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Coho Capital Thoughts on Amazon $AMZN

Amazon is most well-known for its e-commerce segment, which has more than 304 million global users(19% compound annual growth rate over the past five years)and a 41% share of online commerce.  The next largest competitor is Best Buy with a2.7%share.  And yet despite its dominant position, Amazon continues to grow faster than the competition-capturing 60% of total US online sales growth in 2015, according to Forrester Research.  Amazon’s competitors are at such a significant disadvantage in selection and pricing one could argue that Amazon’s e-commerce business has no credible competition.

Despite Amazon’s dominant position within online commerce, the company has years of explosive growth ahead.  It may be surprising to some, it was to us,that e-commerce stills represents less than 10% of all retail spending.  According to the US Census Bureau, e-commerce sales represented 7.8% of all domestic retail sales as of March, 2016. Rates of penetration are even lower internationally at 7%.  

What to Expect When You’re Inflecting

It is interesting to note that growth within technological products and services tends to see a dramatic acceleration at around 20% penetration levels.  This is what is known as the “S-curve.”  Both smart phones and notebook computers reached a material inflection point once market adoption hit 20%.  Contrary to how Wall Street typically prices growth companies, it is later-stage rather than early stage growth that should be most highly valued.  Once the S-curve has been breached, growth can be explosive.  For example, digital music took a decade to reach 20% penetration but leaped to 50% in just four years.  We are not there yet,but many will increasingly view the idea of driving all over the city to fill a shopping basket as an archaic exercise. 

With Amazon’s domestic infrastructure largely in place, we expect margins within the company’s e-commerce segment to inflect materially higher as operating leverage continues to ramp. 

Amazon Prime

Consider the following business:

  1. Approximately 30% of US online shoppers have a membership.
  2. Over 63 million members exist worldwide
  3. Membership numbers are up 50% on a global basis during each of the last two years. 

Amazon Prime is a cornerstone of Amazon’s growth strategy as Prime customers tend to spend more and embed themselves more deeply within the Amazon ecosystem.  According to Consumer Intelligence Research Partners, Prime members spend $1,100 a year compared to $600 for non-prime customers. For long-term Prime members, the numbers are even more compelling with those using the service for 7-10 years spending 8-10x more than non-Prime members.

Prime members are spoiled by Amazon with free shipping, unlimited photo storage and streaming of music and video.  Amazon’s ever-widening collection of free Kindle books, podcasts, music, Fire TV, Prime video, game playing, and now voice assistance through Alexa, are powerful inducements for Prime customers to stick around.  As CEO Jeff Bezos put it, “If you’re not a Prime member, you’re being irresponsible.

It would appear that Prime benefits, as well as higher switching costs incurred through engagement with Amazon’s digital services, do indeed inspire loyalty.  According to Amazon, four-fifths of Prime members who signed up for the service a month after it launched in 2005 are still with the company.  More recent vintage renewal rates are even higher with 96% of customers that have been with Prime for two years choosing to renew for a third.  It is easy to see why Amazon showers Prime members with benefits, for the lifetime value of these customers is very rich indeed.

From a competitive standpoint, the panoply of perks offered by Amazon is impossible to match.  Firms can offer free shipping, but little else in the way of consumer inducements.  Of course, no one can deliver free shipping at Amazon’s unit costs so Amazon grinds the competitive screws tighter.

As an investor, one of the most valuable things one can find in a business is latent pricing power.  Amazon Prime has latent pricing power in spades.  At the end of 2014, Amazon raised Prime prices by 25%.  Few businesses are capable of passing on such dramatic price increases without suffering from consumer churn.  Yet, the next year domestic Amazon Prime members rose by 25%. 

At $100 a year, Prime represents an extraordinary value.  We envision a future where consumers will view the convenience and benefits of Prime as an essential element of eliminating friction in their lives.  When you consider the average consumer pays $100 a month for their cable bill, an annual Prime payment of $150-$200 does not seem far-fetched. 

With 110 million (expected by yearend) members paying annual fees of $100, Amazon has an$11 billion stream of recurring revenue at its disposal. 

Like Costco, we expect Amazon to monetize its Prime members in myriad ways such as credit cards, travel, group buying discounts and car buying.  It is not hard to envision a future in which Prime members utilize a Prime card to secure discounts in offline services and products such as dining, hotels, air travel and merchandise.  In fact, it was announced today that Prime members would enjoy discounts on their student loans through a partnership with Wells Fargo.

If You Can’t Beat Em, Join Em - Amazon Marketplace

After twenty years of building an arc for a flood of online commerce, the rest of Amazon’s competitors are patching up leaky row boats.  In fact, with Amazon so far ahead of the competition it makes little sense for small and mid-tier retailers to build out e-commerce infrastructure.

Close to 50% of the units sold on Amazon are from third parties (3P).  Third party sales comprise Amazon’s Marketplace business where Amazon serves as the storefront but participating merchants are responsible for shipping, logistics and inventory management.  Margins on 3P are higher than Amazon’s regular e-commerce business with merchants paying Amazon a royalty of up to 15% on sales.  Apart from higher margins, Amazon Marketplace serves as a natural on-ramp to Fulfillment by Amazon (detailed later). 

Units sold on Amazon Marketplace have grown at a 42% compound annual growth rate over the past five years.  The enhanced selection fortifies Amazon’s network effects, driving even more sellers and buyers to its marketplace.  Incidentally, while many wonder about the destruction of main street retail at the hands of e-commerce, Amazon has been a great launching pad for future tycoons.  Last year, over 70,000 entrepreneurs made more than $100k through selling on Amazon Marketplace. 

At present, Marketplace features sellers from 172 countries selling to customers in 189 countries.  This is another network effects business within Amazon with winner take all economics.  Sellers will naturally gravitate toward the platform with the most traffic, placing Amazon in a favorable position.  It is still early days but we think Amazon’s Marketplace has the potential to be a more globalized version of Alibaba.

AWS, Amazon’s Crown Jewel

Amazon Web Services (AWS) is Amazon’s cloud computing business and the company’s most profitable and fastest growing division.  Launched nine years ago, AWS was a means to better utilize the company’s server capacity by renting out remote storage and data management.  Over time, AWS has grown to include over 70IT Infrastructure and software services such as storage, analytics and data management.

Originally favored by lean startups eager to tap into high-end computing functionality at lower costs, AWS has since been embraced by large enterprise customers.  Even companies as large as GE, Comcast, Kellogg, Vodafone,and Ford,find it cheaper to rent space at Amazon’s data centers than to build out IT infrastructure on their own.  And those who wish to Netflix and Chill can thank Amazon for delivering the experience. 

Last year, Amazon broke out financial metrics for its Amazon Web Services (AWS) business for the first time and the numbers were a revelation.  AWS grew revenue 70% to $7.9B in 2015 and the division accounted for 83% of Amazon’s operating profit. This year AWS is on pace to surpass $10 billion in annual sales.  If it were a stand-alone company, AWS would be the fastest to ever achieve $10 billion in revenue.

AWS is the undisputed leader within the IT cloud space with more than one million customers.  According to IT research firm, Gartner, “AWS is the overwhelming market share leader, with more than five times the compute capacity in use than the aggregate total of the other 14 providers.”  In terms of revenue, Amazon is five times the size of its next largest competitor, Microsoft. 

AWS’ scale confers significant advantages in unit costs,and similar to Amazon’s e-commerce business, a healthy portion of those savings are passed on to customers(51 price reductions since launch), further widening AWS’ lead over competitors.  The differences between AWS’ solutions and alternative offerings are stark.  Consider AWS’ database engine Amazon Aurora.  Aurora offers up to five times the performance of competing solutions, at one tenth the cost. 

One might think that such a model is a race to the bottom with relentless margin pressure.  AWS’ margin profile, however, contradicts this view with current margins north of 20% and rising rather than falling. Operating margins improved by 24% last quarter and should continue to improve as AWSbenefits from scale economics and is able to lower the capital intensity of hardware purchases thanks to Moore’s Law.  

AWS’ expanding margins are a clue that the cloud computing business is far less commodity-like than commonly understood.  The AWS platform consists of a software layer, developer tools, ten kinds of storage and a variety of systems management options which run across 70 different services.  AWS is premised upon simplicity but there is still a learning curve, which introduces a switching cost over time.

Apart from lowering prices, AWS is using its scale to leverage R&D spend.  Last year AWS introduced 722 new features, an increase of 40% over the prior year.  The pace of AWS’ new product launches is two to three years ahead of competitors,compounding the company’s lead in the marketplace.

The potential market opportunity for AWS is staggering, one can go starry eyed thinking about the possibilities.  The pivot from on premise hardware to IT in the cloud is a multi-decade $trillion+ opportunity in its infancy. The current market is nascent with 3% of computing done in the cloud but many predict it will reach50%by the end of this decade.  Our research suggests AWS can grow at a compound annual growth rate of 30% a year for the next five years and achieve operating margins of 30%.

[lest we forget about the Amazon FBA business, etc. but I’m going to skip ahead to the good stuff … let’s talk valuation]

Given Amazon’s investment in infrastructure,perhaps a better way to examine the economics of the business is to look at operating cash flows.  We believe Amazon is on pace for $15 billion in operating cash flow this year and $21billion next year.  At our purchase price, that represented an enterprise value/operating cash flow multiple of 12.8x, more than reasonable for a business that has compounded cash flow at 30% for the last decade.

We believe Amazon is poised for a multi-decade period of excess economic returns.  One can quibble with Amazon’s valuation on a 12-month basis but if one focuses on the long-term economic potential of its multiple platform businesses, future returns will send many toward happy retirements …. At Coho, e e seek to invest in businesses that are inevitable.  Amazon is the most inevitable business we have ever seen.