Alexa, What Should Investors Know About Amazon?

As the 2016 holiday selling season winds down,

Alexa devices are garnering most of the headlines following the holiday selling season, and rightfully so as it’s becoming apparent that this platform has solidified its position as Amazon’s fourth pillar business that, in management’s words, “can grow to be large, will provide strong financial returns and are durable, and can last for decades,” joining the company’s Marketplace, Prime, and Amazon Web Services businesses (coincidentally, the three primary sources behind our operating margin estimates growing from 3.2% this year to 7.2% in 2020). On Dec. 27, Amazon noted that sales of its Alexa-enabled Echo devices increased more than 9 times over last year’s holiday sales, which could imply 4 million-5 million Alexa units sold to date, based on third-party estimates.

While we view Alexa/Echo as an early-stage product, it’s clear that there are several longer-term benefits. At the top of that list is enhancing Amazon’s network effect--a key source behind our wide economic moat rating--as Echo products offer other consumer companies direct access to Amazon users, which could have positive margin implications via increased third-party sales and advertising. Second, it keeps consumers locked into the Amazon ecosystem while promoting sales of margin-accretive subscription services such as Amazon Music or Audible. Third, we believe Amazon is just starting to scratch the surface of what it could do with Alexa, including licensing the technology to other products (a key theme coming out of this year’s AWS re:Invent conference). Finally, and perhaps most important, Alexa/Echo provides Amazon with unrivaled customer data, offering a key longer-term competitive advantage.

In addition to our longer-term optimism about Alexa and the Echo family of products, we walked away from Amazon’s holiday season with greater confidence in the company’s ability to drive operating income at or even above the high end of previous guidance calling for $0-$1.25 billion, implying consolidated operating margins of just under 3% based on the midpoint of management’s revenue outlook for the quarter calling for $42.0 billion-$45.5 billion. While content costs--particularly in international markets, with Amazon recently rolling out video on demand in each of its operating markets except China--and additional fulfillment center investments loom as potential margin headwinds, we believe there are two key reasons to feel optimistic about Amazon’s fourth quarter, as well as its longer-term margins.

First, based on our conversations with the company and several third-party sellers on Amazon, it’s apparent that the company avoided many of the bottlenecks (and the ensuing incremental freight and labors costs) that its fulfillment centers saw during last year’s holiday season. With third-party units continuing to trend around 50% of total sales, we believe Amazon was much better equipped to handle the tremendous demand for Fulfillment by Amazon services--particularly among smaller- and medium-sized retails/consumer brands--setting the stage for strong gross margin gains this quarter. Our model currently assumes 150 basis points of improvement to 33.4%. Second, based on our own channel checks, price competition appeared to be much more subdued across several categories (including electronics) in the weeks following Black Friday, also supporting our gross margin estimates for the quarter. Taken together, we expect operating margins to come in slightly ahead of the high end of management’s outlook, while also adding comfort to our longer-term operating margin assumptions.