Home Deep Analysis Pay For AWS, Get Amazon.com For Free (NASDAQ:AMZN)

Pay For AWS, Get Amazon.com For Free (NASDAQ:AMZN)

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Pay For AWS, Get Amazon.com For Free (NASDAQ:AMZN)


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Amazon (NASDAQ:AMZN) stock is a sort of contradiction. On one hand, the market seems disappointed by the plunging profit margins in the e-commerce division. On the other hand, the market cannot get optimistic enough for the resilient growth of the cloud computing division Amazon Web Services. Second quarter earnings results showed great near term headwinds from inflation and supply chain constraints, but AWS continues to grow without interruption. The stock continues to trade at compelling valuations – one could even make the argument that the retail side is being given away for free. AMZN remains one of the stronger risk-reward propositions in the market today.

AMZN Stock Price

While AMZN has not crashed as viciously as other tech stocks, the stock has produced zero returns since the summer of 2020.

Chart
AMZN data at YCharts

That is in spite of strong growth in both its e-commerce and cloud computing divisions, albeit with more profits to show for that growth in the latter. I last covered AMZN in June where I discussed the outlook after the stock split. In a market that is razor-focused on near term profits, AMZN remains a long term secular growth story.

AMZN Stock Key Metrics

AMZN only saw sales grow by only 7% in the latest quarter as it faced the headwinds of both tough comparables and inflation.

only sales

2022 Q2 Presentation

In spite of the top-line growth, operating income declined 57% to $3.3 billion. On the conference call, management cited higher fuel, trucking, air and ocean shipping rates as significant drivers of the margin contraction.

operating income

2022 Q2 Presentation

The e-commerce divisions continue to be the main culprits of the margin contraction. AMZN saw its North America segment swing from $3.1 billion in operating income to $627 million in operating losses.

North America

2022 Q2 Presentation

The international segment was even worse with the operating loss swinging to $1.8 billion.

International

2022 Q2 Presentation

Those operating losses did not stop AMZN from continuing to invest aggressively in capital expenditures – free cash flow over the trailing twelve months has dropped from positive $4.2 billion to negative $26.1 billion.

Free Cash Flow

2022 Q2 Presentation

The lone (but significant) bright star was the cloud computing division AWS, which saw revenues grow 33% and operating income grow by 36%.

AWS

2022 Q2 Presentation

Looking forward, AMZN expects net sales to grow by up to 17% to $130 billion. That guidance includes approximately 390 basis points of headwinds from foreign exchange rates. AMZN expects operating margins to contract even further, with operating income expected to land between $0 and $3.5 billion.

AMZN ended the quarter with $60.7 billion of cash versus $58.1 billion of debt. The company repurchased $3.3 billion of stock in the quarter, bringing the total to $6 billion this year. While there is great precedence for the aggressive investment in growth, there is no such precedence for the share repurchase program, which while small in size is an appreciated lever amid the tech crash.

Is AMZN Stock A Buy, Sell, or Hold?

At recent prices, AMZN is trading at a $1.37 trillion market cap. But AWS alone is arguably worth more than that. AWS is generating $79 billion in annualized revenues. Operating margins hover around 30% – I expect net margins to trend towards 40% over the long term. Assuming a 1.5x price to earnings growth ratio (PEG ratio), I could see AWS being valued at around 18x sales, equating to a valuation of $1.42 trillion. I note that I view a 2x to 2.5x PEG ratio to be more appropriate given the clarity of the cloud computing growth story.

The retail segment generated $414 billion in trailing twelve months revenue. If third-party sales and advertising revenues become greater components of total retail sales and the company achieves operating leverage, I could see retail net margins hitting 10%. Applying a 1.5x PEG ratio and assuming 10% long term growth, that segment might trade at 15x earnings – implying a valuation of $620 billion. Adding these together we arrive at around 50% upside.

One may wonder if AMZN should spin off AWS. I am of the view that the answer is no. AWS as a stand-alone company could likely achieve higher multiples, but one mustn’t underestimate the value in being able to reinvest the operating profits from AWS into the retail segment. It is rare to find companies that can continuously reinvest so much cash back into the business at high rates of return. While the retail segment is not currently generating profits, we saw glimpses of the profit potential in 2021 and it is hard to argue with the monopolistic position of the platform. AMZN might not achieve my projected upside until it begins to show improving profit margins in the retail segment, but as a long term investor I am more than happy to continue holding the stock and allowing the company to keep compounding.

Key risks here include that of competition. If independent retailers can improve their e-commerce offerings then they may be able to reduce their reliance on AMZN as a sales funnel, pressuring sales and the ability to sustain high take rates. If that were to occur, then AMZN would have invested so heavily in its fulfillment network with little to show for it. Another risk is that of leverage – the company has steadily seen its net cash position dwindle over the past several years. While I view the company as being capable of taking on net leverage over the long term, the lack of profits in its retail segment increases the associated risk of high leverage. The balance sheet is currently quite strong with $60.7 billion of cash ($2.6 billion of net cash) but if the company takes on too much debt in the future then shareholders may be put at risk. Given the company’s long track record of exemplary execution, the stock is too cheap here – I reiterate my conviction that this is one of the better risk-reward opportunities today.

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