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The Amazon risk

Will Amazon's push to dominate multiple industries ever come unstuck? And if not, what does that mean for investors' portfolios?
The Amazon risk

With good reason, Amazon (US:AMZN) inspires fear in every competitor it encounters. It is one of the world’s largest blue-chips, but displays the strategic hallmarks and optimism of a small technological disrupter. Its founder and chief executive Jeff Bezos’ focus on the customer experience has proved ruthlessly, perhaps unprecedentedly, effective. It has doggedly stuck to a lossmaking model that has allowed it to minimise its tax liabilities while aggressively expanding. Market share, not tradition, is its abiding goal.

Keeping pace with its diverse range of ambitions is no easy task. Just last week, as we were putting the finishing touches to this feature, the company launched a new music streaming platform and a one-hour grocery delivery service in the UK.

Its rate of growth is – and always has been – gargantuan. Annual revenues more than tripled to $104bn (£84bn) between 2010 and 2015, during which time employee headcount swelled from 33,700 to 230,800. And there is no slowing down. Net sales are expected to increase at around 25 per cent a year for the next three years, according to JPMorgan. Some analysts’ forecasts are even higher. You might expect that sort of expansion from a newly formed tech start-up with a clever piece of intellectual property, not a retailer.

Industries, let alone companies, do not grow at that pace without major impact. And as investors in many varied industries will know, that speed of growth means Amazon represents nothing short of an existential threat to its competitors. In fact, the Seattle-headquartered group has long moved beyond its successful and still rapidly growing online retail business with huge moves into business logistics, web hosting and media.

With dozens of once profitable companies laid to waste by Amazon’s business model, it is almost inevitable that others will fall. Ultimately, we think investors should seriously ask themselves whether Amazon is an obstacle to or collaborator with the companies and sectors it has put their money into, and consider – as we do at the end of this piece – whether owning Amazon stock may be a safer long-term bet. Of course, that depends on whether you think that the company’s peculiar valuation and absence of post-tax profits warrant a stake at all. That decision should also be weighed against Amazon’s sometimes controversial history, which has included repeated allegations of tax avoidance, transfer pricing and anti-competitive practices.

Given the company’s ascent, such controversies are part of the deal. Amazon is nothing short of the textbook example of aggressive capitalism, perfected for the internet era.

 

 

In the beginning was tech

Jeff Bezos was working as a quantitative analyst at a New York hedge fund when he began researching the internet and noting its exponential growth. Realising the technology’s potential to transform entire industries, he promptly resigned in order to start the company that would become Amazon.com. “I knew that, when I was 80, I would never, for example, think about why I walked away from my 1994 Wall Street bonus,” he recalled a few years later. “I knew that I might sincerely regret not having participated in this thing called the internet that I thought was going to be a revolutionising event.”

Relentless creativity and a willingness to take risks have been crucial to Amazon’s success. Its list of innovations include one-click ordering, an online marketplace for third-party sellers, the Kindle e-reader and streaming film-and-TV library Amazon Instant Video. It shelled out $1bn for Twitch, an online platform that lets users watch others play video games – an early play on the burgeoning ‘e-sports’ industry. And its latest advances include Amazon Echo, a speaker powered by artificial intelligence. Unsurprisingly, the strategy hasn’t always worked: customers haven’t snapped up its Fire smartphones and tablets, and many people (including us) remain wholly unconvinced by the value of Amazon Dash, a branded button that consumers can stick to a surface in their home and press to order a specific product such as toilet paper or shaving foam.

 

A media empire?

Like Apple (US:AAPL), Amazon wants to rope consumers into its ecosystem and discourage them from shopping anywhere else. The best example is Prime, which lets users pay an annual subscription in return for ‘free’ one-day shipping, access to the company’s music and video services, and other perks. But the real golden goose is Amazon Web Services (AWS), launched after executives realised they could rent out spare capacity in the company’s huge server farms to the likes of Netflix (US:NFLX),

Spotify and Airbnb. This division accounted for just 9 per cent of Amazon’s turnover in the nine months to 30 September 2016, but generated nearly three-quarters of its $2.93bn operating profit.

Amazon’s incessant entry into new markets poses an existential threat to thousands of businesses, but its success also presents an opportunity for others. For example, managed IT services providers such as Softcat (SCT) offer advice and support to businesses on how to effectively use AWS, while data hosting group iomart (IOM) touts ‘hybrid cloud’, which bundles access to public cloud services such as AWS with private data storage and ancillary services.

Bezos and his team spend billions on the rights to popular TV shows and films and producing original content, making Amazon a big potential customer for Entertainment One (ETO), ITV (ITV) and other entertainment companies. Similarly, the likes of Bloomsbury Publishing (BMY) earn a cut from sales of their titles on the tech giant’s Kindle ebook platform. Businesses are also keen to use Amazon’s sales platform effectively: media giant Ascential (ASCL) recently paid an initial $44m for One Click Retail, a business founded by a former Amazon executive that uses data analytics to help brands boost their e-commerce sales. And Amazon relies on several small UK tech companies to power its services: its app store uses Bango's (BGO) carrier billing platform, while AWS has partnered with WANdisco (WAND) to offer the software group’s Fusion technology, which can replicate data across multiple storage platforms. Some UK firms are bound to lose out as Amazon continues on its path to world domination, but others will enjoy the ride. TM

 

CompanyTickerPriceMarket CapSectorAmazon's challengeThreatMitigation
Royal Mail GroupRMG465p£4.32bnLogisticsEnd-to-end UK logistics network, taking greater chunks of the more profitable parcels market. Amazon's greater cash resources and lower outgoings provide a stronger investment base.HighInfrastructure transformation, legislative support, retail contract wins.
Deutsche Post DHLDPW€ 29.12€35.6bnLogisticsPush into European logistics, expansion of fulfilment centres, ownership of the parcels supply chain.Medium/HighPartnering with Amazon, competitive pricing, scale.
OcadoOCDO269p£1.67bnFood & drug retailersSupply and distribution agreements with British supermarkets to create Amazon 'store in stores' undermines Ocado's existing services.HighInvestment in delivery and distribution networks as well as sophisticated IP
J SainsburySBRY240p£5.2bnFood & drug retailersOnline delivery of fresh food items and groceries under threat from Amazon's cut-price, convenience, one-stop shop website. Morrisons tie-up too.Medium/HighPhysical convenience chain should still prove popular with city-based shoppers
WHSmithSMWH1,520p£1.7bnGeneral retailerSpecialism in books, CDs and DVDs is what made Amazon famous, and decimated sales at WHSmith.MediumTravel-hub based sites are outperforming the market thanks to the 'captive audience' nature of the customer base
NextNXT5,158p£7.6bnGeneral retailerDepartment stores are some of the most under-threat retailers thanks to Amazon's one-stop shop model.MediumWill have to remain competitive on price, which might mean sacrificing margin. Ultimately have to compete on convenience options in delivery too.
ITVITV171p£6.86bnMediaAmazon Instant Video, the company's online video-streaming platform, competes with ITV's television channels and its own online platform, ITV Player.MediumMust continue to invest in exclusive, high-quality content to keep its viewers. ITV could also license its programming to Amazon.
Entertainment OneETO241p£1.04bnMediaAmazon produces original films and TV shows and could become a distributor as well.LowLicense films and TV shows to Amazon or launch its own online video platform.
BloomsburyBMY156p£118mMediaAmazon's Kindle ebook business has been a major reason for the decline in print book sales and the closure of physical bookshops, which buy Bloomsbury's books.MediumSell digitised books to Amazon, or expand its own ebook platform. Releasing premium books such as the illustrated editions of the Harry Potter titles has also shored up print sales.

 

Shops, 'til they drop

From the perspective of many retailers, Amazon’s advance is as big a risk as recession. The company’s decimating effect on booksellers, CD and DVD outlets and even small electrical suppliers is well known, but the rest of the retail market continues to worry. As Amazon extends its reach across groceries – even fresh food – and pretty much every other home and leisure category one can think of, the place of the specialist, independent retailer is under threat. But is the trend towards an online one-stop-shop inevitable? And will physical retail really be rendered obsolete by Amazon’s presence?

Amazon was the first online pure-play general retailer to change the landscape of global retail, making the leap from books to general merchandise more quickly and effectively than any of its early competitors. The advent of schemes such as its Prime service have also encouraged significant customer loyalty, something online retailers have often struggled to win.

Interestingly, Amazon has not been able to defend itself against the argument that multichannel retailers are the most defensive. For this reason, the company has recently experimented with bricks-and-mortar stores in Seattle, not only to give customers better browsing ability but also to play into the growing trend for click and collect and reservation-based shopping. It seems customers are still keen to interact with products before purchasing – arguably a hangover from the most recent recession, which perhaps instilled the ‘value for money’ belief all over again. Walmart's (US:WMT) heavy investment in click and collect kiosks could pose a significant challenge to the e-commerce giant, which has been grabbing market share from the Walton family’s box stores for the past two decades. When it comes to food, the incumbents could still stage a fight back.

 

Food fight

But that won’t stop Amazon working with those incumbents when it can, as evidenced this month with the launch of a ‘store in store’ partnership with Wm Morrisons (MRW).

The supermarket chain, which has been busy overhauling its business in light of its customers’ changing shopping habits, first struck up a new supply and distribution agreement with Amazon at the beginning of the year. It’s fair to say that the entire affair reeked of ‘if you can’t beat ‘em, join ‘em’.

It appears to be working. Amazon Prime customers can now log on to the site and order a range of Morrisons’ own-brand products and, for some postcodes, choose a same-day delivery service. That’s key, as existing supermarket websites have been criticised for their delivery practices; although customers can normally select convenient times, services are often expensive and subject to change.

This new agreement has real implications for Ocado (OCDO), which has a pre-existing (albeit much whittled down) agreement with Morrisons. If the supermarket gains much more traction with Amazon, the contract could be further jeopardised, while demonstrating to other grocery chains that teaming up with Amazon is a more attractive cross-selling opportunity.

 

Signed, sealed, delivered

On that note, it’s clear that delivery is almost what Amazon does best, and the development of the Prime service in particular has set the benchmark for convenience. True, this is proving to be a cost burden, hence the recent changes to delivery terms for smaller orders. But this is not unlike many high-street chains, including John Lewis and Tesco (TSCO), which have also been forced to place limits on the value of click-and-collect orders to keep margins sane.

In our view, Amazon will probably continue to set the pace for retailers. Its plans for drone-powered deliveries – first dismissed as fantasy three years ago, and later questioned by US regulators – may still be realised, if UK tests with the Civil Aviation Authority prove successful. Without the fixed costs associated with a large physical store estate, the company can focus instead on a breadth of services. Meanwhile, warehouses continue to provide Amazon with pricing power – something that has dogged retailers since the 2008 recession, particularly when it comes to food. HR

Eating the supply chain

Amazon’s colonisation of the supply chain is not always well understood. At October’s third-quarter results, market commentators pointed to the 52¢ EPS figure to explain Amazon’s 5 per cent share price decline. The earnings number was below Wall Street expectations, and in no small part due to a 31.5 per cent leap in operating expenses to $10.9bn. Arguably, this reaction betrayed some lopsided thinking. It may sound counterintuitive, but if there is one guarantor of Amazon’s future success, it is not profitability but its unceasing capacity to reinvest. That $10.9bn figure – which reflected a sharp increase in spending on its warehouse and delivery infrastructure in the UK, US and Europe – should therefore be taken as a bellwether for even higher future returns.

When it comes to logistics, Amazon is slowly winning a multi-pronged war. Unencumbered by huge unwieldy and creaking systems, pension schemes, or declining business lines such as letters, it already has a competitive edge against many of its large national peers.

Take the Royal Mail Group (RMG).

Despite possessing an unrivalled postal distribution network in the UK, the FTSE 100 company is effectively mandated to preside over a declining letters business while playing catch-up to the UK’s changing postal habits. As part of a transformation programme since its privatisation three years ago, chief executive Moya Greene has invested huge amounts of capital into modern sorting hubs and regional distribution centres. In May, the company launched free standard parcel delivery confirmation on all packages, in a bid to win over small online traders demanding ever-faster delivery and tracking. It’s a difficult battle.

At the same time, many businesses are flocking to Amazon Logistics, the US company’s own end-to-end delivery network, which has been quietly and rapidly expanding in recent years. To Amazon – which according to various market reports handles up to 80 per cent of the sales generated by amazon.co.uk – Royal Mail is a useful partner at peak capacity. With no foothold in the online marketplace world, through which Amazon streamlines its logistics offering, Royal Mail is watching one of its core customers cannibalise sales. The UK company’s only option is to go after the e-commerce delivery contracts of retailers such as John Lewis and Marks and Spencer (MKS). Amazon - not to mention many smaller and mid-tier players such as DX Group (DX.) and UK Mail (UKM) - is already competing in this space.

Other national incumbents are feeling the Amazonian heat. Until now, Germany’s position as Amazon’s second-largest market was great news for DHL Express owner Deutsche Post (DPW), but the wolf is now at the door. Since the US group launched a pilot delivery project in Munich a year ago, DHL has been steadily losing share of the Bavarian capital’s parcels market. Outside Germany, DHL and other continental carriers are likely to face further pain from Amazon’s network of more than 20 ‘fulfilment centres’ throughout Europe, which the online giant believes can beat the competition on shipping times and lower delivery costs. Many argue FedEx (US:FDX) and United Parcel Service (US:UPS), both long-time beneficiaries of the Amazon-spearheaded e-commerce parcel revolution, could be next.

A radical future

As we have noted before (see ‘Stand and deliver’, IC, 5 August 2016: bit.ly/2b2SUtj), the looming arrival of the sharing economy in logistics and delivery could eventually pose a challenge to Amazon, and the premium customers are willing to pay for its one-day Prime service. UberRUSH – the taxi-hailing app’s foray into logistics – is not yet available in UK cities, but could pose a challenge to Amazon’s dominance as the carrier of choice within its own marketplace. However, that would rely on large-scale connectivity with the mass infrastructure and storage facilities required of commerce, which seems like a big leap.

As last mile delivery is likely to remain competitive, Amazon will inevitably find bigger fish to fry. In May, Deutsche Bank published an audacious vision of what this might look like. Analysts at the bank predicted that Amazon’s growing capture of the global supply chain could see it build mega warehouse “consolidation facilities” near Chinese factories, which would send freight to leased ships serving as “active sortation centres” at sea. Container shipping groups such as Hapag-Lloyd (Ger:HLAG) and Maersk (Den:MAERSK B) could be the next companies to find their sea lanes crowded. AN

 

 

AMAZON (AMZN)

ORD PRICE:$788MARKET VALUE:£302bn
TOUCH:$786-790 12-MONTH HIGH:$847LOW: $474
DIVIDEND YIELD:NILPE RATIO:82
NET ASSET VALUE:$37.42NET CASH:$5.38bn

Year to 31 DecTurnover ($bn)Pre-tax profit ($bn)^Earnings per share (¢)Dividend per share (¢)
201374.50.5159.0nil
201489.0-0.11-52.0nil
20151071.57125nil
2016*1373.86511nil
2017*1726.27961nil
% change+25+63+88-

Ex-div: na

Payment: na

£1 = $1.24. ^Also before equity-method investees. *JPMorgan forecasts.