Amazon dominates North American online retail with an estimated gross merchandise volume or “GMV” of approximately $150 billion in 2016. With more than half of the world’s Internet users coming from developing markets, Amazon has meaningful international growth opportunities, including Europe, Japan, and India. Kindle products and complementary devices like Fire TV, Dash, Echo, and Alexa represent intriguing customer acquisition and retention tools that capitalize on the shift to digital media while concurrently promoting Prime memberships and AWS’ various capabilities.

 

Investment Thesis
Amazon is the most disruptive force to emerge in retail in several decades. Its operational efficiency, network effect, and a brand intangible asset built on customer service provide it with sustainable competitive advantages that few, if any, traditional retailers can match. As an increasingly vital distribution channel for consumer product vendors, Amazon commands favorable pricing terms to traditional rivals, which will help drive recurring site traffic. Even with more retailers looking to expand online, we believe Amazon will maintain its consumer proposition through the convenience of Amazon Prime’s expedited shipping, expanding digital content library, and new partnerships coming out of its Whole Foods acquisition. Aided by more than 350 million global active users and recent fulfillment infrastructure, technology, and content investments, Amazon owns one of the wider economic moats in the consumer sector and is likely to reshape retail, digital media, and enterprise software for years to come.

Key top-line metrics–including active users (a 15% compound annual growth rate the past five years), total physical and digital units sold (28% CAGR), and third-party units sold (36% CAGR)–continue to outpace global e-commerce trends, suggesting that Amazon is gaining share while fortifying its network effect. On top of its impressive growth trends, Amazon is gradually building an intriguing margin expansion story, including 3.1% operating margins in 2016. Amazon’s margin expansion is going to be less predictable than its growth trajectory, given the potential for new investment cycles, including international fulfillment infrastructure and content deals, AmazonFresh, tablets and other hardware such as the Echo/Alexa-enabled products, new delivery capacity and technologies, and physical store expansion. Some of the company’s capital decisions haven’t always yielded strong returns. However, we’re optimistic that Amazon can post 6%-7% operating margins by 2021 based on Prime and Prime Fresh adoption and price hikes, segment margins for Amazon Web Services exceeding 30%, fulfillment center scale, third-party sales, and improving international profitability.

 

Economic Moat
A shakeout among traditional brick-and-mortar retailers is under way, particularly in commoditized categories. With nonexistent customer switching costs and intense competition, we’ve already seen Circuit City, Linens ‘n Things, Borders, and RadioShack effectively exit the retail landscape, while names like Barnes & Noble, Sears, the office superstores, and a host of other retailers struggle to reverse deteriorating fundamentals. Market consolidation among mass merchants like Wal-Mart and Costco has played a role in this trend, as have direct-to-consumer investments by key original-equipment manufacturers like Apple and Samsung. However, we see Amazon as the most disruptive force to emerge in retail in several decades. Its operational efficiency, network effect, and laser focus on customer service provide it with sustainable competitive advantages that traditional retailers cannot match; this should yield additional market share gains in the years to come. Despite ongoing fulfillment, technology (hardware devices and AWS), and content investments, we expect Amazon can generate economic returns ahead of our cost of capital assumption over an extended horizon, supporting our wide moat rating.

One of Amazon’s key advantages is its operational efficiency of its fulfillment and distribution network, which allows Amazon to competitively price with its brick-and-mortar retail peers while still generating positive economic returns. This allows Amazon to generate strong cash flow, which in turn can be reinvested in advertising, customer service, and website enhancements that keep its marketplace robust and customer loyalty strong. In fact, we believe Amazon’s brand has come to represent low prices, a wide selection, convenience, and superior customer service–a rare combination among retailers.

Amazon also benefits from a network effect, as low prices, an expansive breadth of products, and a user-friendly interface attract millions of customers, which in return attract merchants of all kinds to Amazon.com, including third-party sellers on Amazon’s Marketplace platform (which represented almost 50% of total units sold in 2016) and wholesalers/manufacturers selling directly to Amazon. According to our research, the percentage of traffic to Amazon derived from search has fallen in recent years at a time when other online retailers have become more dependent on search. We think this indicates that Amazon is increasingly becoming the starting point for online purchases, akin to a mall anchor tenant. Additionally, customer reviews, product recommendations, and wish lists increase in relevance as more consumers and products are added to the Amazon platform, enhancing its network effect.

Amazon’s $13.7 billion proposed acquisition of Whole Foods marks its most significant push into the grocery category, but likely left some investors scratching their heads after more than two decades of building an e-commerce empire without physical stores. While we had expected the company to further test its other grocery concepts before going all in with physical stores, we do see several reasons why this acquisition is more than just a push into the grocery category and can enhance Amazon’s wide moat. First, there is already a high degree of overlap between Amazon Prime members and Whole Foods shoppers, with opportunities to migrate Prime members to the Fresh member tier (which runs $14.99 per month in addition to the $99 annual fee for traditional Prime members). Second, Amazon adds instant credibility in fresh produce and proteins through Whole Food’s supplier base, something that had been slow to materialize with Amazon’s grocery efforts to this point. On top of becoming a reputable player in fresh food, we expect that many of Whole Foods suppliers will explore Amazon as a potential distribution channel, at least those not already using Amazon’s marketplaces. Third, Amazon has a new vehicle to meaningful expand and accelerate its private-label offerings, including its own packaged food and household product private labels such as Happy Belly, Mama Bear, and Wickedly Prime as well as the opportunity to sell Whole Foods’ 365 label to existing Prime customers. Finally, Whole Food’s physical locations offer an opportunity to better showcase new Amazon products and technologies.

We like Amazon’s chances of competing in digital media, given its sizable customer base, the symbiotic hardware/software ecosystem of its Kindle, Fire TV, Dash, and Echo products, as well as intriguing licensing possibilities with Amazon’s Echo and other Alexa-enabled voice-recognition products. We still view the Kindle suite of products as customer-acquisition tools that add multiple layers of upside to our base-case assumptions, including additional Prime memberships and engagement levels, accelerating digital media sales, and a positive halo effect on general merchandise sales. We believe Amazon will continue to develop into a formidable player in digital media, given its vast content offerings, inroads into new verticals (including video games), and ability to sell hardware as a loss leader.

We believe Amazon Web Services has similarly developed cost advantage, intangible asset, and network effect moat sources. Amazon’s public cloud computing offerings possess more than 4 times the computing capacity in use than the next 14 largest providers combined (according to Gartner statistics), providing the company with scale advantages and often making it the preferred name for corporations looking to reduce information technology expenditures. AWS generated $12.2 billion in revenue during 2016, and we forecast average annual revenue growth of more than 30% over the next five years. With recent investments for additional capacity and other innovations, we expect AWS to become an increasingly positive gross margin contributor–the segment posted 25.4% segment operating income in 2016, and we believe this segment can deliver 30%-plus margins over a longer horizon–because of its highly scalable nature and other mission-critical services outside of cloud storage, including a network of third-party software providers selling on AWS Marketplace.

 

Analysts Note
Amazon’s third-quarter update made a convincing case that the network effect underpinning our wide moat is strengthening, with revenue trends before Whole Foods accelerating across most revenue categories and indicating greater engagement among Prime members, third-party sellers, and AWS users. We believe investors should focus on three themes: 1) the shift from Prime acquisition to engagement via new products and services in the U.S.; 2) the jump in Prime international and the lifetime value potential; 3) and continued monetization of AWS. Unpacking each of these trends, we believe that 2017 will go down as a pivotal year for Amazon Prime memberships, where the company’s focus in North America shifted from Prime enrollment to engagement and many international markets seeing a Prime recruitment ramp similar to the U.S. in 2012-13. This is evident in the 59% increase in subscription services (versus 53% currency-neutral growth last quarter), with Prime Day helping to drive U.S. members into new services and a record day for Prime trials globally. Not surprising, this recruitment/engagement is also helping to drive third-party seller activity, where revenue growth remained robust at 40%. AWS posted health currency-neutral revenue growth of 42% and segment margins of 25.5%, which we attribute to adoption of mission critical services and AWS Marketplace contract term changes. For 2017, we now forecast top-line growth of 30% but also a modest reduction in operating margins to 2.2% (versus 3.1% a year ago), which is consistent with management’s fourth quarter guidance for revenue between $56 billion-$60.5 billion and operating income between $300 million-$1.65 billion. Over the next five years, we now expect average annual revenue growth of 24% (up from 22% due to new category expansion like apparel, home furnishings, and pharma) and operating margins of 6%.

 

Valuation
Even with fulfillment, marketing, and technology/content costs in 2017 running ahead of last year’s pace, we’re comfortable with our $1,200 per share fair value estimate (which also incorporates new growth opportunities and cost synergies tied to the Whole Foods acquisition, which is expected to close in the second half of 2017). In Amazon’s case, we do not believe traditional price/earnings and enterprise value/EBITDA metrics are meaningful, given the impact that technology, content, and infrastructure investments are expected to have on near-term margins. Still, we believe Amazon warrants a premium valuation based on its wide economic moat, meaningful avenues for growth, and longer-term margin expansion potential.

Amazon’s competitive position and compelling value proposition should lead to additional share gains in 2017, putting full-year revenue growth around 25%. Our model assumes average annual revenue growth of around 22% for the five years ending 2021 due to contribution from Whole Foods and increased third-party sales from its suppliers but also continued market share gains, digital content sales, international expansion, and the aforementioned nascent growth channels. With respect to Amazon’s sales mix, we forecast retail product sales to grow 16% annually the next five years, with smaller but faster growing segments like third-party seller services, subscription services, and AWS growing 27%, 36%, and 32%, respectively, over the same period.

We project that gross margins will push 40% within five years, compared with 35% in 2016. Amazon’s growing clout with suppliers, the higher proportion of third-party units in the sales mix, and AWS’ increased presence should allow for higher gross margins, partly tempered by a mix shift to lower-margin nonmedia categories. We also forecast operating margin expansion through increasing expense leverage (particularly in the fulfillment, marketing, and general and administrative expense line items), greater contribution from AWS, accelerating third-party unit sales, and cost savings opportunities at Whole Foods. Our model calls for almost 6%-7% GAAP operating margins over the next five years based on the company’s strong competitive positions in AWS and North American e-commerce, as well as early indications of success in certain international markets.

 

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