Amazon’s Capital Market Dependence

Lately, there’s been no shortage of positive coverage on Amazon – and for good reasons. The vast majority of retail is struggling with declining same-store-sales, yet, Amazon continues to post a torrid pace of growth despite its size. In FY16, Amazon grew North America segment sales by 25%, and that growth came at the expense of the rest of the retail industry.

From a business model perspective and from a consumer perspective, Amazon appears to have built an incredible flywheel that is gathering momentum. As the rest of the retail industry is forced to retrench and cut costs (e.g. reduce stores, reduce staff, reduce inventory / SKUs…), it serves to further widen the gap in consumer experience as Amazon continues to invest. Amazon’s product assortment advantage, delivery speed advantage, data advantage all continue to grow. And the wider the gap, the more inevitable Amazon’s dominance.

It’s not hard to see why sentiment has swung so strongly in Amazon’s favor.

However, as an investor, it is almost always prudent to revisit assumptions when the market believes so overwhelmingly in a single narrative.

Amazon’s Overlooked Advantage

Recently, I had the opportunity to catch up with the CFO / Chief Strategist of an Amazon competitor (which will go unnamed). Although this company is doing quite well and holding its own within the retail space, it’s clear that a full-scale showdown with Amazon could be looming. And such a showdown will be painful.

During this conversation, the company asked me an unusual question and offered an interesting remark: How would I feel if the company significantly ramped up investments to fend off competition (i.e. Amazon)? And, perhaps the more interesting part, the CFO remarked that it is unfair that Amazon has the advantage of an investor base that does not care whether they produce any earnings at all, only that they have the ability to do so. He wished he had a similar investor base because it would allow him to compete on a more level playing field.

Those words stuck with me because it’s true. A large part of Amazon’s competitive advantage in pricing and consumer experience (driven by Amazon’s large investment programs) would be far harder if investors required Amazon to produce stronger earnings. After all, the rest of the retail industry is unable to respond precisely because they are forced to defend earnings and unable to invest aggressively to ensure that they exist in the future.

In essence, Amazon’s continued success perhaps does depend in part on capital markets cooperation.

The Dangers of Capital Market Dependence

Reliance on capital markets usually don’t lead to good places. Although it is efficient to utilize capital markets to support operations and growth, a dependence on capital markets has led to the downfall of many companies.

For example, levered companies that suddenly discover that maturing debt can no longer be rolled over.

Or roll-ups / M&A-driven companies that suddenly discover that the market is no longer going to allow them to issue high-valuation stock to purchase low-valuation targets.

Or REITs and MLPs that generally have high payout ratios and therefore require capital markets to grow.

The moment the doors to the capital markets close, companies that depend on capital markets find themselves with few friends and tough choices.

How it Could Hit Amazon

I should reiterate that all of this is purely conjectural, and I remain a fairly firm believer in Amazon’s business model, but investors shouldn’t overlook the small points of weaknesses especially when consensus is overwhelmingly bullish.

If capital markets suddenly stop giving Amazon a pass (which wouldn’t be particularly outrageous since investors did become skittish just a few years ago), Amazon would likely have to pull back on fulfillment and content, which represent two of the largest costs. And these are likely the two strongest differentiators of Amazon’s customer experience vs. traditional retailers.Amazon IS 2016

And on the cash flow side, perhaps stock-based compensation would need to be swapped for cash compensation if equity investors stop believing. In FY16, Amazon recognized $3bn of stock-based compensation, which is quite sizable compared to the $3.9bn of FCF less finance lease repayments and assets acquire under capital leases.Amazon SBC.png

Concluding Thoughts

Jeff Bezos has built an incredible business in Amazon that is gathering strength. However, Amazon’s strength (and momentum) relies at least in part on investor trust. Like a flywheel, speed will beget speed. But if investor sentiment flags even if momentarily, the flywheel’s momentum could slow considerably.

Disclosure: I have no direct beneficial interest in AMZN as of publishing date and have no intent to initiate a position within the next 48 hours. 

The Importance of Focusing on Business Models

“Investment is most intelligent when it is most businesslike.” – Benjamin Graham

“I am a better investor because I am a businessman and a better businessman because I am an investor.” – Warren Buffett

Most investors define themselves along a couple of axes: Technical vs fundamental, value vs growth, long vs (and/or) short, contrarian vs momentum, large cap vs small cap, etc. These labels are well understood and established conventions.

However, these labels distract from what is most important when it comes to investing – an understanding of the underlying business.

Whether you are a fundamental investor, a value investor, a growth investor, a contrarian investor, all of these labels serve only to illustrate the “how” and not the “what” or “why”. It seems remarkably odd that few investors refer to themselves as a Business Model Investor, which I believe is a much truer expression of the essence of investing.

The Benefits of Focusing on Business Models

Though I bear the risk of promoting myself to Captain Obvious, I think it’s important to call out what’s important – investing is most likely to succeed when we think of ourselves as buying businesses, and buying businesses entail understanding the business model and how it works.

I believe this is distinctly different from just understanding a company’s products, describing Porter’s 5 Forces, and assessing strategic vision / management.

Understanding business models can help us uncover great companies with sustainable businesses that otherwise may not be apparent. 

The Scourge of Retail

Today, most investors understand Amazon’s outsized impact on traditional brick & mortar retailers including the venerable Walmart. But it was not that long ago that many assumed brick & mortar would be able to leverage their larger scale (at the time) to ward off Amazon and other threats. Surely, Walmart with all its might and low prices can take the fight to Amazon if it wanted to. And of course, brick & mortar had the benefit of strong earnings / cash flows, whereas Amazon had none of the 1st and few of the 2nd (still has essentially no earnings today but cash flows are a massively different story). These were prevailing views just 3-4 years ago.

I think this is a perfect example where business model investing has been far more fruitful. All of the traditional retailers did have a scale advantage (not anymore), but scale is not a business model. Scale is merely a competitive advantage, and a disrupt-able one against a well-funded competitor.

Amazon has the benefit of a better business model. It’s a retailer that did not have to carry the significant costs associated with physical stores or sales staff. From a  business model investing perspective, it takes just a few words to understand Amazon’s advantage. These advantages are not as easily understood from just looking at historical financial statements (of which earnings look terrible and earnings-based ROIC looks laughably poor). Understanding these advantages require thinking of the business model holistically.

Finding the “Most Valuable Company in the World” in No Man’s Land

Apple, the most valuable company in the world, is a curious case. It continues to thrive in the metaphorical graveyard of tech. Few companies have survived (and thrived) for long in tech hardware because the fundamental forces at work are overwhelming – commoditized products, persistently declining prices (not least driven by Moore’s Law), fragmented landscape with too many competitors to count…Generally a terrible industry. And all of these elements are likely to remain true for the foreseeable future, leading many investors to make the case that sooner (and perhaps rather than later) Apple will succumb to the same forces that has brought down Nokia, Motorola, HP, etc.

But that view ignores Apple’s different (and unique) business model within the tech hardware industry.

From a consumer perspective, Apple’s business model is simple – sell highly-designed, premium products where every element / component is customized for use.

But from a strategy standpoint, Apple’s business model is secrecy. Whereas Apple’s peers like to run their companies like scientific experiments in broad daylight, Apple’s business model is to play the cards close to their vest. Is it any mystery then why Apple has been and will continue to be a disruptor of the industry? Nearly everything that can potentially disrupt Apple is brandished in broad daylight years before the hero’s blade is finished forging. Apple knows what’s coming from nearly everyone else, but does the rest of the industry know what’s coming from Apple?

And how does this business model address the overwhelming forces of the tech hardware industry? It allows Apple to differentiate their products with non-commoditized hardware, which can be monopolized for a (short, e.g. 1 year) period of time. Apple has to keep fighting these forces, but it’s a perpetual 1 year advantage until ideas run out (and the human race has demonstrated for 10,000 years that there are many more ideas than we can pursue).

Apple’s vertically-integrated product model also has the advantage of getting innovations to customers far faster than peers. Google is a very able peer in the smartphone OS space, but their innovations are taking on average about 3 years to get into customer hands. The majority of their customers are still using an OS that shipped in 2014 or earlier.

One should rightfully assume that tech hardware is a tough space, but from a business model perspective, it’s easier to see that Apple plays a different game and should have been apparent long, long before Apple became a household name or the world’s most valuable company.

Business Model Differentiation Worth More than “Competitive Advantages”?

One idea that I’ve been turning over in my mind is the importance of having a differentiated business model rather than just pure “competitive advantage”. After all, BHP and Rio Tinto have the unbreakable competitive advantage of immense scale in an industry where large mines cannot be willed from thin air through cash alone. But I do not think it is a stretch to say that BHP and Rio Tinto do not have differentiated business models and are bystanders to the same industry forces that buffet their peers.

Are differentiated business models the most important thing?