Amazon International and Margin Upside in Focus

A former Wall Street analyst discloses the topics that equity analysts and hedge fund managers are currently talking about. 

It has been some time since I last wrote about Amazon. For a long period of time, between 2014 and 2015, Amazon stock was under heavy scrutiny as investors began to question the underlying profitability of the business. The problem was created primarily by a period of (what appeared to be) bad results, exacerbated by poor financial disclosures.

At the time, Amazon's sales were growing rapidly, but profitability was poor. Investors knew that the company was investing heavily in the retail business, but the question was whether the business model only worked because of how low their prices were. With higher prices, would consumers shop elsewhere? And as a result, was the business model structurally a barely-profitable enterprise? Additionally, investors knew that AWS was becoming a larger and larger part of the business. However, investors feared that the business was also a low-margin, commoditized business with heavy competition. 

As a result of these concerns, Amazon's stock languished for the year. While you might hear C-level executives say that they don't care for stock performance, a poorly performing stock hurts the company's ability to raise capital and to retain talent. For a company like Amazon where many of its workers were paid in stock compensation, this was especially harmful.

However, starting in 2015, Amazon made a number of changes. The company broke out its Amazon Web Services business from its Retail business, disclosing both revenue and margin trends. The disclosures revealed AWS's high margin and fast-growing trends with a strong outlook that would likely grow into even higher margins. Within retail, the company noted that their investments in fulfillment centers and other areas would likely slow, which should lead to more margin expansion. And the company began to show significant margin expansion, signaling to investors that the business was more structurally more profitable than believed.

Source: Company filings

Source: Company filings

 

Today, Amazon has shown to investors that 1) the retail business is structurally profitable, 2) the AWS business is *very* profitable, and that 3) the company still has a significant amount of opportunity ahead of itself to capture. These three points together are the reasons why analysts are now more bullish than ever before on Amazon, and why you are constantly hearing about $1,000 price targets. Now, investors are particularly bullish longer-term on both revenue and profitability for Amazon.

 

In North America, 90% of retail sales are still offline 

Amazon's most significant opportunity is in its retail business. Amazon continues to be a behemoth in the space and now is capturing an estimated 1/3 of US online retail sales. Despite this dominance, Amazon has a significant runway ahead of itself. E-commerce in the US still makes up just 8% of total US retail sales (10% of retail sales excluding auto sales and food services), but is growing at 15% each year. By 2020, at its current rate, e-commerce will still only make up 13% of total retail sales (16% excluding auto sales and food services). Overall retail sales are a huge part of the economy, and we are still in the early innings of the move towards a digital world where consumers order much of their purchases online.

Source: Census Bureau

Within the growing online pie, groceries is a particularly interesting space that is almost entirely unpenetrated from online. The food and beverage sector is roughly $700 billion in size according to the Census Bureau. Amazon, as well as numerous other online startups, have made many efforts to break into this space, but with little success to date. A particular issue is the nature of grocery deliveries in the US. Much of groceries require a temperature controlled, time-sensitive delivery. Many of these deliveries are also bulky and heavy. In the US, where much of the population lives in suburban areas, this proves to be a particular challenge.

However, analysts and investors are beginning to believe it is only a matter of time until such efforts prove fruitful. Several data points suggest that online will inevitability penetrate groceries, just as online has in almost all other retail categories. According to Nielsen data, millennials are much more likely to order online than their older counterparts, and millennials are just now reaching the age where they are purchasing groceries regularly. Additionally, online grocery orders have had success in other countries, particularly in China (where the populations are more densely grouped).

Amazon is making more efforts to penetrate this space. The company currently has Amazon Pantry and Amazon Fresh, and are experimenting with different retail concepts such as Amazon Go to get around some of the challenges of delivery. While it's not likely to move the needle any time soon, investors are bullish on Amazon's chances given their success in just about every other area that they have entered into.

 

Amazon is just getting started in International

International is also an enormous opportunity for Amazon. The company has an established playbook and strong traction in several markets already. The playbook essentially consists of establishing an early presence in the market through its digital media offerings, and then gradually expanding offerings to adjacent, physical categories and rolling out Prime membership. And this playbook has led to Amazon's success in their largest international markets - Germany, Japan, and UK, where revenues are roughly $10B+ in each country and are growing at significant rates.

Source: Company filings

Source: Company filings

 

International represents an even larger opportunity than the U.S. While Amazon's revenues in these countries are now sizable, they are similarly in the early innings of the shift towards e-commerce, just as the U.S. is. Additionally, Amazon is just beginning to increase their efforts in these markets, with Prime membership in the UK and Japan still a small fraction of the total households in those markets, and Amazon only recently rolling out Fulfillment by Amazon in several European countries in April 2016.

Additionally, the "Rest of the World" sub-segment is growing at a rapid pace, and is comprised of several other promising markets. India is a notable market as Amazon has invested heavily there and is already surpassing local incumbents. The company now has a higher brand awareness and a stronger product offering than competitors in India, and the market is likely a major driver of the Rest of the World's 52% growth.

Source: Company filings, brokerage estimates

Source: Company filings, brokerage estimates

 

Recent disclosures revealed other fast-growing businesses like advertising

Investors have also been bullish on Amazon's advertising opportunity. While often speculated as a meaningful opportunity for the company, Amazon's recent disclosures gave an indication to the potential size of advertising currently and its growth rates. The "Other" segment, which Amazon noted as including Advertising, co-branded credit card agreements, and all other revenues, has grown from $1.3B in 2014 to $3.0B in 2016 (with a 73% growth rate in 2016). While advertising does not make up the entirety of the segment, it is thought that it is the majority of the revenues.

Source: Company filings

Source: Company filings

And while Amazon has grown this area significantly, there is still a large opportunity to expand it further and more prominently. Consumers are increasingly going to Amazon's properties first to start their shopping. And as consumers increasingly do this, advertising should become a bigger opportunity in directing traffic to desired listings. Amazon likely has several advertising growth drivers, including a growing number of product searches and increased ad loads. And with a high intent to purchase (prime users have extremely high conversion rates, according to some studies), CPC rates should have room to grow as well.

 

Fast-growing segments are also higher in margin, suggesting margin upside

With the new revenue disclosures in their most recent 10-K, investors have become increasingly focused on margin upside from several sources:

  • Advertising - Advertising is not only a revenue opportunity, but a significant margin opportunity as well given the high margins inherent in the advertising business. Investors speculate that this business has margins well above 50%, which should finance Amazon's many investments and potentially even drive margins higher. To frame the opportunity further, Alibaba's revenue is 50% advertising and marketing related (and is within a segment that has 60% operating margin), suggesting the opportunity for a marketplace like Amazon is significant. 
  • Prime memberships - Amazon should continue to see strong subscription growth, which is likely primarily Prime membership revenue. While US Prime membership growth is likely to to moderate, stronger growth should come from International where Amazon is just beginning to roll out Prime in key markets such as India and Mexico, as mentioned above. 

 

What are the issues?

While the opportunities mentioned above are sizable and significant, many are longer-term in nature. And some investors fear that in the near-term, Amazon could see financial results fall below expectations from several factors.

  • Heavy investments: As mentioned above, Amazon signaled that they had numerous investments to make. All of these opportunities require a supporting infrastructure, and Amazon is racing to build this out ahead of the demand. Additionally, Bezos has long been a proponent of constantly investing and testing out new products. As a result, there is always the fear from investors that CSOI (both reported CSOI for the current quarter and management's CSOI guidance for next quarter) could fall short of expectations due to heavier-than-expected investments. There is particular concern around next quarter's CSOI guidance when Amazon reports on Thursday.
  • Other one-time revenue headwinds: Amazon faces several other short-term hurdles that could slow near-term revenue growth. FX has been a headwind for the last several quarters and is expected to continue, especially as international grows. The company will also be lapping the leap year, which added an extra day in to the quarter last year and makes the comparison a bit more difficult. This more difficult comparison could slow sales this year by several hundred basis points.
  • AWS price cuts: Amazon cut AWS prices that went into effect on December 1. First quarter results will be the first full quarter with the price cut in effect, which could slow AWS revenue growth more than expected.