This overview accompanies the IOI Tear Sheet on Amazon(AMZN) and is split into the following sections:
- Revenue Scenarios
- Economic Profit Scenarios
- Investment Efficacy Scenarios
- Other Considerations
IOI?s explicit forecast period for Amazon lasts five years.
Revenue Scenarios
Amazon?s revenue growth continues to be supported by a shift in purchasing patterns from bricks and mortar stores to online. At present, sales are concentrated in North America, Japan, Germany, and the U.K., but as consumers in other geographies become more comfortable with making online purchases, Amazon stands to gain. Revenue growth percentages in the more mature North American market is still mid-teens year-over-year (YoY), and electronics and other consumer goods is 10-20 percentage points higher. Internationally, even with stiff macro headwinds, Amazon has still been able to increase sales at a brisk pace of over 20% in 2012.
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| YoY Growth Rates for Amazon Segments Source: Company statements |
Once a customer buys or searches for items online, Amazon?s software develops a purchase profile for the consumer and can serve up ads designed to entice that buyer to make further purchases. In this way, Amazon?s business model and Google?s is similar?understand the characteristics of a particular user and give them what they want even before they know they want it.
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| Amazon Consolidated Revenue Growth Source: Company statements, IOI Analysis |
- IOI’s worst case revenue scenariogenerates an average year-over-year (YoY) growth rate of 20% and a 5-year compound annual growth rate (CAGR) of 26%.
- IOI’s best case revenue scenariogenerates an average YoY growth rate of 29% and a 5Y CAGR of 31%.
Economic Profit Scenarios
IOI’s estimate of economic profit deducts an estimate of maintenance capital expenditures from cash flows from operations. Amazon has what is termed Negative Net Working Capital. This means that it collects money from customers faster than it pays out to suppliers so that as long as its business is growing, it will record a cash inflow in the Cash Flow from Operations (CFO) section of its statement of cash flows. As we have explained in a separate note (Amazon?s Riddle: When is Cash Flow from Operations not Cash Flow from Operations), we have adjusted our CFO number to account for this anomaly and added back the benefit of the cash created through the negative net working capital as a ?free? store of cash as a balance sheet item in our valuation. With the adjustment, Amazon?s historical economic profit levels have fluctuated between around 1% to over 5% of revenues.
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| Amazon Economic Profit (EP) and EP Margin Source: Company statements, IOI Analysis |
- IOI’s worst case profitability scenariogenerates an economic profit margin of around 1%–a fall of about two-thirds compared to the previous 5-year period?s average.
- IOI’s best case profitability scenariogenerates and economic profit margin of around 4%–a rise of just under one-fifth of the average over the previous 5-year period.
Investing Efficacy Scenarios
Amazon?s investments generally generate value for their shareholders in that Amazon?s economic profit grows faster than the economy at large.
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| Amazon Marginal Economic Profit Growth Source: Company Statements, IOI Analysis |
- IOI’s worst case medium-term (forecast years 6-10) growth scenario implies a GDP-like growth in free cash flows?a drop of 17 percentage points compared to the average of the last five years.
- IOI’s best case medium-term growth scenariogenerates implies a 15% pe
r annum growth in free cash flows?about the same as the past five year average.
Other Considerations
Amazon is a difficult company to value partially because of the paucity of information the management reveals to the investing public in its financial statements and conference calls. Given this lack of information, it is difficult to handicap which valuation scenarios are relatively more or less likely. Our valuation assumes there is a 50:50 chance for best and worst cases, so the fair value estimate is a simple average of best and worst cases.
Anecdotal evidence is mixed. On the one hand, Amazon?s most recently announced strategy of providing online grocery purchases and deliveries speaks to a company that is running out of compelling investment opportunities. On the other hand, the possibility of robust growth in other regions (Europe and Asia, particularly) speaks to a company that still has growth opportunities.
And what happens to AMZN growth when the Feds start forcing them to collect sales tax? The increase in prices definitely makes local companies more attractive. Could be a boost to Best Buy too (less “showrooming”?).
Hi CxCamp!
Sorry! I am such a Luddite that I hadn’t realized you had left this message until right now… Still trying to sort out all of the technology infrastructure, I’m afraid–apologies for the long delay in replying.
Regarding the sales tax, yes, of course this is an issue, especially with regards to market perception and especially in the short term. Longer term, there are a few possible repercussions to the added tax requirement:
1) Net revenue growth will slow
2) Economic profitability will fall
The effect of the requirement to collect tax on revenues is a bit hard to work out, but let’s do some back-of-the-envelope calculations and try to get a feel for it…
Right now, the revenue split between N. American and International is around 60:40. N. American revenues have grown at an average year-over-year rate and a 5-year compound annual growth rate (CAGR) of around 34%. International growth has been slightly slower, but still over 30%. Our worst-case revenue growth projection is 20% over the next 5 years, which is a drop of 14 percentage points or just over 40% from the historical growth rate. Since the tax collection should affect the N. American revenue stream only, we can say that as long as AMZN’s domestic revenues are still able to grow at about 30% of its recent historical rate (which works out to 11% / year), we are still within our worst-case revenue projections (60% of revenues * 70% decrease in growth rate = a decrease in overall revenue growth rate of around 40%…which is our worst case projection…).
So, AMZN’s N. American business would have to slow from a year-over-year growth of more than 30% to a year-over-year growth of around 11%. Is it reasonable to assume this is can happen? From an economic perspective, it is possible, but I think fairly unlikely. AMZN has selling advantages over a Best Buy or other retailer that goes beyond tax discounts. First, AMZN collects a huge amount of customer preference data the more a customer shops on their site. Every time a return customer visits the Amazon site, the site knows what kinds of products that customer might have interest in and serves up advertisements based on that historical data. If you walk into a Best Buy, the sales clerk does not know you from Adam and certainly has no idea what products might interest you, so cannot direct you toward a specific product or product category in which you might have interest. Also, Amazon’s site allows a customer the ability to comparison shop more easily, and usually over a broader range of inventory than can be kept on hand in a bricks-and-mortar retailer. I know that when I am trying to find a specific item of a certain type, I have an easier time comparing different models in the comfort of my own home and getting a sense of what people who have bought and used these items think of them.
So, in my mind, the threat of a revenue growth collapse for Amazon due to a change in the tax regime is hard to conjure up simply because it seems Amazon has some genuine selling advantages vis-a-vis traditional retail competitors.
The next element of the valuation that might change is the profitability. For instance, AMZN will have to entice customers with more generous free shipping deals and / or lower prices on its items to lure people onto the web. Again, I think that our worst case projections take this well into consideration. When I think about AMZN, I think about a mass-market retailer like WMT or TGT. There are differences in their product mixes that carry with them slightly different margins, but in general, one would expect profitability for a retailer like this to be in the low- to mid-single digit range. Indeed, historically, AMZN has fit nicely into these bounds as has WMT (I haven’t done a valuation of TGT, but I’d be willing to bet it is in the same range, perhaps a bit on the higher end…). In my mind WMT and AMZN are two examples of good operators of retail businesses, so unless there is a major operational or strategic blunder, it is hard to imagine AMZN or WMT generating profitability too far below this level. Our worst case scenario has AMZN generating only 1% economic profit margins over the next five years, and while possible, in my mind, it would be unlikely barring a real goof-up on AMZN’s part.
So, in short, I believe that our worst case scenarios factor in some pretty extreme economic outcomes for AMZN, be it due to regulatory changes, strategic slip-ups, or general economic malaise.
The interesting thing about AMZN in my mind is that it does have a good bit of valuation uncertainty to it–more than the market has baked in, in fact. A good time to invest would be when a short-term factor confuses people and encourages them to sell the stock but the valuation and operational metrics are on the bullish end of the spectrum. Right now, AMZN does not look like a great investment to me, but it certainly might be one in the future…