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.
I’m an Apple shareholder and the meteoric rise in Apple stock has me questioning whether I should hold on or move on.
One problem with this, and why I don’t think Buffett will sell, is opportunity cost. Selling Apple stock to hold cash isn’t really a great option right now. Yes, yes, cash has option value in itself, but the only reason why I’d be selling is my scant perception is that Apple stock has gone up really quickly and so maybe it is “fully valued” at this point.
Personally, whenever I sell a really high quality company due to valuation – that ends up being a bad decision.
Think about what this would mean right now if you count yourself as someone who is a “traditional” value investor (i.e. someone who looks for low P/E stocks) – this means selling a really high quality company to probably go invest in a lower quality company trading at a low multiple. Not a particularly great trade-off in my view. That multiple is probably low because of low growth, low ROIC, high cyclicality or some other reason.
If I stay on this broad topic, I also think the market is rarely so grossly wrong on a blue chip, top component of the S&P500. Yes, we have had instances in the past where everything just gets overbid in a mania (a la, the tech bubble where even GE was trading at 50x earnings). Also there are plenty of cases where the leaders of the S&P at the start of the decade aren’t there by the end of it. But largely the market is a pretty good weighing mechanism.
In sum, tech bubbles are rare. But the stock market being a pretty good estimator of company value? Not so rare. One reason why active management is so hard.
Frankly, if you’re reading this and thinking the stock has gone up too much, you’re probably anchoring to when Apple stock traded at 14x EPS and now trades for 30x without really much thought as to why 14x was right / wrong and 30x is wrong / right.
Ok, back to my view on Apple’s valuation. What do we need to believe here?
First, I like to go a look at Apple’s estimates for some expectations investing. I see that consensus is expecting the company to generate ~$75-$80BN of FCF for 2022-2023.
So let’s say they generate $77.5BN and using a short-hand 20x multiple of FCF (or 5% FCF yield), that’s a $1.5 trillion valuation. Wow. That would be a $363 pre-split price compared to $487 price at the time of writing. What else am I missing?
Well cash on hand is something else. Apple has $93BN of cash & equivalents (another $22/share) plus long-term investments (which is essentially Apple’s hedge fund) which is another $100BN (or $23/share). Yes, Apple has $100BN of debt, but they could have $0 of cash, be 2.0x levered and still be high investment grade. I’m not concerned whatsoever about that debt, so don’t view it as unfair to net the cash.
Add the cash together with the value of the business and you get $363 + $45 of cash, for a quick-hand value of $408 / share. Now, all of this was a very cursory estimate. For example, I change my math from a 5% FCF yield to 4% FCF yield, the price I get is $498/share. At this point, it’s hard for me to say that 4% is any worse than 5%.
I traditionally say my equity IRR over the long-term will approximate the FCF yield + the LT growth rate in the stock. So a 10% FCF yield in a low-to-no growth industrial will probably be around the same return as a 5% grower at 5% FCF yield (as long as you have long-term confidence in the FCF ). Can Apple compound earnings at 6% from here for a 10% total return? Maybe not, but all they need to do is 3% for a 7% return. And for an annuity-like business like Apple, that is as Larry David would say – pretty, pretty… pretty good.
Right or wrong, in a world of 0% interest rates, consistent cash generators will be bid up pretty high. Here’s a quick sample of companies and their FCF yields for 2021. Apple comparatively doesn’t seem crazy.
Of course, there are some other drivers for Apple recently.
The core driver for Apple here has to be the upgrade “super cycle.”
If you’ve been invested in Apple for a long time, you understand the stock goes through cycles and I’ve written about it in the past. It’s frankly frustrating, but the function of short-termism.
To rehash it, Apple’s sales go through a lull as a large proportion of users upgrade every 2 years or so. So there are big booms and then lulls and the Y/Y comps don’t look great.
That’s also when people hark back to the good ol’ days of Steve Jobs and say Apple can’t innovate anymore (right, like the iPad, Watch, AirPods and software moves show the lack of innovation…).
The story really has always been the same, but bears repeating. You don’t buy iPhone for the phone, you buy it for iOS. It has always been a software company and they continuously expand on that (AirPods being the latest hardware move, health monitoring seeming to be the next).
Heading into a new phone cycle is when people start to realize better results are on the come (and I have no back up, but I would say leading up to the launch is great, after launch Apple then starts to underperform again as people typically expect them to announce a new UFO and are disappointed when it’s just a new phone everyone will buy).
ANYWAY – the next upgrade cycle could be huge, especially if Apple is able to launch it with 5G with meaningful new speeds. I’ve seen estimates saying that nearly 40% of iPhone users are due for an upgrade. That would be a huge boon to Apple.
Apple’s bundling could create a “services” powerhouse
First you need to understand how profitable “service” business are. Apple has 64% GAAP gross profit margins for services. I assume its CAC must also be much lower than other players, again because of the iOS ecosystem
Services is growing well and could become a higher and higher % of earnings over time. Services gross profit has nearly doubled since the end of FY2017 and is now $31BN.
Something else to think about: Apple grew Service sales by nearly 15% Y/Y in the latest Q. But COGS only rose by 5%. That’s big operating leverage.
These recurring revenue streams are not only valued highly, but has a positive feedback loop in keeping everyone in Apple’s ecosystem!
Apple next launched “bundling” most recently and this could be a game changer.
Apple reported on its Q3 call that, “we now have over 550 million paid subscriptions across the services on our platform, up 130 million from a year ago. With this momentum, we remain confident to reach our increased target of 600 million paid subscriptions before the end of calendar 2020”
Those are huge figures in comparison to a Netflix and Spotify which have 193MM and 140MM paid subscribers, respectively.
Again, I view this as classic Apple. They changed the game with iTunes and made it tough to compete. The same could be true with whatever they bundle.
Apple could bundle Music, TV+, News, Cloud storage, as well as new growth arenas like gaming and perhaps health monitoring. Charging a low price for all these services / month might mean low profit at first, but huge scale benefits. You also drive your competitors down.
Bundle services… Bundle hardware
What if you were offered $100 off a product bundle if you bought a watch, iPhone/Mac, and AirPods together? Look, I only have 2 out of the 3, but I’d be tempted.
Apple wins despite the discount because they move more hardware and increase adoption of the iOS ecosystem
Then they push the software bundle. Rinse and repeat.
Each of these items make it a bit more exciting to be an Apple shareholder, but more importantly, they may be things that current estimates don’t factor in yet. In other words, especially the latter two items here, there could be further upside surprises.
Nothing I can see jumps off the page to me to say, “holy cow – GTFO.” So I’m staying put.
We’ve all heard that the value of a company is the present value of its discounted free cash flows. But I wanted to share something I found pretty interesting. What drives stock returns over the long run? It seems pretty clear that it is the growth in free cash flow per share.
As the tables below show, this one metric has a high correlation with the long-term growth in the stock price. We just mentioned what a DCF is so that may sound totally intuitive. Yet seeing the results are actually quite surprising to me. I say this in the context of the “random walk” stocks seem to follow day-to-day or even year-to-year. In sum, I think if you have high confidence that a company can compound its FCF/share at above market rates, you’ll probably do pretty well.
The second interesting thing is that I’m not showing starting EV/EBITDA multiple or P/E. All I’m showing is the FCF / share CAGR and the stock CAGR. So did the stock “re-rate” or “de-rate” it didn’t seem to matter in the small sample size.
A couple of notes (admittedly may be selection bias) I’m only showing names with long history and I’m trying to avoid some poor returning stocks with finance arms (Ford, GM, and GE) because that clouds FCF. Last, I’m using the end of 2019 to move out some of the COVID related movements. One thing this doesn’t capture either is dividends collected along the way, but that should be relatively limited in most cases (but I did exclude Philip Morris for this reason).
In closing, I would look for names that you have a high degree of confidence of growing FCF/share at a strong rate. Obviously, the normal investment checklist applies – does the company have a moat to protect those cash flows, does it have a long investment runway, is it in a growing industry, and is it gaining scale to compound cash flows? Clearly, this drives stock returns.
I think if you were to show more commodity names as well, it would show how hard it is to make money over the long term. Not only do commodities have to deal with the larger business cycle, but they often have their own cycles within whatever they are selling (e.g. gold, copper, TiO2, etc. can move around considerably year to year and decide a company’s fate).
Beyond Meat’s stock surged on its first day as a public company. You could say it was BEYOND expectations. The stock surged 163% in the first day of trading. This was one of the strongest one day performances since the 2000 dot com bubble.
Is Beyond Meat’s Stock… Beyond Sensical?
Beyond Meat’s Valuation is currently is $4 billion based on market cap. Based on my calculation, the company is currently trading at 36.5x 2018 sales. For context, Google trades at 5.0x sales. Tesla is 2.4x sales. I would actually be interested to hear any stocks with higher price / sales multiples that are non-pharma related. Clearly, this is a high multiple.
As an aside, this is actually a poor outcome for the company, all things considered. They could have raised the same amount of money by issuing much less shares if the underwriters had priced it correctly at a higher price. That said, hindsight is 20/20.
But the companyIS growing quickly and has noted that it has been capacity constrained. Sales were up 170% in 2018 from 2017 (albeit, only $88MM in sales in 2018 so coming off of a low base). Based on the company’s disclosure, they estimate the total meat market to be $1.4 trillion in size. Clearly, they will not be able to capture the total market here or even come close. What they want investors to say is, “well, if they just get 5% of the market, thats $70BN!”
I don’t think that is going to happen. The product is good, but its not that good. There are also competitors (I’ve personally tried the Impossible Burger and I really like what they’ve done).
When assessing this company’s moat, and taking the ingredient list into consideration, it is hard for me to say over a long period of time no competitor can break in. The ingredient list looks pretty simple to me, so it really comes down to texture. Obviously not an easy task since veggies burgers have been around for at least 30 years, but players are emerging. Again, I’m not being paid by Impossible Burger but it is good stuff!
So is Beyond Meat Stock a Buy?
It seems almost impossible to justify a price to sales multiple like what BYND trades at. That is likely why the underwriters had so much trouble pricing it. But if you take a longer term view, it is actually interesting.
Lets walk through some assumptions:
I am going to assume the company grows 175% in 2019. This is decent deceleration from their Q1’19 pace. The company was able to triple its monthly capacity and its corresponding sales are expected to be up ~290%. Gross margins are also set to improve to ~25-26% of sales, from the 20% area during 2018.
Following 2019, I expect the company to double in 2020, 75% in 2021 (stark deceleration) and 45% in 2022. Once the company has capacity online, its relatively easy to ramp if demand is there and the incremental margins already appear quite strong. I am going to assume they have a 38% incremental gross margins in 2019, stepping up to 40% as they hit the high notes of 2021 and beyond. Long story short, as my snapshot below shows, I have the company reachin 12-13% EBITDA margins by 2022-2023.
The interesting thing is that the business, like most food companies, does not require much capital to grow. Therefore, I have the company FCF positive by 2023. That may not seem that great, but considering the growth, it isn’t too bad.
Unfortunately, as shown at the bottom of this snapshot, Beyond Meat’s stock valuation just is not there. It is just way too high. These are optimistic assumptions and by 2023 we’d still be sitting at 20x EBITDA. That seems too rich for my diet.
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.