Amazon is one of those companies that is always under the scrutiny of investors. Generally misunderstood, it has received criticism from a large portion of professional investors. Many of them have gone so far to say that Amazon was a vehicle to send money from Wall Street to consumers’ pockets. On many occasions, many have indicated that Amazon’s retail business was disastrous and that the company needs to raise prices to increase its margins and maximize cash flow per share in the short term. What is the answer of the founder of Amazon to these criticisms?
We have done studies on price elasticity and the answer is always that we should raise prices. We don’t do this because we believe – and we must take this as an article of faith – that by maintaining our prices very, very low, we gain trust with customers over time, and that actually maximizes free cash flow over the long term.
This is the kind of philosophy that fascinates me. of the philosophy of what is not visible. Building businesses by doing the opposite of what the vast majority of investors want. Think long-term and provide growth resources with a loyal customer base that trusts Amazon and the products and services the company offers.
Over time, Amazon has planted different seeds, some have blossomed and some haven’t, that’s business. The key is that the ones that bloomed did a lot more than the ones that dried up. The image below is proof of that.
The evolution of sales in all segments is fascinating, the result of the continuous reinvestment process and the search to keep the customer satisfied and therefore to maximize cash flow per share in the future. Below I explain in more detail my vision for the company’s business lines and how I believe they can develop in the long term.
In the retail business, Amazon has 40% of the US market and controls 13% of global GMV transactions. In my opinion Amazon should not suffer in this segment. First, e-commerce sales account for 22% of retail sales internationally. E-commerce still has the capacity to grow and continue to steal market share from physical sales. Second, Amazon has managed to gain the trust of consumers and make many customers make a habit of buying products on Amazon. Although the beginnings were complicated, the company realized that expanding its logistics network was essential to deliver orders to customers in the shortest possible time. In 2017, Amazon had fewer than 200 warehouses across the United States. At the beginning of 2022, the company had more than 900 (PP&E investments went from $100 billion in 2019 to $250 billion in 2022). Imagine what investment a competitor would have to make to reproduce such a logistics infrastructure… In addition to this advantage, Amazon has a differentiating point compared to other e-commerce companies. Their customer loyalty. Amazon’s two categories of customers (Prime and non-Prime) have spending statistics that few retailers have. 85% of prime customers visit Amazon once a week, compared to 56% of non-prime customers. Additionally, 1/3 of Amazon visits end in a purchase. In the case of top customers, 50% shop on Amazon at least once a week!
The retail business is not only valuable because of its scale and scope, but also because of the ancillary services that Amazon has developed in parallel. Namely: 3PS business and digital advertising.
Regarding 3PS: Amazon realized that as they achieved growth, many companies were interested in selling their products through the platform. In exchange for the use of its ecosystem, Amazon began to charge for the services provided and, in addition, provided the possibility of storage and logistics in the company’s own distribution warehouses. In exchange for a percentage of the sales value, Amazon provides sellers with the security of transactions and the use of its distribution network. This guarantees the sellers that distribution will be efficient and that the potential market is expanded when they use the company’s sales network. On the other hand, Amazon benefits from other people’s ideas and does not bear the risks of developing a product. A win-win for both sides. If you cannot defeat your enemy, join him.
Regarding advertising services: This segment has provided significant growth for Amazon in recent years. Although the main players in the digital advertising market are the giants Meta and Alphabet (through Google and specifically Google Services), Amazon’s potential is higher. This is because The consumer mindset is in buying mode, unlike Google and Meta, where people are in observation mode. How much is it worth to promote a product in a market where the probability of purchase is high? For this reason, Amazon advertising is more valuable and experiences higher growth than Google and Meta. In a challenging year for digital advertising (2022), where the two giants reported flat results, Amazon grew at a rate of 20%! In addition to all this, operating margins in digital advertising are typically around 40%, so we can estimate that the company is currently generating around $14 billion in this segment alone.
AWS also possesses the characteristics of a good business, mostly high switching costs AND recurring revenue coming from a fragmented customer base. Currently, there are three major scale players (Amazon, Microsoft and Google) fighting to secure a dominant position in the market. It is very unlikely that new competitors will enter this market. Barriers to entry in the form of capital expenditures and high average time to profit (MTTP) protect insiders from competition. Since its inception, AWS has grown from zero to $80 billion in revenue by 2022. The business has expanded, generating profits and adding new features that increase user value. Margins hover around 30%, although that shouldn’t be the focus. The properly phrased question is: will Amazon be able to maintain its customer base in such a competitive landscape with Microsoft or, to a lesser extent, Google? The advantage that Microsoft has over AWS or Google Cloud is that the majority of customers (businesses already digitized or in the process of digitization) already have Microsoft software. It is much easier to develop cloud strategies through Microsoft because the additional cost of adopting them is low (versus the cost of replacing everything and sending it to other cloud providers). In addition, users are already familiar with the Microsoft ecosystem, and switching costs are high for those companies that have developed all their cloud services with them. However, the same argument works for Amazon as well. Companies that have developed all their databases in the Amazon ecosystem will have to make billions of dollars in investments to reverse these changes and not achieve marginal improvements in the long term.
This is why I believe AWS will continue to grow. This growth can come in two ways: attracting new customers (it is difficult to compete with MSFT or low-cost providers like Google) or increasing the functionalities of the platform, currently focused on generative AI for greater data analysis and processing. This increased functionality seeks to increase customer retention and make the long-term relationship more sustainable. This reduces the risk of terminal value and guarantees the sustainability of the business in the long term. The management team has stated, regarding AWS, that:
We wait […] increasing infrastructure CapEx to support the growth of our AWS businessincluding extra InveStment connected with Generative AI and major language modeling efforts.
Once Amazon’s main lines of business are understood, it is important to address the main question of this analysis: how much is Amazon worth? It is conservative to estimate real free cash flow growth (operating cash flow – maintenance capital) of around 13% in the coming years. Where does this number come from? I believe that 3PS, AWS and digital advertising segments will contribute the most to the company’s growth. This is due to higher recurring revenue, higher cash flow and larger potential future market. Estimates of 15% in the next 5 years are justified for these businesses, due to their oligopolistic nature, competitive advantage and tailwinds such as e-commerce, increased digitization and higher market penetration of digital advertising. In the case of online stores, the growth will be somewhat weaker since the control that Amazon has over the result of this segment is much less than in the previous ones. As for Prime, its rating is complex for me. How do you rate a service with which Amazon seeks to increase the loyalty of its customers?
Amazon is actually a very complicated business to value due to its multiple lines of business and complex accounting. Valuing the company with multiples such as the PE ratio or even preparing a DCF seems difficult because of how erratic the company’s investment dynamics can be. The company’s average ROIC is around 10%, although it is heavily depressed by excessive reductions in PP&E purchases in recent years. Return on cash (adding depreciation and amortization) is always higher than 20% in recent years. With a cost of capital of less than 10%, the value Amazon generates over the long term (the gap between ROIC and cost of capital) is greater than 10%.
Although at current prices the company is far from the expected return I have set, I believe that no investor should sell Amazon because of its quality, as well as its culture of reinvestment, innovation and long-term focus. The latest third-quarter results show stability across all segments, with net sales up 13% and operating profit quadrupling over the same period. Reduced fulfillment costs, increased spending discipline and stronger demand across verticals helped Amazon recover the profitability it had temporarily lost during the 2021-2022 inflation crisis. These results, combined with the positive long-term vision I have for Amazon, lead me to insist that any long-term investor should consider Amazon to deliver growth and stability in the years ahead.