Amazon Answers Critics in Fourth Quarter

With Prime memberships, Amazon Web Services, and third-party sales helping to drive an impressive 300-basis-point improvement in gross margins,

We're planning only a modest increase to our $375 fair value estimate, as the better-than-expected fourth-quarter results will be muted by slightly more conservative first-quarter numbers than our model called for (though partly a function of unfavorable exchange rates, which are expected to have a 400-basis-point drag on top-line growth trends). We expect media category weakness to persist through the first half of 2015 as the firm laps last year's video game console-related sales trends, but rebound to mid-single-digit growth in the back half. Amazon's results also give us greater conviction in our outlook calling for revenue growth in the midteens, gross margins of 33%-34%, and GAAP operating margins around 4% within the next five years. Although we still view the shares as modestly undervalued after today's rally, we'd encourage a wider margin of safety.

Capital allocation remains a question coming on the heels of the Fire Phone disappointment in 2014, but we believe one of the key takeaways from the fourth quarter is that many of Amazon's other recent key investments--including sortation centers (which we believe allows for same-day and Sunday delivery for more than half of the country), AWS versatility, and original video content--have translated into returns on invested capital improvements, particularly during peak fourth-quarter sales. In particular, we were encouraged that shipping costs as a percentage of sales were at their lowest point of the year in the quarter (4.6%) and down slightly year over year. In our view, this supports our views regarding the substantial competitive advantages that Amazon's fulfillment center network offers, particularly as speed of delivery becomes as important as pricing from a consumer purchase decision perspective.

Amazon Prime also remains one of the key components behind our network effect moat source and longer-term margin expansion assumptions. Management's disclosure that worldwide paid Prime memberships increased 53% squares with our calculations, and we estimate that there were more than 35 million Prime members globally at the end of the year, up from 23 million this time last year. Additionally, we find several reasons to believe Prime member contributions will continue to increase in the periods to come, including an expanded and higher-quality digital content portfolio (aided by additional original movie and television programming), increased marketing behind the Prime program (including the recent Golden Globe promotion and ongoing AT&T partnerships), and an increasingly more compelling value proposition across many European markets and Japan.

Admittedly, there are still lingering questions about Amazon's ability to monetize overseas markets, especially with international segment operating margins (0.2%, down 130 basis points year over year) lagging North America (5.4%, up 70 basis points compared with last year). Nevertheless, we believe the company has a significant opportunity to replicate its network effect in North America in many regions across Northern and Western Europe, Japan, and India, which also contributes to our longer-term free cash flow assumptions. China strikes us as a much more daunting task, given the network effect inherent in

Morningstar Premium Members gain exclusive access to our full Amazon Analyst Report, including fair value estimates, consider buying/selling prices, bull and bear breakdowns, and risk analyses. Not a Premium Member? Get this and other reports immediately when you try Morningstar Premium free for 14 days.