By Chaim Siegel of Elazar Advisors, LLC
Summary
We recently spoke with Amazon.com (NASDAQ:AMZN) and are of course excited about the fundamentals. Nobody can compete with their momentum in retail. They also have an impressive momentum jump in the cloud. With all that said, for us to get bullish on the stock, we need the earnings numbers to work for us.
The next few quarters could be “blow-out,” beating Street expectations. When we get to the back half however, we have an issue with the math which curbs our enthusiasm somewhat, as we’ll explain.
Longer Term Story Is—Of Course—Amazing
Amazon’s fundamental story continues to improve. Their cloud offering, Amazon Web Services (AWS), has been growing revenues over 50% in the last twelve months and makes up over 50% of Amazon’s total-company profits. This segment has huge revenue and earnings potential.
The key metric we watch to identify if growth has legs is how much growth comes from new customers versus existing customers. We think they are both roughly equal drivers to AWS which gives Amazon visibility ahead.
Fulfillment By Amazon (FBA) has very high margins and now makes up about half of retail revenues. FBA is a synergistic extension to their core retail business allowing other sellers to use Amazon’s fulfillment infrastructure.
FBA is growing faster than the overall retail business as well. That tells a great story for the retail business and adds a cushion to the continued investment the company makes in Prime, video, distribution, marketing, etc.
Revenues And Earnings “Maxed” in Q4; Accelerate in Q1 and Q2
The near term earnings picture looks strong. Looking at this simply, when we compare last year’s Q4 ’15 to Q1 ’16, earnings were very close. Q4 ’15’s $1.00 went to Q1’16 $1.07. This year though, The Street only has $1.04 for Q1’ 17 versus Q4’ 16’s $1.55, The Street is expecting a huge sequential falloff (quarter-to-quarter).
We expect trends to be more like last year which would imply a big upside surprise for the coming Q1.
Q2’ 16 last year also saw a big jump from Q1’ 16 and Q4’ 15. Again, The Street only expects a small pickup this year. Here too we think Q2 has the potential for a big upside surprise.
The fundamental reason for this is somewhat simple. Q4 is more heavily weighted to retail which was the company’s first, integral line-item. That business has slowed (although still growing strong) because incremental sales are tougher to come by in that peak quarter.
The other quarters (Q1-Q3) have two main benefits. First, Amazon is driving more purchases in smaller quarters with Prime and many new product categories like grocery and apparel. The retail growth rate is faster in smaller quarters.
The second reason the “smaller quarters” have more opportunity is AWS. AWS is not as seasonal, so its performance is more linear making its impact felt more when retail is “smaller.”
For those two reasons the “smaller quarters” have more opportunity than Q4, as we saw last year and as we expect to repeat again this year.
That can cause upside surprises in the next two quarters.
If You Want To Own Amazon AWS Profits Need To Accelerate
Here’s the whole story to help you choose how to manage your Amazon position. You have to decide where the AWS profits are heading.
Here’s AWS:
You can see in the bottom row that despite AWS being about 10% of Amazon’s revenues it makes up over 50% of the profits.
You can also see that in the recent Q4 margins slowed from up 612 bp to being up 207 bp (circled in blue). Amazon has said this business will be “lumpy” and they will be investing in price. “Lumpy” is a nice way to tell The Street that pricing is going to be lower than it had been. That negatively impacts margins.
Their revenue growth has been strong but has been gradually slowing due to the law of large numbers. As companies get bigger the growth rate simply gets tougher to sustain. (See the slowing trend circled in green).
Depending on what you model for these two line-items will help determine how you feel about the stock.
We are modeling that the pace of AWS revenue growth continues that gradual slowdown based on the law of large numbers and increased competition from the likes of Microsoft (NASDAQ:MSFT), Google (NASDAQ:GOOGL) and Oracle (NYSE:ORCL).
We are also modeling that last quarter’s pace of margin expansion continues so we don’t expect a snap-back in AWS margins.
Because of that we can’t get to The Street's numbers for the back half, which gives us pause.
If you think margins will pick back up then you can probably get to The Street's numbers or higher and will be more bullish than us shorter-term, going into the back half.
Also, to be fair, this slowdown in margin improvement is self-inflicted by Amazon to hold and gain share. They can easily turn the dial back on investment and allow profit margins to flow through. That’s what the bulls are excited about. In the meantime, based on the company’s statements about price investment, we want to be more conservative on margins in AWS.
Some investors will look through that and see the potential of 100% AWS profit growth. We, however, see the last quarter's slowdown...alongside the company's comments, that gives us closer to 50% profit growth for AWS.
Company Has A Math Issue Though By Q4
So when you do the math on the company as a whole, the retail business will not be as overshadowed by AWS this year as it had been in the past. The potential is huge for AWS, but we may not see that flow through to profits as we have during the past few years on a growth basis.
Amazon is going to be aggressive with investment expenses. We circled total operating expenses in red (in the model below) showing that this line item should continue its growth and potentially pick up from Q4.
We have the revenue growth picking up from Q4 based on the maxed Q4 we spoke about above. That held back Q4 and should help Q1, Q2, etc.
While the next two quarters should look amazing versus The Street's expectations, Amazon has a building problem come the fourth quarter. As the topline growth rates converge with expenses in Q4, we can’t get to The Street's numbers. Again, the only way we can be OK with The Street's numbers later in the year is if Amazon decides to let AWS profits flow through. If not, The Street is likely too high in the back half.
Based on the company’s history though, they don’t typically manage for quarters. That can create a risk or an opportunity, depending on how you look at it.
That doesn’t give us the confidence to own it right here and now.
Valuation And Earnings
We marked the model below with two black semi-circles. The one on the left shows that our first half is bigger than The Street. Our Q1 is $1.55 versus The Street’s $1.04. Our Q2 is $2.03 versus The Street’s $1.62. That would indicate there should be nice momentum for Amazon’s stock in the first half.
We have lower numbers in the second half. That gives us $6.49 for the year versus The Street’s $6.81. That makes us more cautious.
Next year we’re closer to $9.00-$10.00 versus The Street’s $13.00 in earnings. If The Street is right, you are paying 65-times next year’s numbers.
For those tuck-away investors, we agree, Amazon is a long-term investment worth holding on to.
For shorter-term investors, we think there will be opportunities through this year to take advantage as investors get concerned about AWS growth and profits.
Where We’d Warm Up To The Stock
We admit Amazon is tough to value, so we are going to use support levels to determine the right entry. We marked two key lines on the chart above that saw critical action, which creates key levels for us.
High value stocks have a habit of getting more valuable, so we're not afraid of the “close your eyes approach.”
Seriously, there are strong support levels at $735 or $684 as we show on the chart above. That is about 50x P/E on The Street’s numbers for next year. That is about 70x our number. It sounds expensive but there is no other Amazon so we're OK with owning “expensive” on a nice pullback. Amazon has also traded much higher than 70x so we’re OK with it. It’s Amazon.
Conclusion
No doubt about it. We love Amazon.com. They own the retail sector and have an amazing lead in cloud. The cloud is going to become more competitive which Amazon is preparing for. That's why we think there will be opportunities along the way this year to buy Amazon when it's cheaper.
Model
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