amazon march 2019

I have written about Amazon before, and as I have admired the company as a disruptive business, I have never been impressed with its lofty valuations. Value of a business, after all, is the sum of its cash flows discounted at an appropriate rate. It is not anything else. Markets may have been overwhelmed by Amazon, but at the end of it, its value is driven by its cash flows. 

In 2008, Amazon had free cash flows of $773 m. In 2012, they were negative $640 m due to higher capex. In 2015 and 2016, Amazon's free cash flows were over $4.5 b. Just when we thought the business will generate consistent cash flows, we had a surprise. In 2017, because of $13 b Whole Foods acquisition, cash flows were negative $11 b. For 2018, it had $9.8 b of free cash flows. They have been quite erratic as they usually are for a growing business. We have a conundrum: What are the sustainable free cash flows for Amazon? Last 3-year average is $1.1 b; 5-year average is $1.5 b. If we ignore 2017 as an exception, the 3-year average is $6.5 b. Heck, we at least need a starting point. 

I am not much of a story person. I need the business to tell me the story rather than me weaving one. The total market value of Amazon's equity is $820 b. Let's assume that investor's expected rate of return is 10%. I don't want that cost of equity shit. If I want 7% return, I will go to the S&P-500. With that out of the way, we need two more variables. One is the free cash flows, and the other is its growth rate. 

I will be an Amazon bull - which I am not - just for fun. Let's start with the beginning free cash flows of $9.8 b. Let's keep the growth rate high at 25% over each of the next 5 years, which means they will be about $30 b in year 5. I have estimated free cash flows aggregating to be $325 b over the next 10 years. For the record, they totaled $12 b in the last decade. Keeping the stable growth rate at 2.5% after year 10, I have put a break on optimism. Amazon had cash equivalents of $41 b and book debt of $32 b as of December 2018. But, it also had lease debt of $23 b which are off balance sheet because of some funny accounting rules. When I use these numbers as valuation input, I get a value of Amazon's equity much lower than its current market price. That's something to note because I have used high free cash flows as a starting point along with high growth rates.

May be one thing I missed was using high perpetual growth rate. Here's is the thing: If we used 6.5% as growth rate in free cash flows as perpetual, we get to its current market value of $820 b. The present value of Amazon's free cash flows at this growth rate is only 20% of its total value. The bulk of its value is coming from the stable growth (perpetual) period. If we start with lower cash flows as base, we will have lower value. Obviously if we keep the growth rates lower, we have lower value. 

I am amazed that Amazon continues to be priced by the market at such lofty expectations. You cannot buy an asset for its future price. The time value of money will tell you that. And yet...

Of course, when we do adjustments for lease debt, advertising costs, and technology costs, Amazon's operating margins, return on capital, and return on equity look good. But you need cash flows to value its business, and they aren't good enough at its current market price.

In March 2013, I thought long term thinking was doing good for Amazon (market value $120 b). But in February 2014, I asked, how long is long term ($160 b). In May 2015, the question was, when's the money ($200 b). In September 2015, I noted the price and value mismatch ($235 b). In July 2016, I compared Amazon with Berkshire Hathaway, and continued to ask, where's the cash ($347 b). In March 2017, I noted that when Amazon's market value hits $600 b Bezos will be the first $100 b person ($427 b). By August 2017, I talked about the hype ($474 b). In October 2017, I looked at Amazon's q3 numbers ($525 b). In February 2018, Amazon was worth $695 b, and Bezos $100 b. In August 2018, Amazon was worth $908 b as I compared it with Apple. 

Every time I try to value Amazon, I am far from meeting its market price, and I have been wrong in expecting its price to fall. Now Amazon is worth $820 b, and I say the same thing: that Amazon is expensive compared to its cash flows.

Amazon had revenues of $232 b for 2018, an increase of 30% over 2017. North America accounts for 60% of it, and Amazon Web Services, 11%. There was a marked improvement in operating profits for the North American (retail) segment though.

Nevertheless, AWS accounts for much of the operating profits, and the international segment continues to suffer operating losses. AWS has been very profitable and is growing faster than retail. As such, it would be better to look at AWS as a separate business, and value it independently.

There were 2 acquisitions in 2018: Ring for $839 m and PillPack for $753 m. Technology and content costs were $28 b. Amazon is still a growth company, and for that it needs a lot of capital. The key is how much free cash flows it will be able to generate in the next decade. It is a disruptive business, it is a fantastic business. But then it is also richly priced; and it has always been like that.