Amazon Investment Case
3P, Advertising, and Amazon Web Services
Amazon has transformed from a niche online bookstore into a globe-spanning technology conglomerate with over $620B in sales and a market cap of $2.3T!
Many investors believe that Amazon is perpetually overvalued because it always trades for an above-average P/E ratio.
I, however, see one of the most compelling and least risky large-cap companies on the market. With a moat the size of Alaska and many highly profitable and growing segments!
In this inaugural article of my new Investment Case series, I will present the most important pieces that will drive Amazon’s growth story in the next decade.
A Global Equity Briefing Deep Dive is a long-form article that, in greater detail, not only explains the investment case but also provides an in-depth look into a company’s products, business risks, and financial analysis.
An Investment Case is a shorter article that only presents the key factors behind a company’s growth story and its valuation!
I plan to write Investment Case articles over Deep Dives for well-established and widely known companies where I feel that a comprehensive Deep Dive wouldn’t necessarily deliver the best value to my readers.
Amazon’s Investment Case is driven by 3P Merchant Services, Advertising, and Amazon Web Services!
Let’s take a look!
1. 3P Merchant Services
2. Advertising
3. Amazon Webs Services
4. Transforming Costs Into Revenue
5. Valuation
6. Conclusion
1. 3P Merchant Services
By now, it is well known that most items on amazon.com are not sold by the company itself, rather, they are sold by independent merchants. Everyone is allowed to sell on the platform as long as they follow Amazon’s rules.
In the last twelve months, as of Q3 2024, Amazon raked in $152.2B from providing various services to their merchants. In the last decade, this segment has grown over 12 times, a CAGR of 30%!
Amazon’s 3P Sales segment is well-positioned to continue growing and improve margins!
The key factors driving 3P Sales revenue and margin growth are:
Amazon Prime – Prime is Amazon’s subscription loyalty service, with over 220 million members globally. Subscribers get various perks, such as free shipping, access to Prime Video streaming service, and more. The main objective of Prime is to increase customer loyalty and drive repeat purchases. Amazon regularly offers new benefits to its members, ensuring a steady supply of spending customers. Amazon Prime is a sticky subscription whose loyal members are likely to continue spending more and more on the Amazon marketplace, enabling continued growth in 3P services revenue.
Growing E-commerce penetrations – as of Q3 of 2024, 16.2% of all US retail transactions are done online. China is the world leader, with 47% E-commerce penetration. The penetration in the UK is 30.6%, Canada has 11.7%, and Latin America is around 11%. It is expected that in the next decades, the rest of the world will bridge the gap with China. Amazon, as the key player in this space, will benefit greatly as customers in its key markets of North America, the EU, and the UK spend an increased share of their wallets online.
Geographic expansion – In 2002, Amazon entered the Canadian market, since then, the company has expanded all over the globe, with significant operations in over 20 countries. While in the last decade, its domestic growth has been faster than international (22.8% vs 15.8%), I believe that is going to change in the next decade. The company is expanding in emerging markets, investing billions in Brazil, Mexico, India, and Turkey. Additionally, Amazon has signaled plans to expand in more mature markets such as Eastern and Southern Europe.
Logistics moat – Customers will always want fast delivery. If Amazon is constantly two steps ahead of its competitors, customers will remain loyal. The company has built some of the fastest and most efficient e-commerce logistics operations in its key markets of North America and Western Europe. Additionally, it’s investing heavily to create a similar moat in other regions. Fast delivery times reduce churn, drive repeat purchases, and lower customer acquisition costs, enabling higher margins in the long term. Most importantly, quick delivery simplifies the customer decision-making process as it is significantly easier to press that buy button, knowing the package will arrive by the next morning.
Increased automation – As Amazon rolls out AI across its organization, the company will be able to reduce costs in many areas. For instance, the increased use of robots in warehouses will reduce the number of employee work hours needed to process a package and improve the utilization of warehouse space. Specialized trucks, better sorting equipment, and software will make delivery drivers more productive. In 2023, Amazon spent $90.6B on fulfillment, an increase of 166% from 2018. However, 3P sales grew by 228%, while group operating profits increased by 197%. We are starting to see how automation and scale are enabling higher operating profits.
New services – Amazon has a proven track record of broadening the scope of its offerings. Thus, it is highly probable the company will find new innovative ways to service its merchants and customers. I believe Amazon will begin offering more significant financial services products. Mercado Libre shows how using an e-commerce platform to originate loans can drive meaningful growth and be very profitable. Offering loans to customers and merchants essentially finances both sides of the transaction whilst simultaneously delivering the product, taking a cut from each involved party. With the scale at which Amazon operates, the earnings potential of a similar two-sided financing model is astronomical.
2. Advertising
When a customer searches for an item on amazon.com, usually, the first few selections are sponsored products. Merchants are willing to pay a high price for the top place because these are extremely high-intent searches.
When a person types in “cheese” on Google, they are not necessarily thinking of buying cheese, they might be looking for a wine to partner with cheese or curious about the history of cheese. However, a person searching for cheese on Amazon has a clear intent to purchase cheese. Understandably, an artisanal food company would be willing to pay significantly more to be displayed prominently on Amazon than somewhere else. How much a client pays for an advertisement is directly correlated with the expected revenue generated by said advertisement.
Since Amazon started disclosing Advertising revenues in 2019, they have grown by 324%, a CAGR of 35.5%, reaching $53.6B!
I believe a lot of investors and analysts are sleeping on this exploding, highly profitable segment. I find it likely that it will grow significantly, reaching $100B sometime around 2027-2028, becoming a huge cash cow for the company.
The key factors driving the continued explosion in advertising income are:
Growing E-commerce penetrations – Similar to the 3P business, the advertising segment will directly benefit from more people shopping online. The more people shop online, the more advertisers are willing to pay to be prominently displayed. As purchase frequency increases, advertising on Amazon becomes a necessity for all brands that wish to stay relevant in our increasingly digital age.
Geographic expansion – As Amazon expands, it attracts more users to its platform, more users mean more eyeballs to sell to advertisers. More customers mean more search queries, more page views, and more interactions with ads, directly leading to more revenue generated by merchants from ads, enabling them to spend more on advertising. It’s a self-reinforcing growth loop where each additional customer improves the value proposition for the advertiser, and each additional advertiser competing for the customer improves the product offered to the customer.
Improved targeting – As I mentioned before, the expected revenue generated by an ad determines the price. Placing the right ads in front of the right people is a difficult task that requires meticulous data analysis. Amazon has hundreds of millions of customers whose data Amazon can feed its AI algorithms to improve the quality of its ads. Improved targeting will support continued growth in Amazon’s advertising income.
Prime Video – Often dismissed as just a loyalty perk or a way for Amazon to sell more shoes, Prime Video is on a path to become not only a media juggernaut but a huge revenue driver for the company. Amazon doesn’t disclose subscriber figures, just that they are over 200 million globally. Prime Video started showing ads in between shows in 2023 in the US and a few other countries. As cord-cutting continues globally and legacy media struggle to compete in the streaming age, I am confident that Prime Video viewership will increase, leading to more advertising revenue.
Sports Expansion – One of the primary contributors to the increased appeal of Prime Video to advertisers is Amazon’s entry into sports. Just past summer, Amazon signed a $1.8B a year deal to air 66 NBA games. Sports viewers are very loyal, create a recurring viewership cohort, and often have higher disposable incomes than the average population. Businesses are keen to advertise on sports, and Amazon will use this to build strong relationships with brands and increase their usage of other Amazon advertising spots.
3. Amazon Web Services
Amazon Web Services (AWS) is a provider of cloud computing services to tiny and gigantic businesses alike. Large upfront costs to build private servers are no longer necessary, simply sign up to AWS and pay per usage today.
AWS revolutionized the world by enabling businesses to quickly scale as their computing requirements increase!
AWS empowered young cash-strapped startups to spend more funds on R&D and operations rather than server maintenance.
AWS aggregates the computing demand and, through economies of scale, achieves superior unit economics. Chip providers for AWS servers, such as Intel and AMD, offer huge discounts because of the high order volumes. Additionally, by building huge server farms, AWS uses less land per server. Moreover, various other key suppliers offer their services for significantly better prices than it would cost a company to have a few servers in the basements of their office.
As the scale grows, it becomes cheaper and cheaper to store and process data, increasing the threshold at which it would make financial sense for a company to operate its own servers. For instance, in some cases and depending on the nature of the business, if 10 years ago a company could achieve a positive return on investment in its own servers after 5 years, the scale and efficiency of AWS may now push that threshold to 7 or more years. In the next decades, it is expected that most organizations for whom managing and maintaining servers are not their core competency will move to the cloud.
Precedence Research estimates that the global Cloud infrastructure market will grow with a 12.3% CAGR till 2034, reaching $838B. AWS, as the key player in the industry, is projected to capture a significant share of global growth. Key trends driving this expansion include the continued shift from on-premises computing to the cloud and the explosion of AI demand.
Apart from just providing the infrastructure, AWS is increasingly offering new Cloud computing services that run on that infrastructure. A comprehensive suite of application services that support the building, deploying, and management of modern applications. Its cybersecurity products help with identity and compliance. Additionally, their analytics tools deliver important insights alongside various database management services and lots of tools for software developers.
Grand View Research estimates that the US Cloud computing market will reach $771B by 2030, whilst the global market will reach $2.3T.
AWS market leadership and continued huge reinvestment enable the company to continue growing and capturing a large portion of this fast-growing pie!
4. Transforming Costs Into Revenue
One of Amazon’s core business principles is transforming its costs into revenue. All businesses incur large operational expenses.
What if instead of looking at them as an ongoing operational expense, we look at them as an investment into a new revenue source?
Amazon began as an online bookstore that gradually expanded its offerings. Understandably, running a large e-commerce website was very expensive. What if, instead of Amazon shouldering all, the costs can be shared? So, in 2000, they launched Amazon Marketplace, which eventually became a highly profitable business discussed in the 3P Sales section.
Amazon transformed the costs of managing an E-commerce platform into a new revenue source!
Storing and delivering packages takes time and is very expensive. So, in 2006, Fulfillment by Amazon (FBA) was born. Merchants can now store packages at Amazon warehouses and have them delivered using the Amazon logistics network. Furthermore, as Amazon was paying billions of dollars to FedEx, UPS, DHL, and others, the company decided to create its own logistics network. Amazon’s customers and merchants essentially funded the creation of this new business.
Between 2019 and 2023, Amazon spent over $130B on non-AWS capital expenditures, more than doubling their warehouse square footage to a mind-boggling 651 million sqft!
To capitalize on this investment, Amazon is opening its warehouse and logistics network to other platforms through the Amazon Multi-Channel Fulfilment program. Amazon MCF allows merchants to use FBA service even when not selling on Amazon’s platform, directly competing with FedEx, UPS, and DHL.
Amazon used its logistics expenses to create completely new businesses!
Let’s not forget about AWS. Understandably, running such a massive company requires a lot of servers. AWS was born out of the same idea as the 3P and logistics businesses. What if we could turn our costs of running the servers into an investment in a new business? So that is what Amazon did! They started buying more servers and allowed other companies to use the computing power of these servers.
One advantage often overlooked is that Amazon itself uses AWS at cost!
Amazon itself is likely the largest customer of AWS, and obviously, because they own the service, they use it for the price it costs them to provide it. AWS’s operating margin is around 35%, meaning that Amazon effectively saves at least 35% on its server costs. In essence, AWS customers subsidize the computing costs of Amazon’s other divisions.
AWS delivers a huge competitive advantage to Amazon!
I have no doubt that Andy Jassy, the CEO of Amazon, is currently sitting in his Seattle office looking at a particular expense line item in Amazon’s income statement and actively thinking about how to transform that into a new business.
5. Valuation
In the introduction, I mentioned that Amazon has largely always traded at an above-average multiple. This has attracted a lot of ire and anger from value investors who are incapable of proper analysis and just scream “Large P/E bad”.
In the above screenshotted Koyfin graph, we see the last twelve-month (LTM) Price-to-earnings ratio. In the last 8 years, the lowest it has traded at is 38. Most of the time the P/E was above 100 and, at certain times even above 300. For instance, the historical average S&P 500 index P/E is 16.
What Amazon bears and value investors underestimated was Amazon’s ability to build one of the largest and most efficient businesses in the world. Bears thought that Amazon’s business model of low prices, large selection, and fast delivery was fundamentally flawed and would prevent the company from achieving large margins.
I believe they are incorrect, and Amazon is set to significantly increase its margins in the next 5 to 10 years!
From 2016 to 2023, the company spent $267.6B on Capex, Wall Street analysts estimate that in 2024, 2025, and 2026 Amazon will spend another $240B on Capex. We are about to witness the significant returns of these investments.
In my Valuation model, I estimated the potential growth of the 4 key Amazon segments AWS, 3P, 1P, and Advertising. I used the AWS-disclosed operating profit and the total group operating profit, based on my understanding of the segments to reverse engineer the current operating margin of each segment.
I estimate that AWS can easily grow with an 18% CAGR till 2030 because of the factors mentioned in the AWS section, such as the growth of AI. Massive scale, focus on efficiency, and use of internally designed chips will enable AWS to achieve 40% operating margins. I estimate that in 2030, AWS will have sales of $289B, generating $115.6B in operating profits for Amazon.
The 3P services segment will keep growing thanks to rising e-commerce penetrations and Amazon’s continued global expansion. I find it likely that the CAGR will reach at least 12%. Additionally, increased automation and repeat purchases from highly loyal customers will enable the operating margin to more than double and reach 17%. By 2030 revenues could reach $309.6B, with $52.6B in operating profit.
It is widely believed that Amazon has never made money selling products directly to customers (1P) because of its focus on low prices and fast delivery. I estimate that should change in the next few years as huge scale, increased automation, and lower marketing spending enable higher margins. However, I forecast the growth to be slower than other segments at 5%. Revenues could reach $326.3B, with a small operating profit of $3.3B.
The advertising segment is the sleeping beauty. As mentioned in the advertising section, this segment is poised to explode thanks to the growth of the Amazon marketplace and Prime Video starting to roll out advertising to its hundreds of millions of viewers. I find a 20% CAGR quite likely leading to $168B in sales in 2030. Furthermore, as a large part of the costs related to the advertising segment are covered by other segments, advertising profits are likely to explode, delivering $92.4B to the bottom line.
I put all remaining businesses under other. This segment includes Whole Foods, Subscriptions, and all other bets. While Whole Foods is likely profitable, the losses in the remaining segments are noteworthy. As it is hard to estimate, I decided to assume that this segment will not have any profits or losses. This means that, in my view, an Amazon investor gets all these segments “for free”. Higher losses might lead to lower profits, but a new highly profitable segment might drive profits up even more. I find the latter option more probable.
The sum of all these assumptions is revenue of $1.22T and operating income of $264B!
If we assume that taxes and other expenses are 30% of operating income, net income could reach $185B!
A P/E of 35 in 2030 would result in a market cap of $6.47T and a share price of $561.4, a 150.6% upside from today.
6. Conclusion
Amazon is a technology juggernaut with a moat the size of Alaska!
It has built an extremely high-quality business that is in a great position to benefit from various changing global trends. Rising popularity of e-commerce in its core markets of North America and Western Europe means more people are spending more money on Amazon. More customers means Amazon will remain the dominant platform for merchants to sell on, enabling Amazon to sell them new services. Furthermore, a higher number of customers will enable Amazon to show them more, better-targeted ads, growing advertising income.
In all Amazon businesses, massive scale allows operational synergies to come into effect, significantly reducing costs!
Amazon can deliver a package faster and cheaper than FedEx because they deliver much more packages. By combining the scale economies of all of its businesses, their advantage multiplies.
AWS is at the cornerstone of digitizing global economies, benefiting from the rise of AI.
Amazon Prime membership, its logistics network, and merchant lock-in are huge moats that guarantee a steady stream of customers. These customers are likely to continue increasing their order frequency.
The valuation model shows that despite higher-than-average P/E, Amazon is likely to significantly reward its investors in the next few years!
While some of the individual assumptions in the valuation model might end up being widely inaccurate, I find it very likely that the overall picture is correct and Amazon will be a $6.5T company by 2030!
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