Investment Thesis

The DCF valuation of Amazon (NASDAQ:AMZN) indicates that the company’s capitalization does not have a significant growth potential. At this stage, Amazon is fairly assessed by the market.

Probably the most difficult in building the DCF model for Amazon was to forecast the revenue.

According to the internal classification, the revenue structure of Amazon is divided into three segments: North America, International, and Amazon Web Services. Here are the results of each of these three segments at year-end 2016.

Given the significant differences in the growth rate of these segments, I had to build three different predictions in order to forecast the total revenue of Amazon.

Let’s start with Amazon Web Services.

According to Wikibon, enterprise cloud spending will be growing at a CAGR of 19% during the next 10 years.

IDC predicts that the worldwide spending on public cloud computing will also be growing at a CAGR of 19% during the next 5 years.

At that, judging by the data from the past three years, the growth of AWS outstrips the growth of the cloud market as a whole, and I see no reasons for the situation to change in the next decade. Therefore, I believe, that until 2026, the revenue of AWS may well reach $100 billion demonstrating the CAGR of 23.7%.

It is interesting to note that in its forecast titled “How big can Amazon Web Services get?” Wikibon suggests that by the year 2022 the revenue of this segment will reach $43 billion. My forecast assumes $46 billion, which is very close to Wikibon prediction.

Let’s now take a look at North America segment, a substantial proportion of which consists of retail e-commerce sales in the territory of the United States.

According to the model based on Statista forecast, the retail e-commerce sales in the United States will be growing at a CAGR not higher than 5.7% in the next 10 years.

At least over the last four years, the average growth rate of Amazon’s sales in North America has been exceeding the growth rate of e-commerce sales in the territory of the United States approximately twice. Assuming that Amazon most likely will continue its aggressive policy aimed at conquering the market share, I predict that the company’s revenue in the territory of North America will be growing at a CAGR of 10.9% in the next 10 years.

Let’s move on to the International segment.

In contrast to the U.S. market, the global e-commerce market is still in the phase of exponential growth, and its CAGR will reach 16% by the year 2026.

However, given that in the global market Amazon will be competing with the local players such as Alibaba (NYSE:BABA) in China, I believe that at this moment one should expect Amazon’s sales growth rate to equal the growth rate of the entire market. Thus, I predict that the CAGR of the International segment will amount to 16.7%.

Combining three predictions together, we get a general forecast of Amazon’s revenue until 2026.

The internal revenue structure will be as follows:

As you can see, the forecast suggests the growth of AWS’ share from 9% in 2016 to 19.1% in 2026. At that, the shares of the International and North America segments will practically equal. In my opinion, such a transformation of the internal structure of the company’s income is fully consistent with its long-term development policy.

It is worth noting that my prediction of Amazon’s revenue in 2017 and 2018 corresponds to the minimum expectations of analysts according to Yahoo! Finance monitoring. Therefore, my prediction clearly cannot be called overly optimistic or overestimated. Most likely, it falls under the classification of “conservative”.

Let me now explain to you the following key parameters of my model.

Over the past two years, the operating margin of Amazon has been steadily increasing, however, I don’t think there will be a return to the average level of the years 2008–2011 due to the company’s focus on increasing its market share. My model includes the gradual decrease in the operating margin from last year’s 3.1% to 2% in the terminal year.

AMZN Operating Margin (Annual) data by YCharts

The tax rate is assumed to be 30%, which is the world’s average.

AMZN Effective Tax Rate (Annual) data by YCharts

The model involves a gradual increase in the relative size of CAPEX from 5% in 2017 to 6.1% in 2026, reflecting the multi-year capital expenditure growth of Amazon.

AMZN CAPEX to Revenue (Annual) data by YCharts

Here is the calculation of WACC:

Some explanations:

  • In order to calculate the market rate of return, I used values of equity riskpremium geographically weighted based on Amazon’s sales structure in 2016. The final indicator amounted to 6.08%.
  • I used the current value of the 5-year beta coefficient. Building the model, I proceed from the assumption that Amazon’s beta coefficient will tend to the industry average in the long term, thereby reducing the WACC.

AMZN Beta (5Y) data by YCharts

  • The value of debt in my model is the sum of Long term debt (Q2 2017), Long-term capital lease obligations (Q4 2016) and Long-term finance lease obligations (Q4 2016). I will be very grateful for any constructive criticism regarding this approach in determining the debt of Amazon.
  • To calculate the Cost of Debt, I used the interest expense for 2016 divided by the debt value for the same year.

And here is the model itself:

So, according to the model, the fair price of Amazon’s share is 8% below the current level, however, this is a tolerable error.

I would like to note that, according to this DCF model, the decline of the beta coefficient at least till 1 considerably increases the fair share price of Amazon. This means that the current market valuation of the systematic risk associated with owning Amazon’s shares is one of the key reasons why the company’s shares do not have growth potential within the framework of this model.

PUTTING IT ALL TOGETHER

In my opinion, a company deserves a recommendation to buy if the DCF analysis conducted based on conservative forecast parameters demonstrates a growth potential of at least 30%. Unfortunately, this is not the case. In my opinion, Amazon is not a “strong buy” company at the moment.

Disclosure: I/we Long on AMZN