Amazon: One of the Most Underrated Megacap Stocks (NASDAQ:AMZN)

Amazon (Nasdaq: AMZN) reported strong 1Q24 results, and the company’s profitability was the main star as it exceeded the high end of its guidance and came in above the material consensus.

AWS trends are also positive, as noted by management They see optimizations becoming a thing of the past, as customers begin to look to deploy more workloads in the cloud and sign longer and larger deals.

The company is optimistic about the long-term opportunity for AWS in cloud and generative AI, and intends to invest more in capital expenditures in this area compared to 2023.

I like that we are seeing significant improvement in margins across the retail sector, following the implementation of the new regional fulfillment network and the management team sees further opportunities to reduce cost to provide more service.

I have written Widely spread around Amazon on Searching for Alpha, which can be found here. I remain bullish on the company and believe Amazon is perhaps one of the most underrated mega-cap stocks right now, as I’ll explain below, with strong top-line growth accompanied by a strong margin and profitability trajectory.

Review Q1’24

Amazon’s revenue of $143 billion rose 13% from the prior year, in line with consensus and at the high end of its guidance.

Operating income of $15.3 billion, or 10.6% margin, came in 37% above expectations and above the high end of guidance.

Operating income increased 219% on a constant currency basis, or more than $10.5 billion from the prior year.

This was largely due to North America Retail segment operating income of $5 billion, or 5.8%, growth of more than $4 billion in the quarter, and AWS segment operating income growth of $4.3 billion from the prior quarter.

As a result, GAAP EPS came in at $0.98, beating consensus by 17%.

By sector:

In the retail sector, North American retail revenue was $86 billion, up 12% on a constant currency basis and 2% higher than expected.

North America retail segment operating income increased 454% on a constant currency basis to approximately $5 billion. This represents an increase of $4.1 billion in operating income for the North American retail sector compared to $898 million in the previous year.

International revenue was $32 billion, up 11% on a constant currency basis and 4% below expectations.

International segment operating income pivoted into positive territory, generating $903 million in operating income for the quarter, an increase of approximately $2.2 billion from the previous year.

Within AWS, AWS has seen demand accelerate and margins expand.

AWS revenue rose 17% to $25 billion in the quarter, 2% higher than expected.

AWS’s operating margins were 37.6%, above the consensus of 32.5%. On an absolute basis, operating income increased 83% on a constant currency basis from the prior year to $9.4 billion, an increase of $4.3 billion from the prior year.

guidance

For Q2 2024, revenue guidance came in between $144 billion and $149 billion, 2.5% below average at the midpoint and assuming 60 basis points of unfavorable impact from foreign exchange headwinds.

Operating income guidance for the second quarter of 2024 was between $10 billion and $14 billion, in line with expectations.

In 2023, Amazon spent $48 billion on capital expenditures.

With the strong demand AWS is seeing from both generative and non-generative AI workloads, along with customers signing longer and larger deals with AWS, Amazon continues to see a very urgent need to invest in this huge opportunity moving forward in both the cloud and AI space.

As a result, Amazon will meaningfully increase its capital expenditures in 2024 compared to 2023. This increase is largely driven by higher capital expenditures on infrastructure to support AWS growth.

I believe at least 60% of Amazon’s capital spending will likely go to AWS, which translates to accelerating demand for AWS and generative AI.

In my opinion, Amazon has become a very competent organization in managing profitability and growth.

With the progress it has made in operating income and free cash flow over the past 18 months or so, Amazon is now at a point where it can focus on profitability and invest in growth at the same time.

Another important point to note is that with strong free cash flow and operating income generation, while the priority is investing in long-term growth opportunities, Amazon now has the ability and intention to repay its debt that it accumulated during its founding. Time of negative free cash flow.

As such, with free cash flow growing to the upside, Amazon has the ability to pay off at least $25 billion of its long-term debt this year.

For reference, it currently has $57 billion in long-term debt, meaning we will see a significant reduction in debt over the course of the year.

AWS acceleration

AWS has now noted that companies have largely completed most of their cost optimization efforts and are now turning to newer initiatives.

This is of course a positive as AWS has seen growth slow due to the focus on cost optimization, especially in 2022, and with companies once again ramping up their efforts to move from on-premises infrastructure to the cloud, this bodes well for AWS.

Furthermore, AWS is also seeing strong interest in leveraging generative AI in its business.

I think it’s important to note that AWS has already achieved a multi-billion dollar revenue run rate on the AI ​​front already.

I think this just speaks to the advantage that AWS has in being the leader and the largest cloud provider.

Within generative AI, Amazon is looking to position itself across the three layers of the generative AI stack.

At the bottom of the generative AI stack where models are built, Amazon offers Nvidia Compute (NVDA) for developers and companies to build their models.

Furthermore, Amazon has its own custom silicon, which is in high demand due to the price-performance benefits compared to available alternatives.

Amazon’s Trainium 2 chip, its latest generation of chips for training AI models, will be available in larger quantities in the second half of 2024 and early 2025.

Finally, within the bottom tier, Amazon has SageMaker, Amazon’s end-to-end managed service for developers to prepare their data for AI and train models faster.

According to Amazon, with SageMaker, Perplexity AI is now able to train its models 40% faster, while NatWest has reduced its time to value for AI with SageMaker from 18 months to less than seven months.

Encouragingly, Amazon is also seeing a growing number of model builders standardizing on SageMaker.

At the second layer of the generative AI stack where generative AI applications are built from existing large language models (“LLMs”), Amazon Bedrock has the largest selection of LLMs available.

Amazon shared that Bedrock already has tens of thousands of customers such as Adidas, Pfizer, and Toyota, among many others.

Amazon also shared that Bedrock has launched a series of new features and added new models, including Anthropic’s Claude 3 models, Meta’s Llama 3 models, Mistral models, the latest Cohere models, and the all-new Amazon Titan models.

Finally, at the top of the spectrum, where generative AI applications are being built, Amazon announced the general availability of Amazon Q.

Amazon Q is an AI-powered productivity assistant that helps in software development.

This will help developers become more productive, but will also test code, correct code conflicts, and convert code from one form to another. Developers using Q now save months when moving from older versions of Java to newer, more secure versions.

There are many features within Q such as applications and agents that you need to know more about.

But we see many companies using Q, such as Datadog, National Australia Bank, Tata Consultancy Services, and others.

AWS remains well positioned for the long term, as despite a revenue run rate of over $100 billion with AWS, more than 85% of global IT spending remains local.

Furthermore, we will see generative AI added to the AWS opportunity, and the next decade will likely be a huge opportunity for AWS to leverage in this area.

This is likely why more capital expenditures will need to be spent on this front for Amazon to continue to be a leading player not only in the cloud space, but also in generative AI.

However, over time, I expect to see this capital spending reward Amazon in the form of operating income and free cash flow growth.

selling by pieces

We’re seeing Everyday Essentials create more consistent and regular purchases for the retail sector.

This further helps Amazon source more non-optional items and at the same time increases repeat purchases.

Another positive in retail is faster delivery speeds. There was a 65% increase in items delivered same day or next day in the US in Q4, and 60% of Prime member orders now arrive either same day or next day, up 50% from Q3 2013. .

Faster shipping speeds help improve conversion rates, which helps achieve consistent growth in the future.

As a result of the focus on reducing the cost of service, this has helped the retail sector contribute effectively to Amazon’s overall profitability.

As regionalization efforts have reaped benefits over the past year and reduced cost to serve, Amazon continues to find areas within its fulfillment network where it can further optimize costs.

In the international retail sector, Europe appears to be weaker compared to the United States. This has already been factored into the guidance, but the company continues to closely monitor consumer spending and macro trends.

evaluation

Amazon’s 5-year financial outlook was revised upward due to strong profitability in the quarter.

Amazon’s intrinsic value reaches $199, as a result of improved profitability and margin profile. This assumes a 30x multiple for terminal 2028 and a discount rate of 12%.

This means I’d enter Amazon at $160 or better, for a more attractive risk-reward profile.

My 1-year and 3-year price targets also rise by $202 and $291, respectively. Both mean 30 x 2025 and 2027 PE multiples respectively.

Conclusion

This was a strong set of results from Amazon, which the market may not have expected given its strong profitability.

AWS is seeing an acceleration in growth as most companies have completed their cost optimization efforts and are now turning to newer initiatives.

Furthermore, AWS is also seeing strong interest in leveraging generative AI in its business.

Retail margin improvement was also the star of the quarter, with further margin improvements expected to come.

Overall, Amazon’s opportunity remains significant and with the company aggressively shifting toward a profitable growth model, the company is now also able to invest in its future growth while generating significant cash flows.

Amazon is probably one of the most underrated mega cap stocks right now, as I think the market is underestimating its level of profitability and cash flow generation.