Amazon: Still Formidable On Fundamentals

Summary:

• Undoubtedly, over recent years, AWS has accounted for a dominant fraction of operating profits. However, Amazon.com, Inc. is more than simply AWS.
• Driven by the scale up of the e-commerce business, growth in ancillary segments is accelerating.
• Moreover, the firm is investing heavily in potential high growth pipeline ventures.
• We are increasing our Amazon Price Target to $154/share versus the previous $140/share. Reiterate Buy Rating.

Undoubtedly, that Amazon.com, Inc.’s (NASDAQ:AMZN) Amazon Web Services (AWS) grew 16%, Google (GOOG, GOOGL) Cloud 28%, and Microsoft (MSFT) Azure 27% during 1Q23, compared to Gartner’s prediction of 22% for 2023, it appears that AWS might be positioning for disappointing growth over upcoming quarters. So what. It is not as if AMZN has any shortage of growth drivers, or it cannot squeeze out additional earnings by optimizing operations, or it has run out of ideas for new businesses.

Indeed, over the first quarter, third party sellers accounted for 59% of total sales versus 55% a year ago. In addition, on a year-over-year basis, sales associated with advertising, third party seller services, and Amazon Prime expanded by 21%, 18%, and 15%, respectively. In addition, as a percent of revenues, cost of sales and fulfillment expenses declined by 3.7% and 1%. Further AMZN has a vibrant pipeline in the form of One Medical, Kuiper, and AI tools. The company is far from a one-trick pony that will flounder based on the temporary growth shortfall related to a single segment. AMZN is an enterprise trending towards outlasting most of its present investors, reflecting the ebb and flow of the global economy.

During the short term, AWS is likely to experience relatively softer growth, consistent with management commentary indicating 11% growth for 2Q23, and our opinion is that Azure is likely to continue to dominate the cloud computing landscape, over the near term. However, AWS revenue headwinds will possibly be somewhat countered by strong growth associated with the e-commerce business. Folks shop even during recessions, and AMZN with the widest assortment of products on the planet is likely to reflect muted repercussions, of an economic downturn. In addition, retail growth is likely to be bolstered by continued improvement in European economies, as supply-chain bottlenecks related to the Ukraine/Russia conflict ease, and inflation stabilizes fueled by declining gas prices and energy costs. Further, considering that AMZN’s e-commerce business is the growth engine for its ancillary segments, including advertising, third party seller services, and Amazon Prime, we expect these categories to evidence strong growth, despite macroeconomic challenges.

In the context of margins, we anticipate that the positive momentum experienced over the first quarter driven by commodity price tailwinds and lower fulfillment costs to be sustained, as prices of key products decline further, and delivery expenses fall as the fulfillment network shifts to a regional model from the prior national model, leading to year-over-year upside in gross profits, operating profits, net income, and free cash flows.

Longer term, based on additional growth associated with the existing business, opportunities for margin expansion, and the potential success of new ventures, AMZN’s best days are ahead not behind. Below is an analysis of factors that are likely to ensure that the company continues to thrive and deliver strong earnings, over an elongated time horizon.

AWS Growth Rate Well-Positioned To Rebound. Undoubtedly, the Infrastructure as a Service (IAS) segment of cloud computing is positioned to benefit from the AI revolution. AWS, Azure, and Google Cloud, as the largest providers of IaS, are likely to capture a majority of revenues associated with AI in the cloud. Overall, industry revenues are positioned to expand substantially.

AWS and Azure feature largely similar AI services. Both platforms offer speech recognition, image recognition, natural language processing (including code generation), and tools for machine learning model development and deployment. Therefore, we are unsure whether Azure captured 1% of share from AWS during 1Q23 on substance or posturing. Nevertheless, IaS is a largely commoditized developed industry, where small temporary market share shifts are likely to be the norm, in our judgment.

However, considering business dynamics, particularly that all large technology companies for the most part are likely to ultimately offer similar AI services, we do not expect AWS to lose major market share. In addition, AMZN will continue to utilize AI at the backend of its business, driving revenue gains in e-commerce, advertising, and Prime Video.

Core Business Rapid Growth To Continue. AMZN’s e-commerce business, despite significant growth, particularly during the pandemic, underpins opportunities for considerable revenue expansion. In that regard, it is noteworthy that AMZN accounts for merely 1% of global retail and that 80% of sales in the category are generated off-line. Accordingly, we expect AMZN’s growth in the segment to be derived through greater penetration within its developing markets, specifically the 10 new territories the company entered over the previous five years, which include large markets such as India, countries in Africa, the Middle East, and Europe, and Australia, and Brazil. Additional growth is likely to be generated from large scale forays into the brick and mortar grocery channel, particularly in the U.S., where 70% of customers continue to grocery shop off-line.

AMZN is the third largest generator of advertising revenues, behind only Alphabet and Meta Platforms (META). We believe the firm’s sales in the segment are well-positioned to sustain the momentum experienced over recent quarters, based on several factors. These include, that advertisers are increasingly cognizant that ~56% of America (which is AMZN’s largest market), begins its purchase journey by searching for products on Amazon, that as the world’s largest retailer, AMZN is relatively insulated from economic downturns, as folks shop even during a recession, ensuring that products promoted on the brand’s website gain traction, and that AMZN provides advertisers the facility to evaluate the effectiveness of their promotions. In addition, increasing advertising activity in Prime Video content and the grocery channel, which remain under penetrated in regards to monetization potential, represents another opportunity to expand sales in the category.

Third party seller services revenues, which include commissions on product sales and fulfillment/storage charges, are similarly likely to advance, based on the scale up of e-commerce operations, in developing markets, and launch into additional geographies, including the four planned for the current year.

Further, revenues associated with Amazon Prime are positioned for substantial growth driven by penetration within growing markets, and further geographic expansion of the e-commerce business, supported by Prime Video, which appears to be gaining popularity over Netflix (NFLX) within highly populated regions of the globe. We believe AMZN is increasingly focused on acquiring additional content libraries, bolstering the considerable premium material it secured through the takeout of MGM Studios, as the firm’s leadership views the category as a long-term growth driver.

Margin Expansion Foregone Conclusion. AMZN’s Achilles heel is the poor margin structure associated with a majority of its segments. That is where a major opportunity presents itself. As the e-commerce business scales up and economies of scale associated with digital, advertising, and overheads, create operating leverage, margins are bound to improve significantly. In that regard, the North American business, operating margins associated with which have contracted to 1.2% versus the pre-pandemic 4% to 6%, represents a significant opportunity.

In addition, as the company advances towards its objective of a razor-razor-blade model, as the high margin segments including, advertising, third party seller services, and Amazon Prime, begin accounting for a large fraction of total sales, margins will expand accordingly.

Solid Pipeline Represents Sustained Secular Growth. It is noteworthy that AMZN was among the first companies to establish an e-commerce retail business. In addition, cloud computing a business category did not exist until Jeff Bezos and Andy Jassy dreamed it up, in 2003. Therefore, given the combination of almost unlimited resources and the motivation to pioneer businesses and develop them into solid growth drivers, we view AMZN’s pipeline ventures as genuine opportunities that could dramatically expand the company’s value proposition.

One Medical, a primary care enterprise, which fulfills an unmet medical need for same day or next day consultation through chat or video with a medical practitioner, is one pipeline enterprise, AMZN is focused on. In our assessment, although independent primary care offices are catching up with technology, their concentration is on providing patients with scheduling tools rather than options for urgent situations requiring immediate medical consultation, which One Medical specializes in. The service appears to be in a nascent stage of development, providing AMZN an opportunity to strategically expand the business deploying financial and intellectual resources.

Kuiper, is an AMZN attempt to create a low earth orbit satellite system with the ability to provide quality broadband internet connectivity to consumers across the globe. Given that the addressable market is comprised of hundreds of millions of entities, including households, businesses, and governments, and that the terminal for accessing the service is small and light weight and costs less than $400 to produce, we believe the enterprise could represent the next leg of growth for AMZN.

With respect to AMZN’s focus on development of AI technologies, including machine learning chips, large language models, and chatbots (other than that for its own e-commerce segment), the elements are likely to be commoditized, as every large technology company is similarly engaged.

With a view to reflect potential growth from pipeline ventures, we are updating the 10 year normalized growth rate incorporated in our 10 year Discounted Cash Flow model to 20% from the prior 18%. Based on the change, we arrive at Price Target of $154/share versus the previous $140/share. Reiterate Buy Rating.

Bottom Line

Amazon is different. It actually works to make people’s lives better, not simply use the mission statement as a placeholder. Anyone that has dealt with the company will vouch for that. They treat their customers fairly, provide good quality products at reasonable prices, pay their employees competitive rates, and do not nickel-and-dime their vendors and sellers. It is little wonder that folks gravitate towards AMZN’s business, leading to its expansion to 22 countries.

Given its scale and that it is a consumer business, AMZN is bound to be impacted by fluctuations in macroeconomic and geopolitical conditions. In addition, the business is growing rapidly, large investments are being made. When AMZN is outperforming, it can easily absorb the additional spending on growth. However, when the going gets tough, the shortfall flows through to the bottom line.

To evaluate AMZN on a quarterly basis is to shoot yourself in the foot. The firm is likely to be around when most of us are dead and gone. Evaluate Amazon.com, Inc. stock on those terms, and you might possibly have a multi-bagger on your hands.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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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