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Since our last coverage, Amazon’s stock (NASDAQ:AMZN) has gradually grown past both our $182 price target and its 2021 peak towards a new all-time high before paring some of its gains in April. The stock has largely maintained a consistent, gradual uptrend, diverging from the outsized kind of appreciation observed at its mega cap peers that have also been key beneficiaries of the AI rally.
Admittedly, Amazon has found itself in a dimmer corner of the AI spotlight. Yet its results continue to demonstrate robust share gains with accretive growth stemming from AI-driven TAM expansion. Specifically, AI contributions to AWS now amount to a multi-billion-dollar annualized run-rate, with continued growth reacceleration highlighting its benefit from secular tailwinds ahead.
This pairs favourably with Amazon’s swift turnaround of its previously struggling core commerce and fulfilment business. Not only has utilization improved since the pandemic-era expansion spree, but the recently implemented regionalization strategy has also enabled consistent margin expansion for the commerce business.
Meanwhile, emerging segments within Amazon, such as increasing penetration across high-growth digital advertising verticals, including retail media and AVOD, are also expanding its mix of higher margin revenue sources. Taken together with ongoing cost-cutting efforts, Amazon remains well-positioned for reinforced free cash flow expansion underpinning the stock’s upside potential. We are increasing our price target for the stock to $208.
AWS is a Core Driver of the Amazon Stock
Although Amazon has become a household name thanks to its expansive e-commerce and fulfilment network, Amazon Web Services (“AWS”) remains the stock’s core driver. AWS now represents 17% of Amazon’s total revenue mix, yet drives the bulk of its profitability due to the segment’s high margins. Specifically, with the continued scale of newly introduced features across the AI stack, AWS has expanded its operating margin by eight percentage points q/q and 14 percentage points y/y to 38% at the end of 1Q24. With optimization headwinds largely stabilized and out of the way, and the growing AI narrative taking over, AWS remains well-positioned for gradual reacceleration through the years ahead.
Admittedly, AWS has not garnered the same attention as its rivals Microsoft Azure (MSFT) and Google Cloud Platform (GOOG / GOOGL) have in the increasingly heated AI race. But that is not to say AWS has not been a key beneficiary of the emerging opportunity.
Specifically, the emerging transition of AI-related compute power demand from training to inferencing activities is expected to accelerate demand. Many of the generative AI models and applications developed over the past year are starting to enter scaled usage in the years ahead. This is likely to increase inference-driven capacity demand to facilitate the process of running the generative AI solutions already deployed. The anticipated trend is also consistent with the latest management commentary, which expects inference activities to dominate enterprise AI spending given higher frequency of use compared to training activities.
You spend much more in inference than you do in training because you train only periodically, but you’re spinning out predictions and inferences all the time.
And as generative AI solutions become more pervasively used, inference-driven compute capacity demand is expected to overtake that of training’s. Current forecasts expect inferencing to represent “2x the number of cycles and spend as training by mid-2025”.
And AWS remains well-positioned to benefit from said growth opportunities. The cloud-computing giant currently leads in compute power capacity worldwide. AWS alone held close to 40 million square feet of data centers and office space in 2023, doubling from just four years ago when cloud computing started to gain momentum. The segment now operates 105 Availability Zones across 33 geographic Regions worldwide.
It also offers a wide array of instances to fit every performance and cost requirement from customers. This includes instances powered by AWS’ in-house silicon. The latest AWS Graviton4 chip is capable of up to 30% better performance than its predecessor, while also promising power and cost efficiency. Meanwhile, AWS Trainium2, which deploys later this year, is optimized for AI training workloads, and enables as much as double the energy efficiency of its predecessor. AWS also offers cloud instances powered by third-party processors, including Nvidia (NVDA), AMD (AMD) and Intel (INTC). The combination highlights its competitive slate to address varying cloud-computing demands from general purpose workloads to accelerated computing.
Continued expansion of AWS’ data center and AI infrastructure footprint is expected to bolster its market share and reinforce its mission-critical role in driving industry growth. This includes the recently announced $150 billion commitment towards expanding its data center footprint alone over the next 15 years. This adds to the $148 billion that Amazon has spent on the build-out of its critical cloud-computing infrastructure over the past two years, and is consistent with the company’s increased capex earmarked for 2024.
In addition to the build-out of AWS’s global availability, Amazon has also upsized its investment in Anthropic – the AI start-up behind the Claude chatbot which rivals OpenAI’s ChatGPT. Specifically, Amazon has committed another $2.75 billion to its Anthropic investment in March, taking its total stake to $4 billion. As discussed in a previous coverage, Amazon’s investment in Anthropic overtakes the start-up’s existing partnership with rival Google. As part of Amazon and Anthropic’s partnership, the latter will prioritize making its innovations – including next-generation large language models – available to AWS customers through services such as Bedrock. AWS will also become Anthropic’s primary cloud service provider, effectively reinforcing the cloud-computing giant’s foray in emerging AI opportunities.
Aside from investing into opportunities in the bottom layer of the AI stack – namely, model development and training infrastructure – Amazon is also expanding its foray across the middle and top layers. This includes providing developers with access to some of the world’s highest-performing LLMs to customize tools based on their own data through Bedrock. Amazon has also increased the complementary capabilities between Bedrock and SageMaker – its foundation model builder tool – by implementing value-added features such as “Bedrock Custom Model Import”. Specifically, Bedrock Custom Model Import allows developers to integrate both proprietary models developed in SageMaker with existing LLMs within Bedrock to build and deploy end-user applications. This continues to deepen AWS’ partner ecosystem advantage and reinforce its role as the preferred primary cloud service provider amongst customers.
Admittedly, AWS is spending big on future opportunities. Yet it remains well-positioned for generous returns. Its continued progress in capturing opportunities from AI-driven cloud TAM expansion, as corroborated by Q1 outperformance, is expected to reinforce its share of high margin cloud revenue. This will inadvertently improve the business’ longer-term ROI and cash flows, underpinning Amazon’s valuation prospects.
Don’t Blink on Advertising Cash Flows
Advertising represents another emerging cash flow generator for Amazon. The fast-growing business has become an inherently high margin revenue source for Amazon, complementing profitability from AWS operations at scale. And secular tailwinds remain favourable to Amazon.
Specifically, retail media and AVOD are becoming the fastest growing digital ad verticals given their extensive reach and competitive return on ad spend (“ROAS”) for advertisers. While the open internet captures 80% of global viewership, walled garden advertising formats – such as Amazon.com and Prime Video – account for 80% of ad dollars due to their better ROAS. And Amazon is consistently improving this metric, which is a key consideration for advertisers. And this further preserves Amazon’s share of impending growth opportunities in digital ads.
Admittedly, the retail media format has been a key growth source for Amazon’s advertising business. This is largely thanks to the company’s massive trove of valuable first-party consumer data alongside rapidly improving targeting and measurement capabilities for advertisers. But what lies ahead are greater AVOD opportunities, which expands Amazon advertising’s addressable market.
Recall that Prime Video, which comes as a perk with Prime memberships, started incorporating ads as default in the U.S. Users have the option of adding $2.99 a month to go ad-free. The incremental ad-free charge is unlikely to contribute much towards Amazon’s revenues. This is because most Prime Video users see the platform as a freebie from their Prime membership subscriptions incentivized by fast and free shipping on Amazon.com purchases. As discussed in a previous coverage, most streaming platform users today are also ad-tolerant:
More than a fifth of streaming users “prefer ads to subscriptions on an absolute basis,” with more than half of the cohort citing pricing sensitivity for their choice. Age plays a larger role in determining ad tolerance, with users above the age of 44 “more willing to choose ads.”
However, household income appears to play a lesser role in determining ad tolerance, with latest industry surveys showing “no significant correlation around pricing or preference for subscription over advertisements.” In fact, American households with annual income over $100,000 are only willing to pay $6.40 per month on average for streaming without ads, slightly less than the $7.10 per month that those with annual income under the $100,000 threshold are willing to pay.
Source: “Netflix: Ending Q4 With A ‘Tudum’ In Sales And Subscriptions”
Instead, the bulk of upcoming ad revenue growth is going to stem from the sales of incremental ad inventory on Prime Video. Amazon Prime Video reaches more than 200 million monthly viewers, and accounts for more than 3% of TV screen time for Americans. This substantive reach makes a key appeal to advertisers, thus reinforcing demand and driving consistent improvements to average revenue per user (“ARPU”) at Amazon, especially with acceleration in AVOD ad placement growth. Specifically, demand for AVOD ad formats is expected to grow 13% y/y and exceed $10 billion in 2024. This complements continued acceleration in retail media ad demand as well, which is expected to grow 12% y/y in 2024. This, together, makes strong tailwinds for Amazon’s emerging advertising business and its cash flows.
Prime Video is also becoming an increasingly popular streaming platform for live sports, given its exclusive distribution rights. This includes Thursday Night Football on Prime Video, which drove a 24% y/y increase in viewership during the 2023 season. The platform also has broadcast rights for NASCAR, the National Women’s Soccer League, and Premium Boxing Champions in the U.S. Prime Video’s increasing reach into live sports will be key to reinforcing its share of AVOD ad sales growth opportunities. Historically, major sporting events have been a key driver of ad revenue in traditional linear TV. For instance, the 2024 Super Bowl alone generated approximately $485 million in ad revenue. The upcoming Summer Olympics is also expected to generate as much as $1 billion in incremental ad revenue this year.
This highlights the extensive reach that live sporting events have and their appeal to advertisers. The strategy of complementing its growing Original slate of shows and movies, especially after the MGM Studio acquisition, with increasing live sports broadcasting rights underscores favourable growth prospects for high margin Prime Video ARPU ahead.
Staying Lean and Focused
In addition to TAM expansion and favourable opportunity capture strategies across its high margin businesses, Amazon’s ongoing implementation of cost-cutting and operating efficiency initiatives also reinforces its ballooning checkbook. This is consistent with three percentage points of q/q operating margin expansion, underpinned primarily by improved operating leverage, lowered costs to serve, increasing high-margin ad revenue mix, added scale of profitable international regions, and rising penetration of profitable AI opportunities to complement post-optimization headwinds in AWS.
On cost-cutting, Amazon has continued with a string of lay-offs in an attempt to restore leaner and more efficient operations. In the latest development, Amazon has reduced hundreds of headcount at AWS, particularly in sales and marketing. This is in line with increasing focus on hiring more technical talent to facilitate AI growth, and greater adoption of a self-service sales strategy observed across its cloud and software peers. Although the latest round of job-cuts will likely harbinger a one-time severance cost headwind on Q2 profitability, it is expected to unlock greater efficiency and sustained margin expansion over the longer-term.
This cost-cutting strategy is also observed in Amazon’s continued axing of speculative projects, with the latest on the cutting board being its integration of “Just Walk Out” technology at Amazon Fresh grocery stores. This is expected to free up resources for Amazon’s development and implementation of more fitting technologies, such as Dash Cart, for the scale of operations at Amazon Fresh.
In addition to cost-cutting, Amazon has also been persistent in better realizing operating efficiencies across the business. This includes Amazon’s integration of some of its Prime Video and MGM Studio talent earlier this year. The strategy has effectively reduced overlapping roles across the two media units, unlocking greater cost synergies.
Amazon’s adoption of regionalization in its U.S. fulfilment business has also been another effective strategy in becoming more efficient. And the strategy’s success is evident in resilient margin expansion in its North America business to 6% in Q1, driven primarily by “strong unit growth and lower transportation rates”. Specifically, continued improvements in delivery speeds across the U.S. and certain international regions (e.g. Toronto, London, Japan) have been key to driving customer value and encouraging purchase frequency. We believe further expansion of this initiative to international markets is something that Amazon’s robust balance sheet can afford, while also generating impressive returns on relevant investments. This is consistent with rapid margin expansion observed in its U.S. fulfilment operations since the implementation of regionalization. It is likely that the implementation of regionalization efforts are already in the works in international markets, in line with increasing cost efficiencies realized through “network design enhancements” as cited by management in the latest earnings update. The regionalization strategy represents a potential key to restoring acceleration and margin expansion at Amazon’s smaller scale international market, and enabling a sustained trajectory of profitable growth.
Fundamental Considerations
Adjusting our previous forecast for Amazon’s actual Q1 results and forward expectations, the company is expected to grow revenue by 12% y/y to $642.7 billion in 2024. Specifically, AWS and advertising are expected to be two of Amazon’s fastest growing revenue sources. Our forecast expects AWS to exit 2024 with growth of 20% y/y, driven primarily by incremental AI-driven opportunities – especially inferencing demand. Meanwhile, the advertising business is expected to benefit from additional placements through Prime Video, especially with potential capture of upcoming industry tailwinds such as the Presidential elections and Summer Olympics.
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Meanwhile, the focus on core commerce and fulfilment operations will remain on margin expansion enabled by the continued scale of its regionalization strategy in the U.S. and beyond. This will complement anticipated growth acceleration through the end of the year at some of Amazon’s most profitable businesses such as advertising and AWS.
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Price Considerations
We are increasing our price target for the stock to $208, driven by Amazon’s improved growth and margin expansion outlook, as discussed in the foregoing analysis.
The price is derived under the discounted cash flow approach. The DCF analysis considers cash flow projections taken in conjunction with the fundamental forecast discussed above. We apply a 10.4% WACC to the analysis, which is consistent with Amazon’s risk profile and capital structure. The analysis also considers a perpetual growth rate 6% on 2028E EBITDA to determine Amazon’s terminal value. We believe the premium perpetual growth rate compared to the anticipated pace of economic growth across Amazon’s core operating regions is warranted given the company’s market leadership across multiple high-growth segments, including cloud-computing, digital advertising, and e-commerce. The valuation premium is also in line with Amazon’s steadfast culture in prioritizing profitable growth investments, which underscore a sustained long-term trajectory of ROI improvements and FCF expansion. The terminal value generated from applying a 6% implied perpetual growth rate on 2028E EBITDA is equivalent to 3.5% on 2033E EBITDA when secular tailwinds facing Amazon’s business are expected to normalize.
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Conclusion
Amazon is primed for further upside potential from current levels, as a favourable growth outlook on its higher-margin revenue sources contribute to pent-up valuation gains. Although AWS is relatively removed from the stiffening Microsoft vs. Google generative AI race, its leading cloud-computing capacity and ongoing internal developments reinforces emerging AI-driven growth opportunities. Paired with recovering margins at its core e-commerce business, and emerging strength in digital ad sales, Amazon continues to exhibit a tangible foundation for value appreciation.
