Concentrated Compounding – Amazon: Our Biggest Loser, But There Is Significant Value

Summary:

• Amazon was our biggest loser for the year.
• The stock is down given decelerating growth at AWS and reported losses in its retail segment.
• As it stands today, Amazon does have this excess cost in its cost structure, and so retail’s profitability has been lower than normal.
• In a normalized environment, I believe Amazon retail’s earnings power is very high.
• Putting it together, with conservative marks AWS is worth roughly $700-800B and retail is worth $400-600B, compared to a market value of $900B.

The following segment was excerpted from this fund letter.

Amazon (NASDAQ:AMZN)

Amazon was our biggest loser for the year, and while it is perhaps no surprise that the stock is down given decelerating growth at AWS and reported losses in its retail segment, I believe that there is significant value here with the company valued at roughly $900B.

AWS had a good year, although its growth has started to markedly decelerate in the back half. It grew 32% YTD but exited Q3 at probably 25%, and the market expects further deceleration to perhaps high-teens for 2023. This deceleration has spooked investors, as Amazon shares have been under pressure since it released Q3 results and AWS’s deceleration.

For long-term investors, we really care about AWS’s ultimate size and margin profile. Growth should decelerate over time as the company gets larger, and it gets closer to fully penetrating its end market. When thinking about this slowdown, we want to know if it is a structural slowdown or a cyclical one. Although you can never know for sure, the majority of the evidence points to a cyclical issue as growth rates for most cloud-based software providers have dropped in the back half of 2022 given the softening economy and businesses retrenching spend. AWS, additionally, is proactively working with customers to try to rationalize their cloud spend to save costs, which should lessen their growth in the current period although should also lead to better long-term outcomes.

Putting some numbers on AWS, if we assume high-teens revenue growth over the next 3 years, flat margins, a 20x FCF exit multiple, and discount that at 12% then AWS would be worth ~$600B. I believe that each one of those assumptions is conservative, and AWS is likely worth ~$700-800B.

Amazon’s retail business is more complicated and difficult to analyze, as the company includes the financials of some of its money-losing growth projects in this segment. Even so, I believe it’s possible to put a reasonable range on retail’s value.

The number I care most about is retail gross merchandise value, which measures the dollar value of goods that are sold through Amazon’s website. While we don’t know GMV for certain, it is possible to estimate it. GMV grew from ~$325B in 2019 to ~$635B in 2021 and probably ~$675B in 2022. The company saw an unprecedented amount of growth from the COVID pandemic. As mentioned previously, Amazon made huge investments to increase capacity during the pandemic, and while sales have roughly doubled over a short amount of time, Amazon was prepared for even more growth, and so it currently has excess capacity and cost.

I believe that preparing for even more demand was in the best interest of its business long-term, as underestimating demand would hurt the trust that consumers have grown to put in it for fast, reliable delivery, and overestimating demand simply ends up with some excess costs for a relatively short period.

As it stands today, Amazon does have this excess cost in its cost structure, and so retail’s profitability has been lower than normal. This should be a relatively easy fix as they take steps to reduce capacity and further grow into the capacity that remains.

In a normalized environment, I believe Amazon retail’s earnings power is very high, likely with operating margins at perhaps 6-8% of GMV if they were running it to maximize current profitability. Even using 5% would give you a range of its value of ~$400-600B.

Putting it together, with conservative marks AWS is worth roughly $700-800B and retail is worth $400-600B, compared to a market value of $900B. Both businesses have deep, entrenched moats and given switching costs in AWS and terrific logistics and variety leading to convenience in retail, these businesses should be very durable over the long-term.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.