Strong gross margins in the fourth quarter boost our confidence that the firm will be able to leverage Prime, third-party sales and AWS to higher margins in the years to come.
By R.J. Hottovy, CFA | 02-03-17 | 07:38 AM | Email Article

Our view of  Amazon as having one of the widest moats in the consumer space is intact following the firm's fourth-quarter update. For us, the highlight was the 190-basis-point uptick in gross margins to 33.8%, which we find as the metric that best encapsulates our longer-term free cash flow drivers, including Prime membership growth and engagement, increasing third-party sales, and Amazon Web Services. While operating margins fell 20 basis points year over year, we attribute most of the softness to the fulfillment, content, Prime, and Alexa/Echo investments that began in mid-2016 and are likely to persist through the first half of 2017. Still, we believe each of these investment areas strengthens Amazon's ecosystem and lays the foundation for future margin expansion.

R.J. Hottovy, CFA, is a consumer strategist for Morningstar.

While critics might point to revenue growth of 22% versus guidance of 17%-27% as a concern, we believe the growth rate is encouraging after stripping out a $558 million negative foreign currency headwind and accounting for the ongoing shift to third-party units sold (where Amazon records just a commission on the sale). Paid unit growth of 24% was a deceleration from the 28% averaged in the first three quarters of the year, but we attribute the difference to lapping last year's strong holiday demand among Fulfillment by Amazon sellers (which continued throughout the year--evidenced by the 70% increase in FBA sellers this year--and reinforces the network effect behind our wide moat rating).

We plan to increase our fair value estimate to $950 per share from $900 based on time value of money adjustments, and we encourage investors to take advantage of any weakness following the fourth-quarter update. With greater confidence in Prime, Amazon's third-party capabilities, and AWS coming out of the quarter--not to mention Alexa coming into its own as a unique long-term cash flow driver--we're comfortable with our outlook for operating margins to grow to almost 8% by 2021 from 3.1% in 2016.

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R.J. Hottovy, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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