We initiate on Amazon (AMZN) with a $2,000 DCF-based target price, implying a 14% potential upside from the current level. We believe that the market may have overacted the soft revenue guidance for Q4 and the decrease in operating profit. In our view, we believe that AMZN remains a revenue story, given the growing eCommerce penetration in the US (10% of total retail sales vs. 20% in China), global eCommerce opportunities in India and Europe, new retail opportunities with smart store and Whole Foods, media and entertainment opportunities with Twitch and gaming, as well as potential fintech opportunities given AMZN’s scaled consumption setting (i.e., its global marketplace) which sets the perfect foundation for developing Amazon Pay to rival that of Apple Pay (AAPL) and PayPal (PYPL).
We believe the market underestimates these potential opportunities and shifted its focus towards profitability sooner than it should and we argue that investor focus should be on 1) eCommerce revenue growth, 2) AWS market share expansion, and 3) execution on long-shot initiatives in drone delivery, fintech, and new retail. As long as AMZN is moving in the right direction on these projects, we believe that the stories remain well intact.
We value AMZN using DCF analysis, forecasting 19% revenue CAGR from 2018-2023E and 27% growth CAGR for operating profit as operating leverage gradually kicks in due to AMZN’s earlier investments in logistics and the Prime ecosystem.
Our WACC calculation assumes a 10.8% cost of equity that is based on a 3% risk-free rate, beta of 1.2, and 6.5% equity risk premium, while our after-tax cost of debt is 4%. We also assumed a 97.5%/2.5% equity/debt capital structure to derive a WACC of 10.6%.
Our terminal growth of 6.5% is higher than the average long-term growth rate of 3-5% as we believe that AMZN’s other services such as gaming, media, financial services, and AI are capable of delivering higher than the average long-term growth rate.
Factoring all the assumptions above, we derive an implied value per share of $2,000, or 14% implied upside from the current level.
If we were to value AMZN differently using SOTP analysis, we derive a similar valuation level.
We segment AMZN into four business units consisting of North America, International, Cloud, and physical stores.
Using our 2020E estimates, we applied a 20x EV/EBITDA for its North America business, which is roughly in-line with some of the large-cap eCommerce players such as JD.com (NASDAQ:JD) and Alibaba (NYSE:BABA) that are largely concentrated in their home market.
We applied a conservative 1x EV/Sales for the International business but we believe this segment will play a greater role in AMZN’s overall valuation given the increasing maturity in the US market.
A 22x EV/EBITDA is also used for AWS, which we think is fair given the cloud names typically trade between 11x – 60x forward EBITDA with an average of 20x.
Finally, we used 10x EV/EBITDA for the physical store segment as we believe that AMZN is well-positioned to disrupt conventional offline retail similar to how BABA is disrupting this space with its Freshippo brand. Worth noting that 10x EV/EBITDA is conservative as it values this segment at less than 1x sales whereas we applied a 7x EV/sales multiple for BABA’s New Retail segment. The reason for the lower multiple is because AMZN has yet to fully scale its smart stores to the level that is comparable to that of BABA.
Applying all the above multiple assumptions, we also derive an implied value per share of $2,000.
At our target price, AMZN trades at 3x EV/sales and 21x EV/EBITDA on our 2020E estimate, roughly in line with that of BABA. But we want to remind investors that our assumption could be conservative as we think AMZN is arguably a more global eCommerce platform with a superior ecosystem that deserves a higher multiple.
The current valuation of ~18x 2020E EV/EBITDA is just below one standard deviation of its 10-year historical average, which we believe to be undervalued given the growth outlook.
International, the next stage for growth
We believe that the North America eCommerce space is starting to see signs of maturity as online retail as a percentage of total retail sales has largely been stagnant over the past few years. That said, most of the gross merchandise volume growth for AMZN will likely come from its international market rather than the domestic market.
India, Brazil, and Mexico are the top three geographies that offer the most attractive upside due to low eCommerce penetration, younger and tech-savvy demographic, and high mobile penetration along with cheap data to support mobile commerce.
We believe that within the next ten years, IBM will likely account for 20% of AMZN’s international revenue with Japan, Germany, and the UK accounting for 40-50% of the international revenue (vs. around 60-70% now).
India could see the best near-term upside for AMZN, which accounts for 30% of the eCommerce market share, behind Walmart (44%), per data from Euromonitor. Total retail sales are expected to grow at a 11% CAGR from 2019-2022, when it is expected to reach $887bn, with online retail sales expected to grow at a 26% CAGR to reach $92bn by 2023, per Euromonitor. This translates to eCommerce penetration increasing from 5.2% in 2018 to 9.5% by 2023.
Currently, Walmart (WMT), which owns Flipkart, dominates India in terms of overall sales but AMZN has the edge in traffic. We believe this edge in traffic will ultimately result in higher monetization as AMZN expands its Prime Ecosystem, which it launched in July of 2016.
Amazon currently has 50+ fulfillment centers and 90+ delivery stations in India, per MWPVL International. We expect this number to expand over the next few years to ensure a seamless user experience.
Worth noting that India’s retail market ranks third behind China and Japan in Asia and is expected to be the fastest-growing within the region due to its younger demographics that have higher consumption demand compared with those in China and Japan where domestic eCommerce appears to be battling maturity (see:Alibaba: New Growth Drivers In A New EraandJD: Smooth Execution Through Rough Times).
For India’s eCommerce, future growth will come from 1) rising smartphone penetration that translates to higher mobile eCommerce, 2) rapidly growing and evolving middle class, and 3) ongoing expansion of eCommerce players such as Walmart and AMZN.
Brazil is another strategic market for AMZN but we believe that the battle for Brazil will not be easy as AMZN does not have material market share within the country as it is largely dominated by the incumbents including MercadoLibre (MELI) and Lojas Americanas (OTC:LOJPF), which combined have 40% market share in terms of retail sales and 45% traffic share, compared with AMZN that only has 1% retail share and 3% traffic share, per data from Euromonitor.
Long story short, AMZN’s progress in Brazil has not been smooth as it launched its direct sales business in January of this year. The expansion had some setbacks due to the country’s complicated logistics network and tax system, and this has put AMZN at a disadvantage relative to the incumbents. Currently, AMZN offers more than 120k products across 15 categories but the key issue is that Amazon Prime is not available yet so ramping up on the ecosystem will take some time.
Finally, Mexico’s eCommerce market is also seeing fast expected growth with Euromonitor forecasting a 26% 5-year CAGR with penetration increasing from 4% in 2018 to 7.6% in 2023 driven by higher mobile penetration, lower smartphone prices, rising younger demographic and improvement in logistics and infrastructure.
Major players in this country include Walmart, MercadoLibre and AMZN, with AMZN and MELI standing side by side in terms of retail sales market share at 11% each, followed by Walmart at 4%, per data from Euromonitor. However, MELI has a 40% share in traffic followed by AMZN at 23% and Walmart at 6%.
We believe that the lower cost of shipping and integrating the Prime Ecosystem of both the US and Mexico could potentially become a differentiator vs. MELI. We note that AMZN Prime has been in Mexico since 2017 and Prime subscribers currently have free one-day shipping in key markets such as Mexico City, Guadalajara, Puebla, and Queretaro.
AMZN has also taken an effort to drive financial inclusion in Mexico, potentially setting the foundation to roll out its fintech products such as supply chain financing, SME lending, or Amazon Pay. Notably, AMZN launched Amazon Cash to provide users with a secured cash payment service given half of the population does not have a bank account.
The bottom line is that the IBMs offer attractive secular growth for AMZN’s international eCommerce and Prime growth, but execution remains the key and will likely force AMZN into another capex cycle to maintain its revenue growth.
Q3 headlines cause jitters but we remain believers
Q3 revenue was above consensus due to an incremental 4.5% acceleration in North America sales when we exclude physical stores. Although operating income also came in higher than consensus, margin contracted roughly 2% due to investments in one-day shipping.
The deceleration in AWS does raise some concern on the longer-term growth outlook, particularly when AMZN lost the bid against Microsoft (NASDAQ:MSFT) on the JEDI cloud contract, but we believe that there is considerable runway left when we consider the transition of the overall productivity and workload to the cloud remains in its early days, and the shift of traditional offline retail to online still offers incremental upside to this theme. To be fair, losing out on the JEDI contract is clearly a negative but we believe that the cloud market is big enough for AMZN to take shares elsewhere.
Q4 revenue guidance was below consensus forecasts as we believe this is due to a combination of seasonal headwinds, an increase in Japanese consumption tax, Diwali holiday shift, and the ongoing investment at AWS. Operating income guidance was also below consensus due to the ongoing investment in faster delivery and infrastructure spending reacceleration.
We believe that the investment community has been gradually shifting its focus from revenue growth to profit growth for AMZN which resulted in the post-market sell-off. Our view is that AMZN remains a revenue story and future growth of its marketplace, Prime Ecosystem and AWS, will depend on its ongoing investments in logistics and infrastructure. Worth noting that AMZN’s capex investment growth has resulted in incremental revenue growth in the prior years so clearly the company is executing.
In conclusion, we remain bullish on AMZN with a $2,000 DCF-based price target, implying a 14% potential upside and equating to 21x EV/EBITDA on our 2020E estimate.
Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.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.