The recent sell-off makes wide-moat Amazon even more attractive.
After nearing $380 in late March,
Amazon.com (AMZN) shares have fallen to less than $320 and now trade at a 20% discount to our $400 fair value estimate. We attribute the weakness more to an increasingly risk-sensitive market and less to company-specific factors, as Amazon has recently announced several new devices that enhance its network effect and give consumers less incentive to go outside the Amazon ecosystem for purchases. These include the launch of the Fire TV and Amazon Dash, an at-home device with bar code scanning and voice search features that should augment a broader Amazon Fresh launch in 2014. We also believe the decision to raise the annual Amazon Prime membership fee is a signal that management plans to start layering in margin expansion in the years to come after building out its active user and Prime member bases the past several years (Amazon's active user base now exceeds 240 million members, with roughly a tenth of them also Prime members).
We believe the recent sell-off creates an intriguing entry point for a name that we consider to have one of the widest economic moats in the consumer sector today. In addition to its network effect, Amazon's other moat sources remain intact, as the absence of physical stores offers cost advantages that allow the company to be a price leader across most categories (even factoring online sales tax collection) and the combination of a wide variety of physical and digital products, expedited shipping, and strong customer service makes for a powerful intangible asset. We acknowledge that Amazon's margin expansion story is less visible than its growth, given new potential projects on the horizon (international fulfillment centers, Amazon Fresh, smartphone, delivery drones).
However, we remain comfortable with our five-year operating margin target of 5%, driven by increased contribution from Prime members, Amazon Web Services, and digital content sales.
Bytes Beat Bricks (and Mortar)
Amazon has played a prominent role in the structural shift away from brick-and-mortar retail, and it may lay waste to several other retailers in the years to come. Without the cost burden of physical stores, Amazon can price below traditional rivals and drive recurring traffic online. Even with the threat of online sales tax collection, we believe Amazon can maintain its value proposition through other means, including adjustments to shipping policies or Amazon Prime. Aided by the network effect inherent in more than 240 million active users and recent fulfillment infrastructure, technology, and content investments, Amazon owns one of the widest economic moats in the consumer sector and is likely to remain a disruptive force in retail, digital media, and cloud computing.
Amazon's growth potential is undeniable. Key top-line metrics, including active users (which have grown at a 22% compound annual growth rate the past five years), total physical and digital units sold (38% CAGR), and third-party units sold (48% CAGR), continue to outpace global e-commerce trends, suggesting that Amazon is gaining market share and fortifying its network effect. Nevertheless, based on operating margins of 1.0% in 2013 (2.7% excluding stock-based compensation and amortization of intangibles), our fair value estimate seemingly requires a leap of faith based on whether the company will be able to monetize its explosive growth.
Although it isn't likely to be a straight shot, our base case assumes that Amazon will approach 5% operating margins by 2018 (6% excluding stock-based compensation and amortization of intangibles). Behind our longer-term margin assumptions are several building blocks, including contribution from Amazon Prime memberships and fee increases, monetization of Amazon Web Services, leverage from fulfillment center investments, digital media sales due to the expanding Kindle ecosystem, and third-party fulfillment services. Following its heavy fulfillment, technology, and content investment cycle, we believe Amazon is poised to capitalize on these factors and add margin expansion to an already compelling growth story.
Most Disruptive Force in Retail in Several Decades
A shakeout among traditional brick-and-mortar retailers is underway, particularly in commodified categories. With minimal customer switching costs and intense competition, we've already seen Circuit City, Linens 'N Things, and Borders exit the marketplace over the past few years, while names like Barnes & Noble, Sears, Office Depot, and OfficeMax struggle to reverse deteriorating fundamentals. 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. However, we believe Amazon has become the most disruptive force to emerge in retail in several decades. Its low-cost operations, 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 in coming years. Armed with one of the more capital-efficient models in e-commerce, Amazon should generate economic returns well ahead of our cost of capital assumption following its current
investment cycle, supporting our wide Morningstar Economic Moat Rating.
Amazon's primary advantage is its low-cost operations. The cost to maintain its fulfillment center network is lower than having a large physical retail presence, allowing Amazon to price below its brick-and-mortar peers while still generating excess economic returns. Additionally, U.S. tax laws currently mandate that online retailers collect sales tax in states where they have a physical presence, with the tax responsibility falling to the end consumers themselves. As a result, Amazon currently collects sales tax in a handful of states where it maintains a physical presence, providing another layer of cost advantages. These competitive advantages allow Amazon to generate strong cash flow, which can be reinvested in advertising, customer service, and website enhancements that keep its marketplace robust and customer loyalty strong. We believe Amazon's brand has come to represent low prices, 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 attracts merchants of all kinds to Amazon.com, including third-party sellers on Amazon's Marketplace platform (which represent 40% of total units sold) 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.
As media products (which contributed 29% of total revenue in 2013) move from physical to digital distribution, warehouses and an expansive distribution network will not provide the same advantages. Nevertheless, we like Amazon's chances to compete in digital media, given its sizable customer base and the symbiotic hardware/software ecosystem of its Kindle products. We continue to consider the Kindle suite of products as meaningful customer acquisition tools that add multiple layers of upside to our base-case assumptions, including additional Prime memberships, accelerating digital media sales, and a halo effect on general merchandise sales. Even though we don't expect Amazon to supplant Apple's dominance in digital media, we believe it could develop into a formidable player, given its vast content offerings, inroads into new areas (including video games), and ability to sell hardware as a loss leader.
We also believe Amazon Web Services has developed cost advantage and intangible asset moat sources. In particular, 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. We believe AWS generated approximately $3 billion in revenue during 2013, and we forecast average annual revenue growth of more than 30% over the next five years. With recent investments for additional capacity, we also expect AWS to become an increasingly positive margin contributor because of its highly leverageable nature.
Maintaining Value Proposition Is a Must
Despite its leading position in an e-commerce industry with secular tailwinds, Amazon faces a few potential risks, and we assign it a high fair value uncertainty rating. Impairment to Amazon's low-price positioning, whether real or perceived, could have an adverse impact on fundamentals. Amazon must maintain its value proposition to drive site traffic while fending off other online merchants, mass merchants, warehouse clubs, and specialty retailers for market share. This includes preserving the value proposition of Amazon Prime after management announced that it is considering a $20-$40 hike to the annual membership fee during 2014 (citing fuel/transportation costs as well as increased Prime usage), though we believe Amazon's fulfillment capabilities, digital content offerings, and Subscribe & Save platforms will help to keep Prime member attrition to a minimum.
Amazon also faces some regulatory risk, as we expect a federal standard for collecting online sales tax to be put in place within the next several years, potentially weakening one cost advantage and making traditional retailers more competitive. Still, even with more-stringent tax collection laws, we believe Amazon could maintain its value proposition and attract customers through other means, including changes to shipping policies or new Amazon Prime membership features. International growth brings unique regulatory challenges, as foreign governing bodies are constantly amending online commerce laws.
Other downside risks include exposure to volatile discretionary spending patterns and expansion into peripheral business lines, which could distract management or lead to poor capital-allocation decisions. Conversely, we see upside risks in the form of more diversified AWS offerings, advertising services, expanded Fulfilment by Amazon capabilities, the rollout of AmazonFresh across additional urban centers, and new potential pricing tiers for Amazon Prime memberships.
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