AMZN: Winning Christmas

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

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December 8, 2015

AMZN: Winning Christmas

With ~$250B in annual gross merchandise volume (GMV) and more than 250M active customers, AMZN, already 3x the size of its closest US online rival Ebay, is responsible for nearly 20% of global e-tail sales and is on a trajectory to catch and pass WMT to become the world’s largest retailer of any kind by the end of 2020. The inherent scalability of the online model, combined with AMZN’s size, unique capabilities and relentless executional excellence, allows simultaneous improvement in all 4 retail business drivers – price, selection, convenience and service – widening the company’s already considerable strategic advantages and closing gaps in areas that are minuses vs. brick-and-mortar stores. AMZN’s investment in shortening its delivery windows is opening up new markets as it continues to pressure traditional merchants in its core categories. Already able to address the majority of the $6T in US retail sales, we believe that it can successfully lever its extraordinary e-commerce operations toward the even larger B2B market, currently fragmented into the hands of thousands of mostly regional and specialized vendors. While heavy investment in international expansion, new fulfillment centers and IT capacity have obscured healthy underlying profitability, we believe that these investments will deliver handsome long-term returns. Adding in AMZN’s similarly dominant AWS IaaS business, which itself addresses a $1T potential market, we believe AMZN is positioned to exceed investor expectations for both top and bottom line growth.

AMZN on track to surpass WMT. Including 3rd party sales, we believe that AMZN will sell roughly $250B in merchandise in 2015, making it the #2 US based retailer with more than double the sales of #3, COST. On its current trajectory, AMZN’s GMV could make it the nation’s #1 retailer by 2020. Toward that end, AMZN is leveraging its scale, fulfillment expertise, IT skills and superior process design to simultaneously pressure traditional merchants on price, selection and convenience. As the shopping paradigm continues a relentless shift to digital, most traditional brick-and-mortar merchants are falling further behind despite considerable investments in their own online/mobile initiatives.

Cost dynamics shifting AMZN’s way. By replacing stores with massive fulfillment centers, AMZN saves dramatically on real estate, personnel and inventory. Those savings are reinvested in lower prices, but also in improving both product selection and shopper convenience. The big cost disadvantage to the online model is delivery. Here, AMZN’s buying power has wrested ongoing savings from FDX, UPS and the USPS, while it explores options for its own delivery service, including investments in drones. Accepting sales taxes raises prices, but allows fulfillment centers much closer to many cities, speeding delivery while shaving delivery costs. With these advantages, AMZN offers prices competitive with its lowest cost physical store rivals and largely better than online competitors on an all-in basis.

AMZN dominates selection. 380M separate products are available on AMZN, about 5% of which are fulfilled directly by the company and available for 2-day shipping. In contrast, WMT offers 4.6M products on line (less than 1.3% vs. AMZN) and about 150K in its typical Supercenter. Comprehensive selection, along with the deserved reputation for low prices, is the prime reason that 44% of shopping searches begin directly on AMZN, up from 30% 2 years ago. Wide selection also drives purchases of more commonly available items, which are often bought at the same time as a more esoteric product.

Gaining advantage in convenience. Shopping at home is an enormous convenience, but online shoppers cannot touch a product before buying, and cannot take it home immediately after. Liberal and easy return policies, trusted product reviews, and elite level customer service have helped to erode the first factor, and AMZN has invested billions to attack the second – shortening deliveries from days to hours in some markets. This opens new categories, like groceries, where immediacy is an important buying criterion, and improves the shopping experience. That overall experience is an important driver for AMZN – it accurately suggests products to buy, it eliminates the time and effort needed to go to a store, it streamlines finding the product in stock, and simplifies transaction completion.

Prime is the best loyalty program – by far. AMZN Prime has roughly 41M members, each paying $99/yr for free two day shipping, access to Prime Pantry, unlimited video and music streaming and a kindle e-book lending library. Prime is growing ~35%/yr and members typically spend 2x as much as non-members. AMZN has more than 250M active accounts spending nearly $1,000/yr apiece, and 60% of those accounts purchased something during the 2014 Holiday season. For each of those accounts, it has a name, address, email, credit card number, and a detailed record of both browsing and purchase history. 68% of all US smartphone users have installed and use the AMZN app. Meanwhile, brick-and-mortar retailers face substantial and unappreciated hurdles in transitioning their largely less than successful card-based loyalty programs into mobile apps.

Would-be online rivals are FAR behind. We believe that matching AMZN’s costs, selection and customer experience for online/mobile shopping will be impossible in the markets, like the US, where it has established a significant beachhead. AMZN’s hyper efficient fulfillment infrastructure, its world-class IT platform, and locked-in customer base are many years and billions of dollars of investment ahead of potential competitors – in particular those traditional merchants looking to repurpose logistics operations meant to stock store shelves toward a delivery model.

AMZN for Business is a huge opportunity. US B2B distribution is an $8T annual market, spread out over 35,000 largely regional and specialized companies, of which just 160 have sales of more than $1B. AMZN entered this market in 2005 with an acquisition, but kept its service as a Beta test product until earlier this year, when AMZN for business was formally launched, offering 2.2M products while the average competitor offers just 50K. AMZN has begun with high volume products, like office supplies or cleaning materials, that can leverage its existing process, and offers substantial discounts from a characteristically customer friendly site. With time, AMZN for Business could rival the e-tail flagship.

Including dominant AWS, AMZN set to beat long-term expectations. We expect AMZN’s B2C and B2B businesses to top $200B in reported revenues (and $500B in GMV) by 2020. AWS, itself dominant in an IaaS market that has begun to consume the $3.7B in annual enterprise IT spending, could be a better than $50B business in the same timeframe. We believe that this further scale will reduce impetus for investment as a percentage of sales, enabling substantial margin expansion from current levels. This prognosis is significantly above consensus, and, we believe, supports a target share price of better than $900 with the likelihood of strong 4Q15 results a potential catalyst.

The SSR TMT Heat Map

The Juggernaut Can’t Be Stopped

AMZN’s strategy is quite straightforward. Provide the largest possible selection of products at the lowest possible prices with the greatest possible convenience for customers. Cut costs religiously. Cash generated by product margins and by squeezing working capital are then reinvested in order to expand the selection of products, reduce prices, and improve convenience. Wash, rinse and repeat.

Arguably, this is a modern version of the WMT playbook – e.g. rolling over rivals with everyday low prices and a proliferation of massive Supercenter stores – except without the limitations of real estate and personnel. Early on, Jeff Bezos realized that an entirely online retail operation could scale without compromise. Massive fulfillment centers built on cheap real estate each replace hundreds of expensive stores, dramatically reducing the necessary inventory on hand. Software, running in superefficient data centers, replaces sales associates and is always ready for customers 24/7. Opening the platform to 3rd parties allows almost limitless product selection. Building closer to big cities and applying leverage on delivery partners allows shorter delivery windows and improves customer convenience. Online means that AMZN can collect deep information on its customers’ shopping and buying habits that leading edge data centers can analyze to provide better service and build loyalty.

It is working. The GMV sold through the AMZN site is more than $250B, making it the #2 retailer in the US, with more than double the volume of #3 COST. In 2015, the growth in AMZN’s GMV has accelerated to more than 25% YoY, putting the company on a trajectory to top current #1 WMT sometime in 2020. Traditional retailers talk a big game about taking on AMZN. WMT has already invested $6B over 5 years in building its digital presence, but its $15B in annual online sales is just 5% the size of AMZN’s GMV and its anemic 10% digital growth rate means that it is losing a lot of ground to its rival. A study at the beginning of 2015 indicated that a staggering 44% of all online shoppers begin directly on AMZN, up from 30% in 2013. AMZN has 250M active accounts and its app is used by 68% of all US smartphone owners.

As the company continues to relentlessly improve on cost, selection and convenience, it will continue to roll over traditional merchants. 2-day delivery is giving way to overnight delivery with same-day delivery available for free for qualifying orders in 16 metro markets. Short delivery intervals open new markets – grocery today and, perhaps, pharmacy or home improvement supplies tomorrow. Delivery options will also be key to AMZN for Business, which applies the e-tail infrastructure to the even larger B2B wholesale market. Combined, US retail and wholesale distribution moves more than $14T in merchandise annually. This is a LONG runway.

The knock on AMZN is its reinvestment of potential profits back into its businesses – although negative working capital allows for nearly 8% free cash flow margins. We are not so worried – sales growth should soon begin to outstrip investment needs, allowing margins to be more consistent. The extraordinary growth of AWS, itself dominant in an IaaS opportunity that is eroding $3.7T in annual enterprise data center spending, is another, very profitable, driver of future growth. We believe that AMZN could generate more than $250B in reported sales by 2020 with EPS of better than $40/share. We also believe that evidence suggests a very strong Holiday season for AMZN, largely at the expense of its brick-and-mortar rivals, which could be the catalyst for shares to take yet another step up. We believe AMZN is worth at least $900 a share today.

Amazon is Lapping the Field

Holiday sales expectations for US retailers are decidedly ho-hum six years into the weak economic recovery. Estimated sales at brick-and-mortar stores on Thanksgiving and Black Friday were been down slightly YoY, as they have been three of the last four years. Outside of the drug store and home improvement categories, the top 100 US retail chains are growing sales at just 2.9% over the past year. Not surprisingly, the total real estate devoted to retail peaked in 2009 both on retail square footage per capita and total square footage (Exhibit 1-2). Meanwhile, Thanksgiving/Black Friday purchases were up 9.5% YoY online (Exhibit 3). Overall, e-commerce has grown from less than 1% of American retail sales in 2000 to more than 7.5% today, with the growth in penetration accelerating in recent years (Exhibit 4). With more than $6T in total US annual retail sales and $24T world wide, e-commerce may not yet be in its adolescence (Exhibit 5).

Leading the online bull rush is Amazon. 2015 global retail e-commerce sales are projected to be about $1.6T, according to e-marketer. Amazon’s own retail sales are expected to exceed $80B, but, importantly, the sales of 3rd parties through the Amazon platform are another $170B on top of that. On that basis, Amazon is responsible for nearly 20% of all internet retail sales around the world, and is gaining market share. Amazon’s US retail YoY sales growth has accelerated to 28% over the past four quarters. In the US, studies show that 44% of online shoppers begin their journey directly with Amazon’s web site or its app. 68% of American smartphone owners have installed and use that app.

Amazon’s US rivals are choking on dust. The number two American online player is Ebay, with $80B in GMV from its site – less than 1/3 Amazon’s GMV and entirely stagnant. The leading brick-and-mortar merchant, mighty Walmart with its $545B in global annual sales, is selling just $15B from its digital platform and growing that business a paltry 10% in the most recent quarter (Exhibit 6-7). Target and Best Buy, with less than $5B in online sales combined, each grew less than 20% in 3Q15. Even smaller retailers thought to be executing will on e-commerce, like Nordstrom are still losing ground to Amazon. Of the top internet retailers, the only one growing faster than Amazon over the past 12 months was Apple, which was riding the strength of its wildly successful iPhone 6 introduction at the end of the third quarter last year.

Exh 1: Retail Space per capita, 1983-2015

Exh 2: Historical Deliveries of New Retail Space, 1983-2015

Exh 3: Thanksgiving/Black Friday e-Commerce Spending, 2015 v 2014

Exh 4: U.S. e-Commerce quarterly sales and share of all retail, Q1 2000- Q3 2015

Exh 5: Global Retail and E-commerce sales, 2013-2018

Exh 6: Retailer e-Commerce GMVs, 2014 and 2015

Exh 7: Walmart E-commerce, 1CQ13 – 3CQ15

Price, Selection, Convenience, Service

“Amazon.com strives to be Earth’s most customer-centric company where people can find and discover virtually anything they want to buy online. By giving customers more of what they want – low prices, vast selection, and convenience – Amazon.com continues to grow and evolve as a world-class e-commerce platform.” – Amazon PR

The classic business school framework on retail posits that merchants must manage the tradeoffs between four strategic levers – price, selection, convenience and service – to attract and keep their customers. A company that leads with price will find it expensive to keep a broad inventory, locate on well-travelled thoroughfares, or hire an army of sales associates. Vice versa, a store on the best corner in town and fawning customer service usually will not undercut the warehouse on the outskirts of town.

Walmart changed the conventional wisdom. The first paragraph of the Amazon press kit, quoted above, could have been written by the Walmart PR team about itself thirty years ago – just take out the references to online and e-commerce. Walmart started by focusing on price, backing it with a legendary obsession with efficiency. Suppliers were squeezed, warehouses were minimized, shipments were made directly to stores, and overhead was strip mined from the operation. Potential profit was invested back into the business, to support even lower prices and better efficiency. The company expanded, building stores in nearly every city, town and hamlet, places where its chain store competitors couldn’t afford to go. The stores started to get bigger, and bigger, with new departments and growing variety, eventually becoming massive Supercenters with 150,000 SKUs including groceries (Exhibit 8). Employees were trained to cater to customer needs – open a new register if lines get too long, stock shelves quickly, greet shoppers at the door with a smile. Walmart’s investment and growing scale allowed it to pull all of the levers at once – low prices, wide selection, convenient locations, and customer friendly service.

Exh 8: Average Retailer Stock Keeping Unit (SKU) Counts

Jeff Bezos has certainly read Sam Walton’s book, which delves deeply into his business philosophy. Investment and scale, the keys to Walmart, are even more potent levers on the internet, where real estate, inventory, and employee costs can be minimized. A single massive fulfillment center, located on the cheapest available real estate within same-day shipping distance from population centers replaces hundreds of individual store locations. Sophisticated AI systems predict the mix of items most needed in each fulfillment center to keep deliveries short, stock-outs rare, but inventory investment low. State of the art logistics systems and heavy use of automation (including robots) supplement a lean labor force to speed sales from order to shipment dramatically faster and more cheaply than do rival operations. As Amazon has grown, economies of scale in almost every aspect of its business have taken its costs ever lower, allowing surplus that has been invested back into the company to lower prices, increase selection, improve customer convenience and deliver better service.

The Price is Right

Of the four levers – price, selection, convenience and service – price may be the most potent, particularly as scale economies allow price leaders to lower prices as they grow. Walmart, with its $481B in annual sales, is a famously hard negotiator, dangling massive volumes before the eyes of suppliers and wresting superior prices from them. It has fought hard against employee unions, even closing stores where organizing activities have taken hold, emphasizing to workers its own viewpoint that the company can provide fair wages and conditions without the burden of union dues and rules. It was early to recognize the potential for IT systems to greatly improve the processes of buying, stocking and selling products in its stores, investing heavily and reaping the benefits of faster inventory turns. Other than price specialists, like Costco, which drastically narrow selection, expect customers to drive longer distances to cheaper real estate, and offer bare boned customer service, Walmart is the obvious price leader amongst brick and mortar stores in the markets that it chooses to serve.

In its early days, Amazon focused on books. Bookstores are famous inventory sinks. A typical Barnes and Noble store carries over 100,000 titles in stock from spacious stores located in well-trafficked shopping centers. From a central warehouse and without sales tax, Jeff Bezos could offer a 25-30% discount that more than covered the cost customers paid for shipping. As Amazon grew, it demanded better prices from suppliers, it invested heavily to establish new and better processes for managing logistics in its model, and built out world-class IT operations to support an increasingly data heavy business. The cost savings were largely circulated back into even lower prices, which fueled more growth, and turned the cycle.

Amazon has been a product innovator and an aggressive entrant into new categories as well, It was a pioneer of e-books, requiring no inventory at all, and sold Kindle-branded e-readers at below cost to stimulate demand for them. It extended into music and video – product areas that would be later disintermediated by streaming but that were synergistic line extensions in the early 2000’s. It extended into electronics and general merchandise. It extended into apparel. In each case, Amazon led with price, fueling growth, increasing scale efficiencies and enabling further investment (Exhibit 9). It also offered up its growing user base, online platform, and logistical wizardry to 3rd parties, taking an average of 10.7% in fees from each transaction in the marketplace (Exhibit 10). These vendor/partners may compete directly with Amazon – difficult to do given the fee structure and Amazon’s scale – but also greatly extend the scope of Amazon’s selection without adding to inventory costs.

Exh 9: AMZN Number of Listed Products by Category

Exh 10: AMZN Third Party Selling Fee Schedule

Today, Amazon’s revenues per square foot of real estate are still almost double that of Walmart, despite massive investment in new fulfillment centers to handle same day shipping growth and international expansion (Exhibit 11). Revenues per employee are almost three times that of Walmart, down from nearly five times back in 2010, before that run of investment (Exhibit 12). Amazon inventories have risen in the past few years to about 45 days outstanding, about the same as Walmart, as Amazon invested in new business areas like groceries (Exhibit 13). Amazon trails most of its brick-and-mortar competitors in collections – almost all of its sales are credit transactions, while Walmart has the advantage of cash sales and faster to settle debit transactions (Exhibit 14). However, it stands out in collections, with its 90 days of payables more than double Walmart’s (Exhibit 15). Altogether, Amazon’s cash conversion – inventories plus receivables minus payables – comes in at -23.6 days, a considerable source of cash, while Walmart’s 12.7 day cycle is a use of cash (Exhibit 16).

Exh 11: Revenue per Square Foot, AMZN vs. Retailers, CY2009-14

Exh 12: Revenue Per Employee, AMZN vs. Retailers, CY2009-14

Exh 13: Days of Inventory Outstanding, AMZN vs. Retailers, CY2009-14

Exh 14: Days of Sales Outstanding, AMZN vs. Retailers, CY2009-14

Exh 15: Days of Payables Outstanding, AMZN vs. Retailers, CY2009-14

Exh 16: Cash Conversion Cycle, AMZN vs. Retailers, CY2009-14

Amazon’s big cost disadvantage to brick-and-mortar stores has been delivery expenses, originally borne by customers, but increasingly paid by the company as the Prime program and its 2-day free shipping grow. Despite the growth of prime, Amazon’s purchasing power and its efficiency have kept these costs under control. Total shipping costs have bumped around between 4 and 5% of total sales over the past four years, while the average daily package counts for UPS and Fedex ground have grown by roughly a third during the same timeframe, most of that coming from Amazon (Exhibit 17-18).

Interestingly, Amazon, with its 250 million users and $250B in gross merchandise volume sold through its service, has backed off a bit on pulling the price lever. To facilitate faster deliveries from closer fulfillment centers, it agreed to charge sales tax for products sold in 23 states, giving up a major price advantage vs. brick and mortar rivals. All-in relative pricing studies vs. Walmart are ambiguous, with significant variations by product, by geography, whether in store or online, whether as part of a loyalty program or not, and by delivery interval. Typically, Walmart wins for transactions in the store and for long delivery windows, while Amazon’s Prime loyalty program with free 2-day shipping is hard to beat outside the store. As a result, Amazon’s product gross margins have risen into the 25-30% range enjoyed by other large retail merchants.

At this point, being in the ballpark on prices may be close enough. A recent study showed that 44% of US online product searches began directly on Amazon – either its web site or its app – up from 30% two years prior. While some of these users may double back to check prices via Google or other merchant sites, many do not, satisfied that Amazon prices are very likely to be good enough for most of the products in their baskets.

Exh 17: AMZN Shipping Costs, 1Q10-3Q15

Exh 18: Average Daily Package Volume GROUND, 1Q10-3Q15

Selection Bias

All things being equal, shoppers would rather have many choices – categories, brands, product types, sizes, quantities, colors, options, etc. – than few. This was a key aspect of Walmart’s Supercenter store concept. Each Supercenter stocks roughly 150,000 SKUs (stock keeping units), above the 30-50,000 in a typical grocery store or the 3,750 SKUs available at Costco. Amazon blows that out of the water.

In conjunction with its 3rd party sellers, Amazon offers more than 380 million SKUs from its site and app, of which more than 20 million are available with free 2-day shipping for Prime members (Exhibit 19-20). Even with occasional stock-outs for suddenly popular items, the odds of finding what you want are dramatically higher than with a schlep to the local mall. This comprehensive choice encourages consumers to come to Amazon first, particularly if they are looking for something even slightly unusual, and while they are there, they may as well buy some things that aren’t unusual at all. As we noted earlier, 44% of US online shoppers begin their product search directly on Amazon, and we would bet, that the large majority of those product searches END on Amazon as well.

It is obviously easier to support a huge product selection from an online platform with many dozens of well-coordinated fulfillment centers than from a physical store, but Amazon’s size and excellence allows it a massive advantage against other online merchants as well. Number two US online retailer Ebay specializes in individual listings of one-off products, making it difficult to get a count of available skus, but the other retailers in the internet top ten fall far, far short, even of the 20 million items available on Amazon Prime. Walmart, picking on them yet again, offers 4.6 million items on its online site, less than 25% of those Prime listings and less than 1.5% of the products in the Amazon Marketplace.

Exh 19: Average Retailer Stock Keeping Unit (SKU) Counts

Exh 20: AMZN Prime Delivery Windows

Isn’t That Convenient???

On one hand, Amazon has an enormous convenience advantage vs. traditional retailers. Shopping online is easy, and Amazon has made it even easier. Looking for something? Amazon has excellent search tools to find what you want, along with extensive customer ratings and commentary to help you make sense of the choices. Just browsing? Amazon’s AI system will suggest products based on your past purchases and shopping activity. Once you’ve found something to buy, click once to checkout – once you’ve input your payment and shipment information the first time, it is on file for you every time thereafter. You can do this from your home or on your phone wherever you may be, and it only takes a few minutes. Compare that with jumping in the car, driving to a store, navigating the aisles, finding the right product – if it is in stock, queueing up to checkout, and then driving back home again. Big convenience advantage Amazon.

Of course, there is the other hand. Sometimes consumers want to see an item, hold it in their hands or try it on before they commit to buy it. Amazon will gladly pay for returns of clothing or shoes, but for many consumers, it is more convenient to go to a store where they have the physical product in stock. Amazon is working on this, including return packaging and preprinted labels for some products, and beefing up the product descriptions, photos and customer comments to give shoppers more confidence in buying without touching. Some of this is likely generational as well, and as purchasing power continues to shift to younger cohorts, some objections to buying online may pass as well.

Amazon also suffers when time is of the essence. Shoppers in a physical store can return home immediately, purchase in hand. For last second gifts or groceries for dinner, 2-day delivery is not nearly fast enough. This is the focus for Amazon’s four-year fulfillment center investment binge (Exhibit 21). It is the reason that the company has capitulated on sales taxes in major population centers. Amazon now offers same day delivery on more than a million items to Prime members in 16 metro markets, for free on orders of more than $35, and will deliver within an hour for a $7.99 charge. As Amazon invests in local delivery assets, including the potential of deliveries by drones, we expect these fast options to spread and that the delivery window will continue to get shorter.

Exh 21: AMZN Facility Square Footage, 2009-2014

Are You Being Served?

In the most recent American Customer Satisfaction Index survey, Amazon placed first amongst all US retailers in all categories for the fifth year in a row, with a rating of 86. Part of this is a simple appreciation of the online shopping model. As a category, internet retailers outpaced both specialty retail and department stores by a good measure (Exhibit 22). Still, Amazon was an easy first in the group.

Amazon pioneered many of the service features that are now standard for online shopping. In the ACSI survey, respondents called out “ease of checkout and payment” and “ease of navigation” as particular benefits for the group. Amazon patented its methodology for “1 click checkout” in 1999 – allowing a logged in user to execute a transaction with a single action. Amazon Instant Recommendations – which combines signals from a shopper’s personal shopping history and demographic profile, from the experiences of similar users, and from the characteristics of the products being purchased to identify other items potentially of interest – remains the gold standard for recommendation engines. Amazon offers free returns on clothing, shoes and other items where it might be difficult to understand the suitability of a product without physical inspection – this policy has become industry standard.

Amazon’s customer service excellence is noted not just relative to other retailers but to all consumer facing businesses. 24/7’s Customer Service Hall of Fame survey has found Amazon at the top for 6 consecutive years, with 59% excellent ratings vs. just 2% poor. Temkin Customer Service ratings, based on 10,000 consumer interviews, rated Amazon #2 across all industries, just behind the military focused USAA bank, and 9 slots above the next best retailer Costco. MSN’s Customer Service Survey in 2013 told a similar story, this time with Amazon number one with 57% excellent ratings well ahead of number two Marriott’s 46%. The 2015 Retail Customer Experience’s survey, which ranked merchants in four categories – Best Customer Service, Best Online Experience, Best Value for Price, and Best Overall Customer Experience – saw Amazon with a clean sweep at the top of all four lists.

Exh 22: American Customer Satisfaction Index, 2014

Prime Time

In 2005, Amazon announced its Amazon Prime program, allowing members who paid an annual fee ($79 at launch, $99 today) free 2-day shipping on millions of eligible products and discounted 1-day shipping. Since launch, it has added other benefits – free streaming video (2011), a lending library allowing Kindle owners to borrow e-books for free (2011), free music streaming (2014), free unlimited photo storage (2014), free same day delivery in 16 metro markets on orders of $35 or more from a list of more than a million items (2015), Prime Pantry (2015), and a one-day sale, called Prime Day, with special deals for members (2015). For anyone but a casual visitor, the benefits of Prime are compelling. Prime Video alone, with access to a large library of streaming programming, including important exclusives like the Emmy winning “Transparent”, could be worth the $99 fee for many consumers, measured against the popularity of Netflix at $107.88 per year.

Exh 23: Estimated Prime Subs, 4Q10-3Q15

Altogether, we believe 41 million shoppers were paying for Prime as of 3Q15, up from 25 million a year prior, more than 60% annual growth (Exhibit 23). Amazon has indicated that its Prime members spend more than twice as much annual as its non-membership customers, with the free shipping benefit a powerful pricing incentive for members to concentrate their shopping on the service. Amazon has considerable profile data on its Prime members, including their demographic and credit information, their shopping and purchasing history, the names and addresses of gift recipients, and their tastes in media – all feeding the Instant Recommendations engine to anticipate future needs. Amazon also has regular interactions with its Prime members – Kindle and Fire Tablet use, Prime Video and media streaming, shopping sessions, etc. – that it uses to communicate marketing messages to its best customers. 68% of all US smartphone users have the Amazon app installed on their devices and have used it within the last year. Many of these customers are Prime members already, and the rest of them are significant candidates for future membership.

Exh 24: 2014 US Loyalty Program Membership and Participation

Compare this to the loyalty programs offered by traditional retailers. Program membership may be up, but active participation has been falling, as consumers succumb to the proliferation of cards in their wallets (Exhibit 24). Brick-and-mortar merchants push their programs with initial discounts at time of sale, collect contact and credit information, and hope that users come back to use the cards again. Only a few programs that offer obvious concrete value, such as Target’s 5% across the board discount, have been able to generate significant momentum, and even then, the programs lack the reach to deliver marketing messages while the customers are out of the store.

Many retailers are counting on a transition to mobile app based loyalty programs as a panacea for their woes. We are very skeptical. Typical smartphone owners use just 26 different apps in a given month, including the obvious defaults, like email, calendar, search, and maps. In a given month, less than a third of all smartphone users will download even a single new app. Of those that are downloaded, more than 80% are used no more than once. The mobile wallet is just as crowded as the traditional one. This highlights just what an advantage Amazon has with its 68% install/use rate on smartphones and 41 million Prime customers.

We Have a Winner

Retail is a $24T global business, $6T in the US. As we have noted, signs suggest that American brick-and-mortar shopping has peaked, as online/mobile shopping accelerates and erodes traditional merchants category by category. Younger shoppers have been raised as digital consumers and as buying power slowly and inexorably passes to new generations, the paradigm shift will grow ever more pronounced (Exhibit 25). Leading this, far ahead of the pack, is Amazon (Exhibit 26).

We believe Amazon will continue to take share, for itself and for its 3rd party partners. We believe that its retail operations can sustain better than 14% annual growth over the next decade, with steady improvement in the underlying margins as its scale advantages expand and as its investment needs stabilize. This will be very difficult for would-be competitors. Survivors will have to have VERY strong value propositions – unique products, unusual customer service concepts and execution, powerful branding, etc. to overcome the considerable scale economies. We also do not believe that brick-and-mortar merchants can successfully adapt their store-based logistical operations to compete effectively for online/mobile orders for local delivery. This is a recipe that could result in the failure of many, many traditional retailers over the next decade or two.

Exh 25: Generation Y store visit frequency

Exh 26: Amazon Product Sales and Estimated GMV, 2010-2015 LTM

I Can Get it For You Wholesale

In 2005, Amazon acquired Smallparts.com, a start-up dedicated to providing components to smaller manufacturers via the internet. In 2012, it expanded on the concept with Amazon Supply, launched as a beta test service with 500,000 items in industrial categories – lab & scientific, test, measure & inspect, occupational health and safety, janitorial & sanitation, office, fleet & vehicle maintenance, power & hand tools, cutting tools, abrasives & finishing, materials handling, materials, hydraulics, pneumatics & plumbing, fasteners, and power transmission. In 2015, it renamed the service Amazon for Business and relaunched it as an official business unit with expanded categories and more than 2.2 million SKUs.

Amazon for Business leverages the extensive sourcing and fulfillment capabilities of the B2C e-commerce business toward wholesale B2B transactions. On the surface, this is an extraordinary opportunity. B2B is an almost $8T per year market in the US, a full 33% larger than the retail market, and is served by a large, fragmented set of largely regional and functionally specialized distributers (Exhibit 27). Of the 35,000 wholesale distributers in the US, just 160 have sales of $1 billion or more. While the B2B market contains many highly specialized corners, say volatile industrial gasses or specialized machinery, much of the volume comes from fairly straightforward products, such as office supplies, medical supplies, simple tools, building materials, etc., where Amazon’s strengths will matter.

We believe that Amazon for Business can grow to 20% or more of the company’s overall product and services revenues over the next decade, helping to push overall growth close to 20% over that time.

Exh 27: US Wholesale Trade, 2004-2013

It’s a Buy

Lost in our discussion of Amazon’s e-commerce excellence, Amazon Web Service is a juggernaut in its own right. We have written about the IaaS market (http://www.ssrllc.com/publication/infrastructure-as-a-service-the-race-wont-go-all-the-way-to-the-bottom/), and believe that public cloud hosting will eat significantly into the $3.7T global market for enterprise data center spending. AWS has already reached an $8B annual run rate, growing 78% YoY with healthy 25% operating margins. It is the dominant player in the space, with 36% market share making it bigger than its next four largest competitors combined. With substantial inherent scale economies in the IaaS business, and leverage from the IT needs of its core e-commerce business, we believe that AWS can grow to be a $50B annual business by 2020 and a better than $100B business by 2025 (Exhibit 28-29).

Considering Amazon as a whole and the huge markets that it is targeting, we believe that better than 20% sales growth can be sustained. We also believe that current margins conceal substantial investment in personnel, facilities, software development, and other areas that is likely to decline relative to sales as the company grows ever bigger. We also note that the fastest growing businesses – services revenues from 3rd party marketplace sales and AWS – deliver dramatically higher margins than the slower growing core business. Altogether, we expect operating margins to rise from the low single digits to roughly 10%.

On a DCF basis, our base scenario suggests a current value of more than $450B, a 45%+ upside from the current market cap and a better than $980 share price. While we recognize the impact of assumptions on DCF valuations, we believe that the potential for long-term sustainable growth and margin expansion put Amazon on a short list of companies consolidating the value being created by the cloud/mobile paradigm shift. We expect Amazon to substantially exceed current sell side expectations for growth and profitability going forward. Recent data points suggest Amazon has had a strong start to the important Holiday quarter, and look for 4Q15 results to sustain the share price momentum that investors have enjoyed year to date.

Exh 28: AMZN Revenue and Cost Model, 2015-25

Source: AMZN Filings, SSR Analysis

Exh 29: AMZN DCF Valuation

Source: AMZN Filings, SSR Analysis

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