I published an AWS piece in March 2019 that is counter to what most people are saying. My note could be boiled down to 3 thoughts: AWS is a good business with great tailwinds, but:
It’s becoming highly competitive, with Google, Microsoft, Oracle, IBM and others all gunning for a piece of the pie.
Pricing, and therefore margins, will likely go down in the future . In fact, AWS proactively lowers pricing for customers. This is not a sign on a good business, but instead a sign of a commodity. You become the low cost producer by having the highest volume, so you need to incent players to stay and leverage your fixed costs.
I didn’t think it was being mis-priced in Amazon’s stock. In other words, it wasn’t a hidden gem. You’ll see from this post that I still think that is true.
I’m reposting my initial projections for the company below and we’ll discuss how they’re performing to those expectations. I came up with a value of $165BN.
Maybe I was being a little harsh on the out years, especially for margins. But guess what? AWS was somewhat in-line with this estimate in 2019, with $35BN in sales, $9.2BN in Op Income and $17.4BN in EBITDA.
2020 is supposedly the golden era for AWS with COVID-19. Tons of start-ups are growing rapidly with everyone shifting to the cloud and AWS is the backbone they are built on. As those companies grow, they scale up the resources needed from AWS so AWS makes more money.
YTD 6/30/2020, AWS did $21BN in sales and $6.4BN in EBIT. If we annualize that, its $42bn in sales and $12.8BN in Op income for ~30.5% EBIT margin. So they are behind on sales actually, but the margin is holding in there. This is from higher utilization needed during the pandemic (which helps fixed cost leverage), but it looks like the company also changed its depreciation schedule, so I would need to see D&A to get a real sense of what true cash margins are (and they don’t disclose D&A by segment outside of the 10-k). They actually called this out as helping the EBIT margins.
For those that may think AWS can keep up its amazing growth, that’s not so. Its clearly decelerating, but it is on big numbers so that is expected. By contrast, Azure grew 50% in this same quarter (though is about half the size of AWS).
So maybe I’m wrong on the AWS valuation. I do think I am probably too punitive on the out years for margins. If I change my margin assumption to ~22% average EBITDA margins for 2024-2028, the value is ~$275BN. This is solid improvement, but seems well captured in Amazon’s $1.6 Trillion market cap.
Walmart announced a new partnership with e-commerce platform Shopify. Shopify is used today by over 1 million small-to-medium sized businesses, offering services “including payments, marketing, shipping and customer engagement tools to simplify the process of running an online store.” The partnership clearly makes sense for sellers if they can get cheap access to Walmart.com’s 120 million monthly visitors.
I covered Amazon’s third-party marketplace in a previous post, but if you’ve been on Walmart.com recently, you’ve probably seen third-party listings such as the one pictured below. In fact, a cheap-o like me has started to notice that Walmart’s prices in many cases are cheaper than Amazon (with no Prime membership either).
So if Walmart already allows third-party players to sell on its site, why is partnering with Shopify important?
This is Walmart’s first real foray into allowing small-and-medium sized businesses access to its platform. Currently when you shop on Walmart’s site, you’ll see merchants such as Autozone. This opens the playing field to many smaller businesses. As the program ramps, this could allow Walmart to quickly add literally hundreds of thousands of sellers.
It’s very competitive with Amazon. Shopify’s announcement noted that, “unlike other retailers” Walmart charges no setup or monthly fees, though it will charge a “referral fee”. It looks like Walmart will charge anywhere from 6-15% of the sale (except Jewelry is 20%). Amazon charges essentially the same rates, it appears. However, as discussed in my last post, Amazon charges $39.99 for “Fulfilled by Amazon” services as well as other fees.
FBA sellers don’t pay for shipping or packaging, but you do have to pay an “FBA fee” which covers these costs – detailed here
FBA also has monthly storage fees (which can be long-term or short-term)
It is launching at a near perfect time. One challenge with any marketplace is getting sellers and buyers to sign up. Walmart.com already has the buyers and COVID19 has caused all retailers to move most of their business online. That’s why US e-commerce sales were up ~74% in Q1 Y/Y. At the same time, Amazon is under anti-trust scrutiny. Perhaps this is an opportunity to launch competition in the space (while a competitor is both slightly distracted but at the same time, welcoming a competitor).
It is clear Walmart wants to bea platform, not just compete with them as a physical retailer with an online presence. Probably the most important item in the post and research I’ve done on Walmart’s recent actions is that it is clearly trying to pivot and use its already massive scale to its advantage. Clearly, if its going to compete in the future, it must take on Amazon.
Still though, if you are someone who wants to see a competitor to Amazon, this deal leaves something to be desired. With just 1,200 additional Shopfiy sellers (that also have to be pre-approved) it’s not really opening up the floodgates of competition.
I also wonder what products they will sell – is it items that just doesn’t make sense for Walmart to sell? Perhaps this is a way for Walmart to prune low margin sales in its portfolio and just collect a platform fee.
Either way, it’s a positive for Walmart and a clear shot across the bow at Amazon. Walmart wouldn’t be doing this if their 3P marketplace wasn’t a key part of its go forward strategy.
Walmart had just launched “Walmart Fulfillment Services” or “WFS” in February of 2020, so clearly teaming up with Shopify would help both of them to compete with Amazon’s FBA service.
It will be interesting to see if Walmart can market this well enough that consumers and sellers recognize the benefits. Consumers are paying Amazon $120/year for Prime whereas Walmart is free. Returns are free on most Amazon Prime and you can do it through any Whole Foods, but 90% of America lives within 15 minutes of a Walmart store, so returns will also be free and pretty easy for all of America (not just the 1%…). Is this a strategy that Walmart recognizes?
So far, Walmart doesn’t have a ton of sellers on its platform and it seems like its holding them to high standards (e.g. only allowing 1,200 at first in this launch, believe they only have ~300k in total vs. millions at Amazon). This may disappoint shareholders who would prefer Walmart “move fast and break things” but it also will reduce scrutiny and costs down the road like Amazon has received and it also means you’re not competing for space against a bunch of other sellers on Walmart.com.
It seems like Walmart’s stock will be one to watch in the retail space, though I do have caution given some of Walmart’s past attempts haven’t been that great (thinking Jet.com…it just ended up being folded into Walmart.com).
This is also very interesting from Shopify. Shopify in 2020 announced the Shop app which seems to me like a clear desire to be a big platform like Amazon as this would allow Shopify sellers to access buyers in one place. Obviously, its stock has reacted and is now a $96BN (~54x LTM sales at the time of writing). Maybe this is a sign they need a partner? Time will tell.
What better way to open my new Competitive Strategy Series than to focus on Amazon – a company that has had great success the past two decades. But Amazon’s business strategy may surprise people – it got to where it is largely by following the playbook that others laid out before it.
I’ll be starting at the beginning because I hope to show that decisions a company makes compound over time. This compounding of focus and good decisions leads to a competitive advantage that we are seeking. Spotting these moves could help you find investments at the beginning of the curve, which I think will drive to higher returns.
I don’t need to share this, but looking at Amazon’s stock over time shows they’re building tremendous value. Companies don’t do this by accident — they follow a certain business strategy.
I’m actually not talking about the distribution and warehouses that ship literally everything today. Don’t skip ahead — I’m talking about Amazon’s business strategy, its choice, to focus on books in the beginning. Why books?
Books had more items than any other category.
At the same time, a hard copy of “A Tale of Two Cities” is basically the same as any other hard copy. So a lot of SKUs, but at the end of the day this was a commodity business.
Not manufacturing themselves, so quality assurance wouldn’t be a big issue in the beginning – just get the books in customers’ hands
Customers value two things in books from a retailer: availability of the book I want (when I want it) and the best possible price. That is all Amazon really had to focus on in the beginning
Amazon quickly built a catalog of over 2.5 million books, more than what a local bookstore could carry. It would keep inventory of 2,000 bestselling books so it could ship quickly or it would have a relationship with a publisher to print it and ship it as fast as possible. I went back to Amazon’s 1997 IPO prospectus and decided to clip what it said about the business:
control the cost drivers (i.e. continually focus on reducing the cost of producing something so you can edge out competitors), and
reconfigure the value chain to drive costs lower than competitors
These aren’t mutually exclusive, but the e-commerce space was in itself re-configuring the value chain. Publishers produce books, ship them to a Barnes & Noble distribution center and then shipping them to the stores to sell to customers.
Amazon’s business strategy would sell direct to consumer. This would cut out costs in the long run. Amazon was so focused on reaping advantages from being a First Mover, that it purposely kept its margins low to sell more books.
Amazon realized that if throughput increased, they could drive down their share of fixed costs to serve customers. Keeping all other costs constant, scaling up and taking share clearly would help profitability, especially for a commodity product. Here’s a simple example with made up numbers on how scaling up a low margin business (GMs around 20%) can be profitable when you increase throughput:
Obviously in Amazon’s history, they then used this scaled-up power to push on publishers to drive down their costs. Therefore Amazon’s GMs would increase and fixed costs would also be down as a percent of sales which would increase their dominance even furtherbecause customers wanted to pay less.
Increased Buyer Value:
Creating differentiation can’t just be price though. I can enter an industry and just charge less than my competitors and destroy value by earning lower margins and competitors might just follow suit – spoiling it for everyone. Generally, creating true value is raising buyer performance while keeping prices the same as competitors.
Enter two-day shipping – which we all now know and love. This ties back to the last point, but I wanted to bring this up now even though two-day shipping didn’t show up until 2005.
Amazon’s business strategy was a new way of selling products — direct to consumer. This increased satisfaction and kept prices low, increasing total value. It even decreased costs in indirect ways – I no longer need to drive to the bookstore, peruse the aisles, and hope the book I want is there. I go online, point and click to order and it’ll arrive at my doorstep in a couple days.
Many customers looked at the cost of Amazon Prime ($79) and said to themselves, “over the year, I’ll easily make that up in costs I would’ve spent on shipping, I’ll get my goods in two days, and I’ll get those goods at competitive prices.”
“Hey, if we already have a warehouse for books and we’ve figured out online ordering for customers in an efficient way, why don’t we sell more products this way?” This happens in many industries.
For example, in building products distribution, if I am shipping wallboard to a home and the construction team doing the work also needs some fasteners, doors, adhesives etc., why not throw it all on the back of my truck and charge for one order when I show up? I capture more value because I am selling more goods, I can do so at a cheap price because I am going there anyway and making one shipment, and I can pass some of those savings on to the consumer to encourage it.
Amazon’s business strategy has taken this to the extreme by being the “everything store” but you can start to see how the book playbook can just be repeated over and over in each new category.
Focus on Converting Buyers:
Another way to differentiate your company is to change your advertising compared to competitors, educate the buyers on why your product is sophisticated and will reduce their total cost, or get in front of the right buyer at the customer level who understands the value of the product (think the engineer at the company vs. the CEO who doesn’t understand why the company needs to spend more money). Each of these cost money, but will help convert buyers who are on the fence between you and a competitor.
Amazon’s review platform helps solve that problemand actually is a differentiator that builds on itself. A buyer feels comfortable buying from Amazon because thousands have bought the same product from them in the past and had very reliable experience. Or they shared their frustration and helped a buyer not make a mistake. Many other companies have since launched a review section on their site, but none really can match the depth of reviews Amazon maintains.
Share What You Learn.
Ok now we’re getting to things Amazon has done differently, but is extending its lead. Most learning from a first mover is fiercely kept secret. The last thing I want is for a competitor to copy what I am doing and close the gap.
Enter Amazon Web Services. Amazon could share its computing infrastructure, with cloud services, with all companies… and obviously charge for it. This is truly differentiated product which can provide a product & service to companies at a cheaper rate than its customers could themselves – no more buying server equipment for each new business.
The other thing it did to also leverage its existing infrastructure was to become a platform. Now buyers & sellers could connect on Amazon’s site and sellers could leverage Amazon’s fulfillment services. This means that a swath of sellers could offer their products with two-day shipping via Prime, which buyer’s value, and that means these non-Amazon sellers can increase their audience and therefore sales.
In return, Amazon charges inventory storage fees, fulfillment fees, among others. And all the while, it’s leveraging its infrastructure and now not taking inventory risk. You can envision a scenario where Amazon becomes an “infrastructure” company. You want to sell to all these customers we control? You have to pay the toll. In a way it is already charging buyers for access to the platform as well via the Amazon Prime annual membership.
The path forward:
Many of us know Amazon’s history well, but hopefully now you can see its success was meticulously planned to gain a competitive advantage.
So where does it go from here? I think we see Amazon’s profitability expand pretty dramatically over the next 5 years. And I’m not just talking about AWS. In my view, Amazon’s business strategy, its long-term focus, will start to really show itself the next few years.
How does Amazons profitability and return on capital improve?
Continued Scale on Resources: So far, Amazon has been reinvesting every dollar back into the business to grow distribution centers and lower shipping times.
In the short run, this burdens the income statement as Amazon said they would do:
In the long run:
more customers come to Amazon
they are less likely to switch given Prime and shipping benefits that customer’s value
Continues to shift into an “Infrastructure” company: Clearly, we’ve seen the growth of AWS and what that can mean from a profitability standpoint (50% EBITDA margins). We could reach a point where Amazon is selling less goods on its site than other businesses. Instead, it just charges the fee to connect with buyers and sellers.
Preemptively Change the Game: I’ve talked a lot about Amazon’s decisions here, but one I glided over was how it consistently changes the rules. From launching on the internet, to moving to two day shipping with Prime, to AWS, and now Alexa, the company has proven itself to be always one step ahead of the curve. What will they do next? As Bezos said in his 2015 Annual Letter:
” Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there. Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a ten percent chance of a 100 times payoff, you should take that bet every time. But you’re still going to be wrong nine times out of ten”
They may not have all the direct data that you entered, like Facebook has, but they probably know whether you are single or married, a family of four, and where you live.
If I live in Florida in March, while I am scrolling they can show me an ad for sunscreen. That’s valuable because it helps sellers target their audience rather than shooting dollars into a black hole and hoping it works.
Right now, you do a search and a “sponsored ad” appears, promoting a product that is within your search query. It’s only a matter of time before this ads are tangentially related (“looking for an oil filter for your car? Click here to find out how you can save 15% on your car insurance…”)
Advertising is high margin and low capital intensity. It also may improve buyers satisfaction if it directs them to things they want.
As an aside, they also own Twitch, which is essentially becoming a YouTube competitor
I think this will improve Amazon’s return on capital and its free cash flow – more than people realize.
I’ll leave this post with another quote, this time from the 2016 shareholder letter,
“Jeff, what does Day 2 look like?” That’s a question I just got at our most recent all-hands meeting. I’ve been reminding people that it’s Day 1 for a couple of decades. I work in an Amazon building named Day 1, and when I moved buildings, I took the name with me. I spend time thinking about this topic.
“Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death. And that is why it is always Day 1.”
It’s clear to me that Amazon’s business strategy has had focus since day 1.
As cities across the U.S. embarked on huge marketing campaigns to attract “HQ2“, I couldn’t help but ask myself why Amazon was planning a second headquarters. Usually companies like coherence and for the business to act as one under one roof. It is more difficult to do this when you have two “headquarters”. To me, it reminds me of having two CEOs. Two voices. Two cultures. I came to the conclusion that Amazon was preparing for a split up of the company and I would need to think of AWS valuation.
The split would be simple: take the traditional retail business + Whole Foods would go under one umbrella and continue to operate out of Seattle, while the second business would be Amazon Web Services (AWS) and would operate out of its own hub and have its own resources. We should then ask ourselves ahead of time: what is a reasonable AWS valuation.
For those that do not know, AWS is much different than the retail business. It is designed to provide developers quick access to on-demand computing power, storage, applications and development tools at low prices. Thanks to its offering, developers, startups and other companies do not need to focus on infrastructure build out when they are starting a new venture, they can instead focus on their core product and utilize AWS’ resources.
AWS allows faster speed to market in some cases. It also allows this spend to be a variable cost, rather than a high, upfront capex spend.
This led me to ask myself:
What do I think AWS is actually worth? Does Amazon’s valuation today reflect its strength?
Is AWS actually a good business?
Would splitting the company make sense?
Is the AWS valuation not factored in to the stock price today?
I think I am going to go through the answers in reverse order. I do think it makes sense to split the company. AWS operates in a competitive environment with the Microsoft Azure, Google Cloud, IBM among others clamoring for a larger piece of the pie. AWS currently has top share of wallet, but it’s a much different business model than the retail business. Here are my three main reasons for splitting the company:
Allow focus in areas of strength.
Being a company focused on one goal helps keep all employees realize what the goal at the end of the day is: support customers.
Today, while a smaller part of the market, there is a conflict of interest with AWS and CPG sectors (e.g. Target announcement to scale back AWS, Kroger announcing post-Whole Foods it would be moving to Azure and Google)
Typically in conglomerates, new business in certain sectors can go unnoticed or underappreciated as “approvers” up the chain of command have other things on their priority list. Splitting the company reduces this kink in the chain. This appears to be limited risk today as Amazon is growing AWS and its services, but think about the other segments. Perhaps they are moving slower now in the retail segment or internationally than they otherwise would.
Optimize capital allocation
AWS is highly profitable from a EBITDA perspective (though is also highly capital intensive today as it grows). On the other hand, Amazon’s retail business is not only low margin, but also is capital intensive and its return metrics are much lower than AWS (especially internationally where the company still has significant operating losses).
Even if I think returns for AWS will come down over time (discussed more below), you could view the company as funneling good money after bad (i.e. taking resources from a high return business and pushing it into low return business). If I invest $1 dollar into AWS, I get 28 cents back in year 1 compared to 9 cents for North American retail or losing 11 cents Internationally.
You may be optimistic about the LT trends in the retail business and its improving profitability over time, but think about if AWS could funnel more of its cash into higher return projects. It is likely to perform better over time on its own. Freeing up these resources can help AWS invest in its core capabilities and build sustainable competitive advantage.
Better align incentives
Distinct and clear business with their own performance goals matter when you are paying your employees in company stock
Imagine you are a leading employee in the field and asked to work for Amazon. A significant portion of your comp will be in restricted stock that pays out if the entire company does well. But oops, something happens to the grocery business at amazon and the stock falls 20-30%, so now you are well out of the money.
Wouldn’t it be better if your performance and the company’s performance were linked?
Note, AWS valuation being underappreciated is not really a core tenant here.
Is AWS a good business?
“I believe AWS is one of those dreamy business offerings that can be serving customers and earning financial returns for many years into the future. Why am I optimistic? For one thing, the size of the opportunity is big, ultimately encompassing global spend on servers, networking, datacenters, infrastructure software, databases, data warehouses, and more. Similar to the way I think about Amazon retail, for all practical purposes, I believe AWS is market-size unconstrained.”
-Jeff Bezos, 2014 Letter to Shareholders
Clearly, AWS has grown like a weed. Amazon has disclosed the results of this segment going back to 2013 and we can see sales and EBITDA have grown at a ~50% CAGR since then and 2018’s pace actually picked up over 2017.
The business started when Amazon brought infrastructure-as-a-service (IaaS) with global scale to startups, corporations, and the public sector. By this, I mean that they provide the infrastructure that allow these companies to outsource computing power, storage, and databases to Amazon. It essentially turned this services into a utility for consumers, with pay-for-what-you-use pricing models. As an aside, what a beautiful competitive decision that was.
As stated earlier, this allows customers to add new services quickly without upfront capex. Businesses now do not have to buy servers and other IT infrastructure months in advance, and instead can spin up hundreds of servers in minutes. This also means you benefit from the economies of scale that Amazon has built up. In other words, because Amazon has such massive scale, it can pass some of those saving on to you. If you bought the servers and other utilized ~70% of the capacity, your per unit costs would be much higher.
AWS has attracted new entrants as well. Microsoft’s Azure and Google’s Cloud have also grown and attracted share. Microsoft provides some color on the business, which I have estimated in the table above, but Google provides basically no disclosure. Other players with smaller market share include Oracle, IBM and Alibaba in Asia.
Despite growth in Azure, Amazon owns more market share than the next 4 competitors combined. And the rest of the market appears to be losing share.
The logical outcome from this, especially when considering how capital intensive the business is, is that the business forms into an oligopoly. Oligopolies traditionally have high barriers to entry, strong consumer loyalty and economies of scale. Given limited competitors, this typically results in higher prices for consumers. Also traditionally, you would expect earnings to be highly visible and would lead to a higher AWS valuation.
However, this is not always the case and it leads me to some concern on the industry. In some cases, oligopolies become unstable because one competitor tries to gain market share over the others and reduces price. Because each firm is so large, it affects market conditions. In order to not cede share, the competitors also reduce price. This usually results in a race to zero until the firms decide that its in the best interest of all players to collude firm-up pricing.
How could this happen with Amazon Web Services? Well, we all now Amazon’s time horizon is very long and it attempts to dominate every space it is in by capturing share with low prices. As said in its 2016 letter to shareholders:
We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.
Jeff Bezos, 2016 Letter to Shareholders
In addition, other competitors have benefited from movement into the space and have been rewarded in their stock price (see MSFT). Clearly others think Amazon’s stock price rise is largely attributed to investors’ valuation of AWS – and that may be true.
But Microsoft ceding share to AWS may hurt their results (and stock price) so they may attempt to take more and more share at the expense of future returns.
In a way, what could happen here is more of a slippery slope. They give a bit on pricing because the returns are so good now that a small price give here and there want matter. But then they add up…
Lastly, its no secret that building data centers to support growth is capital intensive, and that will impact the AWS valuation (see financial table above).
They also serve a lot of start-ups and other businesses. This creates a large fixed cost base for the cloud players. If there was a “washing out” of start-ups, such as the aftermath of the tech bubble, AWS and others could see excess capacity, hurting returns. In order to spread the costs, they may attempt a “volume over price” strategy. This will result in retained share, but hurt pricing for the industry as competition responds.
Unfortunately, I DO think returns are going to come down materially over time. And that will hurt the AWS valuation.
The industry reminds me too much of commodity industries. The industry is no doubt growing today, but the high margins we see today I believe are from high operating leverage. This tends to be more transitory in nature and means that returns on incremental capacity invested go down over time.
Take for example commodity chemical companies. AWS reminds me of some of their business models (unfortunately). Some operate in very consolidated companies, but operate at very high fixed costs and have exit barriers. The loss of one customer results in very painful results due to operating leverage. Although higher prices are better in the long run, the company will lower price to keep the volume and keep the fixed cost leverage.
Think about commodity businesses that reports utilization (note, we have limited disclosure on AWS, but that might be a helpful statistic in the future). Higher utilization usually results in good returns on the plant (or in the case of AWS, server). However, when you lower price on the commodity, the competitors, in turn, will also lower price so they don’t lose their existing customers. What results in lower returns for everyone.
As a another case study, P&G used to run its HR, IT and finance functions within each of its business units. It decided to form one, centralized, internal business unit to gain economies of scale. It actually formed a leading provider of these services. But then, P&G looked at its core business and said, “do I need to continue doing these functions or can I outsource it? Or maybe I can sell this whole business unit to another provider, which would give them more scale and lower the cost of the function”. The latter is what ended up happening. Although it wasn’t viewed as a commodity at the time, these functions began to become more commoditized and business process outsource companies (“BPOs”) now have very high competition and lower returns.
Another analogy would be to at the semi-conductor or memory businesses, though perhaps not as commodity as these two.
I personally think that over time, we will see this form with AWS. The fact that pricing has come down so much for the service (one unnamed engineer I interviewed told me that AWS will even let you know if they think pricing is coming down soon to keep your business). According to the Q3’18 earnings call, Amazon had lowered AWS prices 67x since it launched and these are a “normal part of business.” They’ve certainly been able to lower costs as well so far, but how will that change as competitors also gain scale?
How could I be wrong? I could be wrong in many ways, but the one case is that I am underestimating how “entrenched” the business is into everyday use. That could result in very low switching by customers. It could also mean that developers get trained using AWS so default to using its services. The counter to these arguments is that there is a price for everything and clearly Azure has taken share over the past year, so it’s not proving out thus far. If AWS become the winner-take-all, then I am dramatically underestimating the valuation.
So is it a good business? Well, lets look at at it from a Porter’s Five Forces perspective. I think the view on these, in brief, plus the current returns we can see in the previous tables would point to the industry being solid. My one concern comes back to the competitive rivalry. We can have a high barriers to entry business and highly consolidated, but returns are not good.
AWS Valution: Final Thoughts
Based on the market share numbers posted above, AWS is currently attacking a $73BN market. At the rates that the market has been growing, as well as the additional services, I think its reasonable the market expands to $100BN in the near term, especially as adoption increases.
I assume Amazon maintains its market share due to its relentless focus on lowering price and maintaining share. I think the additional share gained by Google and Azure will come at the expense of the other players included in the market share chart above.
For the reasons stated above, I think this results in returns coming down over time. I still model goodreturns to be clear, but that the return on assets comes down meaningfully.
This may be hard to read, but I end up with an AWS valuation of $164BN. Given the value of AMZN today is over $1 trillion, even though AWS accounts for over half of EBITDA now, I cant help but think this opportunity is more than priced in, unfortunately.
However, AWS would benefit in the long-term from being on its own for the reasons discussed above. In the short-run, it may get a higher multiple than the rest of the Amazon retail business since its growing quickly with such high margins.
Reading Time: 5minutesA good friend of mine came to me full of excitement about the prospect of Amazon’s “hidden gems.” He had heard Amazon owned Twitch and was very excited for what that could mean for the company given the success of Fortnite and other games, which have driven a new era for e-Sports (that is, watching other people play video games). Twitch could also serve as a platform for other content. I decided to take a moment and explore what Twitch might be worth and put into context what that may mean for Amazon’s share price.
Warning: As with any investment analysis, I make a lot of assumptions in this post given I have very limited disclosure from Amazon.
With that warning out of the way, I hope that you can take these assumptions with you and think about “what do I need to believe?” when it comes to Twitch (and Amazon) and determine whether or not the market is pricing this in (as I wrote recently about here). Let’s get started:
Most internet platforms like Facebook, Twitter and YouTube are analyzed by a popular KPI called, Monthly Active Users (or MAU). MAU is important, and different than valuing a company via “eyeballs” as was common in the tech bubble, because MAU measures engagement with the platform and that helps advertisers determine whether placing an ad on the site has impact or not.
According to a very trustworthy source, Wikipedia, Twitch had 100MM MAUs in 2015. I assume that has likely grown significantly since then, given the dawn of Fortnite and internet celebrities like Ninja. I assume 130MM MAUs for 2017, which compares to Twitter’s 328MM.
As for Average Revenue Per User, or ARPU, I think Twitch is still in its infancy stage. I don’t think it is likely capturing as much money as it can right now because (i) it is owned by Amazon which has a long investment horizon and (ii) they likely want to keep engagement up and growing as much as possible in the near term to drive stickiness with the platform. However, I do have it growing substantially over time. In fact, this may be an aggressive assumption given Twitch has a monopoly on this niche for now, and competitors may move in. In addition, advertisers can move elsewhere, such as Instagram, Facebook, Twitter, Youtube, and so on. There is only 1 advertising pie and all these players are competing for the biggest slice.
On the flip side, Twitch should benefit from a “live TV” aspect of its content, much like ESPN which is able to charge a large premium in the broadcast world compared to its peers. As a result, I expect ARPU to ramp up quickly. Twitter’s total advertising revenue / MAU ramped from $2.20 in 2013 to $5.30 in 2017. I have Twitch scaling much quicker than that given what I’ve noted above.
For now, I don’t think Twitch is a major contributor to EBITDA given investment in R&D, sales staff and general expenses, but with price gains comes scale. For reference on how I derived my assumptions, I looked at Twitter. Twitter in 2015 spent ~36% on R&D, 39% on sales and marketing, and ~12% on G&A (though some of this includes a massive stock based comp expense, at ~30% of sales). This has stepped down to R&D being 22%, Sales being 29%, and G&A being 11.6% (again, these expenses include an 18% of sales expense for stock comp, which is non-cash but is a real expense at the end of the day).
Therefore, you may view my assumptions still as aggressive, but I’m trying to show what you need to believe. Net / net, I have Sales growing at a 127% CAGR from 2017 to 2020 and EBITDA growing at 450% (albeit off of a low base). I’ve also included some multiples so far as a proxy for where the value of Twitch may shake out.
I do not know where Amazon puts Twitch today in its reporting, but I’ll assume it is in the North American Retail business for now, given I don’t have a better idea of where to put it (I know that AWS is distinct from any ad revenues though so I didn’t put it there). here is a snapshot of Amazon today then, including my rough Twitch estimates.
Now, for my next assumptions, I am going to go with some street estimates here, but a big assumption on my end is that I do NOT think they are baking in the value of Twitch. That is a big “if”, but given how small Twitch is today relative to the rest of the business, I don’t think it is out of the realm of possibility. Below are the 2020 estimates for AMZN, including my assumptions in value for Twitch. All in all, it shows pretty strong growth for a company that has already grown massively.
I took the liberty to assign multiples that you may disagree with, but I have a sensitivity table later that will let you be the judge.
The problem you may be seeing is that the total EV of Amazon of slightly less that $600BN is less than the current ~$890BN. As shown below, my “price target” is well below the current price.
Uh ok… Ok OK I must have done something wrong. My multiples must be WAY off. That’s for you to judge and that is the “art vs. science” part of investing. As we see below, I think I am pretty comfortable given where other Tech titans trade on my multiples, especially when we look out 2.5-3 more years.
So what do you need to believe??
Below I show a sensitivity of AMZN’s stock price relative to (a) changes in my EBITDA estimate and (b) estimated changes in the multiple. If you think Amazon is worth 18x EBITDA and will produce $50BN of EBITDA, for example, then today’s price of $1,830 looks OK (if not a little rich given this PT is based on 2020 estimates).
Does this seem reasonable to you? It may, or it may not. That’s part of doing the analysis. After all this you may say, “Yes, actually. Amazon is such a dominant force, with a loyal customer base, I think it is worth a high multiple and the street is underestimating it.” On the flip side, you may say to yourself, “Geez, I don’t know. Those are some lofty figures it will need to reach… Maybe I’ll stay on the sidelines for now.”
Both are equally fair.
That’s all for now. Full disclosure: I am long AMZN.
