AMZN - Amazon.com Inc.

[ni-co]

I think that's apples and oranges.  None of those companies came in with a strategy of underpricing the competition and forgoing profits with a goal of changing the business model and raising prices later.  Facebook and Google have always been higher priced than the competition (as has cable vs satellite).

 

You are completely misunderstanding Amazon's model. It's not about suddenly "changing your business model" or "pricing competitors out of the market". Maybe it's this "flipping a switch" metaphor (I'm guilty of using as well) that leads people astray.

 

 

 

Let me give you a very simplified mental model of their strategy:

 

Imagine two companies that sell only one category of commodity product that you can buy from both – like books for example. At the beginning, both companies sell 1,000 books per quarter at $10 each, which cost them $9 to buy from the wholesaler and ship to their customers. So $1,000 in profit margin for each company per quarter. One company books the profit and pays out $1,000 in dividends every quarter to its shareholders. The shareholders love their company because it's so profitable and pays them such a huge dividend. The other company pays no dividend. It doesn't even turn a profit! That is because it reinvests the money as soon as it comes through the door into building out its infrastructure and into the acquisition of new customers, with the result that it's becoming a tiny bit less expensive to buy and ship the books per unit. This goes on for a while.

 

After 5 years, the expanding company sells 10,000 books per quarter and the cost per book has dropped to $8.50, while the "shareholder-friendly" company still has a $9 cost per book. The larger company now drops the selling price to $9.50, making the same $1 margin per book, and continue its expansion at the same rate (i.e. not showing a profit). The smaller company wants to stay in business, so it has to drop the selling price to $9.50, thereby reducing its quarterly profit and cutting the dividends to $500. The shareholders of the small company cry foul: "The large company wants to price us out of the market. It doesn't even turn a profit! That model can't be sustainable—they will raise the selling price back to $10 after we will be out of business!"

 

After 5 additional years, the expanding company sells 1,000,000 books, cost per book drops to $8 and they lower the selling price to $9. Game over for the small, "shareholder-friendly" competitor. Depending on the size of the market the large company can now either grow further in the same manner or stop their expansion and earn $1 per book and pay out $1,000,000 in dividends. Will the larger company raise its prices back to $10 per book? No. It would be stupid because their competitive advantage is to be profitable at a $9 selling price while none of their competitors are.—No "flipping of a switch" or "changing of business model" or other BS necessary. This game can go on in many product categories, for many years – even decades – during which it looks like the aggressively expanding company is not profitable and, in fact, it isn't! But that's by choice.

 

 

 

Back to Amazon: They are plowing their profit margin right back into the business via growth capex. The only thing you can see from the outside are rapidly expanding sales against the background of very stable capital requirements. Yes, the share count went up by 3.5% during the last 5 years, but they increased their book value by 72.5% at the same time (look at their net debt position). Amazon is not in need of fresh capital to keep its flywheel going. What this shows you is that they are very profitable under the hood and ploughing those "profits" right back into growth capex.

 

What traditional value guys get wrong with those companies is that they think this has to go on indefinitely. In other words, they argue that as soon as Amazon stops spending the capex, competitors will eat its lunch. That's wrong, because it's growth capex, not maintenance capex. Someday Amazon will inevitably stop growing and the growth capex will be significantly reduced–it will have to be. However, at this point in time, far out in the future, their cost advantage per unit (scale advantage) will be so large that Amazon will be able to operate profitably at a price level that drove competitors with less aggressive strategies out of the market and keeps newcomers from entering. This is how scale monopolies get built and this is what Bezos is trying with retail, AWS and media. This is why Stanley Druckenmiller calls him a "serial monopolist".

 

You can argue whether Amazon's lead is already large enough to be safe from competition (I don't think so). But you may see that focusing on "when they will flip the switch to 'profit'" completely misses the point. The market is so large that I have no worries assuming they can grow their revenues by 15% annually or more for many, many years—years during which the shareholder equity should be growing quite nicely (and with zero earnings). That's a lot in a zero (top-line) growth environment.

[FCharlie]

 

 

You can argue whether Amazon's lead is already large enough to be safe from competition (I don't think so). But you may see that focusing on "when they will flip the switch to 'profit'" completely misses the point. The market is so large that I have no worries assuming they can grow their revenues by 15% annually or more for many, many years—years during which the shareholder equity should be growing quite nicely (and with zero earnings). That's a lot in a zero (top-line) growth environment.

 

If AMZN did indeed grow sales 15% per year for the next decade, they would still have less sales than WalMart does today. And if they keep leaking out shares quarter after quarter, in ten years AMZN will have over a $300 billion market cap even if the price of the stock stays flat.... So I understand being excited about growth, but at what point is the expected growth priced in?

[KJP]

Along the lines of what Ni-co and others have posted, here's another take on Amazon's economies-of-scale strategy and how the company appears to be trying to become the essential infrastructure for a wide range of activities:  https://stratechery.com/2016/the-amazon-tax/

 

I don't know whether the author is right or wrong, but the narrative is a powerful one and it is easy to see how the thesis -- incredibly large TAM and competitive advantage from being the low-cost provider through economies of scale -- is attractive.

 

 

[KCLarkin]

Yes, the share count went up by 3.5% during the last 5 years, but they increased their book value by 72.5% at the same time (look at their net debt position).

 

They are issuing shares at 20x book value! It shouldn't surprise you that book value is increasing 20x faster than share count.

[ni-co]

Yes, the share count went up by 3.5% during the last 5 years, but they increased their book value by 72.5% at the same time (look at their net debt position).

 

They are issuing shares at 20x book value! It shouldn't surprise you that book value is increasing 20x faster than share count.

 

Yes, that's a fair point. Anyway, my main point here is that AMZN doesn't need additional capital to grow.

[ni-co]

 

 

You can argue whether Amazon's lead is already large enough to be safe from competition (I don't think so). But you may see that focusing on "when they will flip the switch to 'profit'" completely misses the point. The market is so large that I have no worries assuming they can grow their revenues by 15% annually or more for many, many years—years during which the shareholder equity should be growing quite nicely (and with zero earnings). That's a lot in a zero (top-line) growth environment.

 

If AMZN did indeed grow sales 15% per year for the next decade, they would still have less sales than WalMart does today. And if they keep leaking out shares quarter after quarter, in ten years AMZN will have over a $300 billion market cap even if the price of the stock stays flat.... So I understand being excited about growth, but at what point is the expected growth priced in?

 

Yes, but that is assuming that, after this decade, Amazon's retail sales growth slows towards WMT's sales growth—which I don't think. Further, it assumes Amazon's margin stays about the same. I don't think that's the case either, because the (1) the retail business should have a higher profit margin than WMT's at the same scale (especially because of third party transactions), (2) AWS growth and (3) the growing media business.

 

Take a look at Amazon's FCF growth over the past 5 years (in which AMZN had its fair share of failures) and compare it to WMT's — this is a wholly different animal.

[dwy000]

Ni-co - I respect your opinion but disagree with the premise of the argument.  Amazon is not competing against mom and pop stores, they are competing against Walmart and Target.  The ability to consistently underprice those companies based on volume doesn't make sense.  They are simply willing to operate at lower net margins (or zero if you consider the "growth" investments as something they cannot simply shut off without killing the underlying business).  A lower, more efficient cost base is not a long term competitive advantage unless it is driven by fundamentals that cannot be replicated by competitors.  Walmart killed off most mom and pop stores because of their scale advantage but it hasn't meant reduced competition. 

 

Ultimately this will only be played out over time so it's a theoretical discussion.  But regardless, it is hard to rationalize any assumptions on revenues or profitability over the next 10 years that justify a decent risk/reward return at today's stock price.

[KJP]

 

Ultimately this will only be played out over time so it's a theoretical discussion.  But regardless, it is hard to rationalize any assumptions on revenues or profitability over the next 10 years that justify a decent risk/reward return at today's stock price.

 

What will the standalone AWS business (meaning the portion that provides computing power to third parties, rather than other portions of Amazon) look like in 10 years?

[dwy000]

 

Ultimately this will only be played out over time so it's a theoretical discussion.  But regardless, it is hard to rationalize any assumptions on revenues or profitability over the next 10 years that justify a decent risk/reward return at today's stock price.

 

What will the standalone AWS business (meaning the portion that provides computing power to third parties, rather than other portions of Amazon) look like in 10 years?

No idea.  It's a business that didn't even exist 10 years ago and is operating in a space that seems to be changing daily, so playing it out over the next 10 years (including how competitors will react etc.) is not something I'm comfortable doing or putting dollars behind.  More power to those who are!

[ni-co]

Ni-co - I respect your opinion but disagree with the premise of the argument.  Amazon is not competing against mom and pop stores, they are competing against Walmart and Target.  The ability to consistently underprice those companies based on volume doesn't make sense.  They are simply willing to operate at lower net margins (or zero if you consider the "growth" investments as something they cannot simply shut off without killing the underlying business).  A lower, more efficient cost base is not a long term competitive advantage unless it is driven by fundamentals that cannot be replicated by competitors.  Walmart killed off most mom and pop stores because of their scale advantage but it hasn't meant reduced competition. 

 

Ultimately this will only be played out over time so it's a theoretical discussion.  But regardless, it is hard to rationalize any assumptions on revenues or profitability over the next 10 years that justify a decent risk/reward return at today's stock price.

 

I guess we just have to agree to disagree. FWIW: In case you are unfamiliar with it, here is the bullish case much better stated than I could + why bulls think it's a decent risk/reward investment (of course, it all depends on your assumptions). This, taken together with the aforementioned piece by Ben Thompson pretty much is my investment thesis:

 

https://oraclefromomaha.wordpress.com/2015/12/07/amazon-and-world-domination/

[KCLarkin]

Rumour that Apple has moved a significant chunk of it's cloud services to Google from AWS:

http://www.crn.com/news/cloud/300080062/cloud-makes-for-strange-bedfellows-apple-signs-on-with-google-cuts-spending-with-aws.htm

 

[ccplz]

Amazon is a charity for consumers operating at the expense of shareholders.

[cmlber]

 

 

You can argue whether Amazon's lead is already large enough to be safe from competition (I don't think so). But you may see that focusing on "when they will flip the switch to 'profit'" completely misses the point. The market is so large that I have no worries assuming they can grow their revenues by 15% annually or more for many, many years—years during which the shareholder equity should be growing quite nicely (and with zero earnings). That's a lot in a zero (top-line) growth environment.

 

If AMZN did indeed grow sales 15% per year for the next decade, they would still have less sales than WalMart does today. And if they keep leaking out shares quarter after quarter, in ten years AMZN will have over a $300 billion market cap even if the price of the stock stays flat.... So I understand being excited about growth, but at what point is the expected growth priced in?

 

Yes, but that is assuming that, after this decade, Amazon's retail sales growth slows towards WMT's sales growth—which I don't think. Further, it assumes Amazon's margin stays about the same. I don't think that's the case either, because the (1) the retail business should have a higher profit margin than WMT's at the same scale (especially because of third party transactions), (2) AWS growth and (3) the growing media business.

 

Take a look at Amazon's FCF growth over the past 5 years (in which AMZN had its fair share of failures) and compare it to WMT's — this is a wholly different animal.

 

Why are you so sure AMZN's margins will be equal to WMTs at the same scale (leaving marketplace revenue/margin aside, which actually is a good business)?  A large percentage of WMTs stores operate in small towns that can only support one discount retailer and therefore high margins don't attract entry.  WMT also has huge economies of scale in distribution.  The kind of economies of scale that actually are real and show up in the financial statements. 

 

If AMZN sales grow 10x and they get 10% margins (higher than WMT), they'll earn $100bn pre-tax, which will make it a $1 trillion company that takes $20 billion in equity to recreate.  You don't think there will be competitors who try to take a slice of that $1 trillion (and still growing I guess... :o)?  And what will stop them? 

[ni-co]

You guys all make the same mistake. If I could recreate every company out there with only the capital that has been put into it we'd have no Microsoft, no Apple, no company with any first mover advantage. This is not a valid argument.

[cmlber]

You guys all make the same mistake. If I could recreate every company out there with only the capital that has been put into it we'd have no Microsoft, no Apple, no company with any first mover advantage. This is not a valid argument.

 

When did I say you could recreate any company with just the capital that has been put into it?

 

I think with a nearly infinite amount of capital, it would be impossible to recreate Microsoft.  There are actual network effects that money can't buy.  No amount of money could recreate FB.  No amount of money could recreate Moodys/S&P.  But money CAN buy "scale."  Especially when "scale" is defined as 40bps of global retail and especially when there are a variety of very well capitalized, cash flow machines with nearly the same scale (or significantly greater scale in the case of WMT) as AMZN already.

[ni-co]

…which will make it a $1 trillion company that takes $20 billion in equity to recreate.  You don't think there will be competitors who try to take a slice of that $1 trillion (and still growing I guess... :o)?  And what will stop them?

 

If you could recreate Amazon with $20bn USD there would be 10 Amazon clones in the making in Silicon Valley and there aren't. – Why? Because recreating Amazon with $20bn is phantasy land. Of course, you can't! It takes much more than that. More money (the money that Amazon has been investing for almost 20 years now – which you can't by looking at their equity), more time, people like Jeff Bezos, the creation of the internet… You couldn't even recreate AWS with $20bn. There is such a large first mover advantage to every business Amazon has (successfully) entered and they do everything to make it as hard as possible for other companies to enter.

 

And optimizing your company for profits to shareholders is certainly not the way to do it.

[rkbabang]

You guys all make the same mistake. If I could recreate every company out there with only the capital that has been put into it we'd have no Microsoft, no Apple, no company with any first mover advantage. This is not a valid argument.

 

+1.  I could give you $1T and you couldn't recreate Apple, nor Amazon, nor even Wal Mart.  Amazon could never outcompete Wal Mart by recreating Wal Mart. 

[ni-co]

Amazon could never outcompete Wal Mart by recreating Wal Mart.

 

Exactly.

[rkbabang]

Now give me a few $B and a time machine to go back to 1994...  and even then, I'm not Jeff Bezos.

I'd be better off using it to fund him.

[cmlber]

You guys all make the same mistake. If I could recreate every company out there with only the capital that has been put into it we'd have no Microsoft, no Apple, no company with any first mover advantage. This is not a valid argument.

 

+1.  I could give you $1T and you couldn't recreate Apple, nor Amazon, nor even Wal Mart.  Amazon could never outcompete Wal Mart by recreating Wal Mart.

 

You clearly haven't spent much time thinking about what $1T can do.  Here's how I would destroy AMZN with $1T.

 

1). I'd set aside $100 billion to make the 100 best employees at AMZN billionaires.  Good luck matching that comp Jeff.

 

2). I'd spend $30 billion replicating AMZNs PPE, this could be done in a couple years.

 

3).  I'd buy every Super Bowl ad slot for the next fifty years. This would only cost about $10 billion.  I'd also buy every Facebook ad for the next two years while I'm still unknown so that any time the 1 billion people using Facebook view a page, they see my ads and nothing else.  That'll cost me about $60 billion.

 

4). What id advertise on those ads is a pledge to give every American citizen $1,000 credit to spend, no strings attached, on my site where I would have the exact same merchandise as AMZN.  This would cost me $300 billion.

 

5).  I would provide free two day shipping to everyone, no questions asked.  This is probably a $100 billion NPV commitment.

 

6).  I would offer a low price guarantee. 

 

After doing all that, I have $400 billion left to spend.

 

Do you think anyone would still use AMZN on that scenario?

 

[ni-co]

You guys all make the same mistake. If I could recreate every company out there with only the capital that has been put into it we'd have no Microsoft, no Apple, no company with any first mover advantage. This is not a valid argument.

 

+1.  I could give you $1T and you couldn't recreate Apple, nor Amazon, nor even Wal Mart.  Amazon could never outcompete Wal Mart by recreating Wal Mart.

 

You clearly haven't spent much time thinking about what $1T can do.  Here's how I would destroy AMZN with $1T.

 

1). I'd set aside $100 billion to make the 100 best employees at AMZN billionaires.  Good luck matching that comp Jeff.

 

2). I'd spend $30 billion replicating AMZNs PPE, this could be done in a couple years.

 

3).  I'd buy every Super Bowl ad slot for the next fifty years. This would only cost about $10 billion.  I'd also buy every Facebook ad for the next two years while I'm still unknown so that any time the 1 billion people using Facebook view a page, they see my ads and nothing else.  That'll cost me about $60 billion.

 

4). What id advertise on those ads is a pledge to give every American citizen $1,000 credit to spend, no strings attached, on my site where I would have the exact same merchandise as AMZN.  This would cost me $300 billion.

 

5).  I would provide free two day shipping to everyone, no questions asked.  This is probably a $100 billion NPV commitment.

 

6).  I would offer a low price guarantee. 

 

After doing all that, I have $400 billion left to spend.

 

Do you think anyone would still use AMZN on that scenario?

 

I can't wait to see it. From your calculations I deduct that you're no longer of the opinion that Amazon could be replicated with $20b?

[ni-co]

Just re-read this and think about how things turned out:

 

I agree that the current valuation is tough to justify - especially if you compare them to Walmart.

 

Amazon's market cap - $105B. Sales were $48B last year. Net income has averaged around $1B annually for the last 3 years.

Walmart's market cap - $244B. Sales were around $447B last year. Net income has averaged around $16B annually for the last 3 years.

[plato1976]

I am not an amazon bear

but let's just talk about AWS -

do you think AWS will be a dominating public cloud provider (means maintaining its current share adv against m$ and goog)?

These two competitors have very deep pockets and if aws cannot maintain its current share adv I am afraid its profit margin will be eventually much lower. I am not convinced that this business is very sticky

 

What's your opinion?

 

Just re-read this and think about how things turned out:

 

I agree that the current valuation is tough to justify - especially if you compare them to Walmart.

 

Amazon's market cap - $105B. Sales were $48B last year. Net income has averaged around $1B annually for the last 3 years.

Walmart's market cap - $244B. Sales were around $447B last year. Net income has averaged around $16B annually for the last 3 years.

[ni-co]

I am not an amazon bear

but let's just talk about AWS -

do you think AWS will be a dominating public cloud provider (means maintaining its current share adv against m$ and goog)?

These two competitors have very deep pockets and if aws cannot maintain its current share adv I am afraid its profit margin will be eventually much lower. I am not convinced that this business is very sticky

 

What's your opinion?

 

I'm not sure either way. It's very hard to tell but here are my thoughts:

 

Switching costs are very large. It took Dropbox years to do the switch and storage is the heart of their business—this speaks to the stickiness of AWS. Also keep in mind that they didn't switch to Google or Microsoft but built their own infrastructure. I certainly think the long-term implications of Apple switching/diversifying into Google's cloud are overrated. Apple is going to switch to its own infrastructure as soon as possible, so not a real win for Google, either.

 

Further, it might be a mistake for Microsoft not to do their cloud in an open source way (but I'm not sure how important that is—here I'm really out of my circle of competence; it's just my instinct telling me that).

 

In the end, it's a commodity business and margins should come down; I would be very surprised if they didn't. But I think that Bezos would be too. That's why he entered this business in the end. Amazon is at its best when it comes to operating in a low margin, winner takes it all environment. Never underestimate Amazon when it comes to expanding their business at very low margins/zero profit.

 

I'm not sure whether Google is institutionally set up for this—but I could easily be wrong here. On the face of it, Android is unprofitable but it's very core to their ad business as a defensive move—so is it really unprofitable in the end? If it plays out like I think, I wonder what Google will do when they will realize that Amazon is willing to run AWS at zero profit for many years to come. In the end, they may simply say: there's no money to be made here. Yet, like in online retailing, there is money to be made for the largest guy—it should end in a natural monopoly.

 

That said, Google should have the necessary scale to compete with AWS. So, it's a close call.

[ni-co]

Talking about Google, does anybody know how large Jeff Bezos's Google stake is?