Can Amazon shares deliver an acceptable return to shareholders?

The share market values Amazon.com at US$1.37 trillion, making it the fifth most highly valued company in the world after Apple, Saudi Aramco, Microsoft, and Alphabet. It is also reportedly one of the most widely owned stocks by retail investors.

Last Friday, Amazon’s market capitalisation rose by 10.5%, or US$130 billion, after Amazon delivered quarterly results that were not as bad as the market feared.

Amazon’s $1.37 trillion valuation is remarkable for a company that has produced a profit of just US$11.3 billion over the past 12 months (if we adjust the reported profit to exclude the unrealised valuation gains that it has recognised on its investment in the even more remarkably-valued Rivian Automotive).  Amazon trades on a price/earnings multiple of 121 times, representing an earnings yield of just 0.8%.

Clearly, Amazon shareholders are not going to grow rich just from Amazon’s current level of earnings. To achieve an acceptable return on their investment, they will need Amazon’s profitability to increase significantly. In this article, we look at what sort of long-term return investors should need to justify an investment in Amazon, and consider the prospects of this actually occurring.

What sort of return should investors require from Amazon?

As is common for companies without a track record of steady profits, Amazon’s share price is volatile and more sensitive to movements in the overall level of the share market than the average stock. Over the past two years, its beta with respect to the S&P 500 index has been 1.47, meaning that when the S&P 500 index moves up or down, Amazon’s share price tends (on average) to move by 1.47 times as much in the same direction. In circumstances where the US share market fell by 10%, we might expect Amazon’s share price to typically fall by 14.7%.

This means that an investment in Amazon will add about 1.47 times as much incremental risk to a typical US share portfolio than an investment in an average US stock. For investors who are sufficiently concerned about risk to hold some fixed interest investments in their portfolios, logic would dictate that they should demand a risk premium over bond returns that is about 1.47 times as high for Amazon as they would require for the average stock.

So if an investor requires a 5% risk premium from the average stock, they should require a 7.35% risk premium for Amazon shares. With US 10 year bond yields currently at about 2.65%, this suggests that a return of around 10% per annum should be required to justify an investment in Amazon shares.

However, investors could credibly argue that the beta of 1.47 observed for Amazon shares over the past 2 years is at the high end of what we might expect in the future, and that the equity market risk premium over bonds may be less than 5%. Hence, we’ll lower the bar for Amazon a little, and work on the basis that investors should a require a return of at least 9% per annum for investments in Amazon shares.  

Amazon’s online retailing business

Historically, Amazon’s key business has been online retailing. Amazon both retails goods directly to customers and provides “fulfilment” services for the online retailing operations of other merchants. This retailing business grew strongly for many years, and although it has never been hugely profitable, there had long been an expectation that Amazon would ultimately shift its focus from growing sales to making profit, at which point Amazon’s economies of scale would allow it to monetise its huge online business.

This transition from growth to monetisation now appears to be occurring. Amazon’s own online sales have stopped growing (and are declining in inflation-adjusted terms), and the growth rate of Amazon’s fulfilment services for third party retailers is slowing down, whilst Amazon is aggressively increasing the monetization of its online retailing platform by selling ads on the platform and increasing the subscription charges for its Prime membership (a package that combines free shipping with video, music, and gaming) by 17%.

However, all signs indicate that monetising Amazon’s online platform is proving to be more of a struggle than investors had previously anticipated:

• Collecting substantial advertising revenues from suppliers does not appear to have increased the overall profitability of Amazon’s retailing platform. Perhaps suppliers have increased the prices at which they supply products to Amazon in order to offset the costs of advertising. Pointing customers to the products that Amazon has been paid to advertise may also explain the slowing in sales that has occurred on a platform that used to be very good at driving sales by pointing customers to the products that predictive algorithms indicated they were most likely to buy.
• It would seem that the increase in the cost of Prime membership has resulted in a loss of customers – the pricing of an annual subscription increased by 17% in late March for American Prime members (whilst monthly subscription charges went up by 15%), and this should in theory have led to significant increases in both subscription revenues and the balance sheet item for “unearned revenue” if subscriber numbers had remained unchanged. Instead, there was only a modest sequential increase in subscription revenues and a decline in the value of “unearned revenues”. Although partly affected by foreign exchange translation, this suggests that a number of customers are responding to the increase in price by cancelling their subscriptions.

Overall, the profitability of Amazon’s broader online retailing business (including the associated advertising and subscription revenues) has declined from a US$3.5 billion profit in the June quarter of 2021 to a US$2.4 billion loss in the June quarter of 2022, whilst revenues have only grown by 3.2%.

Balance sheet indicators also suggest that the quality of Amazon’s financial results is deteriorating. Inventory levels have increased by 58% over the past 12 months, and the capitalised value of the video content that Amazon owns (for the benefit of its Prime members) has increased 77% from US$8.6 billion to US$15.2 billion.  The decline in unearned revenues is also a negative sign for future profitability.

What about the future prospects for this business? Although equity analysts often like to pretend to have an oracle-like ability to predict the future, the reality is that their starting point for predicting future revenues is often to simply extrapolate current trends, combined with an assumption that growth rates will gradually revert toward broader economy growth rates in the longer term. For Amazon’s broader online retailing business (including advertising, Prime membership, etc), this is not a helpful starting point. After all, the revenues of this business only grew 3.2% over the past year, slower than many other retail businesses. While this this growth rate is closer to 7% if you adjust for foreign exchange effects, it is slowing rapidly, and it is increasingly hard to see how Amazon can continue to grow this business faster than the broader economy whilst at the same time trying to squeeze more profits out of their existing customers.

AWS (Amazon Web Services)

While the upside potential of Amazon’s online retailing business has been fading, a new star has emerged in the form of AWS, Amazon’s cloud computing business.

AWS allows corporate, government, and other customers to access computing, database, and storage online. This allows customers to avoid significant investment in their own hardware and software. This model makes particular sense for customers who occasionally need large amounts of computing power, but are not using it all of the time. AWS’s model means that it can invest in this computing power and provide it to multiple customers on an as-needed basis, which reduces the total investment compared to the alternative of each customer investing in their own computing power.

The AWS business has been growing rapidly. It competes primarily with Microsoft’s Azure, with Google Cloud being the only other significant “public cloud” provider to western companies. Alibaba provides similar services, although current geo-political tensions mean that it is unlikely that many western firms would select Alibaba for cloud services, nor that many Chinese companies would use AWS.    

The market for cloud services has been growing rapidly, and as the largest participant in this market, AWS has been enjoying this rapid growth, although it has been losing market share to Microsoft’s Azure.  In the June quarter, AWS enjoyed 33% revenue growth, while Microsoft’s Azure business achieved 40% growth. Percentage growth rates have been slowing, but that is only to be expected when you start at such rapid growth rates. Inevitably, this sector’s growth rates will slow down to something in line with broader economic growth rates, as is ultimately the case with every sector, but the trillion dollar question is how big the sector will get before growth rates become more ordinary.

The reality is that no one knows, and the best we may do could be to look at changes in the rate of growth in AWS revenues to get a sense of when they may slow to single-digit growth rates. Estimating the total size of the market for cloud service providers like AWS and Azure is problematic, as most forms of computing could in theory be hosted by these services, but the economic case for outsourcing to AWS or Azure is much stronger with some types of computing services than others. For example, if a company uses AWS for basic data storage (with no added bells or whistles), they’re essentially just paying AWS to invest in the data storage that they could have alternatively bought themselves or accessed through a data centre. My best guess is that we’ll see a gradual geometric decline in growth rates for cloud-computing services which would see AWS’s revenues growing more than 6-fold over the next 15 years, but with an outlook for only slightly-better-than-GDP growth rates beyond 2037.

Providing cloud computing services is reasonably capital-intensive. At the end of 2021, AWS had USS$63.8 billion of assets invested in the AWS business, in support of a US$62.2 billion revenue line, which delivered an US$18.5 billion operating profit. AWS’s assets have been growing at roughly the same rate as its revenues, and it seems prudent to assume this will continue in the future.

What will Amazon Look Like in the Future?

Looking out to 2037 based on current trends, it seems reasonable to expect that Amazon’s online retailing business will have roughly doubled in size, such that it would be producing total revenues of US$825 million. Although this business has struggled to achieve significant profitability to date, I assume that by 2037 it will be achieving a 5% operating margin, producing annual operating profits of about US$41 billion. Such a business might be valued by the market at about US$550 billion.

AWS’s prospects seem far more exciting. By 2037, it could be delivering annual revenues of US$450 billion, and operating profits of US$150 billion. With a strong market position and still-faster-than-GDP growth rates, the market might value this business at US$2,550 billion (an EV/EBIT multiple of 17 times) in 2037.

Altogether, we can anticipate a potential value of Amazon’s businesses of US$3.1 trillion in 2037. This future business might carry about US$300 billion of net debt (excluding lease liabilities) and have a market capitalisation of US$2.8 trillion.

Under this scenario, we should expect Amazon to start distributing cash to shareholders over and beyond the share buybacks necessary to offset the dilution caused by paying stock-based compensation to employees. Based on the assumptions discussed above, I can see over $1 trillion being distributed to Amazon shareholders over the next 15 years, through a combination of dividends and buybacks. Profits from AWS would be the main source of the payouts, although an increase in Amazon’s indebtedness will also contribute to this payout. Offsetting this, Amazon will need to invest over US$400 billion growing its businesses, particularly AWS.

What returns should we expect from Amazon shares?

While the scenario outlined above undoubtedly paints a rosy picture for AWS’s future prospects, it does not generate a sufficiently high return for shareholders to justify an investment in Amazon. Under the assumptions outlined in this article, we would see an internal rate of return from investing in Amazon shares of just over 8% per annum. This potential return would be more than acceptable for a lower risk company that is already generating steady cashflows and has a predictable future, but it is not quite sufficient for a company such as Amazon, where the lack of current earnings and the need for guess work about the future means that its stock is particularly vulnerable to investors taking a “glass half empty” view of the world. We are using the bounce in Amazon’s share price to reallocate investment funds to other companies that we believe promise similar returns for less risk.   

 

Disclaimer: This article is for informational purposes only and is not, nor should be construed as, investment advice for any person. The writer is a director and shareholder of Te Ahumairangi Investment Management Limited, and an investor in the Te Ahumairangi Global Equity Fund. Te Ahumairangi manages client portfolios (including the Te Ahumairangi Global Equity Fund) that invest in global equity markets. These portfolios invest in companies discussed in this article, including Microsoft, Alphabet, and (even) Amazon.