3 Reasons Why I Own Amazon
A simple and straightforward investment thesis can be particularly effective. In the words of Leonardo da Vinci: "Simplicity is the ultimate sophistication."
My bullish thesis on Amazon (AMZN) is supported by 3 key pillars: rock-solid fundamental strength, outstanding execution, and reasonable valuation.
A Long-Term Winner
Amazon has widely outperformed both the SPDR S&P (SPY) and the Invesco QQQ (QQQ) over the long term. Granted, the company was much smaller and explosive two decades ago, and you just can's expect the same kind of outperformance from one of the biggest companies in the world nowadays.
Data by YCharts
Make no mistake, though, Amazon has also crushed the market in the past five years, so size is no limitation for Amazon in terms of the company's ability to deliver big outperformance.
Data by YCharts
Many investors have a short-sighted view of long-term outperformance, and we usually hear arguments such as: "It is already too late to buy Amazon." It makes sense to be patient if the stock is too extended or overvalued, however, staying away from a company because it has performed well in the past is an expensive mistake. On the contrary, winners tend to keep on winning more often than not.
In terms of portfolio performance, missing the big winners can often be much more detrimental than investing in underperforming stocks. Probabilistically speaking, a losing stock can go down by 30% or perhaps 50% before you decide to sell it. Theoretically, it can only decline 100% if it turns out to be a complete failure.
Big winners, on the other hand, can multiply your capital 5 times, 10 times, or even more over the years. A big winner can compensate for several losers and then some more. This is just the beautiful mathematics of investing in high growth stocks with abundant long-term potential.
But the mathematical aspect is just the beginning. From a fundamental perspective, there is a reason why Amazon has outperformed the market over the long term. The company operates in high growth markets, and it has the competitive strengths to capitalize on its opportunities and to consistently create value for shareholders through all kinds of environments.
Brand value is a key source of competitive strength for companies in the consumer sector, and Amazon comes second to none in terms of brand recognition. According to data from the Top 100 Most Valuable Global Brands ranking by WPP and Kantar, Amazon is in fact the most valuable brand in the world right now, with an estimated market value of almost $416 billion.
Source: Kantar
This brand value was built by Amazon through the years by providing outstanding customer service and delighting consumers with a wide selection of products, aggressively low prices, and high-speed delivery. It would be remarkably difficult, or even impossible, for competitors to replicate this brand value via marketing investments in the short term.
Source: Brandz
Amazon benefits from a powerful ecosystem and a flywheel effect that creates a virtuous cycle of growth and increased competitive advantages. More customers attract more sellers to the platform, which creates a greater selection and a bigger scale to reduce costs and prices. This keeps attracting more customers and sellers to Amazon over time. The same dynamic is at play in Amazon Web Services, more scale produces more efficiency and cost advantages as revenue grows.
Source: Amazon.jobs
Amazon is not only the top player in e-commerce and cloud computing infrastructure, but the company is also getting stronger as it gains size over time, which extends Amazon's lead versus smaller competitors.
Excellent Execution
Buy and hold is overrated. It is important to assess a company from a long-term perspective and to focus on the big picture as opposed to the short-term noise. However, we also need to permanently verify that management is executing well and creating value. Buying and regularly verifying the thesis is a much better approach than buying and blindly holding.
Amazon is executing brilliantly, total net sales increased 40% to $88.9 billion in the second quarter. There is obviously an acceleration in demand due to the pandemic, but a large share of this increase is also permanent. Prime members tend to shop more often and they have larger basket sizes, and Amazon is very effective at driving growing revenues from customers.
For example, online grocery sales tripled year-over-year in the second quarter. Even if some of that business goes back to brick-and-mortar stores in the future, most consumers who started shopping for groceries online via Amazon during the pandemic will probably keep doing so in the years ahead, especially for the items that go well via online channels.
Amazon incurred $4 billion in incremental COVID-19-related costs in the quarter, but it still delivered a big increase of 89% in operating income and over $31.8 billion in free cash flow during the quarter.
Source: Amazon
Source: Amazon
Both online retail and cloud computing infrastructure benefit from scale advantages as revenue expands, and third-party sellers now account for more than half of unit sales, which has positive implications for margins too.
Third-party seller services, which include commissions as well as fulfillment and shipping fees, grew 52% to $18.19 billion last quarter. Subscription services grew 29% to $6.02 billion and other sales, which is predominantly advertising, grew 41% to $4.22 billion. These multiple growth engines are firing on all cylinders, and they should produce both sustained top-line growth and expanding margins for the company in the years ahead.
Demand for e-commerce has substantially accelerated, but it still accounts for a relatively modest 16.1% of retail sales in the U.S. This percentage will clearly continue growing for a long time, and Amazon is the right position to benefit from this trend. International markets are even younger in terms of penetration, so Amazon still has plenty of room for growth in e-commerce both in the U.S. and abroad.
Data by YCharts
Cloud computing demand of all kinds will continue expanding strongly during the pandemic and beyond. Besides, AWS is delivering outstanding profitability levels, with operating income in this segment growing 58% year over year last quarter.
Jeff Bezos is one of the most innovative and visionary business leaders in our time. A decade ago, it would have been impossible to imagine that AWS was going to have such a huge impact. Similarly, Amazon is currently expanding into areas such as telehealth and drone delivery, among other projects that will not move the needle in the short term but could have massive potential over the long term.
One of the main reasons why the stock has performed so well over the years is that Amazon has surpassed market growth expectations by successfully expanding into new categories and even new industries. This is embedded in Amazon's DNA, and there is no reason to expect the company to slow down on its aggressive growth ambitions going forward.
Valuation Is Still Reasonable
Assessing valuation for a company such as Amazon is remarkably hard to do. At the end of the day, the true value of the business will depend on the cash flows that the company is going to produce over the long term. Predicting those cash flows necessarily carries a huge margin of error, especially when it comes to such a dynamic growth company with multiple growth engines.
Since Amazon is also aggressively investing for growth, accounting earnings are quite noisy and volatile in the short term. Looking at operating cash flows, however, Amazon is valued in line with historical standards for the company. The EV to operating cash flow ratio has been in the range of 20 to 30 during most of the past decade, and it currently stands at 26.
Data by YCharts
Price targets from Wall Street analysts should always be taken with a big grain of salt because analysts are typically behind the curve when it comes to assessing a company and its long-term potential. That said, it doesn't hurt to check Wall Street expectations for a company in order to see if the valuation is within a reasonable range or not.
The average price target among the analysts following the stock stands at 3733, which represents an upside potential of 17% versus current price levels. This sounds fairly reasonable when considering valuation ratios and growth potential over the mid-term.
Source: Seeking Alpha
Amazon can easily deliver revenue growth rates above 20% in the coming 12 months, and profit margins will probably continue expanding. Considering that EV to cash flow is in line with historical standards and that cash flows will continue growing rapidly, Amazon stocks doesn't look overvalued at all at current prices.
Valuation is not just about the valuation multiples in isolation, we need to consider the valuation ratios in the context of the company's fundamental quality and long-term growth prospects. Amazon is such an exceptional business that the stock is offering attractive upside potential going forward.
Disclosure: I am/we are long AMZN.
Disclaimer: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with ...
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