Well “they” say that you should start investing in businesses that you know. Then Amazon stocks are likely going to appear in the list of companies that you are familiar with.
You probably bought something from Amazon directly or indirectly before. How about booking an apartment or hotel for your vacation through Airbnb? Or streaming your favorite movies or TV series on Netflix? In fact, these two well-known tech companies run their data processing and storage from Amazon Web Services (AWS).
Ok, you may say it’s normal that the company is setting footprints across myriad lines of businesses these days. Indeed you are right, Amazon is investing in innovations and technologies aggressively. But the scale and extent of each project that the company engages in works out differently. Particularly for AWS, it has grown to a segment that deserves more attention than it ever had.
Why? We will take a closer look at where Amazon derives its top and bottom line from. So you can decide whether you to investing in Amazon stocks even though its P/E ratio is hovering around 100. Let’s check it out!
Business Overview of Amazon Stocks
Understanding Amazon Stocks: Products And Services
Today, Amazon operates a wide range of businesses. The company’s primary source of revenue is derived from the sale of a variety of products and services to customers. Of course it includes the merchandise that we are familiar with on its website. They include those sold by Amazon itself and its third-party sellers.
In addition to that, Amazon manufactures and sells electronic devices such as Kindle and Fire TV. They have also ventured into media production, creating original movies and series through its Prime Video subscription. As part of the synergistic strategy, the company also provides fulfillment, advertising and publishing services.
Last but not least, to leverage its huge technological infrastructure to support its e-retailing business, Amazon launched AWS. It allows other businesses to tap on its computing power by providing services such as compute, storage and database offerings.
Understanding Amazon Stocks: Operating Segments
To recognize these businesses appropriately, Amazon organizes them into namely three segments: North America, International and AWS. Basically, all the products and services that the company provides are split into the different geographical regions. While AWS is a standalone operating segment by itself.
Data Source: Amazon 2019 Annual Report / Net Sales Chart By: Carepital
From the FY2019 results, the bulk of the sales is derived from North America ($170.8 billion), followed by the International segment ($74.7 billion). Whereas AWS merely makes up 12% ($35.0 billion) of its revenue.
Now, let’s take a look at the operating income for FY2019. Operating income of North America, International and AWS stood at $7.0 billion, -$1.7 billion and $9.2 billion respectively.
Data Source: Amazon 2019 Annual Report / Operating Income Chart By: Carepital
Notice that the mere 12% revenue contribution from AWS actually makes up 57% of the profit margin of the entire company. On the other hand, the International segment generating $74.7 billion was still making a loss during 2019.
In fact, a quick math tells you that the operating profit margin of AWS equates to a nice 26%. On the other hand, the operating profit margin of North America segment is only 4.1%. We will examine more closely the strength of its competitive advantages, if any, in the following sections
Strategic Analysis of Amazon Stocks
Amazon dominates the e-retailing segment in the US market, with a 38.7% market share based on sales. On the other hand, Walmart, coming in the second position, commands a mere 5.3% of the market share. Likewise for other major competitors in the e-retailing space like eBay. The rapid growth in its e-retail sales is a key element causing the market’s bullishness in Amazon stocks.
Source: eMarketer Top 10 US Companies, Ranked by Retail Ecommerce Sales Share, 2020
No doubt, this gives Amazon the economies of scale required to execute its everyday-low-price strategy. However, US e-retail sales are still growing. Therefore, Amazon will need to continue to reinvest to support the growing market and maintain its dominant position.
Past record shows that Amazon’s strategy is to grow aggressively. Therefore, we believe Amazon will continue to capture the market share in the US e-retailing segment.
Apart from that, ecommerce sales as a percentage of all US retail spending is growing as well. It is expected to reach 14.4% in 2020 itself and 19.2% by 2024. Thus, it is no wonder why brick-and-mortar retailer Walmart with $500 billion sales, is committed to growing its online presence.
Source: eMarketer US Retail Ecommerce Sales, 2018-2024
Cross-Side Network Effects
It is important to note that the concept of ecommerce doesn’t represent a strong barrier to entry itself. However, Amazon’s strategy of maintaining low prices and wide selections of products can create a degree of customer captivity.
In fact, it is inherently difficult to build a marketplace. It requires attracting both the customers and vendors simultaneously. But Amazon has already established a thriving marketplace with its third-party sellers. Understand that such cross-side network effects can be a strong barrier to entry. It will be difficult for other e-retailers to try to attract sellers to their platform.
In addition, the strength of the moat is reinforced by the Amazon Flywheel effect, which is a strategy that the company adopts aggressively. The flywheel concept was first introduced in the book Good to Great by Jim Collins.
See below snapshot of the flywheel for a better understanding. Therefore, we will say that the company does enjoy a relatively strong competitive advantage in this aspect of the business.
Source: medium.com The Amazon Flywheel Effect
However, we wouldn’t say the same for the International segment. The market is more fragmented. The company has to compete with local and international players. They may have already established a stronghold while Amazon was trying to achieve scale in the US market previously.
It does not mean that the company will not dominate the e-retailing market in other countries. Only time will tell whether their expansion and acquisition plans will work in the long run. The barriers to entry in the International segment is not as strong as that of the North America market at this point in time.
Amazon Web Services
As discussed earlier, much of the increase in Amazon stocks price is likely contributed from its cloud computing business.
AWS leads the infrastructure as a service (IaaS) market. According to Gartner research, Amazon commands a whopping 48% of the IaaS market share in 2018. Microsoft was in a distant second position. However, understand that this is a growing market. Amazon will need to continue to invest heavily in order to maintain its dominant market share.
Market Share (%)
Market Share (%)
Source: Gartner Research (July 2019)
The IaaS model itself does not create a strong barrier to entry for competitors. As a result, those with the financial power will be able to build the required infrastructures. Moreover, the business is price competitive in nature. Businesses and startups can switch to a cheaper service provider relatively easily. However, Amazon may continue to find synergy between its e-retailing and cloud computing business. Such economies of scale can be challenging to build for smaller players as it is capital intensive.
However, we do see AWS continued expansion to the Platform as a Service (PaaS) and Software as a Service (SaaS) segments. In fact, Gartner research ranked AWS as the leader in the cloud IaaS and PaaS market segment in their vendor evaluation report.
Source: Gartner Research
A Deeper Look Into The Cloud Computing Market
The basic idea of PaaS is to allow businesses to tap on AWS hardware and operating systems. Whereas SaaS provides developers to build on softwares and applications. Moving towards PaaS and SaaS models will create a stronger barrier to entry for other major competitors.
Businesses will face higher switching costs if they consider changing to competitor’s solutions. Because they will need to ensure data integrity and compatibility issues. And this will create barriers to entry for Amazon stocks, which will ensure the sustainability of the company’s earnings power.
The global cloud computing market is still growing at a compounded annual growth rate (CAGR) of 17.5%. There can be enough pie for more players in the market. The market is expected to grow to USD 832.1 billion by 2025.
It may be still early to ascertain whether Amazon commands a strong competitive advantage in its cloud computing business. It will depend on management’s ability to navigate the growing market and execute its strategies effectively.
Source: MarketsAndMarkets: Cloud Computing Market
As you have seen, whether it is e-retailing or cloud computing, Amazon operates in a growing market. While there’s a certain degree of competitive advantage in its e-retailing segment, the cloud computing business will need to create stronger barriers to entry.
The company has been investing aggressively to grow its business, creating massive expenses that continue to depress its bottom line. Any cost savings or further increase in revenue could boost the bottom line significantly in the years to come.
In fact, we can see that effect in the North America segment which has already achieved substantial scale. You can see that the operating income was up 76% for Q3 2020 compared to Q3 2019.
Source: Amazon Quarterly Results 2020 Q3 Earnings – North America Segment
On the other hand, the company is still expanding overseas and trying to achieve scale. However, it will be much more competitive to do so today. There are other local and international players who already have presence in the respective countries. The short term fluctuation between operating loss and profit can continue for the foreseeable future. Hence, it leaves much to see whether it can capture substantial value in the long term.
Source: Amazon Quarterly Results 2020 Q3 Earnings – International Segment
Finally for AWS, this very profitable segment will continue to grow with the cloud computing market. In other words, it will continue to contribute to the company’s bottom line significantly. And if effectively executed, it can be a business with a very strong moat around it.
Source: Amazon Quarterly Results 2020 Q3 Earnings
Leadership And Management – An Intangible Asset
With the leadership under Jeff Bezos, we expect Amazon to continue to grow in the medium term. The ability of the leadership team to formulate and execute strategies is an intangible asset to the company.
Above all, Jeff Bezos is one of the greatest entrepreneurs of our time. The business principles and philosophies he adopts are very strategic and well thought out. Most importantly, the ability to execute well has helped Amazon stand out in the highly competitive ecommerce market.
Whether you are an investor or business person, you can learn alot from the founder CEO. In fact, the book “The Everything Store” by Brad Stone is very insightful, detailing the birth to the rapid growth in the early days of Amazon. You should check it out too!
Back to the investment aspect of Amazon stocks, there’s already a premium priced in due to its growth potential. At the current price of above $3000 a share, we do believe that it will continue to go higher. However, albeit a great company and leadership team, paying the stocks at this price can translate to a limited return.
Then again, Jeff Bezos’s direction is to increase its innovation budget in proportion to the size of the company. Who knows Amazon might be able to create more profitable lines of business like AWS and fundamentally change its intrinsic value again? Just keep a lookout and consider adding Amazon stocks to your portfolio. If the price dip due to shortsightedness in the market, be sure to consider investing.
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