January 30, 2013 – Amazon: In Jeff Bezos We Trust

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Amazon’s years of investment have built the scale, skills, customer base and infrastructure needed to conquer new retail categories and geographies, establish a world-class IT platform in the process. Store-free operations and systems driven logistics give it lower costs and better cash flow than rivals, but its superior customer experience – i.e. huge selection, powerful shopping interface, efficient checkout, fast delivery and omnipresent support – is an even bigger advantage. Amazon’s cost structure enables it to fund big investments in technology and media content toward future growth, with many significant expansion opportunities ahead of it and few threats to its core business. The biggest threat is in e-media, where Google and Apple can integrate their own solutions into their dominant portable device platforms and where Amazon’s strength in logistics is no advantage. These circumstances spurred Amazon to develop its aggressively priced Kindle line of readers and tablets. Amazon has leveraged its IT investment, with its AWS cloud hosting service, establishing early leadership in a market that could grow to more than $100B over the next decade. Unusually, investors have allowed CEO Jeff Bezos to forego immediate profitability in favor of ongoing investments in future growth. While growth assumptions embedded in both consensus and the current valuation are appropriately robust, there is potential for significant future margin expansion that is not reflected in expectations.

 

 

Amazon competes in three related, but strategically disparate businesses: On-line shopping, Electronic Media, and Cloud Hosting.  From its start in 1994, Amazon has recognized the self-reinforcing value of scale in retail, investing aggressively to build IT and logistical infrastructure, and to attract and retain customers. The retail business now offers a nearly comprehensive array of physical products in 10 categories – from non-perishable groceries, to electronics, to auto parts – at low prices, matchless convenience and fast delivery, with web sites targeted at 11 countries. Amazon has built a dominant e-books franchise, which spurred both the Kindle line of tablets and further extensions into digital music, video, apps and advertising. Finally, Amazon has leveraged its IT investment into AWS, the market’s leading cloud hosting operation. These business offer almost limitless potential for future growth.

 

Amazon’s strategy, skills and scale give it sustainable cost advantages over other retailers, both store-based and on-line.  Amazon’s on-line business model gives it the big advantage of negative working capital – e.g. much lower inventories than rivals, collecting cash faster than it spends it. Traditional operating expenses – fulfillment, marketing, SG&A – are just 13.5% of sales vs. 19% for rival WalMart, and while Amazon spends an additional 10% on “Technology and Content”, much of that is investment against future expansion plans. 17 years of investing in the technology of e-tail and building world-leading scale on-line make it unlikely that would-be rivals will be able to compete on cost, even pursuing the same basic strategy.

 

Superior customer service is a bigger differentiator than price.  While Amazon enjoys a considerable cost cushion vs. brick and mortar retailers, its biggest advantages come from its customer experience. Without store shelves to stock, Amazon has a huge selection of products available 24/365 from any connected device. Shoppers use powerful tools to find the right items quickly, checking out with a single click and receiving purchases surprisingly quickly. Amazon’s customer satisfaction score is the highest in the retail industry. While traditional retail customers are able to physically inspect merchandise and take it right home, easy returns, detailed product information, extensive reviews, and shortening delivery intervals have ameliorated much of this issue for Amazon shoppers, opening new customers and categories to the Amazon experience.

 

Electronic media plays to Amazon’s strengths, but it is vulnerable to platform players.  As the world’s biggest bookseller and on-line retailer, Amazon has obvious advantages in e-media. The opportunity is hot, with no costly inventory or delivery expenses, and Amazon has pursued it aggressively. It leads in e-books, and is going hard after Apple in music, Netflix in video, and Google in apps.  The Kindle platform is a loss leader to drive e-media sales, and has sold 65M+ to date, including 15M+ Fire tablets. However, the large majority of portable devices run iOS and Android, giving Apple and Google leverage to favor their own e-media offerings, integrating apps directly into their platforms and charging tolls for 3rd party apps revenues.

 

Focus on customers paying off in cloud hosting.  Growth will be big, but competition is coming.  We believe that the majority of enterprise data processing will migrate to public cloud solutions over the next 20 years.  Amazon Web Services (AWS) has been a pioneer in establishing this market, with powerful, flexible and IT manager friendly Infrastructure-as-a-Service (IaaS) offerings. While this field will get more crowded, with Microsoft, Google and eventually Facebook likely the most potent rivals, Amazon’s scale, willingness to support a wide range of applications, and cloud hosting experience make it the early leader in a market that we believe will eventually see annual sales in the hundreds of billions of dollars.

 

Investment is muting profits and cash flow but investors don’t seem to care.  Jeff Bezos intends continue investing to attack opportunities – i.e. capex for data centers and distribution sites, R&D for devices, new services and software, new content for e-media, expansion into new categories and countries. This investment, reflected in multi-billion $ capex and the 8-10% of sales spent on “technology and content”, keeps margins low and saps cash flow.  Atypically, Amazon investors have been patient, comfortable with the investment as long as the company delivers growth.  This is a huge advantage for Amazon vs. rivals with less patient investors.

 

Consensus is very achievable, even if embedded assumptions are ambitious.  We believe that Amazon has more than enough opportunity in its three main businesses to drive the 25% annual growth expected by consensus, with significant leverage to improve margins vs. expectations. The iso-curve of the assumptions embedded in the market price is well above consensus, but very sensitive to improving margins or falling capex/sales. As long as Amazon can sustain the patience of its investors, we expect the stock to work.

For our full research notes, please visit our published research site.

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