What’s Driving Amazon’s Stock’s Poor Performance?
19 Nov 2022
Despite Amazon stock’s recent poor performance, there are many reasons to remain optimistic in the long-term view.
With a margin of safety, Amazon’s stock is now easier to buy.
Since its high, Amazon’s stock has decreased by more than 47%.
There might be some company-specific explanations, but the present bear market is most likely the main cause of the decline.
- Amazon’s retail business has its low margins and high investments but it’s essential for the overall business. That’s why we give a full overview.
- Next to AWS, two more internal giants are growing fast and still have a long runway.
- The best way to value Amazon is probably OCF and it shows that there’s a margin of safety at the current valuation.
- I do much more than just articles at Best Anchor Stocks: Members get access to model portfolios, regular updates, a chat room, and more.
This year, the stock of Amazon (NASDAQ: AMZN) has been severely penalized by the market. The stock is currently roughly 47% below its most recent highs:
While there are undoubtedly some company-specific reasons for this steep decline, we believe that the current market environment and investors’ short-termism have a much higher weight on the stock price.
In this article, we will explain why retail is critical for Amazon despite its poor financials and discuss some long-term opportunities for the company.
Without further ado, let’s get started.
The importance of retail
Most people mainly know Amazon for its retail business. Ask anyone on the street what Amazon does, and they’ll most likely tell you that Amazon is an e-commerce retailer. However, this is precisely the part of the business that investors dislike the most due to its poor margins and high investment needs.
The investment community has long discussed a potential spinoff of AWS (Amazon Web Services) so that investors can choose what part of Amazon they want to hold. We know it might be controversial but given the opportunity to hold AWS or the rest of Amazon, we would probably choose to hold both.
Amazon’s retail business is responsible for many essential business lines and is shifting toward a more profitable model, the third-party model or 3P. It’s also an integral part of the company’s moat and why other businesses, such as Ads and Prime membership, have a long runway ahead. Yes, AWS can survive without retail, but we must not forget that AWS was born from an internal solution the company found while trying to scale its retail business. It’s not dependent on retail anymore, but it does exist thanks to retail.
Amazon is a huge company, and it may be difficult to untangle all the threads. That’s why we have prepared a graph with an overview of Amazon’s businesses:
As you can see in the graph, retail fuels several of the company’s businesses, some of which are lucrative and have very high margins. These adjacent businesses have many years of growth ahead, in many cases protected from disruptors thanks to the company’s investments in retail throughout the last two decades.
The long-term opportunities
The stock price’s performance this year could make investors believe it’s not day 1 at Amazon anymore, even though the main building at Amazon’s headquarters is called Day 1.
Retail already is a massive business and will be heavily impacted if we go into recession. We accept both claims are true, but many investors are staying away from Amazon due to what can happen over the next one to two years, completely ignoring what could drive the company to new heights over the next decade.
Let’s go over some of Amazon’s long-term opportunities.
Amazon Web Services – Leading the shift to the cloud
AWS is the growth driver that every investor talks about. Companies are increasingly shifting their tech infrastructure from their premises to the cloud. However, the shift to the cloud is costly due to the required big investments in infrastructure, so these companies increasingly rely on third-party providers. AWS is the clear leader thanks to its first-mover advantage:
There are many advantages to using hyperscale’s (Amazon, Microsoft, and Google. The first and most obvious one is flexibility. If customers were to invest in their own infrastructure, this would create massive capital needs and little ability to control costs during times of lower usage. Instead, by relying on third-party providers, these customers have now transformed a fixed expense into a variable expense, thereby allowing them to be flexible according to their needs and the macroeconomic context.
The pandemic was a warning sign for every company to invest in their tech infrastructure. Consumers and employees increasingly spend their time online, creating a need for a tech infrastructure that allows fast scalability, development, and rollout. The cloud provides just this.
According to several market research firms, the global cloud computing industry is expected to grow at a mid-teen yearly, reaching a size of over $1.5 trillion by the end of the decade. With the industry increasingly consolidating around hyperscale’s, AWS will directly benefit from this growth.
Margins already are high at AWS, but it still requires high capex. The company is currently investing significant amounts to building AWS regions around the world in anticipation of future growth, but the potential for being a stable cash cow is clearly visible. Cloud also has high switching costs, so the growth opportunity comes with significant pricing power attached to it.
Advertising – Another giant in the making
Many investors ask themselves if Amazon will ever come up with yet another AW. We shouldn’t make direct comparisons, but its advertising business might be another giant in the making.
Amazon Ads is the company’s digital advertising offering, which has several parts to it. The most “well-known” part and where Amazon’s competitive position is stronger is in its Marketplace Ads. It’s easy to spot these ads, and it’s also easy to understand why they are doing so well.
If you open Amazon, you’ll see a variety of offers. Some of these offers are things you have already bought and might want to buy on a recurrent basis, others will be offers based on what you have searched for but not yet purchased, and others will be ads. You can spot ads because they have a “sponsored” tag beneath them.
Amazon’s shoppers typically come to the website with a purchase in mind, so there’s high intent in every interaction that happens on the marketplace. This intent, together with Amazon’s first-party data, is what makes Amazon Ads so powerful.
Advertisers on Amazon’s marketplace know that conversion rates for their ads are much higher than in other platforms where there’s no buying intention. Amazon’s first-party data also allow it to “boost” this intent by showing the most relevant ads based on what the user has searched for in the marketplace. Marketplace Ads are Amazon’s bread and butter and are insulated from Apple’s IDFA changes:
Amazon Ads launched 10 years ago, but it was only recently that the company started focusing on its growth. As a result, Ads are now a +$30 billion business, growing at 30% in the most recent quarter despite the broad ad industry going through tough times:
Amazon Ads is made up of much more than “just” marketplace Ads, though. Leveraging platforms such as Fire, Twitch, and Amazon Music, the company also offers “external” ad services. Despite these platforms being outside the marketplace, a prime member accesses them using the same user login, so Amazon can leverage first-party data here too. Unfortunately, Amazon bundles its Ad Revenues, so it’s difficult to understand how each part is performing individually.
Amazon Ads is a great business and is mostly dependent on retail. When merged with Ads ‘ operating margins, I wonder how the retail business margins will look in a couple of years.
The opportunity for Ads is obvious. Amazon’s marketplace is increasingly shifting to 3P sellers, which are evidently the ones that purchase these ads:
We anticipate this trend will continue going forward, helping the Ads business’ growth. As Amazon grows its prime memberships and its activity on the marketplace, impressions will increase, and the first-party data will be more robust to continue driving conversion. Amazon doesn’t separately disclose the profitability of its Ads business, but operating margins as high as those of Meta may be achievable. When nobody thought Amazon could come up with another cash engine like AWS, the company did just that in plain sight.
An investor willing to forfeit retail must be ready to forfeit Ads too.
Prime membership – significant pricing power in the bundle
The Amazon Prime membership bundles many of the company’s benefits for consumers. Prime is a subscription service through which consumers pay an annual fee in exchange for having access to a series of “Prime” benefits:
We will not go into detail about each of these benefits, but it seems clear that the main benefit is on the eCommerce side. Most people become prime members due to fast and free shipping and Prime day. Again, this shows how important retail is for the overall company despite not being the best business in isolation.
Throughout the years, Amazon has built various segments on top of its Shipping benefits, increasing switching costs and even diversifying the top of the funnel. One example of the latter is Amazon’s recent 11-year partnership with the NFL to offer Thursday Night Football. The event was record-breaking when it comes to signups:
Amazon aims to give prime subscribers free and fast shipping, a “Spotify,” and a “Netflix,” among others. By offering such a broad range of services, the company can increase switching costs and widen the top of the funnel. The former will help with pricing power going forward, while the latter should help with volume growth. Prime gives a ton of value, according to JPMorgan’s calculations:
There’s a high probability Amazon will be able to realize significant price hikes in the future without seeing too much churn. 94% of prime members who have subscribed for a year subscribe for a second, and 98% who subscribed for two years renew for a third. We’re already starting to see this play out:
On the Prime fee increase earlier in the year, we’re happy with the results we’re seeing in the Prime program. Prime membership retention is still strong, the change has been above our expectations positively.
Amazon has built a large and loyal customer base through this broad offering. Let’s look at some numbers.
There are currently around 200 million prime members globally, 150M of which are in the US. Growth has been strong over the last decade, although it’s expected to plateau in the next couple of years:
It’s normal for growth to plateau here. At almost 160 million prime subscribers, Amazon has close to a 50% penetration in the US. This number is higher if one excludes kids, for example. At these penetration rates and based on the value that the Prime subscription offers its members, there’s a significant opportunity to grow in price here.
The better opportunity comes from international markets, though. Amazon disclosed in Q1 2021 that it had surpassed 200 million global Prime members. Subtract US Prime members from this number, and we get to around 50 – 60 million international Prime members. This number is significant, but there’s still a long runway to grow in volume.
The international opportunity is even greater if we consider that Prime is much cheaper in international markets than in the US. Let’s look at the example of Spain.
Spotify and the lowest-tier Netflix subscriptions would cost are Spanish citizens around €215 per year. Spotify costs €9.99/month, and Netflix’s low-tier costs €7.99/month. A Spanish citizen pays €36/year for an Amazon Prime membership. Amazon Music Unlimited is not currently included in the Prime membership, so we should add that to make it a fair comparison. With Amazon Music, the total would be €156 per year. This means you’d have access to Netflix (Prime Video), Spotify (Amazon Music), fast shipping, and other benefits for 39% less.
Yes, Amazon Music is not as good as Spotify, and Prime Video still lags behind Netflix, but the gap is closing thanks to Amazon’s investments. When this gap closes, would a Spanish citizen cancel their Amazon Prime subscription after a 100% price hike? It seems highly unlikely.
Price and volume will drive international, although competition will be more intense than in the US.
Amazon’s valuation has always been a controversial subject. Probably the best way to value it is through operating cash flow. Amazon’s stock price has followed its OCF evolution almost perfectly. It’s also no surprise, then, that when operating cash flow went down substantially, the stock dived too. But it has now overcorrected, especially if you look into the future. I think this graph shows more than all the words I could write.
The blue line shows the average OCF valuation of Amazon’s stock, which happens to be almost identical to the OCF growth: 25% growth, an OCF multiple of 25. Of course, this is no coincidence. When you see how much the Operational Cash Flow is expected to grow in the next few years, I think this shows why we rate Amazon as a strong buy now. Even if the growth is not as high as expected, there’s probably a margin of safety here. As you can see on the graph, in the past 15 years, it has not often happened that you could buy Amazon at a discount.
As we know, anything can happen in the stock market. There are no guarantees. But this seems to be an excellent price to buy Amazon shares and hold them for the long term.
Overall, despite the recent underperformance of Amazon stock, there are numerous reasons to maintain an upbeat outlook over the long run. We believe that Amazon’s continued substantial reinvestment in its business is holding back short-term investors. If one does not have a long-term perspective, no one wants to own.