a greater percent of revenue from abroad generated in lower-tax jurisdictions, as well as a slight dilution of share count consistent with the trend due to Amazon's stock compensation. There is no sign of share buybacks in the future. Although Amazon purchased a small amount of shares in 2008, there have been no share repurchases since:
| Amazon Discounted Earnings Model | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 |
| Amazon Projected Net Sales | 49944 | 66497 | 86305 | 105052 | 124072 | 141908 |
| Growth Rate | 46.0% | 24.9% | 23.0% | 17.8% | 15.3% | 12.6% |
| Cost of Sales | 38457 | 51203 | 66455 | 80890 | 95536 | 109270 |
| % of Revenue | 77% | 77% | 77% | 77% | 77% | 77% |
| Gross Margin | 11487 | 15294 | 19850 | 24162 | 28537 | 32639 |
| % of Revenue | 23% | 23% | 23% | 23% | 23% | 23% |
| Fulfillment Costs | 4495 | 5652 | 7336 | 8929 | 10546 | 12062 |
| % of Revenue | 9.0% | 8.5% | 8.5% | 8.5% | 8.5% | 8.5% |
| Marketing Costs | 1498 | 1995 | 2589 | 3152 | 3722 | 4257 |
| % of Revenue | 3% | 3% | 3% | 3% | 3% | 3% |
| Technology and Content Costs | 3246 | 3990 | 5178 | 6303 | 7444 | 8515 |
| % of Revenue | 6.5% | 6% | 6% | 6% | 6% | 6% |
| General and Administrative Costs | 749 | 997 | 1295 | 1576 | 1861 | 2129 |
| % of Revenue | 1.50% | 1.50% | 1.50% | 1.50% | 1.50% | 1.50% |
| Other Costs | 200 | 266 | 345 | 420 | 496 | 568 |
| % of Revenue | 0.40% | 0.40% | 0.40% | 0.40% | 0.40% | 0.40% |
| Operating Margin | 1299 | 2394 | 3107 | 3782 | 4467 | 5109 |
| % of Revenue | 2.6% | 3.6% | 3.6% | 3.6% | 3.6% | 3.6% |
| Other Income | 25 | 120 | 155 | 189 | 223 | 255 |
| Earnings before Taxes | 1324 | 2514 | 3262 | 3971 | 4690 | 5364 |
| Taxes | 25% | 24% | 23% | 22% | 21% | 20% |
| Net Income | 993 | 1910 | 2512 | 3097 | 3705 | 4291 |
| Diluted Shares Outstanding | 460 | 469.2 | 478.6 | 488.2 | 497.9 | 507.9 |
| Earnings per Share | 2.16 | 4.07 | 5.25 | 6.34 | 7.44 | 8.45 |
| Discounted Earnings per Share | 0.53 | 3.61 | 4.24 | 4.65 | 4.96 | 5.12 |
| Cost of Capital used | 10% | |||||
| Terminal Growth Rate | 5% | |||||
| Sum of Discounted Earnings | 23.12 | |||||
| Discounted Terminal Value | 107.58 | |||||
| Amazon Fair Value per Share (after net cash per share adjustment) | 139.88 |
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