Here Is A Unique Tech Investment Opportunity
Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Investors know that to generate alpha, one must constantly seek out new opportunities and new ways of looking at the same things. Alpha can be created by capitalizing on public information that other investors cannot easily process (think footnotes of a 10-K). Building a better mousetrap (think a better trading or valuation model), achieving a better understanding of how the market works (an in-depth understanding of the company and its drivers), or exploiting structural impediments of the market (think cross-methodological work and post-earnings drift). In this article, I will explain why I like Amazon (NASDAQ: AMZN) and explain its main growth drivers and the reasons why I think this company is a solid investment.
One of the best fundamental reasons to invest in Amazon comes from the growth potential of its Amazon Web Services segment. In particular, Amazon's cloud computing services (EC2) eventually could develop into a multibillion-dollar revenue stream as corporations look for ways to reduce technology expenditures. According to the last Amazon annual report, I estimate AWS generated $800 million in revenue during 2011 and I forecast average annual revenue growth of more than 40% over the next five years. Amazon has been investing in additional capacity in order to become a leader in that growing industry. Amazon Web Services is an area that could become an increasingly positive margin contributor due to its highly leverageable nature. As we can see in the chart, Amazon is growing that cloud segment in exponential numbers, going from just 14B objects stored in its cloud to a whopping 262B in 2010.
Amazon is also one of the best cash generators inside the technological segment. Amazon generates strong cash flows (growing at a CAGR of 38% from 2006 to 2011) . I think Amazon is different from other retailers because the company has one of the best cost structures, which reduce volatility in its operating margins. The nature of business does not leave too much room for differentiation, so price competition is intense. However, despite the seasonality in its business and the resultant fluctuation in gross margins, Amazon´s operating margins does not fluctuate as other retailers do. This happens because Amazon has a relatively flexible operating cost structure, which allows the company to curtail technology and content expenses when margins are impacted by discounts and promotions to boost sales during the
holiday season. Given these factors, revenue growth and the expansion of business are the primary drivers of cash flows. Despite the recession, the company has grown revenue at a double-digit rate in 2008, 2009 and 2010. As a result, cash flows increased 94.0% in 2009 and another 6.1% in 2010 (when growth investments were stepped up). Despite continued investment in 2011, cash flows were up 11.7%, as the company had a very strong holiday season, with Kindle Fire emerging the second largest tablet platform after the iPad. Additionally, revenues from digital media (books, songs video, etc) also remain very strong. As we can see in the chart, operating and free cash flow grew exponentially and that shows the strength of Amazon business model.
I always explain investors that it is essential to invest in companies that has proven management teams that are aligned with shareholder interests. In the case of Amazon, Jeff Bezos' stock holdings are huge and his team receives stock awards as the company passes ambitious growth metrics. Management's interests are unlikely to diverge from shareholders. It truly is pay for performance. How management is compensated makes a difference. For instance, Amazon has sacrificed earnings in order to pursue top-line growth. This executive pay alignment with shareholders confirms that management is invested in making the company profitable over the long term. I think that If you want a stock where management wants the stock to go higher just like you do, look at Amazon. Management's interests are aligned with those of investors.
While the US segment is growing nicely with net sales +36% y/y and operating income +61% y/y, Amazon´s International segment balances out the domestic business and gives a great diversification to the company´s core retail model. The International segment generated double-digit year-over-year growth right through the recession. The main growth driver is the Electronics and General Merchandise (EGM) segment, where the - year over year growth rate has been over 50% in six of the last nine quarters. Amazon has been introducing several new products for international markets that are expected to drive demand. It is also building and investing in fulfillment centers to cater to the increase in demand. Although EGM sales have been growing at a much faster rate, Media growth rates (which has higher margins) have also started improving (up double-digits year over year in each of the last eight quarters). I expect that Amazon keeps growing in the US but the real growth opportunity comes from its international expansion.
Amazon has a higher P/E and P/B than competitors eBay (NASDAQ: EBAY) or Wal-Mart (NYSE: WMT). In fact, eBay trades at a reasonable 17x earnings and 3.4x book, Wal-Mart trades at 15x earnings and 3.5x book while Amazon trades at a whooping 313x earnings and 14x book. The real difference comes from innovation and future growth. Neither eBay nor Wal-Mart can currently match the potential in several high growth areas that Amazon has. That is why the market is not truly concerned about Amazon´s high multiples. Shares could appear expensive based on explosive multiples but this company is the true leader and investors will continue paying for that type of growth and prime execution. I recommend Amazon to any short or long term oriented investor.
federicoflom has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Amazon.com, and Google. Motley Fool newsletter services recommend Amazon.com, Apple, eBay, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.