The firm may be spending heavily, but strong grown and consumer engagement trends show these dollars are being well spent, writes Morningstar’s R.J. Hottovy.
By R.J. Hottovy, CFA | 04-28-17 | 09:44 AM | Email Article

In what might become a recurring narrative for 2017,  Amazon's first-quarter update indicates that it may be willing to trade-off some profitability for investment within its North America/International retail segments while becoming increasingly dependent on Amazon Web Services (AWS) for margin expansion. While gross margins--which we view as the best indicator of the health of the business given its direct linkage to key pillars like AWS, Prime, and third-party sales--rose a healthy 200 basis points to 37.2%, operating margins contracted 90 basis points to 2.8%. Management cited investment priorities for the decline, including automation/robotics at fulfillment centers, new devices, and AI/machine learning in North America, fulfillment capacity and the expansion of Prime benefits and content in international markets, and new AWS functionality.

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

The efficacy of these investments is dictated by their returns, and we'd be more concerned if Amazon hadn't retained its strong top-line growth (22.6%) as well as other metrics reaffirming the strength of the network effect underpinning our wide moat rating. These include a 52% increase in retail subscription services (mostly Prime membership fees, but also audio/video content and other subscriptions), a 36% increase in third-party seller service revenue, and a 58% increase in other revenue (suggesting healthy advertising revenue growth, which we view as an emergent long-term cash flow contributor), not to mention the rash of store closures across the U.S. retail industry.

Although first-quarter results were a shade below our expectations, we're planning a mid-single-digit percentage increase in our $950 fair value estimate based on increased optimism over AWS growth trajectory (including 30%-plus average annual revenue growth the next five years), Prime adoption in international markets, stable third-party vendor participation, nascent opportunities like Echo/Alexa and advertising, and U.S. tax reform adjustments.

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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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