- Amazon shares have made stupendous triple-digit gains in 2015.
- The gains were fueled by the fact that the company has reported profits for two consecutive quarters at a time when nobody was expecting it.
- How is Amazon likely to perform in 2016?
Amazon (NASDAQ:AMZN) has enjoyed a bumper year by any yardstick, with Amazon stock making outsized gains of 118% YTD vs. 1% gain for the S&P 500 over the period. And now the positive ink has started flowing predicting that Amazon can once again perform its magic in 2016.Specifically, Barclay’s Paul Vogel has given Amazon a massive $150 price hike to $850 (26% upside to current price).
‘‘We understand they are widely owned at this point, most of the Street is bullish (sell-side,
long-only and hedge funds) and expectations continue to move higher. That being said, we expect fundamentals to remain strong into 2016, with potential upside for many of the names relative to published estimates. Given growth rates and trends, we don't see valuation as that stretched for any of the big three."
Amazon stock is currently trading at just 2.4% below their Nov.3 all-time high of $682.77. But how likely is it that Amazon investors will enjoy another rip-roaring year in 2016?
Amazon's Profitability in Focus
The biggest reason why Amazon has made such impressive gains in 2015 can be summed up in one word: profits. During its third quarter, Amazon, for the second quarter running, made investors happy by managing to put up some black ink. Amazon reported revenue of $24.91 billion, good for a healthy 23% Y/Y gain. It was, however, Amazon’s bottom line that got the investing world excited after the online giant reported net profit of $79 million, or EPS of 17 cents at a time when analysts had projected for a loss of 13 cents.
So what has been fueling the resurgence in Amazon’s profitability? Lower capex spending and AWS are the two key pillars that are responsible for Amazon’s recent spate of profits. Amazon has in the past been reinvesting all its profits in the business mainly to expand its delivery channels of warehouses and fulfilment centers. But lately, Amazon’s capex spending has slowed down considerably. Amazon spent a total of $4.9 billion in 2014 on capital expenditure. During the first 3 quarters of the current year, the company has spent just $3.3 billion in capital expenditure, or $4.4 billion annualized, representing a 10.2% decrease.
AWS Key To Amazon's Profitability
But what has caught the fancy of the investing world is the huge role Amazon’s cloud, AWS, is now playing in contributing to the bottom line. AWS revenue jumped 78% Y/Y during the last quarter to $2.1 billion with an operating income for about $500 million, or a whole 52% of Amazon’s operating income despite contributing just 8% to the top line.
Although Amazon continues to invest heavily on cloud infrastructure (about 10% of capex goes to cloud infrastructure) the rapid growth of the cloud has allowed operating leverage to kick in resulting in rapidly improving margins. AWS’s operating margin during the third quarter of 2014 clocked in at just 5%; one year later it had risen to 25%. With AWS sporting gross margin north of 70%, there is still ample room for operating margins to improve, which should reflect on Amazon’s bottom line.
Amazon Drone Project
Investors have expressed fear that Amazon’s drone project could mean a huge bump in capex and eat into the company’s thin profits. But this is not likely to happen. Tasha Keeney, an ARK Invest analyst, told Business Insider in April that Amazon is likely to spend about $100 million to buy the tens of thousands of delivery drones it would require, and another $300 million or so to deploy the devices to deliver ~400 million orders every year. The analysts told BI that deploying drones in delivery would lower delivery costs from the current $7.99 for one-hour delivery costs to as low as $1.
Amazon is currently testing its drones, and has made significant headway with the FAA which allowed its unmanned drones to fly at altitudes of 400 feet and speeds of 160 miles per hour. Assuming Amazon gets clearance to deploy its drones and spends the $100 million capex in one fell swoop, the effect would be that the company’s profits for an entire quarter would likely be wiped out. But quick math tells you that Amazon would very quickly recoup its investment.
Assuming 10% of the company’s deliveries in the first year are handled by drones (~40 million deliveries), Amazon would realize cost savings of $280 million in shipping costs during the first year alone, almost equal to what the company would spend to deploy the drones. With the proportion of deliveries handled by drones growing incrementally every year, the company would realize huge cost savings as the years roll on, which would trickle right to the bottom line.
So how likely is it that Amazon investors will enjoy another year of triple-digit gains? Not very likely. The biggest reason why Amazon has made stupendous gains this year is because nobody expected the company to report any profits, yet it did. But investors have now sort of come to expect it from the online giant.
It’s more likely that Amazon stock will make gains in the 20%-40% range in 2016 as the company continues to grow its bottom line. Amazon's profits are expanding from a small base, and even small increases could be highly significant. Those kind of gains are a good enough reason to own Amazon stock.