Amazon claims to be Earth's most customer-centric company. And they have evidence to back that claim: American Customer Satisfaction Index consistently ranks them amongst them top when it compiles its list.
A laser-like focus on customers has enabled them to grow like a weed. Here are some measures of growth over the last 10 years:
Revenue/Share: 26% CAGR
Operating Income/Share: 11% CAGR
Book Value/Share: 27% CAGR
I believe that by having this customer-centric approach, Amazon has created a lot of value in the world. They have connected many entrepreneurs with customers through Marketplace, developers with datacenters through AWS and aspiring authors with readers through Kindle Direct Publishing.
Most of the created value is redeployed back into the business, at "high" rates of return, as claimed by CEO Jeff Bezos. So the company doesn't have much of an accounting profit (it has massive depreciation expenses from prior years' CapEx). I don't believe that the company will have an accounting profit for the next 15 years or so. Whenever it makes any efficiency gain, it passes those savings to customers. Without an accounting profit, it is difficult to place a value on Amazon.
How does one value Amazon? We can get some hints from the shareholder letters. I believe that Miss Market is valuing Amazon on the basis of cash flows far into the future (15+ years probably):
Let's break down the business into: Retail (North America and International) and AWS.
North America had $80B of sales in 2016 and $2.3B of operating income. Growing at 25%
International had $43B of sales in 2016 and $-1.2B of operating income. Growing at 24%
AWS had $12B of sales in 2016 and $3B of operating income. Growing at 55%.
Total Retail will grow to $3.5T.
Note that the total world retail spend is around $23T. Assuming it grows at 6% CAGR, it will be $55T in 15 years. So Amazon will be 6.3% of total global retail spend.
Also, Amazon US retail will be $2.2T and if US retail spend is $7T in 15 years, Amazon will be 31% of all US retail spend.
Assuming an operating margin of 5%, operating income from retail will be $175B.
Current rate of AWS doesn't seem sustainable to me (44%), so let's assume it will also grow at 25% CAGR for 15 years. Sales of AWS will be $341B in 15 years. Assuming an operating margin of 20%, operating income will be $68B.
Assuming multiples of 10x operating income for retail and 15x operating income for AWS, the total valuation comes out to be $2.7T.
The current market cap is $700B, so the rate of return is around 10% CAGR.
So apparently back in 2006 physical retailing did not pass the "returns bar" for Amazon. If we take Walmart as an example of a retailer with operational excellence, we can try to estimate the height of the "returns bar". Walmart's ROIC is around 12% or so. So I am guessing Amazon will only enter an industry where the ROIC is greater than that. My hunch is that their bar is perhaps 15%-20%.
A study by McKinsey ranks industries by median ROIC. We can look at industries whose median ROIC is > 15%: pharma, consumer products, software services and media. Amazon has already entered software services and media. They could enter consumer products or pharma next. To me consumer products seems more likely as pharma tends to have a wider range of returns on capital than consumer products. They already have the AmazonBasics brand that they can build up upon.
A laser-like focus on customers has enabled them to grow like a weed. Here are some measures of growth over the last 10 years:
Revenue/Share: 26% CAGR
Operating Income/Share: 11% CAGR
Book Value/Share: 27% CAGR
I believe that by having this customer-centric approach, Amazon has created a lot of value in the world. They have connected many entrepreneurs with customers through Marketplace, developers with datacenters through AWS and aspiring authors with readers through Kindle Direct Publishing.
Most of the created value is redeployed back into the business, at "high" rates of return, as claimed by CEO Jeff Bezos. So the company doesn't have much of an accounting profit (it has massive depreciation expenses from prior years' CapEx). I don't believe that the company will have an accounting profit for the next 15 years or so. Whenever it makes any efficiency gain, it passes those savings to customers. Without an accounting profit, it is difficult to place a value on Amazon.
How does one value Amazon? We can get some hints from the shareholder letters. I believe that Miss Market is valuing Amazon on the basis of cash flows far into the future (15+ years probably):
"Why focus on cash flows? Because a share of stock is a share of a company’s future cash flows, and, as a result, cash flows more than any other single variable seem to do the best job of explaining a company’s stock price over the long term." -2001 Letter to ShareholdersAmazon had operating cash flows of $6.8B, $11.9B and $16.4B in 2014, 2015 and 2016. I believe these do not take into account stock-based compensation, which is a real expense. Also, it is difficult to project these far into the future (given that they are consolidated figures). So let's try a sum-of-parts valuation instead.
Let's break down the business into: Retail (North America and International) and AWS.
North America had $80B of sales in 2016 and $2.3B of operating income. Growing at 25%
International had $43B of sales in 2016 and $-1.2B of operating income. Growing at 24%
AWS had $12B of sales in 2016 and $3B of operating income. Growing at 55%.
Optimistic Scenario after 15 years
Let us assume the current growth rates are sustained over the next 15 years.Total Retail will grow to $3.5T.
Note that the total world retail spend is around $23T. Assuming it grows at 6% CAGR, it will be $55T in 15 years. So Amazon will be 6.3% of total global retail spend.
Also, Amazon US retail will be $2.2T and if US retail spend is $7T in 15 years, Amazon will be 31% of all US retail spend.
Assuming an operating margin of 5%, operating income from retail will be $175B.
Current rate of AWS doesn't seem sustainable to me (44%), so let's assume it will also grow at 25% CAGR for 15 years. Sales of AWS will be $341B in 15 years. Assuming an operating margin of 20%, operating income will be $68B.
Assuming multiples of 10x operating income for retail and 15x operating income for AWS, the total valuation comes out to be $2.7T.
The current market cap is $700B, so the rate of return is around 10% CAGR.
"Realistic" Scenario after 15 years
I suspect growth rates of 25% are not sustainable for 15 years. To me, something like a 15% sales growth for retail and a 20% sales growth for AWS seems more realistic (though it is no small feat).
Assuming the same multiples as described in the "optimistic" section above, the market cap in 15 years will be: $1T. Given the current $700B market cap the return will be a meager 3% CAGR.
Valuation Matters
15% sales growth for retail and 20% sales growth for AWS for 15 years is excellent. Any other company would be very happy to hit 15% sales growth sustained over 15 years. The reason for the meager returns in the "realistic scenario" above are because of valuation contraction.
Given the current market cap of $700B, it seems to me that Miss Market is putting a multiple of 100x on AWS operating earnings and 70x on hypothetical retail "operating earnings" at a 5% operating margin.
So the negative CAGR for "valuation contraction" that Amazon as a stock has to fight is -12%. So while I am bullish on Amazon as a business, I am not sure whether there is enough margin of safety for Amazon as a stock. Anything positive CAGR that Amazon as a business has to produce will have to overcome the -12% CAGR valuation contraction.
What else is Miss Market thinking?
Why is the multiple so high for Amazon? I suspect Miss Market is thinking about Amazon entering new businesses and applying the same "customer-first" mantra to seize market share. If she is not thinking about Amazon creating new businesses, she must be assigning a very high growth rate for retail and AWS.
From Jeff Bezos' commentary, it seems they only want to enter businesses that are highly scalable and have high returns on capital. Online retailing seems to pass that bar while physical retailing does not:
From Jeff Bezos' commentary, it seems they only want to enter businesses that are highly scalable and have high returns on capital. Online retailing seems to pass that bar while physical retailing does not:
"I often get asked, “When are you going to open physical stores?” That’s an expansion opportunity we’ve resisted. It fails all but one of the tests outlined above. The potential size of a network of physical stores is exciting. However: we don’t know how to do it with low capital and high returns" - 2006 Letter to Shareholders
So apparently back in 2006 physical retailing did not pass the "returns bar" for Amazon. If we take Walmart as an example of a retailer with operational excellence, we can try to estimate the height of the "returns bar". Walmart's ROIC is around 12% or so. So I am guessing Amazon will only enter an industry where the ROIC is greater than that. My hunch is that their bar is perhaps 15%-20%.
A study by McKinsey ranks industries by median ROIC. We can look at industries whose median ROIC is > 15%: pharma, consumer products, software services and media. Amazon has already entered software services and media. They could enter consumer products or pharma next. To me consumer products seems more likely as pharma tends to have a wider range of returns on capital than consumer products. They already have the AmazonBasics brand that they can build up upon.
