VGI Partners – Amazon: A Remarkably Compelling Investment Case
Contributor since 2019 / 9939 Followers
Summary:
- US technology and e-commerce conglomerate Amazon is our second largest investment position.
- AMZN’s share price declined nearly 50% in calendar 2022.
- Amazon remains a high conviction holding and we are incredibly excited by its prospects.
HJBC
The following segment was excerpted from this fund letter.
Amazon (NASDAQ:AMZN)
US-listed derivatives and futures exchange operator CME Group was our largest investment position, closely followed by US technology and e-commerce conglomerate Amazon (an investment we first initiated in VGI’s global strategy in 2014).
Amazon is a dominant player in e-commerce (#1 globally), cloud computing (#1 globally), and digital advertising (#3 globally), all massive and structurally growing end markets. Amazon’s share price declined nearly 50% in calendar 2022 due to a myriad of macro and company-specific headwinds, including slowing economic growth, rising inflation, tighter monetary policy, and substantial overinvestment. Free cashflow turned deeply negative.
We are disappointed, to say the least. Nevertheless, the investment case for Amazon today is remarkably compelling. Market expectations have been reset, the valuation is extremely attractive, and management is intent on improving profitability and reducing capital intensity. Amazon remains a high conviction holding and we are incredibly excited by its prospects.
For the past year, the market has been concerned about the growth and profit outlook for its e-commerce business, which is presently loss-making due to overinvestment and cost inflation. Management has responded by laying off more than 18,000 employees — the biggest reduction in Amazon’s history.
Beyond the reduction in force, Amazon has frozen hiring in its e-commerce and corporate divisions, cancelled or delayed warehouse openings, raised prices on a variety of products (including Prime memberships), eliminated several unprofitable lines of business and seeded new ones (e.g. Buy with Prime) to fill excess capacity. (Amazon doubled the size of its e-commerce footprint over 2020-2021.) Buy with Prime has been shown to increase shopper conversion by 25% on average and is now widely available to US-based merchants.
Looking past the short-term headwinds, we are highly optimistic about the trajectory of the e-commerce business. Whilst logistics investments have led to short-term losses, they have strengthened the competitive moat of the e-commerce business and its ability to meet customer demand for years to come.
E-commerce is a highly valuable business which has spawned the 3rd largest advertising business in the world (the best search results in the world for advertisers are those of Amazon customers) and a subscription business (Amazon Prime) which acts as a powerful flywheel to e-commerce and other business lines such as devices, streaming video/music and soon satellite broadband (via Amazon’s Kuiper business). We think the market is overly pessimistic about the prospects for e-commerce (inclusive of advertising) and underwrite scenarios where we estimate the e-commerce business alone is worth more than US$60 per share.
As we wrote last year, we reiterate our view that Amazon’s current share price is more than underpinned by its Amazon Web Services (AWS) business alone. Cloud computing remains in the early stages of growth, with customers across the industry only around 30% through the migration of their workloads from on premise infrastructure to the cloud, based on commentary from industry experts, key corporates and Chief Technology Officers. Until recently, cloud spending has been largely resilient amidst macro headwinds.
This changed last result when all three hyper-scalers warned of a slowdown in growth as enterprises scrutinise technology budgets. Indeed, Amazon is proactively working with its customers to cost-optimise, which will have a negative impact on short-term sales growth but is the prudent long-term business decision. As a result, we forecast AWS growth to slow further in 2023 before re-accelerating in 2024. The long-term revenue growth profile of AWS remains robust, and sustainable operating margins have the potential to exceed 40% given a concentrated industry structure, AWS scale advantages, and a mix shift toward value-added software.
As we look to the future, Amazon’s focus on improving operating efficiencies, reducing working capital, and lowering capital expenditures should result in an exponential increase in free cashflow and shareholder value. We forecast a return to positive free cashflow in 2023. By 2025, we expect free cashflow to exceed US$70 billion, representing a growing 8% free cashflow yield, which we consider incredibly attractive for an asset of this quality.
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