I believe Amazon is an extremely attractive long position for any investor with a 5+ year time horizon (possibly few and far between!).  The company is misunderstood by many investors who focus on its short term earnings, despite the fact that CEO Jeff Bezos has been clear in his intentions to sacrifice near-term earnings for the sake of long-term free cash flow generation and the deepening of the company’s competitive advantage.  Amazon’s moat is wide and growing, and the company is well positioned to take advantage of global internet growth and the resulting migration of retail sales to the internet, one of the most powerful trends of our generation.  10 years from now I believe that 1) the leading online retailer globally will be amongst the largest retailers in the world, 2) that company will be amongst the most valuable of all companies in the world, and 3) Amazon is likely to be that company.  If that is true the stock should appreciate meaningfully from its current $76 B enterprise value, despite the high current P/E that scares most value investors away.

Wait, Doesn’t This Trade at 95x Earnings?

Let me start with the valuation discussion since I’m sure this will generate a healthy debate.  The key point I want to get across is that Amazon’s current earnings are not reflective of its true earnings power, and therefore I don’t believe they should be the primary metric used when valuing the company.  This is because Amazon’s strategy from day one has been to take the profits generated from its scale and superior business model and give some of those profits back to its customers through lower prices.  The idea is that this will lead to higher cash flow generation in the long run given the massive efficiencies of scale in online retail (large fixed costs spread across a larger base and less variable costs than brick and mortar retail).  As Amazon grows its business model gets more and more attractive, and therefore its customers benefit as well (through lower prices).  It’s a true virtuous cycle, and one Bezos has been clear about in his annual letters:

“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” – 1997

“Eliminating defects, improving productivity, and passing the resulting cost savings back to customers in the form of lower prices is a long-term decision…Our pricing strategy does not attempt to maximize margin percentages, but instead seeks to drive maximum value for customers, and thereby create a much larger bottom line – in the long-term.” – 2003

“Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com. We’ve made similar judgments around Free Super Saver Shipping and Amazon Prime, both of which are expensive in the short term and—we believe—important and valuable in the long term.” – 2005

While this is a rather unique model, there are examples of this working successfully – Costco is one of the best, but I’d throw in segments of Berkshire as well (Geico, Nebraska Furniture Mart).  This model is one of the main reasons Charlie Munger thinks so highly of Costco: 

 “I just can't say enough about my admiration for Costco. More of you should look at Costco…It has a frantic desire to serve customers a little better every year.  When other companies find ways to save money, they turn it into profit.  (CEO) Sinegal passes it on to customers.  It’s almost a religious duty.  He’s sacrificing short-term profits for long-term success...Generally speaking, I believe Costco does more for civilization than the Rockefeller Foundation” – Charlie Munger, July 2011, http://money.msn.com/investment-advice/article.aspx?post=7f0e084a-3473-41cc-b7e9-f4353e0deeb3

I believe that exact same argument can be made for Amazon.  It’s also worth noting that in addition to sharing profits with its customers, Amazon also invests aggressively in its systems and infrastructure to further grow its main retail business, and also to fund new areas such as cloud computing and the Kindle, which further cuts into current earnings.  Also, free cash flow is consistently higher than net income given the company’s high inventory turns and resulting negative working capital cycle (in 2010 FCF was $2.5 B versus $1.2 B net income).  So to value Amazon properly, there are several reasons why you need to look beyond current earnings, and in my opinion need to think ahead to where the company will be several years down the line.   

Overview

Bezos started Amazon in 1994, leaving a promising Wall Street career at DE Shaw with the idea to start an online book store.  He was ambitious from the beginning, getting the site launched by 1995, raising $8 mm from Kleiner Perkins in 1996 and listing publicly in 1997, which raised an additional $54 mm and valued the company at $429 mm.  I’d highly recommend reading his shareholder letters (the first of which, in 1997, was titled “It’s All About the Long-Term”) which are available at: http://phx.corporate-ir.net/phoenix.zhtml?c=97664&p=irol-reportsannual.  In short he has many admirable qualities for a CEO – he’s obsessed with serving his customers, only takes an $82 K salary, is focused on long-term free cash flow generation, has proven to have incredible foresight into his industry, is only 47 years old, and has even quoted Ben Graham in his letters.  He’s consistently taken a truly long-term view of his company, down to what now seem like obvious things such as allowing customer reviews of products on the site starting in 1995.  Many merchants thought this was crazy at the time, since negative reviews could hurt sales of certain products, but Bezos knew that in the long run customers would like the service and it has obviously become the norm in the industry since.   

Amazon is now the largest online retailer by a wide margin.  Its sales are estimated to be around $49 B this year, while Costco, Target, and Wal-Mart combined will have under $8 B in online sales.  45% of its business is now outside of the US, with online stores in the UK, Germany, France, Japan, Canada, China, and Italy.  It now sells just about everything online, with 18 main product categories, and it grows its selection every year.  It’s a leader in cloud computing and other related internet services, with groups such as Netflix, NASA, ESPN, The New York Times, and Twitter all tapping into its massive technology infrastructure for a fee.  It has developed several innovative programs over the years, including one-click shopping (which it has trademarked), Amazon Prime, Amazon Marketplace (now 33% of sales), the Kindle, and the Subscription business (where you can sign up to have any product delivered on a regular schedule in exchange for a discount – I highly recommend this for anyone who doesn’t like to shop!) all of which have been focused on improving both its customer experience and the long-term competitive advantage of the business. 

Massive Tailwinds

This won’t come as a surprise to anyone but I think it’s important to reflect on just how big of a theme global internet growth is.  Despite the tech bubble bursting in 2000, the # of internet users globally has grown more than 5x over that time:

Because of continually dropping costs thanks to Moore’s law and other technological advances such as mobile, this trend will almost certainly continue regardless of what happens to the global economy.  I believe the best-positioned companies to take advantage of this trend are those that provide a service to their customers yet also have some degree of pricing power, as it’s tough to compete on the hardware side of things given the consistent price deflation of those products.  I believe internet retail fits this nicely given that it’s a service business that is enhanced by the increasing ease of use and declining costs of technology broadly, while at the same time offering large efficiencies of scale that should act as a competitive barrier.   

Stop and ask yourself two questions: what do you think internet retail will be as a proportion of total global retail sales in 10 years, and what do you think that number was last year?  In several informal polls I’ve found most people think the current #’s are a lot higher than they really are (I also recommend anyone under the age of 25 what % of their purchases are made online): 

While the level in 10 years is impossible to predict with any precision (10%, 15%?) it will clearly by much, much higher and only growing from there as well.  Incredibly not only has Amazon been taking share of this rapidly growing pie, it’s actually done so at an increasing rate every year since 2005:

Amazon’s Ever Widening Moat

Of all the major internet and technology companies, I believe Amazon has the best chance of still being around 10, 20, 50, etc. years down the line.  It passes the simple Buffett test with flying colors in my opinion (could a new, well-funded competitor compete with the business?) given its massive distribution infrastructure that took years to build and required large amounts of upfront investment to get to necessary scale (Amazon racked up $3 B of losses between 1995-2003).  Morgan Stanley estimates that the company will end 2011 with 40 mm square feet of “one-to-one, multi-node fulfillment infrastructure” (in others words, very sophisticated warehouses and logistics) and notes “No other company in the world has such an infrastructure, including offline retailers with much larger revenue bases”.  Replicating that would take many years and billions and billions of dollars.   

Internet retail has several advantages over brick and mortar retail, which give a company like Amazon cost, selection, convenience, and availability advantages over the competition.  As one example let’s compare Amazon to Best Buy since they have similar revenue levels ($52 B vs. $49 B expected in 2011).  Amazon has 33,700 employees while Best Buy has 180,000.  If you assume each of the 146 thousand additional employees that Best Buy has on staff gets paid $25 K on average, that’s $3.7 B of additional costs, or 7% of Best Buy’s total sales!  In a low margin business like retail that is an enormous advantage for Amazon.    It doesn’t stop there though - in addition to requiring more employees, Best Buy’s business model also has significantly higher rent expense than Amazon (more than 3x as a % of sales).  Despite the lean staffing and physical presence, Amazon is able to carry more than 10 times the # of TVs and laptops that Best Buy does, turns its inventory over more rapidly each year (10.6 vs. 7.3 turns/year), and is open for business more than twice the hours of Best Buy.  Simply put, Amazon has a far superior business model to brick and mortar retailers, and yet the migration of sales to the internet remains at an early stage (Best Buy still has more than 4x the market share in US consumer electronics as Amazon, for example).      

For more reading on Amazon’s moat and business in general, this presentation has some good additional detail: http://www.slideshare.net/faberNovel/amazoncom-the-hidden-empire

Truly Long-Term Focus and Customer Obsession

In Bezos’s 1998 letter to shareholders, he wrote “We intend to build the world’s most customer-centric company”.  While that was a particularly bold statement coming from a 3-year old company that had just lost $125 mm that year, incredibly Amazon has become just that.  This table shows Amazon’s scores in the American Customer Satisfaction Index versus several well regarded retail and internet peers.  Not only has Amazon scored the highest rating of any service related business in the history of the index, but it has had or tied for the best score each year since 2000: 

Amazon has delighted its customer base for over a decade, building trust and further widening its moat along the way.  Despite minimal marketing the customer base has grown from 20 million to 137 million over that span and the scores remained consistently high.

So, What is it Worth?

I believe there is a reasonably high chance that Amazon will become the largest retailer and one of the most valuable companies in the world.  Obviously that’s not certain and will take time, but given its massive tailwinds and huge competitive advantage I think it’s more likely than not to occur.  The average market cap of the 10 largest companies in the world is $253 B (at a seemingly reasonable 12x P/E I might add), so if I’m right there is clearly room for Amazon’s $82 B market cap to grow.  Comparing Amazon’s valuation to its peers in the internet/tech and retail space also helps put things in perspective and shows the amount of market cap available for AMZN to eat into:

For some actual metrics, current street consensus has Amazon generating $6.2 B in free cash flow in 2015.  At its current price that would be just over 12x EV/FCF, and I believe that the free cash flow could be meaningfully higher by then and that the true earnings/cash flow power of the company is even higher still.  The nice part of the Amazon story is that the company truly does get stronger as it grows, which compared to a company like Apple (which has to create new innovative devices every year just to keep up) is a huge long-term advantage. 

Another way of thinking about Amazon’s valuation is to estimate the % of retail sales that will be online in the future, the share of ecommerce Amazon has, and the company’s resulting margins.  While this is obviously a guessing game, for one example if total global retail sales grow 4% a year from current levels, 10% of those sales move online by 2021, Amazon has 15% share of that market, and net income margins match Wal-Mart’s current level of 3.6% (despite an inherently better business model), Amazon would generate ~$10 B in net income in 2021.  I believe something along those lines is a reasonably conservative outcome, and remember free cash flow would be even higher and the company’s growth prospects would remain bright at that time as the migration of retail sales to the internet will continue (eventually I could see half of retail moving online, but that could be very far off in the future).     

Another reason for my conviction in AMZN is the team’s consistent track record of innovation and likelihood of building additional earnings streams in the future (the analysis in the previous paragraph only focused on the core retail business, for example).  The company’s effort in cloud computing with Amazon Web Services is a great example – it has become the leader in yet another business in which there are large benefits to scale and significant growth coming in the future.  Goldman estimates that AWS will grow 50% per annum through 2015 and will generate $4 B of revenue at that time.  During Amazon’s May 2010 shareholder meeting Bezos claimed “It has the potential to be as big as our retail business”.  The Kindle has been a great success as well, revolutionizing the e-book market and generating additional book sales for Amazon.  While these segments are difficult to predict they demonstrate Bezos and his team’s creativity and focus on innovation.  Every year Amazon adds new categories to its main retail business, looks to buy small competitors who dominate a niche of online retail who would benefit from Amazon’s infrastructure (Diapers.com, Soap.com, Zappos, etc.), and enters new areas that have the potential to be significant as well (recent ventures include book publishing and grocery delivery, for example).      

While some investors and analysts are beginning to realize what an incredible business model Amazon has, I believe that even those who understand it have a hard time buying the stock given the headline valuation #’s.  It’s not a simple story, and the model of sharing earnings with your customers to increase long-term value is not common.  Imagine your average hedge fund analyst pitching his portfolio manager: “I want to buy Amazon at 100x earnings”.  We are all wired to prefer things that appear statistically cheap, even if the true intrinsic value of certain companies requires looking beyond near-term P/E’s.  During its growth phase in the 70’s and 80’s Wal-Mart never appeared statistically cheap, but in hindsight it was clearly undervalued and ended up as one of the best performing stocks of all time.    You can see this hesitation in recent sell-side opinions for example:

 “We view AMZN’s approach as the right decision for the long run, given AMZN’s attractive prospects and high ROIC…we await a more attractive entry point” - Credit Suisse 10/25/2011 (neutral)

“We require a better entry point, however, as we await follow-through on margin expansion before we can get more firmly positive on Amazon” - Barclays 11/28/2011 (Equal Weight)

“Long-term profit potential could exceed expectations…await a better entry point to take advantage of our multi-year thesis”- Goldman Sachs 12/13/2011 (Neutral)

Risks and Conclusion

Potential change in sales tax law is one risk, as Amazon has clearly benefited from most if its customers not having to pay sales taxes.  The company has stated that it would be comfortable with online sales being taxed at the federal level as long as it was fair, and in the end Amazon will maintain a large cost advantage over its competition because of its scale and superior business model.  There would also be some benefits to the company from being able to build more distribution centers around the country and make its delivery service even faster (as one example I believe they will deliver groceries with same day service to most major cities in the future, but would need more facilities around the country to do so). 

Competition is another risk, as clearly Wal-Mart and other brick and mortar retailers will try to move more sales online over time.  At the end of the day online retail and brick and mortar retail are very different businesses, and Amazon’s large and growing lead over the competition will make it tough to beat.  I believe the odds of Amazon having a larger share of online retail in the future are much higher than the odds of them having less.  I do think there will be several country-specific internet retailers started in other countries that could become quite valuable over time, and while it’s unlikely they would penetrate Amazon’s existing markets, they could dampen the company’s ability to grow in certain fast growing markets (360Buy in China and Flipkart in India are two good examples).   

There are other short term risks such as currency exposure (some risk to the USD going up) and the ongoing mess in Europe, but they shouldn’t get in the way of the long-term success of the business.  Stock price volatility is clearly a risk given the high headline valuation and the historic shifts in sentiment about the company, which can be significant.  I’m comfortable with that risk because the end point for Amazon is likely to be the same given it’s extremely long run way that is protected by a wide moat.  If an investor takes a truly long-term view, or would be prepared (or indeed, thrilled) to buy more if the stock falls, than I believe this is an attractive entry point into one of the world’s best businesses.