*this was a post written prior to the most recent quarterly earnings realease and i am reposting here. A follow up post will follow.

Key in our investing journey is the search for uniquely positioned companies that we expect to grow well into the future providing attractive shareholder returns. Common characteristics of these companies include a “monopoly” market position, strong pricing power, ideally organic growth, multiple operating levers, capital-light businesses, and leadership that can allocate capital efficiently.

Today we are looking into Amazon (Ticker: AMZN) and argue that as the market hit an all-time high AMZN is gearing towards its all-time high as the switch to profitability is turned on.

AMZN is a multinational technology and e-commerce company that a lot of investors believe is too big to continue growing. Looking at their investor filings we can see that AMZN splits their business segments into online stores, physical stores, third party sellers, subscription services, advertising services, AWS and other. The highly profitable segments are third-party sellers, subscription services, advertising services and AWS. Based on their Q3 23 results all of these segments grew from 12%-26%. We argue that these businesses will drive AMZN to stellar fundamentals as we see signs of a greater focus on profitability which will lead to substantial free cash flow increases and hence will lead to AMZN doubling its market cap.

Firstly let us examine quickly the checklist for the common characteristics we are looking for in the business we want to invest in.

Monopoly - AMZN is not a legal monopoly however in the markets it operates in it has a dominant position and unique characteristics that will enable the firm to continue benefiting from substantial market share. For online stores and third-party sellers, AMZN is the place to be. AMZN has the leading position in U.S. e-commerce at 38% with the second, Walmart at 6%. Additionally, AMZN holds leading positions in multiple markets expected to grow at attractive rates over the coming years. Why is this position important? The larger the market share the larger the need for sellers to actually be on this platform, hence the larger the moat. AMZN created a marketplace to attract the sellers and added valuable services to facilitate these sales.

Pricing power - AMZN offers such a tremendous value at low prices that has in our opinion extremely high pricing power that is not fully utilized by the company for now. For example, prime membership offers outstanding value as it includes unlimited one-day delivery, same-day deliveries, prime exclusive discounts, prime video with a deep entertainment collection, prime music with over 100 million songs and prime reading where you can read for free from 1000s of books. Where is the evidence of pricing power? The initial Amazon Prime price was 79 USD during 2005 and the latest prices are 139 USD, a 76% increase. At the same time, Amazon Prime users climbed to more than 200m in over 25 countries. Another one of the most recent moves from AMZN that we believe will test the “pricing power” is the move to add advertisements on Prime Video. Customers that want to benefit from add-free movies will have to pay extra. This is not a direct pricing power move as customers might decide not to pay more for the add-free tier however, indirectly AMZN will be extracting additional value from the same customers in the form of advertising revenues. As long as Amazon Prime customers do not fall we consider this another pricing power lever.

Organic growth - we will keep it simple here. Amazon's revenue increased historically albeit AMZN is also known for strategic acquisitions. AMZN’s revenue grew substantially over the years.

We expect subscription services, third-party sellers, AWS and advertising services to continue to grow. As of Q3 23 year-on-year net sales growth for these sections were: third-party sellers 20%, subscription services 14%, advertising services 26% and AWS 12%.

Operating levers - we think AMZN is at a turning point as leadership is now slowly switching various profitability levers on and we are now moving past the capacity-building period. Clear signs that AMZN is moving towards profitability are signs like adding advertisements on Prime Video and offering Prime members ad-free tiers at an additional cost and the fact that full-time employees year on year saw a decline since Q4 22..) In addition, capex spending is slowing down. In Q3 23 results we can see property and equipment purchases to be lower by c.USD 9B. Since 2020 AMZN focused on building capacity which led to higher capex spending. In 2021 they spent USD 55B and in 2022 USD 59B. Now the focus turns from capacity increase to profitability increase. We think the magnitude of these shifts is underestimated by the market. The trailing 12 months free cash flow as of Q3 23 was an inflow of USD 21.4B compared to a Q3 22 outflow of USD 19.7B. This change will continue and the positive increase will be even bigger as management' profitability levers flow through the business.

Capital light - AMZN is not a capital-light business. However, the profitable segments that we referred to above (third-party sellers, subscription services, advertising services and AWS) are more capital-light than the rest of the business. AMZN's capital-heavy businesses added capital-light add-ons that are driving the profitability story of AMZN. In addition, given the 2021 and 2022 capex spent we do think, as argued above, that the next few years will be capital-light years.

Good capital allocators - ultimately leadership has proven over and over again that they are focused on customers and long-term value creation for shareholders. AMZN started as an online bookstore in 1994 and evolved in being the strongest e-commerce attracting customers and suppliers from all over the world, the leader in the cloud market and a strong streaming provider. There are no signs of AMZN slowing down in any of these areas and we expect over the decades to come their position to continue to strengthen.

Looking at the return on equity or return on invested capital metrics (the more traditional metrics) AMZN does not look attractive.

However, look underneath these numbers and leadership lays out their methods very clearly. We provide some quotes from their 2022 Annual Report.

“We believe that a fundamental measure of our success will be the shareholder value we create over the long term. This value will be a direct result of our ability to extend and solidify our current market leadership position. The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.”

“When we look at new investment opportunities, we ask ourselves a few questions:

If we like the answers to those questions, then we’ll invest. This process has led to some expansions that seem straightforward and others that some folks might not have initially guessed.”

Their focus on longer-term shareholder value and how they constantly asses investments is key. We do think that AMZN will continue to lead and unlock shareholder value over the years. Now moving on to valuation.

Many investors avoid AMZN due to its valuation. Traditional metrics such as the Price to Earnings ratio are looked at to determine the relative valuation of a company. Based on these metrics and a forward P/E ratio of 45 times, AMZN seems overvalued.

Instead, we look at free cash flow and how free cash flow will evolve.

Let’s take a look at current free cash flow and try to understand how this will evolve. The method we will use is operating cashflows/profit less capex. Given that operating profits include non cash movements and operating cashflows do not these are used as a proxy.

Below is how capex moved over the last 6 years.

The average of the last 6 years is USD 39.8B. Given the last 4 years have been exceptional in increasing AMZN’s capacity let’s assume that capex will be around USD 30B every year as leadership focused on profitability.

AWS - AMZN provides a lot of the information we need in their filings. AWS has an operating margin of 25.8% for the last twelve months as of Q3 23. Net sales were at USD 23.1B for Q3 23 and for the last 12 months as at Q3 23 USD 87.9B growing at 15% year on year. AWS sales will continue to grow as the cloud market is also expected to grow at c.16% per annum to 2029. Assuming for the next 5 years sales will continue to grow by 15% year on year and the operating margin will remain steady there is a total operating profit of USD 45.6B.

Advertising services - AMZN advertising margins should be as good if not better than any other advertising company. This is because AMZN has its own platform that gathers data for consumers directly and does not depend on someone else's platform or device. Assuming this to be true and looking at Meta Platforms Inc's (Ticker: META) operating margins we assume AMZN advertising services operating margins to be the same as META at the end of 2022 c.25%. AMZN's advertising services net sales were at USD 12.1B for Q3 23 and grew at 26% year on year; annualising sales at Q3 23 levels leads to USD 48.4B. Since Q2 22, the slowest ad services growth was 21% year on year. Over the next 5 years, we believe AMZN will easily grow advertising services sales by 25%. The reason is that advertising services growth has accelerated in Q3 23 growing at 25% and as we mentioned earlier AMZN will be adding advertising on Prime Video. Analysts at Morgan Stanley estimate in the first 3 years AMZN could see revenues increase by USD 15B on a cumulative basis only from Prime Video advertisements. This is 34% more advertising compared to the last 12 months advertising net sales of USD 43.8B. Growing current sales at 25% for the next 5 years and taking an operating profit margin of 25% leads to an operating profit of USD 33.4B.

Subscription and third-party service sellers - lastly we make a simplified assumption that at the end of the next 5 years, AMZN will have a 15% third-party seller services operating profit margin and 0% on subscriptions. 0% in subscriptions is a way to say that subscriptions are bundled with other segments to cover potential operating losses. Their party sellers' services net sales were USD 34.3B in Q3 23 (USD 132.7B over the last 12 months)and grew at 18% year on year. The slowest quarterly growth rate in the last five quarters was 13% and was back in Q2 22 hence we assume over the next 5 years AMZN will grow third-party sellers services by 10%. Taking into account a 15% operating profit margin third-party sellers operating profit at year 5 will be USD 33.0B.

Hence at the end of 5 years, AMZN will have a total free cash flow of USD 82B (USD 45.6B from AWS, USD 33.4B from advertising serving, USD 33.0B from third-party sellers, less capex of USD 30B). This might seem way far from the USD 21B free cash flow for the last 12 months as of Q3 23 however, AMZN has both significant business tailwinds and the operational levers to accomplish this.

Based on the free cashflow estimation at year 5 and the below free cashflow to price ranges between 2% and 3.5% AMZN will return an annualised return between 20.1% and 7.4%.

AMZN will generate some impressive free cashflows over the coming years. We think this is a fantastic opportunity to invest in a leader across many markets at current prices. AMZN is entering a period where the operational profitability switches will be turned on. There are already signs that leadership is focused on these switches including lowering capex, reducing workforce and adding ads on Prime Video. This is just the start of the profitability path and AMZN's free cashflow will increase significantly over the next 5 years and beyond. Customers will continue to want fast deliveries and cheap prices, suppliers will want to sell on AMZN’s marketplace capitalizing on AMZN's vast reach and services and firms will continue to onboard and increase usage of AWS. AMZN is a strong buy today.