Deep Dive - Amazon.com

A Quality Amazon.com stock analysis on business segments, future prospects, and valuation. Compiling and decoding the entire business in a simple and coherent manner for readers to understand.

(Disclosure: All of this information is at the time of this writing. I am currently long AMZN 0.00%↑ )

Welcome Readers!

This analysis will attempt to cover in-depth research deep dive on Amazon.com on the following sections of the company:

1. History of the business

   • Introduction to Amazon.com

   • Company culture

   • Management

2. Business Model

   • Online stores

   • Third-Party (3P) Seller Services

   • Amazon Web Services (AWS)

   • Advertising Services

   • Subscription Services

3. Extensiveness of Amazon’s Moat

4. Financials

5. Risks

6. Valuation

1) History of Amazon.com

Amazon's culture is the cornerstone of its success. When Amazon was founded in 1994, it appeared to be just another company selling products online that were previously sold offline. However, Amazon managed to survive the Dot-Com Bubble and has grown to become the second-largest company in the world by revenue as of 2024 (as of this time writing).

1.1 Amazon’s culture

The book "Working Backwards" by Colin Bryar and Bill Carr offers a unique insight into the culture underlying this tremendous success:

Amazon’s working backward method starts like this:

1. Begin with the customer. To create successful products and services, it is important to start by understanding the customer and their needs. This involves identifying their desires, pain points, and customer perspectives that build the bulk of new ideas. Today, a business like Amazon Prime offers benefits such as same-day delivery, access to streaming services, and exclusive discounts, all tailored to enhance the customer experience and keep them engaged.

2. Identify the problem first before the solution. Before developing solutions, it’s important to clearly define the problem you’re addressing. This ensures that the solution targets a genuine customer need rather than simply selling a product or service.

3. Primary focus on customer experience. Building a customer-centric product or service requires an emphasis on the overall experience. This encompasses not only the product itself but also its delivery, support, and marketing. Today, Amazon has an efficient customer service with reliable delivery systems all part of reinforcing a positive customer experience.

4. Leverage customer feedback to guide development. Successful product and service development relies on incorporating customer feedback. This can involve conducting customer research, interviews, and analyzing data from customer interactions to guide the development process.

5. Embrace innovation. Staying competitive necessitates a continuous pursuit of new ideas and opportunities. Encouraging a culture of innovation and embracing new technologies and approaches is essential for ongoing success.

Here’s what Jeff Bezos has to say:

“We’ve had three big ideas at Amazon that we’ve stuck with for 18 years and they’re the reason we’re successful: Put the customer first. Invent. And be patient. […] We have an unshakable conviction that the long-term interests of shareholders are perfectly aligned with the interests of customers.”

This principle is at the heart of Amazon's customer-centric approach, which prioritizes customer satisfaction above all, leading to strong financial results over time.

Bezos outlines the four critical components part of Amazon’s DNA culture:

1. Customer Obsession: Prioritizing customer needs over competition obsession, which drives customer loyalty.

2. Long-Term Thinking: Possessing a longer investment horizon than most industry peers. This means continually reinvesting back into the business to continually improve.

3. Inventiveness: Accompanied inevitably by failure. “You cannot invent without experimenting […] and the thing about experiments is, lots of them fail.”

4. Operational Excellence: Taking professional pride in this area. “What happens in big organizations is, we tend to confuse experimentation with operational excellence. Simply doing a new iteration of something the organization already knows how to do well is not an experiment”.

These principles guide every aspect of Amazon’s operations and decision-making processes. Leaders at Amazon are expected to start with the customer and work backwards, think long term, and innovate continuously while maintaining high standards and frugality. These cultural elements collectively create an environment where innovation thrives, employees are motivated, and customers remain at the forefront of every decision, driving Amazon’s ongoing success continually for the years to come.

In summary, by using the Working Backwards process, teams start with identifying the customers’ needs, generating ideas by innovating, and then implementing a final solution that solves these needs. Through this, teams at Amazon work toward a shared goal of prioritizing customer experience that allows Amazon to make adjustments with aligned interests or discontinue projects as needed.

I enjoy the fact that Bezos prioritizes customers first. Every company relies on its customers, and while some might think their customers have minimal bargaining power today, ignoring them is a poor long-term strategy. Customer loyalty is a tremendous asset for several reasons. First, word-of-mouth can significantly impact a company’s business at no cost. Second, customers with high lifetime value are extremely profitable, as the cost of acquisition is a one-time expense, and these customers can generate revenue for years. Amazon recognizes this, and uses it to their advantage.

Treating customers well can significantly extend a company’s moat. Let me illustrate this with an example of the semiconductor company ASML that I read recently from Leandro (@invesquotes, be sure check him out!):

“One would argue that ASML does not need to focus too much on its customers because it has a monopoly in EUV, meaning customers have no choice but to buy the company’s equipment. While treating them poorly would not erode the company’s moat over the short term, it might lead customers to finance other projects to displace ASML’s technology (i.e., they might be incentivized to look for alternatives, even if they don’t exist today). However, ASML is well aware of this and works hard to please its customers and ensure they enjoy great profitability despite the elevated cost of its systems. This way, customers don’t have a reason to look elsewhere.”

I love the way Leandro articulates this example. In essence, regardless of a company’s market dominance, mistreating customers is not a strategy that maximizes long-term returns. Ensuring customer satisfaction is important for sustaining and expanding a company’s competitive advantage.

This same situation also applies to Amazon.

1.2 Executive Compensation

In Bezos’ first letter to shareholders, Bezos emphasized that executive compensation is crucial to Amazon’s long-term success. Amazon’s approach to executive pay is indeed unique, designed to drive strategic thinking, innovation, and continuous reinvention, while ensuring fair compensation that attracts and retains top talent.

Amazon primarily rewards its executives with stock, and performance is measured solely by the stock’s price over the past three years. This method ensures that executives are incentivized to think beyond short-term gains. Had Amazon tied compensation to conventional metrics like the growth of its e-commerce platform, we might never have seen the creation of AWS, Kindle, or Amazon Prime.

Unlike most companies, Amazon avoids cash bonuses and short-term goals, offering minimal base salaries intended only to cover basic living expenses. For example, CEO Andy Jassy receives a modest $175,000 in cash annually. However, when he became CEO in 2021, Jassy was granted a stock package with a 10-year vesting period, valued at $211 million based on 2022 prices. This means that ~99% of his 2021 compensation was at risk, aligning his interests closely with those of long-term shareholders.

Jeff Bezos still holds around ~9% of Amazon total shares outstanding, while Andy Jassy’s shares were valued at over $345 million as of February 2023. This figure is expected to rise, further aligning management’s goals with shareholder interests.

However, this high compensation structure does have a downside: dilution. Issuing shares decreases the ownership percentage of existing shareholders. Despite this, Amazon’s strategy ensures that its leadership remains deeply invested in the company’s long-term success, fostering a culture of relentless innovation and strategic growth. This alignment of incentives is a cornerstone of Amazon’s enduring competitive advantage and market leadership.

All in all, if you really want to dive into Amazon’s mindset into how they approach things in their business, read over their shareholder letters. It really helps investors to think in the mind of a business owner.

2) Amazon’s Business Model

From Amazon.com’s Annual Report, they report on three main segments:

1. North America

2. International

3. AWS

This is mainly to disclose Amazon’s sheer size in markets all over the world to regulators in the future. As the duty of an investor, it is important to read between the lines and understand the different product categories they offer under the absolute behemoth that Amazon is. Each category has its own unique differentiating moat that all has led to Amazon’s total success.

There is also correlation between the product categories, for example:

More Amazon.com e-commerce customers → More advertising revenue from sponsored ads → Potentially more Amazon Prime signups and members

Let’s explore the different product categories that Amazon has to offer. Here’s a few quick and digestible diagrams from FourWeekMBA on Amazon’s various business segments (in case I bore you!):

Out of all the business segment categories listed in their Annual and Earnings reports, I believe that Third-Party (3P) Seller Services, AWS, and their Advertising Services business will be the main intrinsic value drivers of the business going forward.

2.1 Online stores

Secular trend: Transition from physical stores to e-commerce in a newly digitized world where online purchases are more prevalent than ever towards convenience, accessibility, and price.

As we transition towards more digital transactions, Amazon remains a dominant player that will be set to benefit from this global secular trend.

As of FY2023, Online store sales account for roughly ~40% of Amazon’s total revenue. The products from these online stores are sold by Amazon worldwide, ranging from beauty products to home appliances to electronics.

Today, Amazon’s retail business has more than 300 million monthly active users and has ~40% of market share in e-commerce in the US:

Amazon’s e-commerce business has been growing at roughly mid to high-single digits these past few years as they take more market share from brick-and-mortar stores but I expect growth to decelerate in the coming years.

Everyone knows about Amazon’s e-commerce retail business and how it works but I do not think it will be a major intrinsic value driver for the business going forward. I believe that while Amazon’s total revenue reliance is still high on this segment, over time other, more profitable business segments (explained in the following) will catch up. Therefore, I do not think it is worth diving very deep into this business segment.

2.2 Third-Party (3P) Seller Services

Secular trend: By leveraging Amazon’s extensive logistics network and vast customer base, smaller businesses are empowered to compete on a global stage, efficiently expanding their reach and capabilities.

For a fee, Amazon offers inventory management for sellers, giving end customers access to Amazon’s renowned fulfillment and delivery systems. This service alleviates significant pain points for both sellers and customers, streamlining the process by centralizing customer service and returns with Amazon, rather than individual sellers. This approach contrasts sharply with other e-commerce sites, where customers must deal directly with individual sellers for any issues. Today, third-party services—comprising of marketplace commissions, delivery commissions, and fulfillment services — contribute approximately ~24% of Amazon’s total revenue. This integration not only enhances customer experience but also solidifies Amazon’s competitive edge, reinforcing its moat by creating a seamless, efficient system that benefits all parties involved.

Here’s a general snapshot of price increases in seller fees over the years that I found that illustrates Amazon’s pricing power in this market:

As Amazon’s marketplace has around ~60% third-party sellers, Amazon receives a commission on the sales these third-party sellers make. Essentially, Amazon acts as a toll booth in this space.

Even more, according to a new Marketplace Pulse report compiled from a sample of sellers (you can read more here), Amazon takes a cut of ~50% from every third-party sale on its platform. Third-party sellers end up paying to Amazon:

• ~15% in transaction fees (referred to as “referral fee” by Amazon)

• ~20-35% in fulfillment by Amazon (“FBA”) fees — for storage and inventory

• ~15% in advertising and promotions (discussed later in “2.4 Advertising Services”)

These fees vary based on the category, product price, weight, and seller’s business model, however these rough figures itself already paint quite a picture towards Amazon’s dominance in these third-party sellers’ businesses just acting as a toll booth.

What’s more is that a lot of these fees are necessary for third-party sellers to thrive in an ever increasing competitive market with some even competing by price. For example, Amazon doesn’t set advertising prices but as more sellers begin to advertise, advertising fees become increasingly more expensive due to increased demand and competition. These advertisements have now become important since advertised products are featured more and can be shown more, which may be the differentiator in a customer choosing one product over another. While most smaller sellers don’t pay as much for advertising, bigger private-label brands spend more than ~10% to grow their brand recognition on Amazon.com.

FBA fees have also been increasing steadily and rapidly. For example, from 2020-2022 in just two years, FBA fees rose by over 30%. However, the FBA service is arguably the cheapest and best option for sellers, and it often is the case for most sellers. Amazon has been exploiting this benefit by raising prices, becoming a monopoly in this space. Let me briefly explain why this may be the case.

Imagine you're running a business, and you have an opportunity to offload the grunt work—warehousing, shipping, handling returns—to a powerhouse like Amazon. That’s what FBA offers. It’s a service that scales just like cloud computing: you pay a fee based on your usage, and Amazon handles the rest. The more you sell, the more products you send their way, but your cost per unit stays the same. It’s almost like having access to an infinite warehouse and a logistics team, all without the hassle of running one yourself—arguably the cheaper and best option for a seller.

By leveraging Amazon's infrastructure, third-party sellers can focus on what they do best: growing the business. Think of it as Amazon becoming an extension of your operations, enabling you to scale effortlessly without the usual growing pains. As sellers send more items to FBA, they continue to pay the same per-unit fee, enjoying the benefits of a system that expands with their needs.

2.3 Amazon Web Services (AWS)

Secular trend: As businesses of all sizes migrate from traditional on-premises systems to the cloud for scalable, flexible, and cost-efficient computing solutions in an ever-increasing digitalized world.

Amazon’s infrastructure challenges during its early hyper-growth stages necessitated building its own in-house storage solutions. This wasn’t merely a tactical move, but more of a pivot to accommodate the burgeoning demand and scale that traditional infrastructure couldn’t support. This self-reliant approach laid the foundation for what would become Amazon Web Services (AWS), a critical pillar of the company’s long-term growth and a testament to its innovative resilience. This not only solved immediate operational hurdles but also catalyzed the creation of a robust platform that now powers much of the internet, showcasing Amazon’s ability to turn internal challenges into market-leading opportunities.

AWS is first to provide the cloud computing service as it was established in 2006, it has a well-developed infrastructure and it is the leading cloud computing service provider. As of FY2023, AWS accounts for ~16% of Amazon’s total revenue. However, interestingly enough, AWS accounts for ~62% of Amazon’s total operating income in Q1 2024 and ~66% in FY2023.

But what makes Cloud Computing so important in today’s digitalized world?

Scalability.

Why “Scalability”? Scalability encapsulates the unique advantage that AWS offers to businesses of all sizes. Typically in the nascent stages, a company’s infrastructure needs are minimal and easily managed. However, as the company evolves, so does the complexity and volume of its IT demands. Herein lies the genius of AWS — its ability to seamlessly scale resources to meet these burgeoning requirements.

Consider the traditional model where businesses had to forecast their infrastructure needs years in advance, often leading to either over-provisioning (resulting in wasted capital) or under-provisioning (leading to performance bottlenecks). AWS revolutionizes this by offering a pay-as-you-go model that ensures companies only invest in what they need, when they need it. This not only optimizes costs but also enables agility—a crucial factor in today’s fast-paced market.

Now, scalability isn’t merely about handling increased traffic or data. It’s about empowering businesses to innovate without the constraints of physical hardware. AWS allows for rapid deployment of applications and services, meaning a company can test new ideas and roll out updates at an unprecedented speed. This fosters a culture of continuous improvement and responsiveness to market changes — traits that are invaluable in maintaining a competitive edge.

Moreover, AWS’s suite of tools and services grows with the business. From data analytics and machine learning to storage and database management, AWS provides a comprehensive ecosystem that supports a company’s entire digital transformation journey. This holistic approach ensures that businesses are not just scaling their infrastructure, but also their capabilities and potential.

It’s important to highlight that AWS’s scalability is a major driver of its widespread adoption and a key factor in Amazon’s robust financial performance. As more businesses migrate to the cloud, AWS’s revenue streams diversify and strengthen, contributing significantly to Amazon’s bottom line. The foresight to build and continually enhance a scalable cloud platform is a testament to Amazon’s long-term strategic vision — one that long-term investors can appreciate and trust.

Scalability is not just a feature of AWS; it’s the backbone of its value proposition. It enables businesses to grow, innovate, and stay resilient in the face of change. For investors, understanding this core strength of AWS provides a deeper insight into why Amazon remains a dominant force in the tech landscape.

AWS also strengthens the efficiency of businesses in their day-to-day operations, so to speak.

Efficiency in business operations is significantly enhanced through cloud computing in several key ways:

1. Accessibility — One of the major advantages of cloud computing is its global accessibility. With just an internet connection and a device, you can access your data from anywhere in the world. This feature ensures that businesses can operate seamlessly, whether team members are in the office, working remotely, or on the go. The ability to access critical data and applications anytime and anywhere supports more agile and responsive business operations.

2. Security — Cloud platforms are renowned for their robust security measures. Some of the world’s most prestigious banks trust cloud services to store their data, showing the high level of security these platforms provide. Cloud providers invest heavily in security technologies and protocols, including encryption, intrusion detection, and regular security audits, ensuring that client data is well-protected from threats and breaches.

3. Cost Savings — Cloud computing allows companies to optimize costs effectively through the “Pay-as-you-go” model. AWS, for instance, charges businesses only for the services they use within a specific time period. This model eliminates the need for significant upfront investment in hardware and reduces ongoing maintenance costs. Companies can scale their storage and computing resources incrementally, paying only for what they need, when they need it, which can lead to substantial cost savings.

4. Disaster recovery — This is one of the most crucial services provided by cloud providers due to which people migrate their business to the cloud. No one knows about the natural disasters and your business might be destroyed in seconds. But here, the cloud providers give you a 99.99% guarantee (well, perhaps not) that you won’t lose your data even in case of any disasters.

Even NASA, the government agency, says:

“By 2014, like with many government agencies, NASA was trying to get away from buying hardware and building data centers, which are expensive to build and manage. [AWS] also provided the ability to scale with ease, as needed, paying for only the capacity we use instead of having to make a large up-front investment.”

• Amazon Elastic Compute Cloud (Amazon EC2), provides resizable and secure computer capacity.

• Elastic Load Balancing (ELB), helps in distributing the traffic to multiple servers.

• Amazon Relational Database Service (Amazon RDS), which is used for automatic synchronization and failover.

• Amazon Simple Storage Service (Amazon S3), which supports object storage for incoming (uploaded) media, metadata, and published assets.

• Amazon Simple Queue Service (SQS), which is used to decouple incoming jobs from pipeline processes.

• Amazon Simple Notification Service (SNS), which is used to trigger the processing pipeline when new content is uploaded.

Companies use these multiple services offered under the AWS umbrella today and the use of AWS provides the following benefits:

• Easy access to hundreds of petabytes of data, which is common in large enterprises

• Good use of dollar per use “Pay-as-you-go” model

• Built-in scalability

You may ask, is AWS perceived as a ‘plague’ to businesses who have to use it? No. I’ve spoken to a few and they have said that AWS is dependable, reasonably priced as businesses scale, and offers great functionality. Businesses do not mind growing on top of AWS.

In fact, I recently stumbled across this in Netflix’s Annual Report under Item 1A: Risk Factors:

Netflix says that, “we cannot easily switch out AWS operations to another cloud provider […or] our business would be adversely impacted.” This sentence alone demonstrates the immense switching costs and significant role AWS plays in businesses’ data that would even hinder their day-to-day operations. It can even be considered as a ‘bull case’ for Amazon, which I find to be surprising considering that it’s found in another company’s annual report.

While AWS has such a massive foothold in business operations today, Amazon believes that it does not seem wise to exercise full pricing power abilities just yet until they have reached a more mature stage in their growth stage. Additionally, exercising full pricing power in AWS can draw the attention of regulators. This will be mentioned more in a later stage of this analysis.

This level of pricing power, I would argue, is on a similar level to Apple’s App Store 30% fee on app and in-app purchases. Customers are forced to accept these terms and conditions because of the lock-in.

From what it seems, AWS possesses pricing power that rivals, if not surpasses, any form of technological lock-in currently to date.

Here’s an interesting chart from Precedence Research showing the expected market of cloud computing by 2030:

AWS’ operating margin as of Q1 2024 was 37.6%, the highest it’s ever been since 2014. That is good news for investors since despite its sheer size and rapid growth, profitability is still increasing. In other words, roughly speaking, if AWS can maintain a ~30% market share of the cloud infrastructure service provider market with a ~40% operating profit margin, it may translate into ~$485 billion cloud revenue and ~$195 billion in operating profit.

Of course, this is a much optimistic case scenario and I usually like to use more conservative and pessimistic numbers as a margin of safety. But the point of AWS being a cash-printing machine still stands well into the future.

I’ll leave this diagram from Statista here:

2.4 Advertising Services

Secular trend: Businesses are now capitalizing on the power of the internet, rather than more traditional / physical advertising, to provide precise audience insights and measurable results across wider audiences.

Amazon’s advertising business, which accounts for approximately ~8% of revenue, is growing rapidly compared to its bigger peers like Meta and Google (which is sensible given its size) and is continuously taking market share year on year:

What’s also interesting is that advertising services did not have its own category in Amazon’s annual and earnings report until as of recently, and arose from the ‘Other’ section since its size in revenue increased dramatically as its own category.

Amazon’s advertising business operates under a model called the ‘Amazon PPC’ (Pay-per-click)— an advertising model that assists sellers and brands to boost their product sales by creating ad campaigns for their products. Each time a shopper clicks on one of these ads, Amazon charges the seller a small fee.

Here’s how it works in a step-by-step process:

1. Shopper searches “iPhone Case” on Amazon.

2. Amazon gathers all the relevant ads for the keywords typed, “iPhone Case”.

3. Sellers and brands bid on the keyword through an auction, highest bidder wins.

4. Amazon displays the winning ‘Sponsored’ product ad at usually the top of the search results.

5. When a shopper clicks the ad, the seller pays a small fee to Amazon.

Amazon’s shopping marketplace has increasingly become a pay-to-play environment, with the best placement going to paid advertisers as opposed to those offering the lowest prices. Sellers who look to advertise their products pay more to appear at the top of search results with the word ‘Sponsored’ above:

On average, I spot three sponsored products every six products in the search results page. Quite a significant amount of products that are sponsored are overruling those that aren’t. Interesting to see.

Amazon PPC ads push products to the top of search results, preventing them from getting lost among competitors. This visibility boost drives more sales, which then improves the product’s organic ranking for key keywords, creating a cycle of growth and increased exposure.

These Sponsored Ad Products are known as one of three Amazon PPC Ad types, this one called ‘Sponsored Products’. This is by far the most common ad that sellers opt in for, used by ~70% of third-party sellers. The advantage of using Sponsored Product Ads is that it’s easily integrated with the organic search results and are therefore not intrusive to the user experience.

The next category is called ‘Sponsored Brand’ ads which are only available as an option to brand-registered sellers. These ads drive brand awareness and sales by offering more customized and creative ads from brands on relevant Amazon shopping results. These ads can be placed at the top, bottom, and sides of the search result page, including the brand seller’s logo:

Sponsored Brand ads can generate higher higher return on ad spend (“ROAS” — refers to the amount of revenue that is earned for every dollar spent on a campaign) by bringing shoppers who click on the ads directly to the brand’s custom landing page with products only solely from the brand’s seller. This also allows for complementary products beside others that can incentivize buyers to add more products to their carts.

The last category is the ‘Sponsored Display’ ads that allow sellers to engage with buyers from a range of platforms like on Amazon affiliate sites, Google, Facebook, Netflix, etc:

By using these Sponsored Display ads, sellers are able to connect with users both on and off Amazon. This can sometimes even target a wider audience and can attract new customers. Users who click on these ads are directed towards the seller’s advertised product back on Amazon.

The digital advertising industry is slowly growing over time as more households switch from linear TV, too:

As more and more people switch from linear TV to subscription services like Amazon Prime, advertisers, too, will switch due to a growing population on these subscription sites. It’s more lucrative for advertisers and more target specific to certain audiences and demographics.

Amazon isn’t just a web store, it’s also a marketing channel now! Talk about the optionality the business has to offer! It’s great when a business can grow with a secular trend as a tailwind.

Additionally, other than advertisers from linear TV moving to Amazon, a significant amount of advertising dollars is shifting from Google too. Think about it: if you’re a merchant, you have several options—Google, Facebook, or Amazon. But Amazon stands out because people visit Amazon with a specific intent to buy, making it a goldmine for advertisers. The conversion rates on Amazon ads are likely higher than those on Google or Facebook because of this intent. Amazon is closest to customers at the moment of purchase and ties purchase data directly to the advertisement.

I firmly believe Amazon’s digital advertising business is far superior than the likes of Google and Meta’s because there’s a higher ROAS for advertisers. People using Amazon search for a product they want or have in mind. They have a specific intent of purchasing and that in itself already builds an advertising profile on an individual, noting their purchasing habits, preferences, and thus advertisers are able to target very specific audiences compared to the likes of a platform like Meta’s Instagram for example.

Amazon’s advertising business is built on a uniquely powerful foundation: its extensive customer base and the rich data it collects on shopping habits. This isn’t just about browsing history or social media activity, which other digital advertising platforms rely on. Amazon’s insights come directly from actual purchase data. This gives advertisers unparalleled insights into consumer intent and preferences. It’s a direct line to consumers who are already in a buying mindset, making Amazon’s advertising platform extraordinarily effective. This is another clear example of Amazon leveraging its core strengths to create high-value, high-margin businesses just from the power of optionality it has to tie different businesses together seamlessly.

As for the advertisements in subscription services like in Amazon Prime Video, we will discuss that integration and the potential monetization behind it in the next segment, under ‘2.5 Subscription Services’. Because almost all of Amazon’s businesses are integrated together so seamlessly, it is difficult to discuss each business segment solely on its own in its entirety.

Here’s a diagram from Quartr that I think illustrates the potential of Amazon’s advertising business that is still growing rapidly despite its large size (even surpassing YouTube!):

Like in the cloud computing industry with AWS, Azure, and GCP consolidating the entire market, I expect the same in the digital advertising business with Google, Meta, and Amazon to consolidate most of the market as to where ad spending is going towards:

In conclusion, with the growth of the advertising service business at such a rapid rate that even exceeds the scale of YouTube’s advertising business, I think it will continue to accelerate even further given the recent addition of ads in Amazon Prime Video, which will be discussed in the following segment.

2.5 Subscription Services

Secular trend: Broader movement towards consumers enjoying movies and TV shows on demand at any time, where consumers seek convenience, consistent value, and seamless access to a variety of services.

Amazon Prime is more than just a subscription service; it’s a multi-stage powerhouse. Initially, it acts as a magnet for new customers, enticing them with the allure of fast shipping and exclusive content. Once they’re in, Prime’s extensive benefits ensure they stay, effectively reducing churn.

Here’s a bit of statistics and data I found on Amazon Prime:

• Amazon Prime is one of the most popular subscription services in the world, with over 230 million members worldwide. It offers a variety of benefits, including free two-day shipping, streaming video and music, and exclusive discounts.

• A typical Prime member spends an average of $1,400 annually on Amazon. This is significantly more than a non-Prime member, who spends an average of $600 annually.

• The number of Amazon Prime members in the United States is predicted to reach 171.8 million in 2024.

• Amazon generated $40.2 billion in revenue through Prime membership in 2023.

• Amazon Prime holds approximately ~53% of paid retail membership fee revenue in the United States as of 2023.

• Amazon Prime Members purchased 375 million products during Amazon Prime Day in 2023.

• Amazon Prime Video’s market share was 21% in the subscription services on demand market in the Q2 of 2023.

• Amazon Prime Music had 80 million users in 2023.

Looking ahead, the real magic lies in its potential as a lucrative advertising platform. By embedding ads within its vast ecosystem, especially in high-engagement areas like sports programming, Amazon can unlock new revenue streams with minimal risk of losing subscribers.

Amazon’s move to integrate ads into its Prime Video service is a classic example of leveraging optionality across its diverse business segments. Despite only being a few months into this strategy, Amazon is already experimenting with increasingly aggressive ad formats, such as displaying ads when users pause their content. This reflects Amazon’s relentless push to optimize every touchpoint for revenue generation.

Recently, Amazon announced three new ad formats for Prime Video: shoppable carousels, interactive brand trivia ads, and pause ads. The shoppable carousels, set to appear during ad breaks, offer viewers a “sliding lineup” of products that can be purchased directly on Amazon. Essentially, these are ads within ads, which automatically pause the content to allow viewers to browse. This is a clever strategy, converting passive viewers into active shoppers.

Interactive brand trivia ads present another innovative approach. By engaging viewers with trivia, Amazon can offer rewards like shopping credits, seamlessly integrating entertainment with e-commerce. Pause ads, which appear as a translucent overlay when content is paused, allow viewers to add promoted products directly to their Amazon carts. This extends engagement beyond traditional ad breaks and taps into those idle moments to drive sales.

From an investment perspective, this aggressive ad strategy could be a significant growth driver. Prime Video serves as a customer acquisition tool initially, drawing in subscribers with its vast content library. Over time, it becomes a retention tool, providing continuous value that keeps subscribers engaged. Now, with these new ad formats, it also stands to become a profitable advertising platform. Amazon’s ability to integrate e-commerce with entertainment and advertising truly exemplifies its strategic advantage in leveraging its ecosystem’s optionality.

In essence, while these ad tactics may seem intrusive, they demonstrate Amazon’s broader strategy to maximize the lifetime value of its customers. By creating synergies between its retail and entertainment arms, Amazon not only enhances user engagement but also unlocks new revenue streams.

This is the power of Amazon. It’s able to extensively leverage optionality and tie it multiple business segments like advertising services, reinforcing all of them under one big umbrella to rein in new revenue streams.

If Prime Videos do not want these ads, subscribers can pay an additional $2.99 per month on top of their existing subscription plan to opt out. This approach not only provides an alternative for users who prefer an ad-free experience but also serves as a brilliant revenue-generating mechanism for Amazon.

In my opinion, this is a win-win scenario for Amazon either way.

Consider the dual pathways Amazon has crafted. For those who opt to pay the extra fee, Amazon reaps additional subscription revenue directly. It’s a clear-cut increase in monthly earnings from each ad-averse customer. However, the real genius lies in the alternative scenario. Subscribers who choose not to pay the extra fee will be exposed to ads, which translates into advertising revenue for Amazon. This revenue isn’t just from the ad views but also from potential transactions spurred by interactive and shoppable ads, creating a feedback loop of increased sales and ad effectiveness.

This dual revenue stream just shows how incredible the robustness of Amazon’s moat is. If users pay to avoid ads, Amazon’s subscription revenue swells. If they don’t, the company benefits from the ad revenue, and given Amazon’s sophisticated ad targeting and integration with its vast e-commerce platform, this can be highly lucrative. It’s a win-win scenario for Amazon, where each path leads to increased profitability.

Moreover, the presence of ads might even enhance the perceived value of the ad-free option, pushing more subscribers toward the premium tier.

Here’s more, Jassy explains the pricing power stemming from Amazon’s subscription services:

“If you step back and think about a lot of subscription programs, there are a number of them that are $14, $15 a month really for entertainment content, which is more than what Prime is today. If you think about the value of Prime, which is less than what I just mentioned, where you get the entertainment content on the Prime Video side and you get the shipping benefit, the fast shipping benefit you can't find elsewhere and you get the music benefit, you get the Prime Gaming benefit and you get the photos benefit and you get the Buy with Prime capability, use your Prime subscription on websites beyond just Amazon and some of the grocery benefits that we provide, and RxPass like we just launched to get a number of medications people take regularly for $5 a month unlimited, that is remarkable value that you just don't find elsewhere.”

Amazon’s ability to leverage its vast ecosystem to create multiple layers of value is something you do not see in a business often. By turning potential friction points into revenue opportunities, Amazon continues to widen its economic moat, solidifying its dominance across diverse market segments and just about demonstrates its solid management team.

3) Extensiveness of Amazon’s Moat

What is an economic moat?

An economic moat is a distinct competitive advantage a company possesses that protects its market share and profitability from competitors over time.

Amazon faces the difficult task of attracting billions of customers, over and over again, in a highly competitive environment where people can switch to an alternative e-commerce store, with minimal cost. However, Amazon's strategy that focuses on customer obsession and investing heavily in user experience has allowed itself to develop:

The Flywheel Effect.

3.1 The Flywheel Effect in E-Commerce (Scale Economies Shared)

This flywheel effect, also known as Scale Economies Shared, was first coined by legendary investor Nick Sleep from Nomad Partners. The effect sets a continuous flywheel cycle that once started, is difficult to disrupt. This is the main characteristic to Amazon’s success.

Because it forms a circle, it does not matter where you start. For example:

Amazon prioritizing customer experience → increased traffic of users → attracts more sellers for a marketplace → contributing to wider selection of products → lower prices → further improving customer experience.

The loop just keeps on going. Here is what Jeff Bezos has to say about this strategy:

“I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question; it’s a very common one. I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time. … In our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now.”

This cycle continuously drives growth for Amazon, enabling a cost structure whereby Amazon can choose to lower its prices and/or improve product offerings in order to gain market share over the long-term than pricing its products higher to maximize profit in the short-term.

Amazon knows that the lifetime value of customers is much more important to extract out of, and thus a long-term strategy trumps a short-term one. Amazon will always prefer to lose one sale than lose one customer. They know the customer’s lifetime value is thousands of times over one sale. If you keep one customer for 20 years, you’re gonna make up the loss of any one lost sale.

Amazon understands that the lifetime value of a customer far outweighs the importance of any single transaction. For Amazon, the equation is simple: losing a sale is preferable to losing a customer, prioritizing enduring relationships over immediate gains. They recognize that the value a loyal customer brings over two decades can eclipse the profit of countless individual sales. It’s this focus on the bigger picture that has driven Amazon’s sustained success, reinforcing their commitment to customer satisfaction and retention.

According to Nick Sleep, Amazon’s commitment to price reductions as part of Scale Economies Shared ensures customers save between 2% to 10% compared to other retailers! This would certainly attract customers from the lower prices.

In addition to this, e-commerce companies have a capital advantage over traditional brick-and-mortar businesses. The very weakness for internet companies are its operating costs, which are especially high as a proportion of revenue, especially at the early stages in a firm’s development. By adopting scale economics shared, Amazon’s revenue quickly ramped up and operating costs as a proportion of revenue went down significantly, so much so that they became lower than some large chains such as Walmart! As a result, Amazon possesses an operating cost advantage over their competitors.

Amazon’s management executed this idea of scale economies shared so well that even if Amazon’s competitors priced their products at break-even profitability, it still wouldn’t disrupt Amazon’s prices and profitability!

When considering the nature of compounding, the time of the compounding process is the component that drives the most growth. Amazon, who has mastered scale economies shared significantly, can thus increase the chance of further compounding in the years to come.

“We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or ten years. 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 a much more valuable Amazon.com.” — Jeff Bezos

The economic moat of Scale Economies Shared is also the very moat that allowed Costco, another compounder, to thrive from its continued customer satisfaction and loyalty. I find this type of moat to build customer loyalty and great company culture, which I love.

At the end of the day, customers love low prices.

3.2 Network Effect

Network effects are one of the most powerful and elusive forces in the business world. At its core, a network effect occurs when the value of a product or service increases as more people use it. Think of it as a positive feedback loop: the more users a network has, the more attractive it becomes to new users, which in turn makes it even more valuable to the existing ones.

Consider the telephone. In the early days, owning a telephone was of limited use if only a few people had one. But as more households and businesses got connected, the utility of each phone increased exponentially. Suddenly, the network became indispensable. The same principle applies today in the digital age with platforms like Facebook, Uber, and Airbnb. Each new user enhances the experience and value for everyone else in the network.

For starters, Amazon’s marketplace is a bustling hub where millions of sellers list their products. As more sellers join, the variety and depth of the product catalog grow, attracting more buyers. This influx of buyers, in turn, makes the platform more appealing to even more sellers. It’s a virtuous cycle that continuously enhances the value of the platform for all users.

The platform that attracts the highest number of visitors wields the greatest influence.

This dominance allows Amazon to command higher fees from third-party sellers. Additionally, the sheer volume of customers leads to more and higher-quality reviews, attracting even more customers and setting Amazon apart from other online stores. With hundreds or even thousands of reviews per product, shoppers can make informed decisions, buying with the confidence that each item has been thoroughly seen, checked, and used by other users. This feature significantly reduces the friction of online shopping, enhancing the overall customer experience. Historically, this has been one of Amazon’s key strengths. Again, the more customers will reinforce the network effect.

But Amazon doesn’t stop there. Its Prime membership program can be harnessed to build loyalty and scale. Prime members enjoy perks like free shipping, exclusive deals, and access to a vast library of digital content. As the number of Prime members grows, so does the incentive for more merchants to offer Prime-eligible products, enriching the customer experience and making the membership even more enticing.

Moreover, Amazon’s extensive data on customer preferences and behavior feeds into its sophisticated recommendation algorithms, making shopping more personalized and efficient, further cementing customer loyalty and increases spending and therefore reinforcing the network effect.

When you click on a product or search for something specific on Amazon, the algorithm diligently tracks your actions. If a recommended product on your homepage catches your eye and you click on it, that interaction is also logged. The next time you search for an item, the algorithm leverages this data, presenting options tailored to your past searches, browsing patterns, and overall activity.

Amazon’s recommendation algorithm is a marvel of data science, designed to personalize the shopping experience at an individual level. By analyzing a wealth of customer data—ranging from search queries and purchase history to click-through rates and browsing habits — it continuously refines its suggestions. This sophisticated system not only enhances customer satisfaction by making relevant recommendations but also drives higher conversion rates and sales. It’s a dynamic feedback loop where every interaction helps the algorithm get smarter, ensuring that Amazon remains the go-to platform for a seamless and intuitive shopping experience.

Beyond the marketplace, AWS leverages network effects in the cloud computing space. As more businesses adopt AWS, its infrastructure becomes more robust, attracting even more customers and fostering a thriving developer community. This creates a competitive edge that is difficult for rivals to match.

AWS currently has much more functionality than competitors like Azure and Google Cloud Provider (GCP), a much bigger market position in terms of developer support and knowledge base, and more available third-party resources for developers to use on the internet. Thus a company choosing to use AWS will have a much better time on AWS than competitors.

For companies leveraging AWS, it translates to access to a vast talent pool. For software engineers, it opens up a plethora of job opportunities. This is a competitive advantage that’s tough for Azure or GCP to replicate. Software engineers are motivated to learn AWS because it offers the most job opportunities, creating a positive and self-reinforcing cycle.

For Amazon Prime, the beauty of the network effect is particularly evident. As the number of Prime members increases, Amazon achieves greater economies of scale, enabling them to lower prices across the board. This, in turn, attracts even more members, creating a virtuous cycle of growth. With a larger membership base, Amazon can invest more heavily in Prime Video content and enhance their fast shipping capabilities. Consequently, Prime members enjoy a richer array of benefits, including exclusive access to a growing library of high-quality video content and ever-faster delivery options. This continuous improvement in value proposition not only keeps existing members loyal but also attracts new subscribers, reinforcing Amazon’s dominant position in the market.

In fact, Amazon Prime Video as of October 2023, is one of the lowest in monthly prices in the video streaming services industry compared to its competitors:

A company like Amazon that possesses a network effect, although not its primary source of the moat, can drive superior returns to the index. According to Morningstar, companies that possess a network effect tend to outperform other sources of Wide Moat companies in the long run:

3.3 Switching Costs

Switching costs are high and are of significant challenge when it comes to businesses transitioning from AWS to Microsoft Azure, or a competitor. The costs can vary widely depending on the nature and volume of data being transferred, but such a move typically takes months and thousands, if not millions, of dollars. Consequently, a decision to switch cloud providers is not made lightly and requires thorough deliberation by the management team of the business that is thinking of transitioning.

The transition to cloud infrastructure from physical IT setups is a significant undertaking. It is not something that can be accomplished in a short period, often taking up to 18 months. Despite AWS offering robust data transport solutions like “snowballs” to facilitate this process, the complexity and cost remain high. So when a company does transition to the cloud, it would be a daunting task to switch again.

The moat of AWS strengthens as businesses grow. The more a customer builds on AWS, the higher the lock-in. Over time, customers transition from trying to avoid the lock-in to embracing it to leverage the full spectrum of AWS’ services. This phenomenon is a testament to the depth and breadth of AWS’ offerings, which go beyond basic infrastructure to include advanced tools for machine learning, data analytics, and IoT.

AWS’ vast and ever-expanding array of services creates a compelling ecosystem that becomes increasingly difficult for customers to leave. The initial investment in migrating to AWS and integrating its services is significant. As businesses develop more applications, store more data, and utilize more AWS tools, the complexity and cost of switching providers increase exponentially. This deep integration fosters a strong dependency on AWS, making the idea of moving to another provider not just daunting but often impractical.

Furthermore, AWS continuously innovates and adds new features, ensuring that it stays ahead of competitors and remains the preferred choice for enterprises. This relentless innovation means that customers who stay with AWS benefit from cutting-edge technology and services, which can provide a significant competitive advantage in their own markets.

3.4 Brand

According to Brand Finance, Amazon has taken up the spot as the #1 Most Valuable Brand in America 2023:

Amazon’s brand is an indomitable moat that has been meticulously crafted through years of unwavering focus on customer service, innovation, and expansive product offerings. Recognized globally, Amazon’s brand instills a level of trust and loyalty that is rare in today’s market. This brand strength doesn’t just happen overnight; it’s the result of consistent and deliberate efforts to exceed customer expectations at every turn.

Consider the breadth of services under the Amazon umbrella: from e-commerce to cloud computing with AWS, to entertainment through Prime Video. Each of these ventures benefits from the overarching trust in the Amazon brand. Customers have come to expect a certain level of quality and reliability from Amazon, which significantly lowers the barrier to entry for its new products and services. This trust is a powerful asset, allowing Amazon to venture into new markets and quickly gain a foothold where others might struggle.

The sheer scale of Amazon’s operations also feeds into this brand power. The company’s commitment to fast, reliable delivery, often facilitated through innovative logistics solutions, reinforces its brand promise. Moreover, Amazon’s dedication to continuous improvement and customer-centric innovations, such as one-click purchasing and Alexa-enabled devices, further cements its reputation as a leader in technology and convenience.

However, what truly sets Amazon apart is its ability to integrate these diverse offerings seamlessly. For instance, the convenience of Prime membership extends across shopping, streaming, and even cloud storage, creating an ecosystem that becomes increasingly valuable as customers engage with more of Amazon’s services. This interconnectedness not only enhances customer loyalty but also creates a significant competitive advantage that is difficult for rivals to replicate.

In summary, Amazon’s brand is not just a name; it’s a promise of value, innovation, and reliability. It’s this robust brand moat that allows Amazon to maintain its leadership position across multiple industries, constantly pushing the boundaries and setting new standards for customer satisfaction and business excellence.

Think about this: would you buy a Sony smart thermostat? Probably not, because Sony is not perceived as a leader in home automation. But when Amazon introduces a smart thermostat, it’s widely accepted because Amazon is synonymous with quality and innovation, especially in the tech and consumer space. This reputation allows Amazon to venture into virtually any business sector with confidence.

Renowned worldwide for its exceptional customer service, vast product selection, and relentless innovation, Amazon’s brand stands as a formidable asset. This brand strength fosters deep customer trust and loyalty, distinguishing Amazon from its competitors across e-commerce, entertainment, and cloud computing sectors. This unique position is a testament to Amazon’s ability to consistently deliver value and adapt to evolving market demands, solidifying its leadership in multiple industries.

However, Amazon’s brand is not the primary strength of where the moat lies, it being primarily its scale economies shared and switching costs from AWS.

4) Financials

Here’s where it gets tricky. Here is where a lot of investors fail to realize Amazon’s potential. Here’s where screeners do not pick on such intangible qualities that Amazon possesses.

Amazon reinvests all of its profits back into the company in forms like R&D and CAPEX. This obfuscates Amazon’s real free cash flow (“FCF”) generating abilities. Amazon continuously reinvests back into the business to gain more of the market share pie. To become the market leader. Only when it has reached its full potential, will the profits begin to show:

“Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity and correspondingly stronger returns on invested capital. Our decisions have consistently reflected this focus.” - Jeff Bezos’ 1997 Shareholder Letter

We can also see that Amazon’s FCF has been growing rapidly in the past few years:

It’s important to note that Amazon’s FCF was negative in 2021 and 2022 due to Amazon reinvesting all their FCF back into the business to build out more of their large and ever-widening logistics infrastructure and was utilizing the pandemic as an opportunity to capitalize on increased consumer spending online. This included warehouses, factories, airplanes, machinery, vans, and all sorts of things to double their network. But now that this has been invested into, the large surge in CAPEX is over for now. Here is a chart of the CAPEX spending increasing substantially as the business entered the pandemic, and is now slowing down:

Revenue has also been increasing steadily over the past few years which is amazing to see as usual:

Here’s a look at Amazon’s total cash vs its total debt:

Again, it is preferable for a company to have a pristine balance sheet where it can use all of its cash to pay down debt, however much of its debt is actually long-term debt, and Amazon’s current ratio is > 1 to pay off any short-term liabilities:

But since Amazon reinvests almost all it can for new opportunities and organic growth, I don’t find the balance sheet to be an issue so far.

In addition, a lot of Amazon’s profitability from its operating income has been almost solely due to its AWS profitability, accounting for 61% (!) of its operating income in Q1 2024:

This just goes to show that Amazon’s profitability as of this stage relies heavily on AWS as a cash-printing machine like we explained earlier in 2.3 AWS, so it’s worth keeping an eye on how much of a proportion Amazon’s operating income will be dominated by AWS in the coming future. If AWS’ growth stalls, this may materially impact the future operating income of the business going forth. However, I believe that with the optionality from the different profitable segments that are more service-based and are growing rapidly from services like Third-Party (3P) Seller Services fees, advertising services, and subscription services, the reliance of the company’s operating income on AWS will diminish in the future.

One thing to note here is that Amazon’s return on invested capital (“ROIC”) on paper has not been very high in the past few years, averaging at around ~10% in recent years. However, this is because Amazon currently focuses on the reinvestment part rather than the profitability part of the business that it can achieve even today. Additionally, as more higher margin business segments that are the true intrinsic value drivers of the business grow at a much faster clip, it will eventually reduce the reliance on its lower margin businesses that take up a higher percentage of revenue of the business like their e-commerce business:

Now I know what you may be thinking. Amazon’s financial characteristics do not seem to be of ‘quality’, but that’s only if you look at it at face value. A lot of the reinvestments they’re doing to build out the company even more to take more market share is so high to the point where the fundamentals aren’t necessarily ‘quality’ yet. Currently, it seems like Amazon’s intrinsic value is increasing mostly due to its long runway of reinvestment opportunities as opposed to a high return on capital employed. However, I have a strong conviction that when they do reach a stage when the business finally stops, matures, and achieves full profitability, that is when the business will be deemed as a ‘quality’ one with a higher return on the capital that they will employ.

Many believe that a high-quality company must be capital-light, for example. While I understand their reasoning, I’ve found that capital intensity doesn’t strongly correlate with quality. Numerous high-quality companies are quite capital-heavy but still generate substantial excess cash. In fact, the capital intensity itself can serve as a moat. Think of TSMC for example. Amazon, too, is a prime example: replicating its distribution network is nearly impossible for competitors at this point. In fact, it’s even at this stage of overtaking the likes of FedEx and UPS. Interestingly, Amazon’s capital-heavy distribution network has enabled it to develop several capital-light businesses, like subscriptions and ads, naturally decreasing capital intensity over time as their revenue moves away from primarily product-based revenue to service-based revenue.

Additionally, investors should distinguish between Growth CAPEX and Maintenance CAPEX. Some capital-heavy companies are only so due to abundant reinvestment opportunities. Once Amazon deems their infrastructure and logistics division to be completed, that is no longer Growth CAPEX but Maintenance CAPEX, which in turn will boost the FCF.

I also want to discuss the idea of high profit margins as a characteristic of a quality business. Many people claim that higher profit margins are always better. While I agree if all things are equal, I don’t think current profitability levels are as indicative of quality as many believe.

First, it’s not about the margin itself but how defensible that margin is. An investor might fare better with a company that has modest but sustainable margins rather than one with high margins vulnerable to competition. The key is how protected those margins are because high margins often attract competitors, which chips away at the supernormal profits a company may enjoy at only one moment in time.

Second, consider the margin’s resilience. A company with lower margins might seem fragile in a recession, but this heavily depends on the business’s overall resilience. Just because a company enjoys a 30% profit margin doesn’t mean it will outperform one with a 5-10% margin during tough times.

Lastly, the current margin level might be self-induced and not reflective of the business’s true earnings power. Companies like Amazon and Costco, which follow the scale economies shared model as Nick Sleep identified, have seemingly low margins but much greater underlying earnings power.

In short, while high margins are generally better than low margins, the reality is more nuanced. It’s crucial to assess the sustainability, resilience, and true earnings potential behind those margins rather than taking them at face value or labeling them.

5) Risks

The following are some common questions that I’ve seen investors ponder upon for Amazon going forward.

Q: Regulation?

A: I’ve seen people also say that regulation is Amazon’s biggest risk that could separate segments like Amazon from AWS.

If your biggest risk is regulatory intervention, that is a testament to your dominance in the market. Essentially, it means that your competitors have admitted defeat, and only the government can stand in your way. That’s a powerful indicator of your company’s strength and market position.

Amazon, however, must not do anything large that may catch the eye of a regulator, like significantly marking up the prices of third-party seller fees or prices of AWS especially since Amazon has such a large grasp on these customers with a high leverage of pricing power.

Q: Competition from Temu: How will Amazon compete against e-commerce platform Temu, who are offering lower prices than even Amazon?

A: Competition from Temu is a significant consideration for Amazon, but understanding the depth of Amazon’s competitive moat provides some assurance. Amazon’s immense scale, brand, and network effects create a formidable barrier that is difficult for competitors to breach over the long term.

For instance, Amazon’s ability to leverage its vast user base allows it to offer lower prices, superior logistics, and extensive benefits through programs like Amazon Prime. As the number of Prime members increases, Amazon can further reduce costs due to economies of scale, which in turn enables more investment in Prime Video content and faster shipping. This cycle of continuous improvement and reinvestment enhances the value proposition for Prime members, making it challenging for competitors to match the comprehensive service offered by Amazon.

Consider a practical example: even if a competitor like Temu from China offers lower prices temporarily to gain market share, maintaining such low prices while delivering the same level of service as Amazon is a daunting task. Temu might attract price-sensitive customers initially, but sustaining this strategy without eroding profit margins is challenging. Moreover, Amazon’s extensive infrastructure and customer loyalty, built over years, provide a cushion against short-term competitive pressures. I mean, to what extent and for how long can you keep those prices much lower?

This scenario mirrors the classic investment insight shared by Peter Lynch:

“The real key to making money in stocks is not to get scared out of them.”

Applying this wisdom to Amazon, it’s essential to focus on the long-term business fundamentals and the strategic advantages that have cemented Amazon’s market position.

However, it’s important to monitor competitors like Temu continually and reassess Amazon’s moat over time as buy-and-hold investors. Amazon’s robust network effects and the ongoing investment in prioritizing enhancing customer value make it a tough competitor to unseat. This can help investors to understand and maintain confidence in Amazon’s long-term prospects despite short-term competitive threats like Temu.

Q: What about increased competition to AWS from Azure and GCP?

A: First of all, AWS market share eroding and Azure and GCP taking market share from Amazon is a perfectly natural phenomenon. AWS had a first-mover advantage and was the dominant player in cloud first.

But even then, AWS’ market share is only deteriorating slightly:

While AWS has been slowly losing market share (since it’s the biggest and most dominant), I see this trend to be a long-term one but nothing detrimental to the overall fundamental cloud business. Market share of AWS has decreased from 32.3% to 31% from 2017 to 2024. This is barely noticeable and over time, I think that the market will consolidate into the ‘Big 3’ of the cloud market, being AWS, Microsoft Azure, and GCP, creating an oligopoly.

The market is slowly consolidating into an oligopoly with just the three players:

1. AWS

2. Azure

3. GCP

And investors should be perfectly fine with this. While AWS may be seen as the ‘best’ cloud provider for enterprises, it’s important to remember a few key points.

Firstly, the overall cloud market is growing rapidly. This growth means that even if AWS’s percentage of the market share declines slightly, the absolute size of the market and AWS’s revenues can still increase significantly. AWS continues to innovate and expand its service offerings, maintaining its appeal to a broad range of customers.

Secondly, competition drives innovation and efficiency. The presence of strong competitors like Azure and GCP forces AWS to continually improve its services and pricing, which ultimately benefits customers and keeps AWS sharp and forward-thinking.

Thirdly, AWS’s leadership in the cloud market isn’t just about market share. It’s about the ecosystem and the network effects. AWS has a vast array of services and a massive partner network, along with a significant number of developers and enterprises deeply integrated into its platform. This creates a sticky ecosystem that is difficult for competitors to replicate quickly.

Lastly, customers that are using AWS already are likely not to switch any time soon to AWS’ competitors. The switching costs are far too high.

In essence, while increased competition from Azure and GCP is natural and expected, it is not a cause for concern. AWS remains a robust and integral part of Amazon’s business, continuing to grow and innovate within an expanding market. This dynamic competition ensures that AWS remains competitive and customer-focused, reinforcing its long-term viability and leadership in the cloud space. However, it is still important to continually monitor any progressions in growth rates and market share over time to see if there are any large, disturbing developments for AWS in the future.

6) Valuation

We try to invest in companies who have compounded over long and sustained periods of time that beat the S&P500 by a a considerable margin. If it has not beaten the S&P500 in the long term, why bother investing in the company?

We can see that over the past 10 years, Amazon has beaten the S&P500 by a whopping +1017.12% vs +176.52%! (as of this time writing.)

It seems like the growth of Amazon’s true earnings are appreciating much faster than its share price appreciation at this stage, even though Amazon is more than a two-trillion dollar business. I don’t usually do this since I don’t find it to be a good proxy when measuring the valuation, but I know a few investors like looking at charts comparing the best opportunity within the “Magnificent 7” stocks:

Although, I believe a more suitable assumption to make when using a multiple on Amazon is its price-to-operating-cash-flow (“P/OCF”), which is currently bottoming at almost decade lows at just 16.3x (the average is around ~27x over this past decade):

I find it much better to use the P/OCF than the P/E ratio or even the P/FCF ratio since we discussed about Amazon obfuscating its true earnings power and its CAPEX is very heavy that it weighs down its potential FCF. They reinvestment most of their gains instead of distributing the gains. Furthermore, when considering the valuation of the business, Amazon sits at a multiple lower than the current multiple of the S&P500 while having a higher expected growth rate into the future with a superior business model. I prefer those odds.

Without spending too much time on anything too mathematical, here’s a quick and simple Discounted Cash Flow (“DCF”) model on Amazon forecasted out ten years:

This suggests that Amazon’s fair value from its last trailing twelve months (“TTM”) FCF is at around ~$235 a share, implying a ~40% margin of safety at today’s current price (as of this time writing). The growth assumptions I inserted are my base case scenario where I think Amazon’s FCF will explode in the next few years, and normalize out five years afterwards. I even used a 15% discount rate for a more conservative model since I’m aiming for a 15% annualized return on Amazon. If you, as an investor, like a higher margin of safety, consider price levels below $160 a share. Here’s a hot take—the quality of the business is also a source of margin of safety. Most of the time, investors think price alone is one’s margin of safety. But owning a great business can bail you out of a valuation mistake over time.

We can also see that since COVID-19, Amazon FCF has grown significantly since the peak of the COVID-19:

When the company’s FCF was negative during the peak of the COVID-19, Amazon has been heavily investing in its fulfillment infrastructure, doubling its network in the last two years, like we discussed in “4. Financials”. This investment is not just about the capital but also about the operational expertise—integrating software, robotics, and human capital to create a distribution network that’s nearly impossible to replicate. This infrastructure is a formidable moat, ensuring Amazon’s long-term competitiveness and decreases reliance on FedEx and UPS.

I believe that Amazon’s FCF will explode in due time as they move towards more profitability in the coming future. Now that they have spent a lot of their CAPEX during the peak of the pandemic, it is coming down, which will in turn boost FCF. If they choose to reinvest even more into the business through CAPEX, that is acceptable when thinking in the perspective of a long-term business owner. If Amazon decides that its reinvestment opportunities are much more rewarding in the long-term than distributing its cash to shareholders in the form of dividends of buybacks (which is sometimes misused and inefficient), that will be the most rewarding form of shareholder value creation. Therefore, it is important that Amazon investors should trust the management team in due time.

On a side note, here’s another interesting graph I found using Koyfin again that graphs Amazon’s share price evolution against its cash from operations (“OCF”) over the years:

Share price evolution always follows the cash flows of a business in the long-run.

In closing, I’ll leave you with this. The following is a diagram from Terry Smith’s Fundsmith about the P/E multiple you could have paid to make a ~7% CAGR return after 50 years:

"If you bought the S&P 500 at a P/E of 5.3x in 1917, and sold it in 1999 at a P/E of 34x, your annual return would have been 11.6%. Only 2.3% p.a. came from the massive increase in P/E. The rest of your return came from the companies’ earnings and reinvestments." - Terry Smith

The simplistic shorthand of using high P/Es to equate to expensive stocks lacks nuance. It’s more important to understand the underlying business quality rather than relying solely on the price-to-earnings ratio to gauge value. You have to get the business right though. And I think Amazon is one of those businesses.

In my opinion, for the case of good businesses, if you don’t like the valuation here, you can always buy a bit now and buy more later when the valuation drops. This way, you can ride the wave of a quality business, capturing its upside regardless of short-term market fluctuations.

I don’t put too much of an emphasis on the multiple. The way I see it, one can forecast out a return on the incremental capital a business will employ over the next decade and the reinvestment rate that comes with it, and put an exit multiple over it to calculate a simple IRR. You also obviously can’t overpay too high of a multiple though, of course. My point is, even with a great business with many reinvestment opportunities that can compound its capital over long periods of time, overpaying a little in the short-term seems acceptable if your holding period is for at least a decade. The valuation will start to fade as time goes on. If you get the valuation wrong, the quality of the business should bail you out in the long-run. The longer your investment horizon, the less valuation matters and the more the quality of the business matters.

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Thanks for reading. I put a lot of hours into completing this deep dive for free, so I would appreciate it if you could subscribe to this Substack and follow me on X/Twitter @Pngfund for more of my insights like this. Cheers!