Amazon: Disconnect Between Share Price And Intrinsic Value In A Cloudy Environment

Summary:

• Amazon has been controlling costs by reducing headcount and shutting down experimental businesses that it does not think have a long-term potential.
• AWS remains a leader in the cloud industry, with strong commitments and production innovation supporting the business in a tough operating environment for cloud players.
• The incremental cost headwinds should alleviate further, with room for more network optimization and further existing space that can be rationalized.
• With the Amazon stock at 12x 2023 EV/EBITDA, I think that most of the slower growth expectations for e-commerce and cloud has been priced in and there is a disconnect between the stock price and intrinsic value of the company.
• My 1-year target price for Amazon is $159, implying 67% upside from current levels.

Investment thesis

I am starting to see a disconnect between Amazon’s (NASDAQ:AMZN) stock price and what I think its intrinsic value should be and this article aims to highlight that Amazon continues to improve fundamentally in both its e-commerce and cloud businesses even in a rather uncertain business environment.

My investment thesis for Amazon is as such: Firstly, Amazon’s e-commerce business is prioritizing cost control and profitability as the business has expanded too quickly during the covid-19 pandemic. As such, rationalization and optimization efforts have been underway to ensure that the business is aligned with the current demand and with improvements in the productivity and fixed cost leverage of the business, I expect the e-commerce segment to emerge stronger from this. Secondly, AWS continues to be a leader in the cloud industry but there are some headwinds that the business is facing in the meantime as the macroeconomic environment worsens. That said, the company remains focused on product innovation and has a strong level of commitments that will steer the company forward even in these challenging times. Lastly, I expect that the incremental cost headwinds that Amazon faced in 2022 will alleviate in 2023 as its efforts to improve its cost structure, rationalize, and optimize its processes are reaping benefits for the business.

I have written earlier articles on Amazon, including the most recent article about the outlook for Amazon in 2023.

Job cuts and shutting down experimental businesses to reduce costs

Amazon CEO Andy Jassy announced in a memo that the company was looking to reduce its headcount by as many as 18,000, with the job cuts starting in November. This will be its largest job cut in its 28-year history and the job cuts will affect people in its human resources and stores divisions.

As a result of a hiring spree that the company did during the covid-19 pandemic to cope with the surge in e-commerce demand due to the restrictions put in place all over the world, Amazon grew its workforce from 798,000 from the end 2019 to 1.6 million at the end of 2021.

Amazon is trimming its head count after it went on a hiring spree during the Covid-19 pandemic. The company’s global workforce swelled to more than 1.6 million by the end of 2021, up from 798,000 in the fourth quarter of 2019, representing a 100% increase in its headcount over the 2-year period. On top of this, Amazon is also confirmed a hiring freeze across its corporate workforce.

The company’s slowing revenue growth and increasing expenses comes at a time when the macroeconomic outlook was starting to turn sour. As a result, the company has shut down some of its pilot and experimental projects to reduce expenses and preserve cash. For example, Amazon announced that it decided to shut down its new healthcare service called Amazon Care at the end of 2022 as a result of management deciding that the offering was not going to work in the long-term for its customers. Amazon’s venture into Amazon Glow, a video calling device meant for kids, was also cut as the company looks to keep costs under control.

Cloud business solid amidst industry weakness

Late last year, the United States Department of Defense stated that it awarded the Joint Warfighting Cloud Capability (“JWCC”) contract to 4 players. These included Amazon’s AWS, Microsoft (MSFT), Google (GOOG) (GOOGL) and Oracle (ORCL). This new contract awarded replaces the previous contract that was awarded to Microsoft in 2019.

With the contract awarded to four different players, I think that it illustrates how strong competition is in the cloud industry, with the big players continuing to show relative strength in demand. Furthermore, the contract also demonstrates the improving levels of adoption of a multi-cloud approach amongst customers. With about 90% of enterprises operating a multi-cloud strategy, this illustrates that the public sector is likely to follow such an approach.

Also, this JWCC going to four players will likely help boost the public sector practice of each company and help them penetrate deeper into the sector. This contract will likely provide additional catalysts for the public sector to adopt either one of the four cloud players into their business.

There are near term headwinds that AWS are facing today that the entire cloud industry is facing, which is leading to slower near-term growth. More customers are increasing their efforts to optimize their cloud spend and also delaying their new workload migration in order to avoid the upfront costs, causing near-term headwinds as customers grow cautious in an uncertain macroeconomic environment. There are also talks that the industry could be moving into a more difficult second phase where the market shifts more towards workloads that are more difficult to migrate.

For AWS, I think that while the market is currently focused on the decelerating of growth in the business, it continues to be the leader in the cloud industry in scale, capabilities and products. I remain positive about AWS given continued product innovation, $104 billion in commitments as well as retail wallet share gains.

Cost savings in 2023

For Amazon’s cost savings initiative, I expect that Amazon achieved approximately $3 billion to $4 billion in annualized savings for the year of 2022, some of which have not been fully reflected in the financials of the company yet as of the third quarter of 2022. Further cuts in costs are needed in 2023 as there remains to be about a third of Amazon’s existing space that can be rationalized further. As the company’s network is roughly underutilized by 20%, I think that there is more room to improve the utilization of its network in 2023. Lastly, in order to ensure better profitability, Amazon needs to be strategic in identifying the geographies and products for which it will be providing speed delivery in 2023 to achieve positive net margins in its retail business.

Valuation

Amazon is currently trading at 12x 2023 EV/EBITDA and 10x 2024 EV/EBITDA. Simply on a relative valuation perspective, Amazon does seem attractive given that the company has been trading at an average of 19x EV/EBITDA over the past 10 years. The company may be facing near-term headwinds, but the company remains well positioned to ride the continued growth in e-commerce and cloud once the dark clouds of the macroeconomic environment scatters.

My 1-year target price for Amazon is $159. This is based on an equal weight of both the EV/EBITDA method and the DCF method. I applied a 17x EV/EBITDA multiple for the EV/EBITDA method, while I assumed a terminal multiple of 15x and discount rate of 8% for the DCF model. This 1-year target price implies 67% upside from current levels.

With the EV/EBITDA multiples this low, I think that the slower near-term growth has been largely priced in by the market. I think that there is currently a dislocation in Amazon shares right now and would recommend investors with a long-term perspective to take advantage of this opportunity. I believe that AWS will continue to be seen by customers as a core strategic partner while the e-commerce business will continue to reap the benefits of the investments made during the pandemic.

Risks

Macroeconomic environment

With the recent weakening of retail sales, consumer spending could remain muted in 2023 as uncertainties about the global economy continues. Amazon’s e-commerce business, in particular, is affected by consumer spending levels and if the macroeconomic environment were to worsen, we may have further downside risks to Amazon’s e-commerce business in the near-term.

Competitive pressures

Amazon has an envious position of being a leader in both the e-commerce and cloud industry, but it also makes it easier for Amazon to be disrupted given the larger market share it has in both markets. These industries remain highly competitive, with AWS competing against big tech companies like Microsoft Azure and Google Cloud. The retail scene also is competitive as many online and offline players are embracing and offering e-commerce as part of their strategy. Companies like Walmart (WMT) and eBay (EBAY) could invest further into their e-commerce capabilities to threaten Amazon in the future.

Conclusion

I am of the view that investors with a long-term view should take advantage of this disconnect between the current Amazon stock price compared to its true value. As elaborated in the article, the management team has taken concrete and difficult steps to reduce the incremental cost headwinds that it highlighted in 2022. With further cost control measures like the 18,000-headcount reduction as well as eliminating experimental businesses that do not have long-term potential, I think that we could see expenses for the next quarter surprise to the upside as management has been intent on lowering and controlling cost at a time when growth is slowing. Furthermore, AWS remains to be a leader in the industry, and I like the strong level of commitments it has, as well as the product innovation that it brings to the market. At the current environment, the entire cloud industry is seeing slower growth as a result of near-term headwinds like optimization of cloud spend, pushing back of migration to the cloud, amongst other things. However, I think that we will look back and see 2023 as an opportune time to invest in these leading cloud players given that the weakness in cloud has been largely priced into the stock price. My 1-year target price for Amazon is $159, implying 67% upside from current levels.

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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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