Aug 5 2020 - Amazon: Blowout Quarter, Path To Trillion Underway

Amazon reported one of the best quarters in the "Super Thursday" group of mega-tech companies that reported.

EPS, free cash flow, and core retail revenues exploded past expectations, and the guidance was mind-numbingly good for both earnings and revenue.

In my view, Amazon has the best chance of achieving the trillion market cap and holding onto it for the long term in comparison to other mega-tech companies.

With the phenomenal results we saw this quarter, I'll explain why the company's shares are not only not overvalued, but are actually very undervalued. In my view, Amazon is easily the best FAANG stock.

Reiterating Buy rating, PT raised from ,740 to ,300.

Amazon's Blowout Quarter

This "Super Thursday," a group of the largest tech companies on Earth reported 2Q earnings. Amazon (AMZN) was one of them. And honestly, this was one of the best reports in an earnings season chock full of strong numbers. Let's break down the numbers and the guidance.

• Revenue: .91 billion vs. .29 billion expected (~9% BEAT)
• EPS: .30 vs. .50 expected (~587% BEAT)
• AWS Revenue: .81 billion vs. .02 billion expected (~2% MISS)
• Q3 Revenue Guide: - billion vs. .44 billion expected (~4% BEAT at midpoint)
• Q3 OpInc. Guide: -5 billion (including billion in COVID-19 costs) vs. .1 billion expected (~13% BEAT at midpoint)

As you can see, despite the weakness in the broader economy, Amazon delivered strongly, and well beyond expectations in nearly every segment. The one weak spot in Amazon's quarter was likely AWS. As Microsoft's (MSFT) cloud computing segment, Azure, alluded to in the company's 2Q print, cloud spending wasn't nearly as robust in 2Q as it was in 1Q. I expect that this was because of the quick and voracious ramp of cloud spending in March to address lockdowns across the nation and the work-from-home economy's sudden existence. On a positive note, AWS margins remained strong. While growth slowed, it was impressive nonetheless, coming in at ~29% y/y in 2Q. AWS will be a long-term growth driver for Amazon - investors just need to wait out the choppiness in short-term cloud spending shifts.

The most impressive part of this quarter was core retail at Amazon. Obviously, as lockdowns progressed, traditional brick-and-mortar purchasing activity moved increasingly online. Naturally, considering Amazon's advantages (logistics, unique variety of offerings, and scale), it was most likely to capture a high portion of this tailwind. In addition, as traditionally small offline businesses move online, they likely began listing products on Amazon. In addition, Amazon saw a drastic increase in demand for its grocery offerings, even as in-store grocers like Whole Foods (an Amazon subsidiary) were likely negatively affected by the lockdown.

Conference Call Breakdown

Delving a little deeper than the headline numbers, we see that underlying trends at Amazon were extremely strong in 2Q, and will likely continue to be strong in 2H and beyond.

Strong top line performance was driven by increased consumer demand, led by Prime members. We continue to see high Prime member engagement throughout the quarter. Prime members shop more often with larger basket sizes. Worldwide streaming video hours doubled year-over-year driven largely by Prime video. We’re reaching more customers with our grocery offerings.

- Brian Olsavsky

Essentially, the company confirms top line growth was driven by eCommerce growth in the quarter. Increasing Amazon Prime subscribers and spend per subscriber led to increased eCommerce revenue. In addition, Amazon saw a strong boost from the stay-at-home economy, with viewing hours on Amazon Prime Video hours doubling y/y. In addition, the company notes that grocery helped drive revenue growth in the quarter as well. It added to this point later on in the call.

Online grocery sales tripled year-over-year. Existing Prime member renewal rates improved, and the Prime member growth rate accelerated both in the U.S. and worldwide.

- Brian Olsavsky

The key idea here is Amazon's increased penetration of the grocery market. The company has been making moves in the grocery market for a few years now, acquiring Whole Foods in 2017 and expanding its Amazon Go retail footprint. Because of consumers' reluctance to go out and purchase groceries in-person, they have resorted to grocery delivery. Amazon has made a great offering to the grocery-delivery market with its Amazon Fresh offering. I believe that the growth of Amazon Fresh will continue for a while as consumers realize how convenient an online grocery delivery service is. Then the company told us what basically everyone already knew - that Amazon Prime and general eCommerce traffic was strong in the quarter.

Our third-party seller services revenue grew faster than online stores revenue in Q2, with strong growth in both fulfillment by Amazon and merchant fulfilled or MFN seller sales. Third-party units continue to represent more than half of overall unit volume, helped by improved quarter-over-quarter growth in active sellers.

- Brian Olsavsky

Interestingly enough, Amazon's 3P (third-party) sellers were actually growing faster than 1P (first-party) revenue in the quarter. This is in spite of its focus on selling essential items in 2Q over non-essential items. As traditionally in-person small businesses were forced to lockdown physical operations, a lot of them might have turned to digital sales of their products to stay open. The company's ability to offer small businesses a clean and simple seller-services platform was likely compelling to businesses that could easily transition to an online model. This is likely why 3P was so strong for Amazon.

Additionally, as a reminder, Q2 is typically our lightest volume quarter for the retail business. That’s not the case this year, but what that’s meant is that we can flex into space normally used for second half peak demand. This led to strong operating leverage in Q2. As we move towards peak in the second half of the year, we will ramp up our space needs even further, and we’ll be adding significant fulfillment center and transportation capacity in the second half of the year.

- Brian Olsavsky

The company notes that it had to move into fulfillment and transportation capacity normally reserved for the holiday season. That goes to show just how strong demand was for eCommerce, and Amazon in particular, in 2Q. The company also said it plans on adding capacity in 2H as demand trends remain strong regardless of the spread of coronavirus. Essentially, it seems that management is implying the strength we saw in 2Q will continue into the back half. This isn't a demand pull-forward, but rather, an acceleration of eCommerce penetration as a portion of total retail.

Yes, sure. I’ll give you the backlog number. It grew 65% year-over-year and 21% quarter-over-quarter. So that’s healthy, and we have the average contract length is over three years for our AWS contracts. I would say contract volume and negotiations are strong and have maintained through this period. So it is – that’s a good sign. It really does boil down to short-term versus long-term incentives here for a lot of our customers. They’re – if you’re in an industry that’s been heavily impacted by COVID in the economy, you’re looking for ways to save money and you’re trying to do a click and we’re trying to help in that regard.

- Brian Olsavsky

The thing to note here is that while we know that AWS growth decelerated in 2Q, this was because companies that operate in a coronavirus-prone industry needed to reduce costs quickly. This resulted in generally lower IT/cloud budgets, dampening revenue growth for the segment despite the pick-up in activities like remote learning, video conferencing, gaming, etc. It notes that this is likely a short-term dynamic. I think that we could see a reacceleration in growth as churn decreases over the quarters to come.

Valuation, Rating, and Price Target

One of the hardest things for investors to do nowadays has been valuing high-flying growth companies like Amazon. It has been a challenge many investors have struggled with for years. On traditional valuation metrics like P/E, the stock has always appeared expensive. The low earnings, however, are by design. The company intentionally plows almost all potential profits back into the business, growing existing businesses and growing into new verticals. This has led Amazon to grow for years on end, defying the law of large numbers. For this reason, earnings are not (currently) the best metric to value the stock on.

Amazon has ~40% gross margins in its most recent quarter, but it plows profits back into growing revenue. So, I believe the best metric for valuing the company currently is revenue. With the recent improvement in its core operating results, analysts have been forced to raise estimates for this year as well as next year. Right now, analysts are modeling revenues of 9.6 billion. For a company with wide moats, enormous scale, a mid-teens revenue growth rate long term, and access to numerous growth verticals, I am surprised that the stock trades at just ~3.7x '21 sales. I believe considering the future prospects of the company and the growth verticals for the stock, a valuation of 5x revenue is warranted. Let's compare Amazon to its tech peers:

As you can see, relative to other large-cap tech stocks, Amazon remains the cheapest on a P/S basis by a decent margin. While it is growing at a slightly slower pace, the growth gap isn't large enough to justify this much of a valuation discrepancy.

And even then, 5x is not an egregious multiple for the fundamentals and the narrative at Amazon. Based on 5x consensus 2021 revenues, the company's YE (year-end) 2021 valuation should be .148 trillion. Divide that by its outstanding share count of 498.78 million, and the fair value is ,306.50/share. Because of the great risk/reward proposition, and the continued strength of Amazon's fundamentals, I continue to rate the stock as a Buy.

(Source: Amazon)