Amazon Is Undervalued Despite Challenges – Seeking Alpha

Large Amazon distribution warehouse

georgeclerk/iStock Unreleased via Getty Images

Introduction

Amazon’s 1Q22 release had 809 words on entertainment highlights and just 525 words on shopping highlights. I remember when large Sears (OTCPK:SHLDQ) department stores had everything from men’s suits to miter saws. By trying to do everything, they were disadvantaged relative to specialty stores who had more focus and better direct measurement capabilities. Now Amazon (NASDAQ:AMZN) is attempting to do a bit of everything, acquiring MGM for $8.5 billion in an effort to bolster Primer membership such that first-party (“1P”) and third-party (“3P”) sales increase. Sales growth has slowed, and it is difficult to measure the ROI of various Prime investments. My thesis is that Amazon faces challenges with focus and measurement. Rather than pouring additional money into Prime streaming offerings, they should consider spending more money in areas that have measurable benefits for merchants. Moving forward, I’d like to see them focus more on supporting merchants, maintaining reliable reviews and keeping competition fair.

Inconsistent Support For Merchants

An October 2019 Washington Post article talks about a seller named Jeff Peterson who had thousands of fraudulent orders placed on his account after it was hacked. Negative reviews hurt his business and he couldn’t get answers as he hadn’t joined the Amazon Marketplace Growth program. The article goes on to talk about another seller who was also hacked but this seller received help from an account manager seeing as this seller was paying $5,000 per month for support:

Chandiram, the chief executive of Bellevue, Wash.-based Kaliber Global, spends $5,000 a month for a service called Amazon’s Marketplace Growth, where he has an account manager who fixed the problem within 48 hours. Despite Chandiram’s seven-year record selling on Amazon, as well as being a top-150 seller, he said it can be nearly impossible to get help from Amazon’s mostly automated systems without the service, so he pays up. He now also has to spend millions of dollars advertising on the site.

Amazon should invest more money in their merchants and help all their merchants quickly when hacks occur, whether or not the sellers are paying extra fees each month to have special support.

Unreliable Reviews

Honest merchants who play by the rules are negatively impacted by nefarious competitors with respect to reviews. In June 2021, Amazon talked about efforts to stop fake reviews but I wish they would provide more information including the amount of money they’re investing in this crucial area:

In 2020, we stopped more than 200 million suspected fake reviews before they were ever seen by a customer, and more than 99% of reviews enforcement was driven by our proactive detection.

Black hat search engine optimization (“SEO”) is a practice where folks use unethical tactics against search engine guidelines. Google (GOOG) (GOOGL) has been spending vast amounts of money fighting against this over the years – changing their algorithm continuously. A March 2021 Socialnomics article talks about the destruction from 10 well-known black hat tactics on Amazon. One tactic is to have a team of people leave negative reviews on the pages of competitors. Next, a team can click “helpful” on the obstructive reviews to give them more credibility. Finally, fake infringement claims can be filed:

To make the negative feedback look more admissible, and to quicken the suspension of a competitor’s account, the black hats of Amazon go as far as filing fake infringement claims against their competitors. Claims of crooks include violation of patent laws, or they report that the products do not abide by Amazon regulations on dangerous and prohibited products. On Amazon, accounts are suspended during the investigation process, so when complaints like this reach Amazon, seller accounts are prohibited from selling until proven innocent of the claims, thus putting you behind your competition in sales during this time.

Amazon is now a product search engine, and they should consider spending more money fighting the black hat tactics above and less money on Prime initiatives like the MGM acquisition and Thursday Night Football.

Unreliable positive reviews can be a problem as well and a November 2021 CNET article talks about this issue. Amazon banned incentivized reviews in 2016 but some sellers still do this by offering shoppers refunds and gift cards in exchange for positive reviews. In May, Amazon removed products from Aukey and Mpow as there were reports that they were doing incentivized reviews. The CNET article talks about the ways in which shoppers can be recruited:

After buying a product based on positive reviews, an honest shopper might get recruited for a fake review scheme in a couple of different ways. In the first scenario, the product arrives in the Amazon smile box, and the customer notices a card with a QR code or a website printed on it. This is so common no shopper would blink, and the link might lead to a regular customer support website that’s above board. However, it might also lead the shopper to a group on Facebook or another social media site where the brand offers up more products for review — in exchange for a refund. The second scenario is more direct. The card in the package might directly offer a gift card or PayPal credit in exchange for a positive review. If the shopper follows through on the offer, it will add an “incentivized” review to the listing for the product they just purchased.

Amazon should outline what types of investments and initiatives they plan to do in the future to make the review system fairer.

Unfair Competition With Merchants

In October 2021, the House Judiciary Committee wrote Amazon a letter citing reports from Reuters and The Markup about unfair competition. The Reuters report discusses Amazon’s internal documents saying Amazon has a history of manipulating product search results to increase the sales of Amazon’s own brands. In a similar theme, the report from The Markup says Amazon places its own brands ahead of competitors who have higher ratings and sales.

It’s one thing when Amazon makes private label batteries to compete with the likes of Energizer (ENR) but when they go after smaller merchants with newer products then it discourages merchants from participating in the marketplace. Brick and mortar stores like Costco (COST) and grocers have private labels but the threat level is lower. When Amazon has the ability to use machine learning to copy innovative new products for private label alternatives and more machine learning to give private label products unfair placement then it makes merchants nervous and hesitant to sell in the Amazon marketplace. The above report from The Markup explains that Amazon’s digital platform is different from a brick and mortar retail store:

“Unlike a retail store where you see everything on the shelf, the platform may be in a position to elevate its goods in a way that is harder to do in a retail outlet,” said Baer, the former FTC official and assistant attorney general at the Justice Department.

In the worst-case scenario, it sounds like the equivalent of Costco ripping off the ideas of merchants and then making a special section where these Costco private label brands are not easily identified as private label alternatives. Finally, this section would be placed prominently by entrances and exits. Rather than reading about Amazon doing things this way, I’d like to read more about the ways Amazon’s private label products like their HDMI cables save customers money as described by Marketplace Pulse:

“Right now you can buy a 6-foot-long HDMI cable for $3.50. Or $19.99. Or $99.99. Or $699.99. Salespeople, retailers, and especially cable manufacturers want you to believe that you’ll get better picture and sound quality with a more expensive HDMI cable. They’re lying,” wrote Geoffrey Morrison, CNET. AmazonBasics 6 feet HDMI cable sells for $6.99 and is the number one best-seller HDMI cable on Amazon. Because on Amazon there are no salespeople to create the perception of value for the more expensive cables.

Valuation

Amazon used to be an excellent company but with the challenges they face today, I’d say they’ve fallen down a notch such that they’re now merely a good company. I’m still long, in part because I believe they can fix these issues and go back to being excellent again. Amazon has disparate segments, so I like to do a sum of the parts valuation:

1Q22 Segments

1Q22 Segments (1Q22 release)

Synergy Research Group shows that AWS continues to lead the global cloud market:

1Q22 Cloud Market

1Q22 Cloud Market (Synergy Research Group)

As we saw above, the global hyperscale cloud market belongs to AWS, Azure (MSFT) and Google. Incumbents who used to talk loudly about cloud investments in the past do not generate much of their overall revenue from Infrastructure as a Service (“IaaS”) today and in the case of Oracle (ORCL), their overall revenue is fairly flat:

AWS vs Oracle

AWS vs Oracle (Author’s spreadsheet)

I believe the future economics for AWS, Azure and Google Cloud will be enjoyable as they continue to separate themselves from other companies who can’t make substantial capex investments in this area. In 1Q21, AWS had operating income of $4,163 million on revenue of $13,503 million for a margin of 30.8%. In 1Q22, this went up to operating income of $6,518 million on revenue of $18,441 million for a margin of 35.3%. Year-over-year revenue growth was nearly 37%. Ostensibly year-over-year operating income growth was nearly 57% but much of this was due to an accounting change with depreciation for servers and networking equipment. As such, I believe the true operating income growth was closer to the revenue growth of about 37%. In the 4Q21 call, CFO Brian Olsavsky explained the dynamics of the operating income accounting change:

We’re prospectively updating the useful life of our servers and networking equipment, beginning in January. As a practice, we monitor and review the useful lives of our depreciable assets on a regular basis to make sure that our financial statements reflect our best estimate of how long the assets are going to be used in operations. We are increasing the useful life for servers from four years to five years and network equipment from five years to six years. As a result, our first quarter guidance includes an approximate $1 billion of lower depreciation expense.

I think this segment is worth 25 to 30 times the annualized operating income of $26 billion which implies a valuation range of $650 to $780 billion.

A recent WSJ article notes that global digital ad spending grew 30% in 2021 but this is expected to slow down to 13% for 2022:

Global Ads

Global Ads (WSJ)

Amazon’s 1Q22 ad revenue was $7,877 million which was a 23% increase from the 1Q21 figure of $6,381 million. The market cap of Meta (FB) was about $430 billion in early May 2017 when they came out with their 1Q17 results showing quarterly revenue of $8,032 million. I think the ad segment has a valuation range of $325 to $375 billion in this environment where interest rates are expected to rise.

Per a March 2022 Supply Chain Dive article, Amazon’s distribution footprint for 1P and 3P sales is massive:

Amazon Distribution

Amazon Distribution (Supply Chain Dive)

Amazon isn’t alone in terms of seeing disappointing gross merchandise volume (“GMV”) for 1Q22; growth has also slowed for the Shopify (SHOP) ecosystem:

GMV & Revenue

GMV & Revenue (Author’s spreadsheet)

*Amazon estimate for 3P is sales times 3.75.

*Walmart quarters end 1 month late and their fiscal year is different too. In other words, their 1Q22, 2Q22, 3Q22, and 4Q22 periods go through Apr ’21, Jul ’21, Oct ’21 and Jan ’22, respectively, such that we show them in our graph as 1Q21, 2Q21, 3Q21 and 4Q21, respectively. Target’s fiscal year ends on the Saturday nearest January 31, so each period is about 1 month late, but they don’t have the issue of a different year that we see for Walmart.

Amazon’s 1Q22 1P revenue was $51,129 million, down 3% from $52,901 million in 1Q21. Given this decline, the segment is worth less than I thought in the past. Trailing-twelve-month (“TTM”) revenue was over $220 billion while annual revenue for Target (TGT) and Walmart (WMT) through January 2022 was $106 billion and $573 billion, respectively. The market caps for Target and Walmart are about $104 billion and $412 billion, respectively. Costco’s last fiscal year ended on August 29, 2021, and they had $195.9 billion in revenue composed of a little more than $192 billion in sales and a little less than $3.9 billion in membership fees. Sometimes Costco just breaks even on sales such that much of their net income comes from membership fees; Costco’s market cap is about $223 billion. I think Amazon’s 1P segment is worth about $125 to $150 billion.

Amazon’s 3P revenue in the 1Q22 quarter was $25,335 million, up 7% from $23,709 million in 1Q21. GMV for this segment is estimated to be about 3.75 times sales which comes to around $95 billion. I think this segment is worth double the 1P segment or $250 to $300 billion.

I don’t think the physical stores, subscription services or “other” segments are worth much on their own. Amazon spent about $13 billion buying Whole Foods. The 1P and 3P segments rely on the subscription segments. The “other” segment is small right now with quarterly revenue of just $661 million. Combining these segments with other considerations like new businesses might add another $25 to $50 billion to the overall valuation.

In summary, I think of the valuation range as follows:

$650 to $780 billion AWS

$325 to $375 billion Advertising

$125 to $150 billion 1P

$250 to $300 billion 3P

$25 to $50 billion Other Considerations

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$1,375 to $1,655 billion Total

The 1Q22 10-Q shows 508,720,481 shares outstanding as of April 20, 2022. Multiplying this by the May 6th share price of $2,295.45 gives us a market cap of $1,168 billion which is relatively close to the enterprise value. The market cap is near the bottom end of my valuation range, so I think the stock is a good buy right now.

Disclaimer: Any material in this article should not be relied on as a formal investment recommendation. Never buy a stock without doing your own thorough research.

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