2019 came and went in a flash. I don’t know about you, but I definitely ran out of shopping time and leaned on old Amazon – vintage of 1994 – to save me. Have a few minutes to spare while you are (not) at work (I swear)? Knock out a gift or two. How about a prank gift for a business colleague? Bags of coal? Check. Gift + Amazon gift wrapping? Check. All the while we are buying, Amazon is selling and almost sitting among the trillion-dollar market cap club.
It led us here at Canadian Value Investors to wonder 1) What is Amazon today, and 2) How big and profitable can Amazon actually get (i.e. can we make money off it)?
If you bought Amazon at its IPO you would be sitting on a gain of over 119,000%, or roughly $21,000 for every $18 invested! Although the stock sits at ~$1,800 it also split three times along the way (first 1 for 2 split, then 1 for 3, followed by another 1 for 2 split).
We argue that Amazon is in multiple market segments in multiple regions, all with huge runways, and can get much bigger. Spoiler alert – we don’t think there is another 119,000% in the cards, roughly a 1 (one) quadrillion market cap, unless we end up in that dystopian future envisioned in Disney Pixar’s Wall-E…. we will cover the odds of this in a later article. In the meantime, let’s start at the beginning.
First, what is Amazon anyway?
While we will go into more detail later, we thought it was best to start our story with some high-level numbers. Most of us think of Amazon as an online store, it is actually much more than that. The Company breaks its results out as shown below in the annual report:
Really the key takeaways are its own online sales (and third-party sales, which is intertwined) are important, but Amazon Web Services, subscription services, and physical stores are growing fast too. Of course we need to talk about margins and cash flows, but let’s not get ahead of ourselves… We have to go back to where things started.
One of the best summaries of the origins of Amazon we have come across is over at zackkanter.com (https://zackkanter.com/2019/03/13/what-is-amazon/).
[Excerpt] Whereas a traditional retailer had to weigh tradeoffs within finite shelf space, an online retailer could display page after page of items with near-zero marginal cost for more items. Instead of choosing which items to stock, Amazon could let its customers do so – it would add all sorts of items to its catalog, measure web traffic for each item, and bring the items into stock that seemed most likely to sell.
Bezos, in other words, wanted to build an unbounded Walmart. By removing the constraint of geography – and therefore the local economy – and by adding search functionality, the new formula became simpler: the more SKUs it added, the more items would be discovered by customers; the more items that customers discovered, the more items they would buy. In this world of infinite shelf space, it wasn’t the quality of the selection that mattered – it was pure quantity. And with this insight, Amazon did not need to be nearly as good – let alone better – than Walmart at Walmart’s masterful game of vendor and SKU selection. Amazon just needed to be faster at aggregating SKUs – and therefore faster at onboarding vendors.
And so, back in 1994, Amazon kicked off its unbound search for the optimal selection of SKUs. Its algorithm – borrowed and modified from Walmart – was simple: a) a vast selection, b) delivered fast, c) at the lowest possible prices, d) backed by guaranteed satisfaction.
There’s much more and we encourage you to read the article in full.
Day One Vision - The Bezos DNA, the Amazon Culture
Amazon is clearly methodical and fierce, However, it’s important to realize 1) how consistent Amazon, or really Jeff Bezos, has been with the vision, and 2) how Jeff and Co have focused on building a scalable culture from day one. All you have to do is pick up any annual report since they went public. As part of the report they include the same 1997 letter to shareholders that Jeff wrote. We have included the beginning verbatim:
To our shareholders:
Amazon.com passed many milestones in 1997: by year-end, we had served more than 1.5 million customers, yielding 838% revenue growth to $147.8 million, and extended our market leadership despite aggressive competitive entry.
But this is Day 1 for the Internet and, if we execute well, for Amazon.com. Today, online commerce saves customers money and precious time. Tomorrow, through personalization, online commerce will accelerate the very process of discovery. Amazon.com uses the Internet to create real value for its customers and, by doing so, hopes to create an enduring franchise, even in established and large markets.
We have a window of opportunity as larger players marshal the resources to pursue the online opportunity and as customers, new to purchasing online, are receptive to forming new relationships. The competitive landscape has continued to evolve at a fast pace. Many large players have moved online with credible offerings and have devoted substantial energy and resources to building awareness, traffic, and sales. Our goal is to move quickly to solidify and extend our current position while we begin to pursue the online commerce opportunities in other areas. We see substantial opportunity in the large markets we are targeting. This strategy is not without risk: it requires serious investment and crisp execution against established franchise leaders.
It’s All About the Long Term
We believe that a fundamental measure of our success will be the shareholder value we create over the long term. This value will be a direct result of our ability to extend and solidify our current market leadership position. The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.
Our decisions have consistently reflected this focus. We first measure ourselves in terms of the metrics most indicative of our market leadership: customer and revenue growth, the degree to which our customers continue to purchase from us on a repeat basis, and the strength of our brand. We have invested and will continue to invest aggressively to expand and leverage our customer base, brand, and infrastructure as we move to establish an enduring franchise.
Because of our emphasis on the long term, we may make decisions and weigh tradeoffs differently than some companies. Accordingly, we want to share with you our fundamental management and decision-making approach so that you, our shareholders, may confirm that it is consistent with your investment philosophy:
We will continue to focus relentlessly on our customers.
• We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.
• We will continue to measure our programs and the effectiveness of our investments analytically, to jettison those that do not provide acceptable returns, and to step up our investment in those that work best. We will continue to learn from both our successes and our failures.
• We will make bold rather than timid investment decisions where we see a sufficient probability of gaining market leadership advantages. Some of these investments will pay off, others will not, and we will have learned another valuable lesson in either case.
• When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.
• We will share our strategic thought processes with you when we make bold choices (to the extent competitive pressures allow), so that you may evaluate for yourselves whether we are making rational long-term leadership investments.
• We will work hard to spend wisely and maintain our lean culture. We understand the importance of continually reinforcing a cost-conscious culture, particularly in a business incurring net losses.
• We will balance our focus on growth with emphasis on long-term profitability and capital management. At this stage, we choose to prioritize growth because we believe that scale is central to achieving the potential of our business model.
• We will continue to focus on hiring and retaining versatile and talented employees, and continue to weight their compensation to stock options rather than cash. We know our success will be largely affected by our ability to attract and retain a motivated employee base, each of whom must think like, and therefore must actually be, an owner.
We aren’t so bold as to claim that the above is the “right” investment philosophy, but it’s ours, and we would be remiss if we weren’t clear in the approach we have taken and will continue to take.
With this foundation, we would like to turn to a review of our business focus, our progress in 1997, and our outlook for the future….
And what does Amazon go on to talk about? How they “Obsess Over Customers”, their “Infrastructure”, and “Our employees”.
On some markets they are just starting to get into groceries and other new segments, but the online bookstore company has always wanted to sell everything to everyone. Since the 1990s, they “seek to offer Earth’s Biggest Selection and to be Earth’s most customer-centric company, where customers can find and discover anything they may want to buy online”
Jeff explained the business model quite succinctly in 1997 (the opener “hi there, who are you?” really ties the interview together):
Books were great as the first best [product to sell online] because books are incredibly unusual in one respect, and that is that there are more items in the book category and there are items than any other category by far. Music is number two; they're about two hundred thousand active music CDs at any given time. But in the book space they're more than three million different books worldwide active and printed at any given time across all languages and more than one and a half million in English alone. So when you have that many items it literally build a store online that couldn't exist any other way.
They were methodical and grew fast. A fun side story that is somewhat forgotten is that the clear top dog operator in consumer sales was Wal-Mart and several key earlier hires at Amazon were actually from there:
[1997 Annual Report] Richard L. Dalzell. Mr. Dalzell joined Amazon.com in August 1997 as Vice President and Chief Information O‚cer. From February 1990 to August 1997, Mr. Dalzell held several management positions within the Information Systems Division at Wal-Mart Stores, Inc., including Vice President of Information Systems from January 1994 to August 1997. From 1987 to 1990, Mr. Dalzell acted as the Business Development Manager for E-Systems, Inc. Prior to joining E-Systems, Inc. he served seven years in the United States Army as a teleprocessing o‚cer. Mr. Dalzell received a B.S. in Engineering from the United States Military Academy, West Point.
[1999 Annual Report] Jimmy M. Wright. Mr. Wright joined the Company in July 1998 as Vice President and Chief Logistics Officer. From 1985 to 1998, Mr. Wright held a variety of logistics management positions with Wal-Mart Stores, Inc., most recently as Vice President of Distribution. Additionally, during 1998, Mr. Wright served as managing partner of Diversified Retail Solutions, L.L.C., a retail consulting firm. From 1972 to 1985, Mr. Wright held a variety of positions at Fina Oil and Chemical Company, a branch of Petrofina S.A. based in Brussels, most recently as General Manager of Distribution. Mr. Wright received his B.B.A. in personnel management from the University of Texas.
Wal-Mart did not just sit on the sidelines; this whole thing led to a legal battle in 1998 (settled in 1999):
Wal-Mart Stores, Inc. In October 1998, Wal-Mart Stores, Inc. ("Wal-Mart") filed a lawsuit in Bentonville, Arkansas against the Company and other defendants alleging actual and threatened misappropriation of trade secrets and ancillary common-law claims. Wal-Mart subsequently requested a temporary restraining order preventing the defendants from misappropriating Wal-Mart's alleged trade secrets, from placing employees in positions in which they would "inevitably disclose" Wal-Mart's alleged trade secrets and from soliciting, inducing or recruiting Wal-Mart employees. In January 1999, Wal-Mart filed an identical action in Seattle, Washington, and the Arkansas court dismissed Wal-Mart's action on jurisdictional grounds before deciding the temporary restraining order. The dismissal is pending appeal. Wal-Mart has advised the Company that it will file a preliminary injunction motion. In addition to injunctive relief, Wal-Mart has requested compensatory damages, pre- and post-judgment interest and attorneys' fees and costs. The Company believes that Wal-Mart's claims are without merit and intends to vigorously defend against the plaintiffs' claims. Amazon.com has filed a counterclaim based in part on unfair competition and intentional interference. Litigation is inherently uncertain, and there can be no assurance that the Company will prevail in the lawsuit.
To the moon
Amazon’s combination of the internet, scaling, extreme customer focus, and long-term thinking has led to remarkable growth. In 1997 “sales grew from $15.7 million in 1996 to $147.8 million - an 838% increase.” Things aren’t quite that great these days, but still shockingly huge.
[Amazon 2002] With customer experience costs largely fixed (more like a publishing model than a retailing model), our costs as a percentage of sales can shrink rapidly as we grow our business. Moreover, customer experience costs that remain variable such as the variable portion of fulfillment costs improve in our model as we reduce defects. Eliminating defects improves costs and leads to better customer experience.
AWS – It’s live!
Another arm of Amazon that most of us see every day is Amazon Web Services. The service launched in 2006 and is effectively on-demand, pay-as-you-go cloud storage and compute resources. Amazon uses it in house, but it is also used by the likes of Dropbox, Airbnb, Siemens, Shell, Expedia, Netflix (an awkward quasi-competitor now) and on and on.
There’s a lot going on in this business unit (never mind Amazon), and this is an article not a book, so we will keep things simple. We’ve narrowed it down to: The numbers, how Amazon talks about it, and a user story.
Jeff Barr, an Amazon employee, wrote an interesting article covering the early days - http://jeff-barr.com/2014/08/19/my-first-12-years-at-amazon-dot-com/
It was easy to talk about the promise of web services but there was very little to actually show…. All that changed in the spring of 2002 when the very first Amazon.com Web Service (as it was called at the time) emerged in beta form. This simple service offered SOAP and XML interfaces to the Amazon product catalog and allowed developers to earn revenue through the Amazon Associates program. I became aware of this service, signed up for the beta, and downloaded the SDK. I wrote some simple PHP applications to try it out, and then built and briefly distributed a PHP library to simplify access to the data. I was impressed and intrigued and sent them some feedback and offered to meet with them to share my feedback in person.
Amazon covers the vision quite well in their 2014 Annual Report (abbreviated, worth taking a read):
Amazon Web Services
A radical idea when it was launched nine years ago, Amazon Web Services is now big and growing fast. Startups were the early adopters. On-demand, pay-as-you-go cloud storage and compute resources dramatically increased the speed of starting a new business. Companies like Pinterest, Dropbox, and Airbnb all used AWS services and remain customers today.
Since then, large enterprises have been coming on board as well, and they’re choosing to use AWS for the same primary reason the startups did: speed and agility. Having lower IT cost is attractive, and sometimes the absolute cost savings can be enormous. But cost savings alone could never overcome deficiencies in performance or functionality. Enterprises are dependent on IT – it’s mission critical. So, the proposition, “I can save you a significant amount on your annual IT bill and my service is almost as good as what you have now,” won’t get too many customers. What customers really want in this arena is “better and faster,” and if “better and faster” can come with a side dish of cost savings, terrific. But the cost savings is the gravy, not the steak.
IT is so high leverage. You don’t want to imagine a competitor whose IT department is more nimble than yours. Every company has a list of technology projects that the business would like to see implemented as soon as possible. The painful reality is that tough triage decisions are always made, and many projects never get done. Even those that get resourced are often delivered late or with incomplete functionality. If an IT department can figure out how to deliver a larger number of business-enabling technology projects faster, they’ll be creating significant and real value for their organization..…
……We’ve increased our pace of innovation as we’ve gone along – from nearly 160 new features and services in 2012, to 280 in 2013, and 516 last year.
[business runway] I believe AWS is one of those dreamy business offerings that can be serving customers and earning financial returns for many years into the future. Why am I optimistic? For one thing, the size of the opportunity is big, ultimately encompassing global spend on servers, networking, datacenters, infrastructure software, databases, data warehouses, and more. Similar to the way I think about Amazon retail, for all practical purposes, I believe AWS is market-size unconstrained.
[making AWS sticky] ….its current leadership position (which is significant) is a strong ongoing advantage. We work hard – very hard – to make AWS as easy to use as possible. Even so, it’s still a necessarily complex set of tools with rich functionality and a non-trivial learning curve. Once you’ve become proficient at building complex systems with AWS, you do not want to have to learn a new set of tools and APIs assuming the set you already understand works for you. This is in no way something we can rest on, but if we continue to serve our customers in a truly outstanding way, they will have a rational preference to stick with us….
In addition, also because of our leadership position, we now have thousands of what are effectively AWS ambassadors roaming the world. Software developers changing jobs, moving from one company to another, become our best sales people: “We used AWS where I used to work, and we should consider it here. I think we’d get more done.” It’s a good sign that proficiency with AWS and its services is already something software developers are adding to their resumes.
[scale and returns on capital] Finally, I’m optimistic that AWS will have strong returns on capital. This is one we as a team examine because AWS is capital intensive. The good news is we like what we see when we do these analyses. Structurally, AWS is far less capital intensive than the mode it’s replacing – do-it-yourself datacenters – which have low utilization rates, almost always below 20%.
By combining developer tools and scaled infrastructure (servers) in a standardized way, it allows customers to start easily, scale, and ultimately happy, easier than building in house, but then also pretty stuck using the service. Show me an organization with people in charge willing to understand their IT team and retrain or re-hire them, and I have a bridge to sell you.
Amazon-Other-Stuff Inc.
There’s also a bunch of other businesses and products that are beyond the scope of this article, like:
Amazon buying Whole Foods for $14 billion in 2017….
Amazon Alexa, Amazon Video..
New growth areas – Just this month they filed applications to trademark "Amazon Pharmacy" in Canada and the U.K.. (they acquired PillPack Inc. in 2018).
Amazon having over 200,000 robots, up from 15,000 in 2014… - https://www.ctvnews.ca/business/as-robots-take-over-warehousing-workers-pushed-to-adapt-1.4747071 - “Much of the boom in warehouse robotics has its roots in Amazon’s US$775-million purchase of Massachusetts startup Kiva Systems in 2012. The tech giant rebranded it as Amazon Robotics and transformed it into an in-house laboratory that for seven years has been designing and building Amazon’s robot armada.”
Some of these other business as standalone entities would be bigger than most companies we have worked for here at CVI.
How big can Amazon be (and is it cheap???)?
Amazon is in a lot of pies, and step 1 is figuring out how big these pies can be. We have done a lot of work on this, but knowing attentions spans are shrinking faster than an ice cube in the Nevada desert we have distilled things down to the best infographics we have found (source: https://newsroom.mastercard.com/press-releases/mastercard-spendingpulse-u-s-retail-sales-grew-3-4-percent-this-holiday-season/ and https://techcrunch.com/2018/07/13/amazons-share-of-the-us-e-commerce-market-is-now-49-or-5-of-all-retail-spend/):
Online sales have grown a lot, faster than overall consumer sales, and continue to grow a lot, but are still less than a quarter of all sales even on the best of days like Cyber Monday. What’s particularly interesting is the share of Cyber Monday. While obvious that this of all days should be the best, it brings up the question… why aren’t people spending even more online already? Or, what roadblocks are there? I think the answer lies in how Amazon is focusing on improving the business. They are spending billions to get same day/next day delivery to your home, which is already the case for some products in some markets. Ran out of toilet paper or milk? All you will have to say is “Hey Alexa…” and a few more words gets it to your door. One of our team members have already seen behaviors change dramatically – a family member hates shopping and did Christmas entirely online this year.
Anecdotes aside, sales continue to go up and raw cash flow from operations has been growing at about 40% a year for a decade…. where revenue, net income, and cash flow should be thought about in the context of a ~$900 billion market cap.
So, should you buy Amazon? We think John Hempton has said it best:
Right from the beginning it was impossible to compete with Amazon in books and now it's almost impossible to compete with Amazon in any [business]. And this is the iconic Steve Mandell-type stock, and it's hard to do because Amazon went from peak to bottom in the dot-com crash down 90%. It's recovered all that many times, and yeah he would have been better off if he'd sold it all at the peak and rebought five times as much all at the bottom. But you can’t do that; I've never worked that way. So you know find your superior business and hold it forever. Now I'm not sure whether I'd be buying Amazon now - it's not obviously cheap - but then truth be told it was never obviously cheap. It was expensive when it was a bookshop and it's expensive and it's an everything shop! And if I look at the value Amazon traded at four years ago and compare it to its current sales it was obviously cheap then. So I'm sort of a little bit puzzled by that.
Well said John.