Amazon is a compelling investment opportunity as the market continues to underestimate the secular shift toward e-commerce, the long-term opportunity for public cloud, and the growing importance of advertising within Amazon’s online presence.
The company’s wide economic moat is driven by powerful network effects, cost advantages, high customer switching costs, and intangible assets, which we do not see being threatened.
Amazon grew 37.6% in 2020 to $386 billion in total revenue. The company maintains a solid balance sheet, with year-end 2020 cash of $84.4 billion and $31.8 billion in debt, which represents 0.7 times gross leverage on 2020 EBITDA.
Outside of financial debt, $52.6 billion in long-term operating lease liabilities resides on the balance sheet as well. The long-term debt has maturities of $1.2 billion in 2021, $1.6 billion in 2022, and $2.3 billion in 2023. Because we project more than $26 billion in free cash flow in 2021 and material growth afterward, we do not foresee debt maturities as problematic.
Amazon is the e-commerce leader in the U.S. with 42% share, representing about $374 billion in gross merchandise value. We see its e-commerce market share expanding by 200 basis points annually over the next several years, culminating with a share of more than 50% by 2025.
Amazon has a marketplace where third parties can sell items, which significantly expands the overall selection available to consumers on Amazon.com. With $80.4 billion in 2020 revenue, or 21% of the total, third-party seller services is Amazon’s second-largest segment by revenue and grew 50% last year. This segment experienced the same pandemic-related spike in growth as the online stores segment. We model a 20% compound annual growth rate for segment revenue over the next five years, as Amazon has demonstrated its power as the dominant demand aggregator in the U.S. In third-party seller transactions, Amazon is not the seller of record. Rather than revenue being generated from the sales of an item, Amazon collects a commission on the sale, along with any related fulfilment and shipping fees.
Prime is the secret sauce in subscription services. Amazon’s subscription services include annual and monthly fees from Amazon Prime memberships along with digital video, audiobook, digital music, e-book, and other subscription services. Subscriptions are the company’s fourth-largest segment, with $25.2 billion in 2020 revenue, or 6.5% of total revenue, and grew 31% in 2020. We model an 18% CAGR for subscription revenue over the next five years. Like the company’s broader e-commerce businesses, we view this as a long-tail business that will continue to outgrow the company’s overall growth rate over the next decade.
Amazon’s physical stores include sales from traditional brick-and-mortar stores, including Whole Foods, Amazon Books, Amazon 4-Star, Amazon Fresh, Amazon Go, Amazon Go Grocery, and Amazon Pop Up. Physical stores are the company’s smallest segment at $16.2 billion in 2020 revenue, or 4.2% of total revenue, and contracted 6% in 2020. The pandemic had a negative impact on physical stores, as year-over-year comparable sales declined and even today some locations remain closed as a result of local conditions. We expect this to improve throughout 2021 as the US in particular moves to open up as vaccine distribution proliferates. We model a 4% CAGR for physical store revenue over the next five years.
- Amazon Web Services, or AWS.
AWS has driven profitability for the entire company; although it represented 11.8% of total revenue in 2020, it generated 59% of total operating profit dollars for Amazon. We model a 22% CAGR for AWS revenue and expect the segment to remain a key growth driver for the company over the longer term.
Azure is widely perceived as the leader in public cloud—a view we share. We see Microsoft Azure as the only other legitimate competitor, with Google Compute Engine a distant third. We expect this market to eventually surpass $1 trillion as enterprise workloads increasingly move to the cloud. With AWS generating $45 billion in revenue in 2020 and Microsoft generating about $25 billion in revenue for the 12 months ended in December 2020, we believe the public adoption remains in its early stages.
The advertising business is a hidden gem. We estimate that Amazon’s advertising business was at least $15 billion in 2020 and would be the third-largest internet advertising model in the U.S. if it were a stand-alone company. Overall, the other segment generated $21.5 billion in revenue in 2020, which was up 52% over 2019 and represented just 5.6% of total revenue. The company has not provided disclosures, so we estimate that approximately 75-80% of the other segment is advertising, which is growing rapidly and is likely the business with the highest operating margins in Amazon’s portfolio, in the range of 35-40%.
We believe advertising dollars flow to where the eyeballs are and where information is known about the online user, which fits in very well with Amazon’s strengths. We therefore expect advertising to grow rapidly over the next several years and continue to boost the company’s overall profitability.
The uncertainty for Amazon is high, and despite being an e-commerce leader, the company faces a variety of risks.
Amazon must protect its leading online retail position, which can be challenging as consumer preferences change, especially after the pandemic, as shoppers may revert to prior behaviours and traditional retailers bolster their online presence. Maintaining an e-commerce edge has pushed the company to invest in non-traditional areas, such as producing content for its Prime Video subscriptions and building out its own transportation network.
The company must also maintain an attractive value proposition for its third-party sellers. Some of these investment areas have raised investor questions in the past, and we expect management to continue to invest according to its strategy, despite periodic margin pressure from increased spending.
The company must continue to invest in new offerings. AWS, transportation, and physical stores are three notable areas of investment. These decisions require capital allocation and management focus and may play out over a period of years rather than quarters.
