Amazon Is Emerging as a Leaner E-Commerce Leader in a Post-Covid-19 World

Senior Equity Analyst

Dan Romanoff

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Amazon dominates its served markets, notably for e-commerce and cloud services. It benefits from numerous competitive advantages and has emerged as the clear e-commerce leader given its size and scale, which yield an unmatched selection of low-priced goods for consumers. The secular drift toward e-commerce continues unabated with the firm continuing to grind out market share gains despite its size. Prime ties Amazon’s e-commerce efforts together and provides a steady stream of high-margin recurring revenue from customers who purchase more frequently from Amazon’s properties. In return, consumers get one-day shipping on millions of items, exclusive video content, and other services, which result in a powerful virtuous circle where customers and sellers attract one another. The Kindle and other devices further bolster the ecosystem by helping attract new customers, while making the value proposition irresistible in retaining existing users. 

Through Amazon Web Services, or AWS, Amazon is also a clear leader in public cloud services. Additionally, the firm’s advertising business is already large and continues to scale as ads have made their way into Amazon’s streaming outlets, thus offering an attractive option for marketers looking to access a vast audience with a variety of proprietary data points about those very consumers. AWS and advertising growth should continue to outpace e-commerce growth and should be the main growth drivers over the next five years. This is critical, as each of these segments drives higher margins than the corporate average, which in turn should allow both operating profit and EPS to outgrow revenue as margins continue to expand.

From a retail perspective, we expect continued innovation to help drive further share gains in a post-lockdown world. We also look for continued penetration into categories such as groceries and luxury goods that have not previously translated into the same level of success as other retail categories. We see technology advancements in AWS and a bigger push to service enterprise customers as helping to maintain the company’s lead there. Overall, we see strong revenue and free cash flow growth for years to come.

Business Strategy & Outlook

We assign a wide moat rating to Amazon based on network effects, cost advantages, intangible assets, and switching costs. Amazon has been disrupting the traditional retail industry for more than two decades while also emerging as the leading infrastructure-as-a-service provider via Amazon Web Services. This disruption has been embraced by consumers and has driven change across the entire industry as traditional retailers have invested heavily in technology in order to keep pace. Covid-19 has accelerated change, and given the company's technological prowess, massive scale, and relationship with consumers, we think Amazon has widened its lead, which we believe will result in economic returns well in excess of its cost of capital for years to come.

We believe Amazon’s retail business has a wide moat stemming from network effects associated with its marketplace, where more buyers and sellers continually attract more buyers and sellers; a cost advantage tied to purchasing power, logistics, vertical integration (proprietary brands, owned delivery, and so on), and a negative cash conversion cycle; and intangible assets associated with technology and branding. We also believe AWS is a wide-moat business, thanks to high customer switching costs; a cost advantage associated with economies of scale where few competitors can keep up with Amazon’s investment pace; intangible assets arising from semiconductor and facility development; and a network effect associated with a marketplace for software created to make AWS work better. We also would assign Amazon’s burgeoning advertising business a narrow moat based on intangible assets from its proprietary data on hundreds of millions of users and a network effect again focusing on buyers and sellers meeting in the largest available venues. We believe that the wide moat for Amazon’s entire business is greater than the sum of its parts; we prefer to analyze Amazon’s moat on the whole, as the company's segments reinforce one another and returns result in an unrivaled consumer experience.

Together, we believe Amazon’s retail business enjoys a wide moat supported by cost advantages, intangible assets, and network effects. We assess the moat around Amazon’s retail business based on a combination of online stores, third-party seller services, subscription services, and physical stores, as we find it challenging to think about durable competitive advantages for each of these segments in isolation. Given its massive scale, Amazon has created cost advantages including buying power, economies of scope, route density, and research and development. From a total gross merchandise value perspective, with approximately $580 billion in 2021, it finally surpassed Walmart. Similarly, Amazon is the largest online retailer and is an order of magnitude larger than Walmart and 4 times larger than Shopify, assuming we classify Shopify as a demand aggregator. Additionally, the company has become more vertically integrated over time and most recently has built out its own transportation network. Size dictates certain scales of efficiency, but we think Amazon is the definition of operational excellence. 

These advantages are related and reinforce one another in a virtuous circle. Low prices and an unmatched selection have come to define the company in consumer’s minds, giving rise to intangible assets from branding and technology (search capabilities and recommendation engine). Product searches are more likely to begin on Amazon at this point than they are Google. Amazon has become the only demand aggregator at scale in the US because of its wide selection, intelligent recommendation algorithms, low prices, and convenience, which combine into a powerful business model.

We also believe Amazon’s retail business benefits from network effects. The sheer number of consumers shopping on Amazon makes it attractive to third party sellers, while the marketplace expands the selection available to shoppers and makes Amazon a more attractive online destination for consumers. In fact, 50%-55% of total goods sold by Amazon are through its third-party marketplace. At the heart of third-party seller services is the commission Amazon collects from the independent seller. However, these services also include Fulfillment by Amazon, distribution facility storage, shipping, payment processing, and other related items.

To improve the consumer experience and more tightly tie users to Amazon, the company has moved increasingly into content. Consumers can now have Prime Video, Music Unlimited, Kindle Unlimited, Prime Gaming, and other similar subscription services. The company even produces original content for Prime Video to help reinforce the notion that consumers can get anything they need from Amazon. We view the Kindle, Echo, Fire, and other Amazon original devices as interesting on their own merits, but think the underlying point is to once again draw in more consumers to Amazon’s retail properties and engage those customers that are already within the ecosystem. Amazon’s hardware helps to enable Amazon’s services. The Kindle, for example, dovetails perfectly with Kindle Unlimited, which for a $9.99 monthly subscription, allows users to read from a selection of more than one million book titles. The company even offers a direct-to-Kindle book publishing service. 

The common thread that weaves throughout Amazon’s retail business is Amazon Prime, which for $139 per year allows users unlimited free shipping on millions of stock-keeping units, including same-day or one-day shipping on many items, access to Prime Video and Prime Music, and a variety of other benefits. We view Prime subscriptions and the differentiated user experience they offer as critical to attracting and retaining customers. Prime memberships generate high cash flow that can be reinvested in further improving the user experience on the technology, content, and delivery fronts. Prime customers are very sticky and tend to purchase from Amazon more frequently and across more retail categories. We think content combined with Prime subscriptions actually build a switching cost that consumers would need to overcome, although these switching costs might not last for decades in order to warrant it as a moat source.

Advertising is tangentially related to Amazon’s retail operations in that it takes place on Amazon’s own online properties. Advertising is growing rapidly and is likely the segment with the highest operating margins in Amazon’s portfolio, likely in excess of 30%, which is would be directionally comparable to margins earned by Facebook when it was a similarly sized business (other was $21 billion in revenue in 2020, compared with $18 billion in revenue for Facebook in 2015). We believe advertising dollars flow to where the eyeballs are and where information is known about the online user, which fits in very well with Amazon’s strengths. We therefore expect advertising to grow rapidly over the next several years and continue to boost the company’s overall profitability. 

Looking at advertising in isolation, we would likely give it a narrow moat rating based on intangible assets arising from proprietary technology (data), and network effects, although assigning a moat rating here is difficult because Amazon doesn’t disclose much about this business. That said, we can see Amazon’s advertising becoming a wide-moat business as it becomes more established and more details are disclosed. We think Amazon’s advertising business is attractive to advertisers because there is proprietary information about the consumers and real-time data about when they are searching for a particular product, and Amazon already enjoys substantial traffic. We expect this business to continue to grow rapidly and offer an attractive alternative to platforms from social network and internet search providers.

Amazon Web Services enjoys a wide moat supported by switching costs, network effects, intangible assets, and cost advantages. Amazon was a pioneer in public cloud infrastructure as a service and platform as a service and retains a substantial lead over its closest rival, Microsoft. AWS has driven profitability for the entire company; although it represents 10%-15% of revenue, it generates 60%-65% of total operating profit dollars for Amazon. We also expect AWS to remain a key growth driver for the company over the next decade.

AWS differs from the company’s e-commerce operations in that it is enterprise-facing rather than consumer-facing. Enterprise customers rely on AWS for core IT infrastructure, which represents significant switching costs in terms of the time and expense of integrating applications with core software elements, such as the database, and dedicates a user to a specific set of software development tools. Ultimately, the operational risks to changing mission-critical technology infrastructure is high, which is why core elements such as ERP systems and cloud providers are rarely changed.

Further, we believe it is cheaper initially for companies to move workloads to the cloud, as there are fewer upfront costs and a lower bar to clear for maintenance and administration. Additionally, Amazon has devoted significant R&D resources to adding advanced features to the platform. Along those lines, AWS offers scale advantages to clients in that it is cheaper and faster to set up IT infrastructure in the cloud compared with undertaking the same effort independently. Customers also benefit from the ability to scale up compute power for burst requirements, paying for only what they need and having it available effectively on-demand. We have seen some of the largest technology companies in the world simply fail to keep pace with Amazon’s massive investments in IaaS over the years, and AWS’ cost advantage over its rivals is obvious. Those firms struggle to compete in a meaningful way against AWS.

Amazon has amassed significant technology and process knowledge, which we believe is an intangible asset for the firm as a whole and also for AWS. These assets could also apply to the logistics aspect of the retail business. The company expanded its distribution network by roughly 50% in 2020 while managing through a global pandemic. Given the size of its footprint, this is a monumental achievement and speaks to the company’s ability to quickly plan, construct, and expand facilities based on specific needs. The knowledge base to quickly and efficiently bring massive server farms online for AWS is similarly impressive and only comes from the experience of previously building hyperscale data centers. Additionally, the firm designs its own semiconductors, which are used to power its server arrays, and also developed proprietary robotic automation technology used in its fulfillment centers.

As with other large software companies, we see a network effect within AWS’ ecosystem for third-party software, although we view this as more of secondary moat source. The large ecosystem of AWS users has benefited from the software development efforts of those same users, as they turn around and offer applications written on AWS for AWS users. Thus, users help attract other users to AWS. We see Microsoft and Salesforce in particular as the best comparable examples in software of creating network effects. 

We think network effects, intangible assets, cost advantages, and switching combine to form a powerful moat for all of Amazon. We think many of these areas reinforce one another and see little difficulty in Amazon continuing to deliver returns on invested capital well in excess of its cost of capital over the long term.

Wide

Economic Moat

Amazon

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Amazon.com, Inc. is a multinational technology company, which engages in providing online retail shopping services. It operates through the following segments: North America, International, and Amazon Web Services (AWS). The North America segment is involved in the retail sales of consumer products including from sellers and subscriptions through North America-focused online and physical stores. The International segment focuses on the amounts earned from retail sales of consumer products including from sellers and subscriptions through internationally focused online stores. The AWS segment includes global sales of computer, storage, database, and other services for start-ups, enterprises, government agencies, and academic institutions. The company was founded by Jeffrey P. Bezos in July 1994 and is headquartered in Seattle, WA.

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