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The Power of the Model and the Rich Valuation – Part I

Why I believe in Amazon's model

June 05, 2017 | About:

Whenever I visit a company’s management team, I’d ask the following two questions, which I learned from Warren Buffett (Trades, Portfolio):

  1. You have to put 50% of your net worth in a company in your industry, and it can’t be your own company. You have to hold it for 10 years without looking at it. Which company would it be and why?
  2. If you have to put 50% of your net worth shorting a company in your industry for the next 10 years, which company would it be and why?

Most of the time the management team has never heard these questions before so it sweats a little bit before providing the answers. But sometimes it comes to the answers very quickly and that’s a sign of the dominance of the best competitor in the field.

In retail, almost 100% of the time the answer to the first question is a quick Amazon (NASDAQ:AMZN). But in a recent meeting I was surprised when a member of the management team I visited said that if he were to short a company for the next 10 years in retail, it would be Amazon. Why? He said there was too much Bezos hype built in the stock.

These recent management meetings tell me two things – Amazon is undoubtedly the most powerful force in retail, and Amazon’s valuation is very rich. I’ve covered the topic of Amazon dominance in a few past articles. Today I’d like to share a few thoughts on the power of Amazon’s model. I'll cover the valuation part in the next article.

For a while, I have argued that Amazon’s earnings power is much higher than Amazon’s income statement suggests. The investments Amazon made in fulfillment centers and R&D are widening Amazon’s moat day by day but at the same time severely burdened Amazon’s short- to medium-term financial results.

Two things are obvious from the financials:

  1. Amazon’s gross margin has been expanding at an impressive rate. Interestingly I have not seen much discussion regarding Amazon’s GM expansion.
  2. Fulfillments and R&D expense have skyrocketed, both outpacing revenue growth.

The billion-dollar question (could be a trillion-dollar question in the future) is how investors should view these investments. I bumped into a quote by Stuart Chase the other day that goes “for those who believe, no proof is necessary and for those who don’t believe, no proof is possible.” In the case of Amazon, you either are a believer or a nonbeliever and for those who believe in the power, no current financial proof is necessary. I fall into the believer category. Why? There are a lot of reasons, but two really convinced me – Jeff Bezos’ vision and his ability to combine his vision with ultralong-term value creation. With the latter, I get comfortable with Bezos’ frequent quotes of Ben Graham and Buffett. In fact, he’s used the famous Ben Graham quote a few times in his letters to shareholders: "In the short run the market is a voting machine, but in the long run it is a weighing machine."

In terms of his vision, Bezos has actually laid them out in plain sight – go read his letters to shareholders. The one that resonates with me the most is his 2006 letter to investors. In it, Jeff Bezos wrote the following:

“At Amazon’s current scale, planting seeds that will grow into meaningful new businesses takes some discipline, a bit of patience and a nurturing culture.

Our established businesses are well-rooted young trees. They are growing, enjoy high returns on capital and operate in very large market segments. These characteristics set a high bar for any new business we would start. Before we invest our shareholders’ money in a new business, we must convince ourselves that the new opportunity can generate the returns on capital our investors expected when they invested in Amazon. And we must convince ourselves that the new business can grow to a scale where it can be significant in the context of our overall company.

Furthermore, we must believe that the opportunity is currently underserved and that we have the capabilities needed to bring strong customer-facing differentiation to the marketplace. Without that, it’s unlikely we’d get to scale in that new business.

I often get asked, 'When are you going to open physical stores?' That’s an expansion opportunity we’ve resisted. It fails all but one of the tests outlined above. The potential size of a network of physical stores is exciting. However, we don’t know how to do it with low capital and high returns; physical-world retailing is a cagey and ancient business that’s already well served; and we don’t have any ideas for how to build a physical world store experience that’s meaningfully differentiated for customers.

When you do see us enter new businesses, it’s because we believe the above tests have been passed. Our acquisition of Joyo.com is a first step in serving the most populous country in the world. E-commerce in China is still in its early days, and we believe it’s an excellent business opportunity. Shoes, apparel, groceries: these are big segments where we have the right skills to invent and grow large-scale, high-return businesses that genuinely improve customer experience.

Fulfillment by Amazon is a set of web services APIs that turns our 12 million square foot fulfillment center network into a gigantic and sophisticated computer peripheral. Pay us 45 cents per month per cubic foot of fulfillment center space, and you can stow your products in our network. You make web services calls to alert us to expect inventory to arrive, to tell us to pick and pack one or more items and to tell us where to ship those items. You never have to talk to us. It’s differentiated, can be large and passes our returns bar.

Amazon Web Services is another example. With AWS, we’re building a new business focused on a new customer set software developers. We currently offer 10 different web services and have built a community of over 240,000 registered developers. We’re targeting broad needs universally faced by developers, such as storage and compute capacity – areas in which developers have asked for help and in which we have deep expertise from scaling Amazon.com over the last 12 years. We’re well positioned to do it, it’s highly differentiated, and it can be a significant, financially attractive business over time.

In some large companies, it might be difficult to grow new businesses from tiny seeds because of the patience and nurturing required. In my view, Amazon’s culture is unusually supportive of small businesses with big potential, and I believe that’s a source of competitive advantage.

Like any company, we have a corporate culture formed not only by our intentions but also as a result of our history. For Amazon, that history is fairly fresh and, fortunately, it includes several examples of tiny seeds growing into big trees. We have many people at our company who have watched multiple $10 million seeds turn into billion-dollar businesses. That firsthand experience and the culture that has grown up around those successes is, in my opinion, a big part of why we can start businesses from scratch. The culture demands that these new businesses be high potential and that they be innovative and differentiated, but it does not demand that they be large on the day that they are born.”

IBM (NYSE:IBM) is a great example of a company that shows great earnings but has gradually lost its edge. I’ll offer some numbers here so we can see the contrast between IBM and Amazon.

In 2006, Amazon spent more than $600 million in R&D while IBM was spending about $6 billion. In 2016, Amazon spent a whopping $16 billion on R&D while IBM is still spending about $6 billion on R&D.

Amazon’s cloud business has grown from nothing to a $12 billion business with a fat 25% current operating margin and oh, yeah, Amazon’s cloud business grew 55% last year. Microsoft (NASDAQ:MSFT) and Google, a subsidiary of Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), are catching up, but Amazon’s got a few years' head start in this and as Buffett said, "You do not want to give Jeff Bezos a few years' head start."

And that’s why I believe in Amazon’s model. But it seems like the market is currently more like a voting machine for the model than a weighing machine. I’ll cover that in my next article.

About the author:

A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

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