3 Reasons Amazon Is A Strong Buy And Why I’m Tripling My Position

Written by The Dividend Sensei (https://dividendsensei.com/)

Recently I explained why I initiated a position in Amazon (AMZN), which I consider a must own, buy and hold forever growth stock. In fact, there are six reasons Amazon is the only non dividend stock I intend to own in my high-yield income growth retirement portfolio. Since I made that purchase tech stocks in general, but Amazon in particular, have sold off. The Nasdaq is now 8% off its all time high, while Amazon has fallen 14%, putting it officially in a correction. The cause of the sell off is largely due to long-term interest rates spiking sharply higher for four main reasons.

But while some might look upon such a sharp price drop and cringe, I’m taking a very different, long-term, value focused approach. So let’s take a look at the three reasons why I am taking advantage of this correction to triple my position in Amazon. Most importantly, we’ll see why, despite what many investors fear, Amazon is likely NOT a bubble stock likely to crash 50% to 80%, but is actually 10% to 20% undervalued. This means today is a great time for long-term investors to add the greatest growth story of our age to their diversified portfolio.

Lowering Your Cost Basis And Building Positions Over Time Is The Core Of Successful Long-Term Investing

Many investors think that stocks are inherently risks and no different than gambling. And while it’s true that short-term trading is fraught with peril, long-term investing is as close to a “sure fire” way to get rich over time as you can find in this world.

The core difference is that traders are looking for quick profits, derived from swing trades or even day trading in and out of a stock with modest profits. In contrast long-term investors take a completely different view. We recognize that a share of stock is an ownership stake in a real company, whose management and employees are working to maximize long-term cash flow growth and shareholder value. Thus long-term investors focus on steadily accumulating more shares over time, hopefully at prices that are at, or below fair value. When a stock drops it’s actually a great opportunity to lower your risk by reducing your cost basis. That’s because quality companies like Amazon appreciate over time as their sales, earnings, and cash flow grow. This means that during corrections like this one, you can increase the size of your share of the company’s assets and future cash flow, all while lowering your breakeven price. When the stock eventually recovers, as it does for all quality companies, you’ll own more shares at a lower cost basis, resulting in much larger capital gains.

Best of all, remember that price is an integral part of risk management. The lower your cost basis the lower your risk of a permanent loss of capital. This is why it’s generally a good idea to dollar cost average into a stock (building positions over time), as long as the company is at fair value or less. If you can lower your cost basis? Well that’s an even better time to add to your position. But of course there is a very important caveat to dollar cost averaging and reducing your cost basis by buying during corrections and bear markets. Adding to a position should only ever be done as long as the fundamentals remains healthy and the investment thesis (why you bought the stock), remains intact.

Fortunately, Amazon’s fundamentals have never looked better, which is why I can buy with confidence at today’s prices.

Amazon’s Fundamentals And Investment Remain Stronger Than Ever

Amazon’s investment thesis is centered around continued strong top line growth, which thanks to rising margins, means even stronger earnings and cash flow growth in the coming years. That thesis has three cornerstones.

The first is Amazon’s dominant position in retail, both online and more recently, in brick & mortar. This is the lynchpin of Amazon’s ecosystem, which is designed to lock in consumers into with ever improved convenience and values, such as created by its fast growing Prime Membership (now over 100 million subscribers). Amazon’s domestic and international retail sales are growing at 44%, and 27%, respectively. That’s both thanks to a big push into offering ever more products (over 100 million) to consumers in ever more countries. And delivering them with ever greater convenience, including as fast as two hour deliveries in some markets.

Thanks to this laser like focus on ever improving convenience and value, Amazon’s share of online sales in the US hit 49.1% in July of 2018, according to analyst firm eMarketer. That’s eight times greater than its nearest rival eBay, showing just how dominant the company is in this fast growing space. Amazon’s total retail market share in America is about 5%. That small figure is due to the fact online sales still make up just 10% of US retail sales. But according to Statista that is likely to keep increasing for the foreseeable future, hitting 13.7% by 2021. Or to put another way, Amazon’s fast growth in America’s $525 billion (and rapidly expanding) online retail market is likely to continue for many more years.

Online Sales As % of US Retail

Source: Statista

But ultimately, while Amazon will likely be able to keep improving its operating margins on retail sales (5.7% currently, up 200% in the past year), it’s major earnings and cash flow drivers are going to be its fastest growing and most profitable businesses, Amazon Web Services (cloud computing) and advertising.

Amazon Web Services or AWS, was launched in 2006 as a way of letting corporate partners rent excess cloud computing space that Amazon needed to run its core retail business. Amazon had already spent 10 years streamlining its computer based logistics and data analysis in house, and AWS has proven to be its largest and most successful entrance into a new market ever.

That’s because AWS is growing at 49% per year (three straight quarters of accelerating YOY growth), and generating annualized revenue of over $24 billion. More importantly, operating margins on AWS are excellent, 26.9%. More importantly, Amazon’s pricing power in cloud is strong enough, and its cost cutting good enough, that that margin is up 21% in the past year.

Those margins keep improving largely because Amazon’s early lead in cloud and artificial intelligence driven data analysis applications mean that today Amazon controls 35% of the global cloud computing market. And since its AWS revenue is growing as fast as the market in general (50%) that market share has remained stable over time.

In the past year Amazon added over 800 new applications to AWS, which allow companies to better use their stored data to increase productivity and profitability. It’s also added a new corporate database transfer system that 80,000 corporate clients have taken advantage of. Currently Amazon says it has a growing backlog of clients waiting to migrate their databases to AWS, which bodes well for revenue and cash flows from that business continuing to grow quickly or even accelerate in the next few quarters.

Analyst firm Gartner estimates that the global cloud market will hit $186 billion in 2018, and grow to $303 billion in 2021, or 18% annually. Amazon’s market share in cloud is likely to increase, because of strong network effects in cloud and AI driven data analytics. Basically, the more customers move to AWS the more data Amazon has to feed its AI algorithms and the faster its machine learning based system can improve. That creates ever improving cloud offerings and a stronger competitive advantage that locks in more customers into the AWS ecosystem and raises Amazon’s pricing power (and margins). But as great as AWS is from a profit perspective, the best thing about it, and Amazon’s overall business strategy, is how the company leverages its retail and cloud business into its newest and greatest growth market of all, online advertising.

Global online advertising is a $273 billion market currently, but eMarketer expects that to grow 16% annually to $427 billion in 2021.

Amazon’s online advertising business is currently growing at 130% per year and eMarketer expects it to achieve 4% market share in 2018, second only to Google and Facebook. By 2020 that market share is expected to grow to 7%. But there is good reason to believe that Amazon’s ad business will remain its best profit growth engine in the coming years. That’s because Amazon’s advertising is based on deep data analysis, generated by its AI powered AWS. After 20 years of collecting and analyzing customer data, Amazon knows retail tastes better than even Google. That’s why 55% of all US product searches are done directly on its site. It’s also why Amazon’s ad conversion rates (what % of ad clicks convert to sales) is 250% higher than Google’s. That higher conversion rate means it can charge more for ads volumes that are growing rapidly (but that consumers actually find useful). Combined with the fact that advertising overhead is very low (runs on AWS) and you get sensational operating margins that Piper Jaffray estimates are currently 75%. For context Facebook and Alphabet’s operating margins are 44% and 28%, respectively.

What this combination of super growth in online sales and sky-high margins (because overhead is covered by other businesses) means is that by 2021 Piper Jaffray estimates that Amazon’s ad business will be generating $16 billion in operating profits each year. That’s actually more than the $15 billion AWS is expected to deliver. Combined AWS and advertising could deliver $31 billion in operating income, which would be nearly triple the company’s entire operating profit over the past year.

The bottom line is that, despite what many investors think, Amazon’s growth isn’t necessarily going to slow in the coming years, due to the “law of large numbers”. In fact, it’s revenue growth has averaged between 20% and 25% per year (currently 39%), since 2003. That means Amazon’s growth has actually slightly accelerated in recent years. This is because it finds new giant and increasingly profitable markets to break into. More importantly, because of how it leverages data and costs across its various business segments, the company’s profits and cash flow are growing even faster than its stable but impressive revenue growth. That operating cash flow is then reinvested into further expanding its economies of scale (cost cutting such as via automating warehouses) to further boost profitability.

Ok, so maybe Amazon’s growth isn’t likely to slow anytime soon, and its profitability is set to rise significantly thanks to excellent margins on AWS and advertising, it’s fastest growing businesses. But what about valuation? Surely Amazon’s recent 14% slide is proof that the stock was in a bubble, which might lead it to much lower levels right? Actually, both I, and the conservative analysts at Morningstar, think Amazon is significantly undervalued today.

Amazon Is 10% To 20% Undervalued, Making Today A Great Time To Buy

When it comes to highly innovative, disruptive, and fast growing companies like Amazon valuation, is an educated guesstimate at best. That’s because you have to try to model numerous factors far into the future to try to get an idea for the fair value of the company today. While there are dozens of approaches one can use, when it comes to a complex growth machine like Amazon, I and Morningstar tend to favor a discounted cash flow model or DCF. This estimates the fair value of a stock based on the net present value of all future cash flow and earnings.

While not a perfect system, since it can be highly dependent on changing long-term smoothed out growth assumptions and the discount rate you use , it does allow you to factor in several of the company’s most important fundamental variables. The reason I trust Morningstar’s DCF estimate is because its analysts are 100% long-term focused, fundamentals driven, and usually far more conservative than analysts in general. Thus their estimated fair values tend to represent the lower end of a reasonable buy price.

Morningstar’s three stage DCF model assumes the following growth through 2022:

physical stores: 9% CAGR
online retail: 13% CAGR
third-party seller services: 26% CAGR
AWS: 33% (with operating margins rising to 30%)
Subscription Services (Prime): 37% CAGR
Advertising: 66% CAGR
Overall company sales growth: 23% CAGR
Overall operating margins: 8% (vs. 5.6% in Q2 2018)
Overall company operating income growth: 33% CAGR

How reasonable are those assumptions? Well while we don’t have access to other analysts proprietary models, we do have their overall consensus growth forecasts. Those call for 57% and 50% CAGR EPS growth over the next five and 10 years, respectively. Note that Morningstar is estimating just 33% earnings growth, far below the consensus figure. So what does Morningstar’s DCF model estimate is Amazon’s net present value of future earnings and cash flow? Morningstar thinks Amazon is fairly valued at $2,200, or 20% above today’s price.

But let’s say you want to be even more conservative than Morningstar, who is already assuming much slower growth than the rest of Wall Street. This is where my personal simplified, but even more conservative DCF model comes in. I use a 2 stage DCF that assumes the following:

2018 EPS (analyst consensus): $17.30
10 year CAGR EPS growth: 25% (half of analyst consensus and lower than Morningstar’s)
Terminal growth rate (growth beyond 2028): 10%
Discount rate: 13% (most people use 6% to 12%)
Estimated fair value: $1,947
Discount to fair value (margin of safety): 10%
Expected 10 year CAGR return: 15% to 25%

My DCF model assumes that when Amazon finally runs out of new growth opportunities (new markets to conquer) it will be generating massive free cash flow due to slowing of capital investment. That FCF can then be used to initiate a large buyback program, along the lines of what Apple has been doing in recent years. This in turn will allow its EPS over the long-term to maintain double digit rates. In addition, to err on the side of caution, I use a very high discount rate of 13%. The discount rate is your target return, and since 1871 the S&P 500 has delivered 9.2% total returns. Other popular forms of discount rates are based on the risk free rate of return (10 year treasury yield + risk premium). Usually discount rates used in DCF models range from 6% to 12%.

A 13% discount rate, combined with far smaller growth assumptions than other analysts, means that my DCF estimate for Amazon is potentially conservative. Yet even it shows Amazon 10% undervalued. Under the Buffett principle of “it’s better to buy a wonderful company at a fair price, than a fair company at a wonderful price”, I’m happy to buy Amazon at fair value or better. In fact, my long-term plan is to use my dividend income to buy more shares each quarter, two weeks ahead of earnings, as long as the price is at or below fair value.

So with Amazon between 10% and 20% undervalued, I consider it a fantastic time to initiate or add to a position in this world class growth company. One that I expect to generate market beating annualized total returns of 15% to 25% over the coming decade from today’s levels.

Bottom Line: Thanks To Tech Correction Amazon Is A Great Buy Today, Which Is Why I Am Tripling My Position

Don’t get me wrong, I’m not predicting that Amazon is necessarily bottoming. It’s a high volatility growth stock, that has historically been 80% more volatile than the S&P 500. In the short-term investor panic selling, especially of index funds and ETFs, could very well drive Amazon significantly lower than the current price of $1,755. However, for long-term, fundamental investors this kind of volatility is a blessing in disguise. Because the very same short-term price risks (high volatility, heavy concentration in index funds) that can cause the shares to drop quickly, also means they are likely to overshoot to the downside.

Thus such times as this are perfect for building out your position in a world class growth machine like Amazon. You can lower your cost basis, and thus reduce your risk, while boosting long-term total return potential. Best of all, despite claims that Amazon is in the mother of all bubbles, conservative discounted cash flow models say it’s actually 10% to 20% undervalued. That means today is the perfect time to “be greedy when others are fearful” and add this proven innovation and disruption powerhouse to your diversified portfolio.