It’s been a rough year for growth stocks as rising rates are slowing the economy and analysts revise down their previously over-extrapolated long-term high-growth targets that were based on the relatively short-lived pandemic bump. But don’t let the negative short-term sentiment fool you into believing certain long-term secular trends have ended; they have not, and attractive businesses are now trading at increasingly attractive prices. In this report, we review one mega-cap high-growth stock in particular (including the financial metrics that mislead some investors) and then conclude with our strong opinion on investing.
Amazon (AMZN), Business Overview:
For reporting purposes, Amazon divides its business into three segments (North America, International and Amazon Web Services), but that is a bit of a disservice to analysts considering essentially 100% of the profit is generated by AWS. North America and International are basically the geographical breakdown of retail sales, which generate essentially zero profit on a segment basis, but have very profitable and growing sub-areas in those segments (mainly subscriptions like Prime and the burgeoning advertising business) that will likely be growth and profit drivers in the future. Again, most of Amazon’s revenues come from North America (~60%) and International (~27%), but virtually all profit (100%) currently comes from its third segment, AWS.
Competitive Advantages:
Amazon has huge competitive advantages over its peers stemming from massive economies of scale (which enable it to deliver low cost services) and network effects (for example, Amazon gathers all types of information about users that will help its advertising efforts). Amazon Web Services is the leading cloud services provider (ahead of Microsoft Azure (MSFT) and Google Cloud (GOOGL)) and this segment has massive long-term growth potential stemming from the ongoing digital transformation and migration to the cloud (an enormous long-term secular trend).
Risks:
Amazon faces risks. For starters, the company announced disappointing earnings at the end of October (whereby the shares sold off sharply) stemming from slower growth than expected in AWS as the aftereffects of pandemic-driven social distancing (and work from home) continue to wear off). What’s more, this negative trend could continue as overall economic growth has slowed and the potential for an ugly recession continues to loom. Furthermore, there are reports that Amazon is set to lay off 10,000 employees (a recent trend among large technology-driven companies); this is encouraging from a proactive cost-control standpoint, but concerning, and indicative of potentially rough roads ahead.
Another risk is foreign currency effects whereby earnings have recently been impacted negatively by negative translation effects.
Cloud competition from Microsoft (which is gaining ground on AWS) and Google are also a risk. However, given the scale of the massive cloud secular trend—there is room for multiple big players to succeed, and cloud will likely be a leading profit-driver for the next decade at least.
Valuation:
Don’t be fooled by Amazon’s low net profit margins (see table below). It is largely a high-sales low-net-margin retail business. And this massive revenue retail business creates massive economic moats and network effects that strengthen its other profitable high-growth operations (AWS, subscriptions and advertising).
Currently trading at only 2 times sales (the lower end of its historical range), and with revenue expected to grow (and keep growing) at roughly double digits (based on massive long-term secular trends), Amazon is extremely attractive—despite the fact that it’s growing at a slightly slower pace than most analysts had previously expected (as they over-extrapolated the short-term “pandemic bump”).
Furthermore, the Fed’s aggressive interest rate hikes this year have had a particularly negative impact of high-growth stocks like Amazon (see performance in the table above). We believe these factors helps explain the sharp share price declines, and also contribute to the attractiveness of the investment opportunity as inflation will eventually slow, the fed’s aggressively hawkish policies will moderate, and Amazon will keep growing rapidly for many years.
The Bottom Line:
Amazon shares have recently sold off hard, but it remains a truly impressive long-term business. Its shares just now trade at a more compelling price. Amazon faces near-term headwinds (inflation, slowing growth, pandemic aftershock), but the long-term leadership opportunities remain fully intact.
If you are seeking long-term capital appreciation, Amazon share are attractive. It is the type of stock you could add to your portfolio now, and then wake up 5 years later to find them trading at a dramatically higher price. We are currently long shares of Amazon in our Disciplined Growth Portfolio, and have no intention of selling anytime soon.