Here’s Why We Think Amazon’s Stock Is Fairly Valued At $295

Amazon (NASDAQ:AMZN), the leading online retail giant, posted strong earnings during the fourth quarter of 2014, which led to more than 20% rise in its stock price. Significantly, the company posted a 2.0% operating margin in Q4 2014, which came in above its prior guidance and market expectations. Additionally, the news that Prime subscriptions grew by 53% year over year during 2014  also drove the recent surge in the company’ stock price.

Notwithstanding the substantial change in market valuation of $380 per share, we believe Amazon’s stock is actually fairly valued at $295. The key factors that support this estimate include:  1) revenue growth that is likely to slow down over the coming years, owing to difficult year-over-year comparisons; 2) operating margins that are likely to be pressured by fulfillment, marketing, technology, content, and other costs that grow faster than revenue; and, 3) the continued heavy investment in various growth strategies including cloud business, international expansion, and other initiatives over the coming years to accelerate its growth.

See our complete analysis for Amazon

Top-Line Growth Is Expected To Decelerate In The Coming Years

We think Amazon’s top-line will continue to rise at a robust rate over the coming years.  However, the growth rates should come down due to difficult year-over-year comparisons and rise in competition. Here are the key factors that underlie this estimate:

• We believe the electronics and general merchandise (EGM) product category, which comprises for about 70% of the company’s business, will continue to grow at a stellar pace in the coming years, fueled by market share expansion both within the U.S. and in the international markets. The share of Amazon’s U.S. EGM sales in the region’s e-commerce market is expected to rise from about 13% presently to over 16% in the long-run (according to our estimate).
• Prime subscribers, which could total over 35 million worldwide (in our view), provide significant competitive advantage as these subscribers are known to buy heavily on the platform. According to reports, Prime subscribers spend almost twice as compared to other non-Prime subscribers. ^[1] In addition, we think Prime subscriptions will continue to grow at a healthy pace in the future as well, due to the service’s strong value proposition.
• Though media and international sales have under-performed in the recent past, we expect these to return to more healthy levels in the future, buttressed by an expansion in product categories, faster delivery, and rising demand in the market.
• However, rising competition from traditional retailers, as well as other online companies, will likely weigh on year-over-year growth rates, especially within international markets.

Profitability Will Continue To Remain An Area Of Concern

Keeping aside our optimistic top-line outlook, we think Amazon’s margin trends will continue to dominate its stock price performance in the coming future. We are skeptical on the company’s ability to improve its bottom-line significantly and hence, we have modeled its EBITDA margin to hover around 8.5% over our forecast period. The key rationale behind this forecast includes:

• Slowdown in top-line growth will make it difficult for Amazon to achieve operating leverage in its business. This means an increase in expenses will likely match or surpass top-line growth over the coming years (as per our estimates).
• Rising competition from traditional retailers, which have begun engaging in heavy price-based competition, will make it hard for Amazon to raise its prices. This, in turn, will cap its ability to improve gross margins significantly.
• However, the rising proportion of third-party sales is a key positive for Amazon, which will make its gross margin move northwards in the future. Third-party owned units comprised for 43% of Amazon’s volume sales during the fourth quarter of 2014, and this a business we think will expand at a fast pace in the coming years, weighing positively on the margins.
• On the other hand, fulfillment, marketing, technology and content, and general and administrative expenses will likely grow faster than top-line growth in the coming years, given Amazon’s continued investments in data centers, fulfillment and sortation centers, technology upgrades, and hardware and content initiatives.
• While the latest Q4 2014 results showed improved efficiency against cost of sales and fulfillment expenses, we think the same costs need to decline meaningfully as a percentage of sales over the future for Amazon to improve its profitability. However, we are doubtful on Amazon’s long-term ability to curtail these costs, given the historical trends.

Capital Expenditure Should Remain High Over The Short-Term

Capital expenditure as a percentage of revenue was seen at 4.6% and 5.5% in 2013 and 2014 respectively. We think these expenses could stay high in the short-term due to heavy investments in international expansion, the cloud business (Amazon Web Services), data centers, fulfillment centers and sortation centers, content and hardware businesses. Down the road, these expenses (when seen as proportion of top-line) could subside due to faster revenue growth and maturity in the business model. While we have modeled capex as a percent of revenue to decrease to 5% over the long-run, in the event this figure drops down to 4%, it would result in over 10% upside to our price estimate.

Net Working Capital Change Will Continue To Be A Significant Source Of Cash

We expect changes in net working capital to result in a cash inflow of around $2 billion to $4 billion over our forecast period. Expressed as a percentage of sales, we expect increase in net working capital at around -2% over our forecast period. This is in line with the recent historical trends and our view that Amazon will continue to manage its working capital efficiently over the coming years. As its size continues to grow, Amazon will continue to exert greater bargaining power against suppliers, which will result in a favorable trend in this metric over our forecast period.

Our $295 price estimate for Amazon’s stock, represents near-20% downside to the current market price.

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