The report below was taken from our Quarterly Focus Buy List which is a list of buy ideas selected by our team of analysts every quarter driven by AFG’s Economic Margin methodology.
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Overview: Amazon.com is the largest Internet retailer in the world with a wide customer set, including consumers, sellers, developers, enterprises, and content creators. AMZN also provides services, such as advertising and co-branded credit cards. The company operates in three segments: The North America segment (60% of sales) consists of consumer retail product sales and subscriptions through www.amazon.com, www.amazon.ca, and www.amazon.com.mx in the U.S., Canada and Mexico, respectively; The International segment (over 30% of sales) consists of consumer retail product sales and subscriptions in key geographies in Europe and Asia, such as the U.K., Germany, Japan and China; and the Amazon Web Services (AWS) segment (less than 10% of sales) consists of global sales of storage, database and compute services. Besides providing an online platform for sellers to reach customers globally, for a fee, AMZN also produces and sells its own products and online content. Geographically, 66% of AMZN’s sales are in the U.S., with Germany (10% of sales) and Japan (8% of sales) making the biggest portion of sales outside the U.S.
Online Retail Dominance: Based on the annual UPS survey, Pulse of the Online Shopper, 2016 was the first year when more items were purchased online than in brick-and-mortar stores. Furthermore, the consumer confidence index, as reported by the U.S. Conference Board, increased to 125.6 in March 2017, the highest level in over 16 years. While ecommerce is booming in a high consumer confidence environment, news headlines are bombarding traditional retail stocks, as companies such as J.C. Penny, Macy’s, and Sears are struggling with sales and announced large store closings. For example, AMZN has reported y-o-y sales growth for each of the past 4 quarters of more than 20%, while J.C. Penny reported y-o-y sales declines in each quarter of 2016, except Q2, when it realized 1.5% sales growth. The results are more dire for Macy’s and Sears with negative y-o-y sales growth reported for every quarter of 2016. Wal-Mart is bucking the trend, as it has significant distribution facilities with e-commerce fulfillment capabilities from online shopping, including mobile devices. AMZN and Wal-Mart are competing fiercely for sales dollars, and Amazon is building physical presence to help compete. For example, Amazon Books stores are opening in key locations to help in its strategy. There are currently 5 Amazon Books locations, with plans to open three more in 2017, as a way to attract potential customers to its Amazon brand electronics, in addition to selling books. Also, AMZN is utilizing its vast online customer base to tap into the grocery market with both home delivery and a hybrid grocery pickup model, currently in test phase. It is clear today that the retail companies that can successfully usher traffic through an online portal will be the ones that capture more sales going forward.
Digital Devices: AMZN sells equipment designed to bring more customers to Amazon.com or to facilitate more time that an existing Amazon customer uses an Amazon service. For example the Kindle e-reader allows authors to sell books in digital form and receive a 70% royalty for sales through the Kindle Store and Amazon Publishing. The Guardian reported that Amazon e-book sales surpassed physical book sales for the first time on Christmas Day 2009. And by early 2017, there were more than 5 million e-books available in the U.S. Kindle users can subscribe to newspapers and magazines at costs that are often much lower than consumers would pay in print form. E-books purchased through the Kindle Store can synchronize reading progress through the Amazon Kindle or Kindle apps, keeping track of bookmarks through all synced devices. The Kindle Fire is a tablet computer with access to the Kindle Store as well as Amazon online streaming and the Amazon Appstore. The Fire is sold at a price that is often noticeably lower than competitors’ tablets, but Amazon sells much more online content through the Fire than for the device itself. The newest Fire HD 8 utilizes Alexa, Amazon’s virtual assistant with voice recognition and skills improvement capabilities. Alexa is also the user interface for Amazon’s Echo, a smart speaker used as a home automation hub. Third-party developers add to Alexa Skills Kit for uses such as the ability to play music, order food online, hail an Uber ride, and answer general questions. Part of the strategy behind the aggressive physical Amazon Books store openings is to let people to see all the devices that AMZN offers – allowing people to handle the digital devices, increase their intrigue, and ultimately buy the digital devices in order to access more digital content.
Grocery Market: Amazon sells groceries and household items for home delivery through AmazonFresh, guaranteeing freshness or a full refund. Delivery time is reserved by the customer, but usually occurs same-day or next-day. AmazonFresh is available in key U.S. geographies, as well as in parts of London. AMZN’s push into grocery delivery is an attempt to capture part of the $800 billion food and packaged goods market that is currently dominated by Wal-Mart, Target and Costco. Wal-Mart has been successful in implementing an order-online-and-pickup-in-the-store model, as well as home delivery for orders over $35. Currently, AmazonFresh is available for Amazon Prime members for $14.99 per month in addition to the annual Prime subscription fee for unlimited daily deliveries on orders over $40, or $7.99 for orders under $40. To further compete with brick-and-mortar stores that are utilizing pickup/delivery services, AMZN is testing AmazonFresh Pickup in Seattle. AmazonFresh Pickup, if successfully rolled out, will allow customers to order groceries online and schedule to have the groceries loaded into their car at the store. Additionally, in May 2017, AMZN will meet with major packaged foods companies, such as General Mills and Mondelez, in order to see if the foods companies will be willing to change the packaging on their food items that allow for better delivery and improve the customer experience. AMZN is trying to take away more market share from the brick-and-mortar majors, as consumer tastes change.
Amazon Prime Growth: Amazon’s growth for subscription service fees have outpaced overall company sales for the past two years. In 2016, AMZN sales grew 27% y-o-y, while retail subscription services sales were up 43%. Most of the subscription sales are from Amazon Prime, a $99 per year membership fee that gives members unlimited free shipping on millions of products, guaranteed two-day shipping, unlimited online streaming of thousands of movies and television episodes, and other benefits. According to The Motley Fool, Prime members spend as much as $500 more than nonmembers each year. In large cities, Amazon has offered Prime members free two hour delivery in a free service called Prime Now, available in 28 U.S. metropolitan areas, as well as in key international cities, such as London, Milan, Berlin, Madrid, and Tokyo. As much as 25% of Prime members have used Prime Now to buy groceries, electronics, household products, clothes, personal care, and toys. Also, Amazon added Prime Video to Prime members for free to access unlimited online streaming for select content, or $8.99/month without a Prime membership, to compete against Netflix. In December 2016, Amazon Prime Video launched globally to over 200 countries, often at the price point below Netflix. Finally, in 2014, Amazon Music was added to Prime members at no cost to compete against Spotify, Pandora and Google Play Music. Continued growth in Amazon Prime, as well as additional benefits for Prime members, will increase subscriptions. Growth in Amazon Prime will provide AMZN with a steady sales stream and an opportunity to be able to meet its Q1 2017 goal of 14% – 23% y-o-y sales growth.
Order Fulfillment: AMZN fulfills customer orders through either its own global fulfillment delivery networks, outsourced arrangements, or digital delivery for non-physical items. 3rd party sellers pay Amazon to fulfill orders with variable or fixed fees, depending on the relationship. AMZN takes pride in its fast and reliable fulfillment, that the company has taken steps to control more of the supply chain infrastructure for physical deliveries. Part of the control involves taking ownership of logistics, which the company began with its own fleet of Amazon branded delivery trucks. Also, in August 2016, the company began to use the first of many branded cargo planes and will invest $1.5 billion to build a cargo hub in Hebron, Kentucky, near existing Amazon fulfillment centers. Moreover, in 2016, AMZN built 26 new fulfillment centers in North America to further improve product delivery times, with more fulfillment center buildouts to come. In terms of international fulfillment, Amazon has begun to reserve its own space on ocean freightliners, acting as a global freight operator and logistics organizer and competing directly with UPS and FedEx in a $1 trillion freight market. Finally, AMZN’s investment in drone delivery is currently in test phase. The company’s initial investments in order fulfillment improvement will eventually lead to lower overall shipping costs, as Amazon continues to work to optimize its fulfillment network and inventory.
Catalyst: Amazon has 300 million customers that utilize its online marketplace and its base is continuing to grow, while traditional retail peers struggle to keep their stores open. The company is heavily investing in controlling more of the supply chain in order to be able to optimize the product flow from sale to delivery, while challenging long-time stalwarts with disruptive investments to compete market share away from grocery and logistics businesses. AMZN management states that capacity expansion will continue as long as sales volume remains high and growing. With all investments geared toward lowering prices for customers, and current consumer sentiment at multi-year high, we believe that sales will continue to grow because Amazon has been evolving as consumer trends point more heavily towards e-commerce. With recent expansion targeting groceries, a global rollout of digital content, and a willingness to stay ahead of the competition, we believe that AMZN’s shares will continue to outperform its peers.
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