Buy AWS, get Amazon Retail for free (NASDAQ:AMZN)
There are two things I generally don’t like people quoting out of context; Bible verses and quotes from Warren Buffett. Both are often selected to support a concept that may differ significantly from their original use or meaning. In the case of our investment saviour, Mr. Buffett, his words are often used out of context to peddle an investment idea.
I’ve seen this a lot lately for what are supposed to be good stocks for inflation. But what did Buffett actually say about it? Check out the Berkshire Hathaway (BRK.A) (BRK.B) shareholder letter from 1983. As you probably know, the start of that decade was marked by double-digit inflation. Then, as now, it was at the forefront of investor concerns.
You can read the letter yourself, but in summary, it goes over the math of a company with lots of intangibles, See’s Candies, and compares it to a company heavy with tangible assets. The bottom line is that small cap companies like See’s Candies are the most successful during inflation.
“And that fact, of course, has been difficult for many people to grasp. For years, traditional wisdom – long tradition, short on wisdom – has held that inflation protection is best provided by companies loaded with natural resources, plant and machinery, or other tangible assets (“In Goods We Trust”. It doesn’t work that way. Asset-heavy businesses typically earn low rates of return—rates that often provide barely enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, distribution to owners, or acquisition of new businesses.
By contrast, a disproportionate number of the great business fortunes amassed during the inflationary years came from ownership of operations that combined intangible assets of enduring value with relatively minor needs for tangible assets.”
This brings me to Amazon Web Services, better known as AWS. Yes, I do exactly what I despise; comparing a Buffett concept to an action, Amazon.com, Inc. (NASDAQ: AMZN).
AWS versus everything else
As I’ve discussed in previous articles, Amazon’s retail, Prime Video, advertising and their other bets are of little interest to me, at least from an investment perspective. If you were to rate Amazon based on retail, it’s a bubble. Why should it trade at 2-4x sales when Walmart (WMT) has averaged 0.54x over the past 10 years?
But Amazon is not a bubble. In fact, it’s a deep value game. For starters, keep in mind that during the dotcom bubble it peaked at 25-35x sales, which of course is a far cry from today. Whether we’re talking about Walmart or Amazon, the reason price/sales deserve to be low is because retail is a low-margin business. It is an asset-heavy business due to stores/warehouses and logistics, and there is a lot of human labor involved.
Not great during inflation.
Compare that to software and similar asset-based business models. You can increase the prices of these services without a corresponding increase in input costs.
Of course, programmers’ salaries will go up with inflation, but you’ve already paid them for the heavy lifting of building the moat (the software). Now you only need it for iterations. Of course, they are still essential, but their talent is more comparable to, say, hiring a plumber or a painter to do your home maintenance. You don’t need to pay them to build your whole house because it used to be done.
Plus, your entry cost for adding new customers is insignificant, compared to an asset-heavy business. If you’re an oil refiner already running near capacity and want to double your production, you need to build or buy double everything. You need to build a new facility or expand your existing facility. You will need to double your numbers.
On the other hand, if you’re AWS, to pick up a new cloud customer, you’re literally copy-pasting your pre-built code. Yes, there are server hardware, electricity costs, etc., but that’s only a small slice of the pie for this high-margin business.
AWS Value vs. AMZN Enterprise Value
Since Amazon has virtually no long-term net debt (relative to company size), enterprise value and market capitalization are fairly comparable. If it looks like I’m using them interchangeably, that’s why.
At $125/share, the current market cap is $1.27T.
In its last quarter, total revenue was $116.44 billion. AWS accounted for just 16% of that at $18.44 billion. A small piece of the pie but a big part of the revenue; operating profit of $6.52 billion. That’s a profit margin of 35%. Compare that to retail, which typically shows a mid- to high-single digit percentage (at best).
Granted, that juicy 35% margin on AWS is a few percent higher than the recent average, but it’s not an outlier. Before Amazon began detailing the AWS segment in its reports, UBS estimated the margin ranged from 47% to 53% in its first 8 years of operation.
While some construction DCFs forecast AWS revenue over the next few years or until 2030, I think that’s far too presumptuous for a high-growth company. A lot can change, for better or for worse, by then. DCFs are like a cozy blanket, a false sense of security. These are just guesses on top of guesses. You can paint any picture you want with them.
Let’s be more conservative and just focus on the next 2-3 years.
This year, AWS is expected to exceed $80 billion, and next year, $100 billion. This actually assumes a slowdown in growth to “only” 25%. Well below the 37% growth we’ve seen in the last quarter, or all recent quarters and years of over 30%. If we assume another 25% y/y after that, that brings us to $125 billion for 2024.
Let’s not go with the 35% profit margin on that. Let’s stick with 33%. This equates to $41.25 billion in operating revenue for AWS in 2024.
If you apply a multiple of 25 to that, that brings us to a market cap of T$1.03. Remember that the current market capitalization is only $1.27 billion. If you project another year of growth and this time let’s reduce it to just 20%, that means by 2025, the current market capitalization would equal a multiple of 25x on AWS alone.
Yes, that’s a high multiple, but not out of place – even during today’s tech wreckage – for a high-growth, high-margin blue chip company. Just look at Microsoft (MSFT) for a comparative assessment.
In other words, you can buy AWS today and in a few years it will be like getting retail and everything else for free.
Yes, there may be dilution for stock-based compensation, but based on history, it should be trivial. Maybe there won’t be any now that they’re doing buyouts.
Don’t bet against Bezos, same goes for Jassy
For those who say Amazon’s growth days are over, keep in mind that the current CEO – Andy Jassy – was the former head of AWS. He is a 20 year veteran of the business.
His salary of $212 million might seem excessive until you realize his salary is only $175,000. That $212 million is stock-based compensation (61,000 shares before the split) and vests over a decade, between 2023 and 2031.
In other words, valued at around $21 million a year, based on the then higher share price. However, more than 80% of this amount is not acquired until years 5 to 10. As such, he is more motivated than anyone to bring massive growth throughout this decade as well. Given his track record in creating and building AWS, I bet he’ll be up to it.