Throughout this article, money amounts are expressed in billions of dollars.
Covid gives Amazon a near monopoly in retail
During the confinement induced by Covid-19, Amazon has become one of the few ways to get hold of goods that one would previously have sought from local shops that have been forced to close. As I sit by the window of my home, looking out on to the street, I can see delivery vans reaching neighbours at all times of the day. Amazon's dominance of retailing at the moment is reflected also in the rubbish left out for collection. A large fraction of it has Amazon's livery.
Investors have reacted by driving Amazon's share price up from around $1700 in mid March to around $2600 now, just twelve weeks later. Is that increase rational? Let us have look.
Present value
Examination of Amazon's balance sheet shows that it has
63 of debt, offset by
55 of cash
If we combine …
this 8 of net debt
the value of its equity, being the 1,300 market capitalisation implied by the $2601 share price on 8 Jun 2020
… then we find that Amazon's enterprise value amounts to 1,308. That is one and a third trillion dollars.
Necessary cash flow
For this valuation to be justified , we need to believe that Amazon has a fairly certain prospect of generating enough cash to
return the 1,308 to stakeholders
compensate stakeholders for the risks they are exposed to while they wait for that to happen.
The two key questions are
how long do we give the company to deliver this return of capital and associated reward? Pier Analysis uses a standard period of 15 years
what rate of return do we look for? Pier Analysis uses a standard rate of 10% pa.
These are more challenging requirements than most analysts demand. You can investigate the effect of different ones, if you prefer them, because a distinctive quality of Pier Analysis is that we give you the model.
There many ways that Amazon could achieve these objectives.
One way is to deliver cash flows around 163 to 189: this is the violet line on the graph below
Another way is to accept a cash flow that is lower than this range in the early years, say 70, but makes up for that by growing rapidly so that it is significantly higher in the later years, reaching 232. This is the red line on the graph. We concentrate most of the growth in the first five years. This too is demanding by conventional standards.
There are infinitely many contours between these two extremes. Any one of these patterns would put Amazon in the position to return our investment within 15 years and give us a 10% pa return. Technically, what we are saying is that the 15 year cash flow profiles shown in every one of these lines has a net present value of 1,308 when discounted at our chosen rate of 10% pa. If the cash flows that Amazon generates in the future follow one of those lines, the benefits of holding a stake in the company (our entitlement to our share of these cash flows, discounted back to today) match the cost of buying that stake.
Actual cash flow
Now that we know what Amazon needs to achieve to reward us appropriately and return our capital to us, we can look to see what the company has actually managed. The black lines in the graph above show what Amazon’s enterprise cash flow looked like in the last five years. There are
a dotted line, which is what the accounts show
a solid line, which reflects what the cash flows would be when subjected to some necessarily subjective adjustments aimed at stripping out items that are unlikely to recur in the future.
The main such adjustment is elimination of the 2017 acquisition of Whole Foods, which costs $14. One has to be careful when making eliminations of this kind, as the acquisition will certainly have contributed to the growth in Amazon's revenues. Removing the cost of the acquisition but keeping its benefits is at risk of being inconsistent. The counterargument is that we are trying to establish what cash generating platform Amazon has for the future. Now that that acquisition has been made, revenues, and costs, will be at current levels, without the need for that one-off acquisition cost to be repeated.
In the opposite direction, we have eliminated the benefit that Amazon enjoys from working capital, which results from it managing to extract payments from its customers before it settles with its suppliers
What we find is that Amazon has generated positive cash for just two years. It's currently in the region of 16-19.
Interpretation
Can Amazon get this cash flow from 19 to the 160 and beyond that we need to believe to justify the current share price? Arguments that it can grow its cash flow rest on two main ideas
These days, only 60% of Amazon's revenue involves selling tangible items. The other 40% is selling software services. Amazon supplies the platform on which a large fraction of the world's e-commerce websites run. This activity is getting bigger as a proportion of Amazon's business, because it is growing faster; and it is more profitable.
Many have long claimed that Amazon has depressed its profitability artificially, mainly to buy market share; and that it can turn on profitability as soon as it feels like it. In terms of gaining market share, the firm has certainly succeeded. Some think that the positive cash flow of the last two years is a sign that the conscious choice to make money just mentioned has now been taken. Certainly, some complain that Amazon's prices are no longer particularly competitive.
But 19 to 160 and beyond? That is asking the largest company in the world get almost ten times bigger. Perhaps it can manage that. Anything is possible. But betting on it is not an investment; it's a speculation, and there are safer bets elsewhere in the market.
We could dig further into Amazon’s different lines of business, their growth rates and their margins. We could study Amazon’s financing cash flows to see what it is doing with the enterprise cash flows that it is now generating. So far, paying dividends has not been among those applications, but maybe it will be before long. None is this is a good use of our time at this valuation.
Those happily invested in the firm will be content to wave "Loser" as they cruise past those who have not been aboard during the share price's climb from $1600 to $2600 in just three months with which we opened this article. They will argue that it was obvious that Amazon would benefit from a lock-down of competing retailers. The counterargument is that the current valuation is resting on the existence of a crowd of like-minded people, and has no plausible connection with or safe underpinning from the company's fundamentals.
The more nuanced retort of believers in the current valuation is that the above analysis implies that the business will be valueless in 15 years time. True: but again, recall how the retail industry looked fifteen years ago. Is it inevitable that it will be in Amazon’s hands in fifteen years? Will you commit the family fortune to that possibility, at these prices?
Some will argue that if one makes requirements so demanding, nothing will every be worth buying. Not so: both Google and Microsoft have been appealing according to these criteria at times during the last decade, and both have since risen around six fold. And there are companies now that have the same characteristics, which Pier Review will seek out in coming articles.
What next?
A distinctive feature of Pier Review is that it provides the financial model that underpins each analysis. If you are content with a return less than 10% pa, or willing to wait more than 15 years for the return of your investment, you can impose less demanding requirements and see how the coloured lines on the projection of cash flow required to justify the valuation shift downwards. (The black lines on the chart will not move, since they are the result of Amazon’s reported historic performance.)
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