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Nicholas Coppola CFA
November 15, 2018
In our day to day routine of researching a wide variety of investment opportunities, we occasionally run into a great business where it’s difficult to justify the purchase price. These businesses get set aside and put into a metaphorical filing drawer to be revisited at a later date when the price looks more attractive. Amazon (AMZN) fits this description rather well and has recently gone on sale with the stock selling off ~15% since early October, despite strong earnings growth. Our note provides our rationale for the investment and includes 1) a brief description of the company, 2) competitive advantages in their e-commerce business, 3) go-forward drivers of Amazon Web Services (AWS), and 4) thoughts regarding the risk/reward profile for investors.
Amazon surely needs no introduction, but here is a quick reminder of the breadth of their offerings. Amazon was founded in 1994 as an online bookstore and since then has been an astounding success story, growing revenues to ~$220 billion derived from a wide variety of products and services across the globe. Amazon, primarily through their retail websites, offers hundreds of millions of unique products through both Amazon and third-party sellers. As most of us are well aware, the company also offers the Amazon Prime membership, which includes unlimited shipping and access to instant streaming of TV episodes and movies. Amazon also manufactures and sells the Kindle e-reader, Fire tablets, Fire TVs, and Echo devices with built-in Alexa voice assistant. Additionally, Amazon is well entrenched in the cloud computing business with Amazon Web Services (AWS), serving the compute, storage and database needs for enterprise customers. And more recently, Amazon has expanded in the grocery business with their acquisition of Whole Foods last year.
Starting with e-commerce, we believe Amazon has a strong competitive advantage with a wide moat. When we ask ourselves what consumers are looking for in a shopping experience, characteristics include a wide selection, low price, great customer service and convenience. Amazon, in our view, is well positioned in each of these areas, with customers taking advantage of the wider selection afforded by third party sellers, free shipping, and the convenience and time savings associated with shopping from home. We also believe that customer reviews are an under-appreciated competitive advantage relative to the in-store experience. One of our investing heroes, Charlie Munger, often talks about the importance of maintaining a latticework of mental models with ‘big ideas’ from a variety of subject matters, including psychology. We think the ‘social proof tendency’ is particularly applicable to Amazon and the online retail experience, as customers prefer to buy products they see others have purchased and enjoyed in the past. Along these same lines, Amazon is opening physical ‘4-star’ locations, that offer products that have been rated four stars or above on their platform. Given their scale, Amazon also has a difficult-to-match logistics network that has led to operational efficiencies, allowing the company to offer lower prices to customers. Additionally, we believe there is a network effect at play here, with their massive customer base attracting more sellers, which in turn attracts more customers. To state the obvious, Amazon has been disruptive in the retail industry and we certainly expect that to continue.
We also believe that more retail-related searches are beginning at Amazon. In our view, this should contribute to marketers directing more advertising dollars to the platform going forward (i.e. advertisers products can appear higher in search results marked as sponsored items or on related individual product pages). Many marketing professionals will also point out that Amazon’s customers are already visiting their site with an intent to purchase, which is an important differentiator versus traditional media or even other tech peers.
Lastly, Amazon’s cloud computing business is increasingly driving results. Cloud computing is cheaper and more efficient than on-premise technology, and that compelling rationale has been driving strong growth. AWS has been seeing revenues regularly grow ~40% or more, and importantly, is a high margin business. As a basis for comparison, in Q3’18, AWS reported 31.1% operating margins, which was up from 25.5% in the prior year quarter. Meanwhile, the North American segment posted 5.9% operating margins and the International business remained unprofitable as the company continues to invest in growth.
In our view, the value proposition for Amazon’s cloud computing customers is strong and multi-faceted. At a high-level, enterprises that use AWS avoid the capital expense of building out data centers and the required maintenance and support of internal systems. They also leverage Amazon’s massive economies of scale, which should lead to cost savings. Other advantages include the ability to pay for only capacity used, rather than making estimates for required need and then incurring the risk of under or over-utilization. And in regards to the competitive landscape, there are a limited number of players with similar capabilities (i.e., Microsoft and Google), and Amazon has been a proven innovator that’s quickly adding new services and features.
So why has the stock sold off recently? There are certainly concerns among investors about slowing top-line growth. Note that Q3’18 posted ~29% year-over-year revenue growth, which represented a modest miss relative to Street expectations and was a deceleration from earlier in the year. Headwinds to revenue and unit growth included a laundry list of items including a tough comparison after reducing the threshold for ‘Super Saver Shipping’ in the prior year, a shift to subscription services, lapping the Souq acquisition in the Middle East, and Diwali falling fully in Q4 this year and thus impacting the timing of certain sales in India. From an operating income perspective, Amazon posted a massive beat, at $3.7B vs. consensus of $2.1B, due to particularly strong growth in profitable businesses like AWS and advertising, as well as strong cost control. Looking forward, Q4’18 guidance was also weaker than expected, calling for ~10% - 20% revenue growth, in part due to lapping the Whole Foods acquisition, currency headwinds, and a change in accounting for Amazon Prime revenue recognition. We also think there is likely some conservatism baked into guidance. More importantly, we believe that the economic value of the business and the longer-term story remains fully intact.
As always, we need to consider the risks. Surely, growth rates at the company have been high, and if growth were to substantially slow, the stock would be negatively impacted. Primary concerns include the potential for lower discretionary spending on the heels of a weaker economy, higher shipping costs (i.e., USPS rate hikes), greater competition in the cloud due to IBM’s acquisition of Red Hat, the potential for regulatory actions, and a continued mix shift to more third party sales that generate less revenue. Additionally, valuing Amazon is somewhat more challenging than many other companies we study. Note that Amazon espouses four guiding principles in their business including a customer obsession rather than a competitor focus, a passion for invention, a commitment to operational excellence and long-term thinking. While we applaud this approach to business, management’s long-term thinking also translates to decision-making that often represents a short-term drag on profits. As a result, looking at traditional metrics (i.e., price to trailing twelve months earnings), may be less appropriate for investors. As we project out further with a discounted cash flow model, valuation begins to look more attractive, due to our expectations for compound growth and margin expansion.
All in, we believe that Amazon is run by outstanding leadership that will continue to innovate, benefitting both customers and shareholders. In our estimation, Amazon has built a ‘better mouse trap’ with a number of competitive advantages in their e-commerce and cloud computing businesses. With Amazon’s ‘passion for invention’, we also believe there are likely opportunities yet to surface that will disrupt future businesses and generate new profit streams. That said, we currently like the risk/reward profile of this innovative company and are happy to add a small position to portfolios.
Thank you for your continued trust and please let us know if you have any questions.
Senior Portfolio Manager