Consider Buying Amazon Stock On Weakness Caused By Wells Fargo’s Downgrade

Summary:

• Wells Fargo downgraded Amazon’s shares due to margin pressures and the reduced, positive impact of its advertising business, but maintains a long-term bullish outlook on the name.
• AWS is poised for growth as companies migrate more of their infrastructure to AWS and increasingly outsource cloud management.
• AI trends are boosting AWS, with AWS CEO Matt Garman noting that its Bedrock platform is growing rapidly.
• Adobe forecasts an 8.4% increase in U.S. online sales for Nov-Dec, representing a significant acceleration of the sector’s growth.

On the afternoon of Oct. 7, Amazon’s (NASDAQ:AMZN) shares were sliding 3% after Wells Fargo downgraded the shares to “equal weight” from “overweight” earlier on the same day. Among the reasons for Wells’ bearish view on the shares are margin pressures due to investments that AMZN is making and the reduced, positive impact of its advertising business on its operating income.

But I believe that Wells may have overlooked multiple signs which indicate that Amazon’s main businesses are likely to strengthen in the near-to-medium term.

And even Wells remains bullish on the long-term outlook of AMZN, as the bank stated that “Amazon is likely still a solid margin expansion story over the long term.” What’s more, Wells cut its price target on the name to $183 from $225. However, the $183 price target is roughly in-line with the stock’s current price, implying that wells does not expect the shares to drop much in the coming year. Therefore, by buying the shares, I believe that long-term investors get a low-risk name that, based upon both my research and Wells’ positive long-term outlook on the shares, will be very rewarding down the road.

In light of all of these points, I recommend that long-term investors buy AMZN stock.

Wells’ Points Are Mostly Legitimate But Are Likely Baked Into the Stock and Will be Offset by Positive Catalysts

It’s true that Amazon’s operating margin dropped by 2% last quarter versus the same period a year earlier. Moreover, the company’s capital investments jumped 50% last quarter versus the same period a year earlier, and Amazon stated that it expects its capital investments to climb in the second half of the year than in the first half. And Wells cited some areas in which the company is known to be investing significant amounts, including its internet satellite initiative, Project Kuiper, and reductions in the shipping fees that it charges third-party retailers.

But, as I’ll explain below, AMZN stock is changing hands at historically low valuations. As a result, I believe that the negative margin pressures cited by Wells are already baked into the stock’s valuation.

What’s more, AWS’ YOY sales growth accelerated to 19% last quarter from the 17% seen in Q1 and the 12% generated in Q2 of 2023. And the unit’s revenue came in at $26.3 billion, above analysts’ average estimate of $26 billion. Further, its bottom line jumped to $9.3 billion from $5.37 billion in Q2 of 2023. Also, noteworthy is that its backlog surged 19% YOY to an impressive total of $156.5 billion. Based on my research, I expect the unit’s growth to continue to accelerate and once again beat analysts’ mean estimate this quarter. The latter trend should boost the company’s overall margins, as AWS has relatively high margins.

I think that the signs of strength that I will cite below are likely not baked into the shares, given their historically low valuation and the propensity of many on the Street (in my experience) to often overlook non-quantitative developments.

Also, importantly, Amazon is taking multiple steps to improve the margins of its e-commerce business. Specifically, the firm noted that it is increasing its” use of automation and robotics, further building out (its) same-day facility network, and regionalizing (its) inbound network.”

The one main point made by Wells with which I disagree is that the contribution of the company’s ad business to its operating income is falling. As you’ll see below, the company’s ad unit actually has multiple, strong, positive catalysts going forward. In light of the fact that the firm’s ad business carries high margins, the acceleration of its growth that I expect to see going forward should boost the firm’s overall margins.

Signs of Strength for AWS

In a report released on Oct. 7, tech research and advisory firm Information Services Group (III) stated that, “Companies are shifting more on-premises infrastructure to AWS, driving up demand for cloud migration services in the U.S.” Also importantly, Information Services reported that, “It is becoming more common for enterprises to outsource cloud infrastructure management and operations.” As the leading cloud infrastructure provider, AWS is very well-positioned to benefit a great deal from the latter trend. Indeed, Information Services stated that the market for AWS’ services is expanding.

Meanwhile, suggesting that AWS is continuing to get a sizeable boost from the AI megatrend, the unit’s CEO, Matt Garman, recently said that AWS’ Bedrock platform is “growing like a weed right now.” Bedrock allows Amazon’s customers to utilize “a wide variety of open and proprietary (AI) models.” On Amazon’s Q2 earnings call, CEO Andy Jassy reported that “tens of thousands of companies (were) using” Bedrock. Thus, given the platform’s large user base, if utilization of the platform is “growing like a weed,” there’s a good chance that it could move the needle positively for AMZN in terms of the firm’s Q3 results.

Also, noteworthy is that Jassy did not directly state that Bedrock was growing very rapidly on the earnings call, while Garman did so in his recent interview. Jassy may have just chosen to be more conservative or reserved than Garman. Or the discrepancy could mean that Bedrock’s growth has meaningfully accelerated since July.

U.S. E-Commerce Is Reportedly Going to Meaningfully Accelerate

Last month, Adobe predicted, based on its analysis of “commerce transactions online,” that U.S. online sales would jump 8.4% from Nov. 1 to Dec. 31 to $240.8 billion. That would represent a major acceleration compared to the 4.9% YOY increase in 2023. Adobe did note that more than $2 billion of the increase would be driven by “strong discounts.” Still, that represents only about one percentage point of the three-and-a-half-percentage-point acceleration that Adobe expects to occur this year.

Of course, since Amazon is by far the largest e-commerce player in the U.S., it should benefit meaningfully from this acceleration.

FedEx (FDX) also indicated that e-commerce’s growth is accelerating. On its earnings call held on Sept. 19, CEO Raj Subramaniam reported that ” e-commerce is resetting and starting to grow again.”

Wells expects Amazon to be hurt by “a mixed consumer and trade-down pressure on average selling prices.” These are valid concerns. As I’ve noted previously, Citi CFO Mark Mason reported last month that consumers’ spending is “going from discretionary to more staple-type spend,” while “all of the spend growth is skewing from (its) largely affluent customers.” What’s more, the executive noted that card “payment rates are starting to come down a bit.” The latter point suggests that some consumers are under pressure.

Nonetheless, the statements by Adobe and FedEx lead me to believe that e-commerce’s growth is accelerating despite these negative catalysts.

Advertising and Healthcare

As I noted earlier, Wells Fargo expects a “moderating..contribution” to the company’s operating income by its ad business.

But Hollywood Reporter, which often covers the ad sector, sounded much more enthusiastic about Amazon’s ad business. Noting that Amazon had reportedly secured over $1.8 billion in upfront commitments from marketers for ads on Prime this year, Hollywood Reporter stated that “Amazon is in prime position (pun intended) to continue that growth into 2025, as a number of strategic moves appear set to converge.”

The publication noted that Amazon intends to add “a little bit” more inventory in 2025, And AMZN’s “Thursday Night Football is averaging nearly 15 million viewers per game, according to Nielsen, 25 percent above last year’s numbers,” Hollywood Reporter added. Moreover, Amazon is now showing “shoppable and interactive ads” during the games. In light of the latter points, I think there’s a good chance that Amazon meaningfully increased the amount that it is charging marketers for ads during the games this year.

What’s more, Amazon is slated to start showing NBA games on Prime for the first time next year, giving it another opportunity to benefit from showing ads during live sporting events.

Also, noteworthy is that Amazon’s pharmacy business may be starting to move the needle in a positive direction. In July, Jassy, Amazon’s CEO, reported that the company’s pharmacy business was generating “a lot of growth.” The U.S. retail pharmaceutical market, according to one estimate, was worth nearly $570 billion last year. Amazon’s revenue last year was $574.79 billion. So if Amazon can increase its share of the U.S. pharmaceutical market by five percentage points this year, that could add nearly 5% to the firm’s sales.

Risks and Valuation

Investment bank Oppenheimer recently downgraded Microsoft to “perform” from “outperform.” One of the reasons for the downgrade was Oppenheimer’s belief that utilization of AI by enterprises would be weaker-than expected. If the bank is correct, AWS could be hurt by the same trend, despite Gorman’s positive comments about Bedrock.

Wells Fargo could be correct about Amazon’s e-commerce and advertising business, along with its margins, at least in the short-to-medium term. Amazon’s shares could take a hit as a result of developments in the FTC’s antitrust case against the conglomerate. Higher oil prices going forward would hurt the company’s margins, while an acceleration of wage growth and/or any trends toward the further unionization of Amazon’s workers would have the same impact.

On the valuation front, Amazon’s forward EV/EBITDA ratio is 14.4. That’s well above the sector average of 10.1. But it’s also historically low for AMZN. Its EV/EBITDA ratios at the end of 2023, 2022, 2021, and 2020 were 19.88, 28, 21.27, and 32.2, respectively.

Also noteworthy is that Amazon’s price-to-earnings ratio tumbled from 102.65 times in June 2023 to 43.25 times as of Oct. 7. Finally, the company’s EV/FCF ratio was 40.5 times as of Oct. 8, down from 47.6 in January 2024 and 82 times a year ago.

The Bottom Line

Amazon appears to have many positive drivers that will boost its financial results going forward, including the apparent strength of its AWS, e-commerce, advertising and pharmacy businesses. What’s more, even Wells Fargo agrees that the company’s long-term outlook is positive. Also importantly, the firm’s valuation is historically low. In light of these points, I recommend that investors with a time horizon of 18 months or more buy the shares.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of AMZN either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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