Today's Deal Is Amazon

With the rout in global equity markets at the start of the year, we find much of Morningstar's global e-commerce coverage universe--home to some of the widest economic moats in the consumer space--trading at significant discounts to our fair value estimates. While we acknowledge the possibility of more pronounced economic headwinds facing consumers across the globe in 2016 and the implications for discretionary consumer spending, we believe the market is overlooking the powerful network effect that many of these companies have developed over the past several years, not to mention a host of other leading players in more nascent e-commerce markets that are successfully bridging the transition to a business-to-consumer from consumer-to-consumer marketplace through enhanced payment, financing, logistics, and branded store offerings.

Looking at the past decade, we've found economic downturns can actually be conduits for e-commerce adoption rates given the competitive pricing, rapidly expanding product selection, and convenience of expedited shipping that these platforms generally offer--something we don't believe is reflected in current stock prices across the group. While e-commerce volume trends do typically slow during the onset of a recession, we believe value-seeking consumers flock to these marketplaces as economic headwinds persist, making them recover before other consumer cyclical names. Additionally, with online grocery expected to be one of the fastest growing e-commerce categories over the next several years, we expect the mix of consumer purchases online will become more defensive in nature, making many of the leading e-commerce marketplaces better insulated from potential recessionary conditions.

Once e-commerce players amass more than 10% of their operating regions' population as active users, it becomes very difficult for competitors to unseat them, which can lead to a multidecade period of excess economic returns. As several e-commerce players enjoy well-entrenched network effects in key markets, they recently have taken more steps to lock in their customers through membership and other subscription-based services while leveraging their network effects into new growth categories such as mobile payments, cross-border trade, third-party fulfillment, and online-to-offline services such as restaurant delivery. While some of these businesses extensions are already meaningful cash flow contributors--Amazon Prime in particular--we believe many of these other endeavors are natural extensions of these companies' network effect moat source and should drive improved profitability over an extended horizon.

Amazon's Growth Potential Is Undeniable Amazon has played a key role in the structural shift away from brick-and-mortar retail, and it may lay waste to many other retailers in the years to come. Without the cost burden of physical stores, Amazon can price below traditional rivals and drive recurring traffic online. Even with online sales tax collection, we believe Amazon will maintain its consumer proposition through other means, including the convenience of Amazon Prime's expedited shipping and expanding digital content library. Aided by the network effect inherent in 304 million global active users and recent fulfillment infrastructure, technology, and content investments, Amazon owns one of the wider economic moats in the consumer sector and is likely to remain a disruptive force in retail, digital media, and cloud computing.

Amazon's key top-line metrics--including active users (a 19% compound annual growth rate the past five years), total physical and digital units sold (33% CAGR), and third-party units sold (42% CAGR)--continue to outpace global e-commerce trends, suggesting that the firm is gaining share while fortifying its network effect. Nevertheless, with 2.1% operating margins in 2015 (4.2% excluding stock-based compensation and amortization of intangibles), Amazon continues to face questions about being able to sustainably monetize its growth.

We acknowledge that Amazon's margin expansion is less visible than its growth trajectory, given the potential for new investment cycles, including international fulfillment infrastructure and content deals, AmazonFresh, tablets and other hardware, and new delivery capacity and technologies. Admittedly, some of the company's capital decisions haven't yielded strong returns (the Fire Phone, in particular). However, we're optimistic that Amazon can reach 6.5% operating margins by 2020 (8.3% excluding stock-based compensation and amortization of intangibles) based on Prime memberships and fee increases, segment margins for Amazon Web Services pushing 30%, fulfillment center scale ("getting closer to the consumer"), third-party sales, and early signs of profitable growth internationally.

Highly Disruptive Force in Retail A shakeout among traditional brick-and-mortar retailers is under way, particularly in commodified categories. With nonexistent customer switching costs and intense competition, we've already seen Circuit City, Linens 'N Things, and Borders exit the marketplace over the past few years, while companies like Barnes & Noble, RadioShack, Sears, and Office Depot are struggling to reverse deteriorating fundamentals. Market consolidation among mass merchants like Wal-Mart and Costco has played a role, as have direct-to-consumer investments by key original-equipment manufacturers like Apple and Samsung. However, we believe Amazon has become the most disruptive force to emerge in retail in several decades. Its low-cost operations, network effect, and focus on customer service provide it with sustainable competitive advantages that traditional retailers cannot match; this should yield additional market share gains in the years to come. Despite its ongoing fulfillment, technology, and content investments, we expect Amazon can generate economic returns ahead of our cost of capital assumption over an extended horizon, supporting our wide Morningstar economic moat rating.

One of Amazon's key advantages is its low-cost operations. We contend that the cost to maintain its scalable fulfillment and distribution network is lower than having a large physical retail presence, allowing Amazon to price below its brick-and-mortar peers while still generating excess economic returns. Additionally, U.S. tax laws currently mandate that online retailers collect sales tax in states where they have a physical presence, with the tax responsibility falling to the end consumers themselves. As a result, Amazon currently collects sales tax in states where it maintains a physical presence--roughly half of the United States at present--providing some cost advantages. These allow Amazon to generate strong cash flow, which in turn can be reinvested in advertising, customer service, and website enhancements that keep its marketplace robust and customer loyalty strong. In fact, we believe Amazon's brand has come to represent low prices, a wide selection, convenience, and superior customer service--a rare combination among retailers.

Amazon also benefits from a network effect, as low prices, an expansive breadth of products, and user-friendly interface attract millions of customers, which in return attract merchants of all kinds to Amazon.com, including third-party sellers on Amazon's Marketplace platform (which represented 46% of total units sold in 2015) and wholesalers/manufacturers selling directly to Amazon. According to our research, the percentage of traffic to Amazon derived from search has fallen in recent years at a time when other online retailers have become more dependent on search. We think this indicates that Amazon is increasingly becoming the starting point for online purchases, akin to a mall anchor tenant. Additionally, customer reviews, product recommendations, and wish lists increase in relevance as more consumers and products are added to the Amazon platform, enhancing its network effect.

As media products (which contributed 21% of total revenue in 2015) move from physical to digital distribution, warehouses and an expansive distribution network will not provide the same advantages. Nevertheless, we like Amazon's chances to compete in digital media, given its sizable customer base and the symbiotic hardware/software ecosystem of its Kindle, Fire TV, and Dash products. We continue to consider the Kindle suite of products as customer acquisition tools that add multiple layers of upside to our base-case assumptions, including additional Prime memberships and engagement levels, accelerating digital media sales, and a positive halo effect on general merchandise sales. Even though we don't expect Amazon to supplant Apple in digital media, we believe it could develop into a formidable player, given its vast content offerings, inroads into new verticals (including video games), and ability to sell hardware as a loss leader.

We also believe Amazon Web Services--which boasts more than a million active customers--has similarly developed cost advantage, intangible asset, and network effect moat sources. Amazon's public cloud computing offerings possess more than 4 times the computing capacity in use than the next 14 largest providers combined (according to Gartner statistics), providing scale advantages and often making the company the preferred name for corporations looking to reduce information technology expenditures. AWS generated $7.9 billion in revenue during 2015, and we forecast average annual revenue growth of approximately 35% over the next five years. With recent investments for additional capacity and other innovations, we expect AWS to become an increasingly positive gross margin contributor and believe it can deliver 30%-plus margins over a longer horizon, thanks to its highly scalable nature and network of third-party software providers selling on the AWS marketplace.

Competition and Regulation Pose Risks Despite its leading position in an e-commerce industry with secular tailwinds, Amazon faces potential risks. Impairment to Amazon's low-price positioning, whether real or perceived, could have an adverse impact on fundamentals. Amazon must maintain its value proposition to drive site traffic while fending off other online merchants, mass merchants, warehouse clubs, and specialty retailers for market share. This includes managing the value proposition of Amazon Prime after management announced that it was raising its annual Prime membership fee with more potential price hikes in the future, though we believe the convenience of Amazon's fulfillment capabilities, expanded digital content offerings, and Subscribe & Save platforms will continue to drive new Prime memberships and keep attrition to a minimum.

Amazon also faces some regulatory risk, as we expect a federal standard for collecting online sales tax to be put in place within the next several years, potentially weakening one cost advantage and making traditional retailers more competitive. Still, even if more-stringent tax collection laws were put in place, we believe Amazon could maintain its value proposition and attract customers through other means, including faster shipping capabilities and new Amazon Prime membership features. International growth brings unique regulatory challenges, as foreign governing bodies are constantly amending online commerce laws.

Other downside risks include exposure to volatile discretionary spending patterns and expansion into peripheral business lines, which could distract management or lead to poor capital-allocation decisions. Conversely, we see upside risks in the form of more diversified AWS offerings, advertising services, expanded Fulfilment by Amazon capabilities, the rollout of AmazonFresh across additional urban centers, and new potential pricing tiers for Amazon Prime memberships.

Corporate Stewardship Is Exemplary Not even the most senior managers at Amazon have golden parachutes. Founder, chairman, and CEO Jeff Bezos owns about 20% of the shares, takes no equity compensation or bonus pay, and collects a paltry salary. Although the board is small, it is elected every year, receives no cash compensation, avoids insider relationships, and hasn't implemented antitakeover provisions. The company also provides a good deal of supplementary financial data in its quarterly releases. Our only complaint is that such disclosures have not increased as the company has expanded into new areas, including digital downloads, the Kindle suite of products, and Prime memberships (though to its credit, management broke out AWS as a separate business unit in the first quarter of 2015).

Amazon has made sound investments in developing a moatworthy business model, including an efficient fulfillment infrastructure in North America, a vast content portfolio, and Amazon Web Services capacity. However, a $170 million charge tied to the Fire Phone in the third quarter of 2014 and operating losses internationally underscore the importance of Amazon being more selective with its capital allocation. We believe the Fire Phone charges were a wakeup call for management's future capital decisions, as the company runs the risk of losing key personnel without stronger returns on invested capital due to the equity component of many employees' compensation structure. However, we're comfortable with this risk, given recent capital discipline and investments more directly aligned with the core commerce and AWS platforms.