Amazon Is Tier 1

"And, by the way, the bulk of the billions in Berkshire Hathaway has come from the better businesses ... And most of the other people who've made a lot of money have done so in high-quality businesses."
--
Charles Munger

At Tier 1 Investments, a Motley Fool Rising Star Portfolio, I seek out and invest in elite businesses. These include companies with the most valuable brands, best management, superior products and services, and strongest competitive advantages. I call these businesses Tier 1 enterprises, and Amazon (Nasdaq: AMZN  ) fits that description perfectly.

A dominant brand
Founder and CEO Jeff Bezos chose the name "Amazon" well. Rather than choosing a name that would have made it difficult for the company to expand beyond books and CDs, Bezos chose a name that signifies Amazon's massive scope and growth potential, and Amazon's product line now includes just about everything under the sun. "Amazon" has become a trusted household name that holds the dominant mindshare among consumers when it comes to Internet shopping, and I believe that one day Amazon could very well earn a place in consumers' minds as the place to shop. After years of torrid growth, Amazon's brand is now one of the most valuable in the world.

Superior products and services
Amazon consistently ranks at the top of the list in terms of customer satisfaction. The numbers bear this out. Amazon's sales surged a staggering 41.6% in the past year, as Amazon's core retail operations continue to gain share from its bricks-and-mortar competitors. In addition, Amazon's ultra-popular Kindle line of products dominates the e-reader industry with a market share approaching 50%. And the new Kindle Fire, while not technologically superior to Apple's (Nasdaq: AAPL  ) iPad, is positioned to command a lion's share of the low-end tablet market at a hard-to-beat $199 price point.

A deep and expanding moat
Amazon has several extremely strong competitive advantages. The fact that Amazon doesn't have to maintain physical store locations gives it a lower cost structure that its traditional retail competitors, such as Target (NYSE: TGT  ) or Best Buy (NYSE: BBY  ) , which Amazon then passes on to its customers in the form of lower prices. Amazon is also able to offer a wider selection of items for sale than could be housed even in the giant storefronts operated by these big-box retailers. And although it has recently come under political pressure, Amazon benefits from the tax-free shopping experience its customers enjoy in most U.S. states. These are advantages that traditional retailers simply cannot match.

Beyond these more obvious benefits, Amazon is expanding its moat through its Amazon Prime program. For $79 per year, Amazon offers free two-day shipping for all orders placed by those who join this program. And although at first it may seem like a strange combination, Amazon also offers free Internet video streaming of more than10,000 movies and TV shows as part of the deal. This puts Amazon in direct competition with Netflix (Nasdaq: NFLX  ) , the current market leader in video streaming.

Netflix has a broader selection of movies and TV shows, but at $79 per year, Amazon's offering comes out to less than $6.59 per month, a 17% discount to Netflix's $7.99 monthly subscription fee. Throw in the free shipping feature and you can begin to see why the number of Prime members is growing at 20% per year. But the advantage to Amazon is not the recurring revenue stream Prime provides, which is low-margin at best, but the incentive it gives its customers to make more of their purchases through Amazon. Once a person plunks down $79, they're going to want to get their money's worth. This helps explain why Amazon customers are believed to more than double their purchases on Amazon after they join Prime.

The Kindle Fire should only help to expand the value of Prime, and in turn the value proposition of shopping through Amazon. The device gives customers another way to enjoy the video streaming feature, and helps to make it even more convenient to shop on Amazon's website or through its mobile app. And as an incentive to purchase a Kindle rather than Apple's iPad or Barnes & Noble's (NYSE: BKS  ) Nook, Amazon Prime is offering a digital-book lending service for Kindle owners.

With each new feature Amazon adds to Prime, the service becomes more valuable to its customers, making them more likely to renew. And the more "sticky" Prime becomes, the more purchases consumers are likely to make through Amazon. With the launch of the Kindle Fire, Amazon now stands to control one more part of its customers' purchasing experience. That strengthens the core of Amazon's competitive advantage: value and ease of use.

Simply stated, Amazon's website offers customers the ability to shop from one centralized location that offers lower prices on an unmatched selection of goods, with free shipping and tax savings, from a brand that consumers trust. That's a tremendous recipe for success.

Visionary leadership
I love founder-led businesses. Especially ones with passionate leaders who manage their business for the long term with an unwavering focus on the customer experience. I believe Bezos fits that description perfectly. Bezos has managed Amazon's staggering growth through the boom years of the late 1990s straight through the bursting of the tech bubble and on to today, while staying a step ahead of larger competitors such as Wal-Mart (NYSE: WMT  ) . What's more, Bezos owns nearly 20% of Amazon's shares, currently worth more than $17 billion. To say that Bezos' interests are aligned with shareholders' is an understatement.

Risks and why I'd sell
Amazon faces many external threats. Several formidable competitors are gunning for the company's market share in multiple businesses. Retail behemoth Wal-Mart has been ramping up its online business, and offers customers the ability to shop in person and pick up or return items at its stores. Furthermore, with Amazon's entry into the tablet market, Amazon is now going head-to-head with tech titan Apple and its ultra-popular iPad. And Google (Nasdaq: GOOG  ) is rumored to be developing a Prime-like service of its own.

These are top-tier companies and not to be taken lightly, but I believe Amazon's competitive advantages are strong enough for Amazon to compete successfully, and win, in many of these areas. However, if these rivals do more harm to Amazon's business than I anticipate, I'll recommend selling Amazon.

Valuation
I will not deny that Amazon's shares are expensive. At more than 100 times earnings, Amazon is much more richly valued than most stocks I will purchase in the Tier 1 portfolio. But I've been following Amazon for over a decade, and the stock has never looked cheap. Quite simply, this is a superior business of which I want to own a piece. And although shares look expensive now, I believe they will be worth much more in the future.

Amazon's earnings are being depressed by the massive investments the company is making to fuel its torrid growth. There will come a time when Amazon dials back these capital expenditures, and when that happens, Amazon's cash flow will explode. I can't say for certain when that will happen, but to put a long-term value on the business, I look to Wal-Mart's $200 billion market cap, which I believe Amazon will ultimately surpass.

The Foolish bottom line
Amazon is one of the best companies in the world, and with the current share price down about 20% from the highs of the year, I believe now is a great time to buy. This is the type of opportunity I look for at Tier 1 Investments, and so tomorrow I will be buying shares and adding Amazon to my Rising Star portfolio.

Next steps:

  • If you'd like to follow along with Tier 1 Investments as I build out the rest of my portfolio, keep checking back in with my Rising Star page, which is updated with all of my buy recommendations.
  • Keep track of Amazon's share price and breaking news by adding Amazon to My Watchlist.
  • And finally, you can follow me on Twitter @Tier1Investor.

Joe Tenebruso manages a real-money Rising Star Portfolio for The Motley Fool and is an analyst for the Fool's Million Dollar Portfolio and Income Investor premium services. Joe has written puts on Apple.

The Motley Fool owns shares of Google, Apple, Best Buy, and Wal-Mart Stores. Motley Fool newsletter services have recommended buying shares of Amazon.com, Wal-Mart Stores, Netflix, Apple, and Google. Motley Fool newsletter services have recommended creating a diagonal call position in Wal-Mart Stores; writing covered calls in Best Buy; and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (19)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 08, 2011, at 2:44 PM, accelerando wrote:

    Amazon has basically bought market share by selling goods and services at close to cost. They have been doing this for years and have never made a substantial profit, even though their top line has been rising. Although it is possible that they will be able to extract profits from their huge business in the future, I, respectfully, doubt it.

    For example. I go to a bookstore. I see a book I like. I decide (usually) not to buy it for, say 24.99 because I can buy it for 17.99 on amazon, a substantial savings. Amazon gives me free shipping and probably loses money on the deal. Or makes a tinsy profit. Now, let us say, they decide to make me pay for shipping, or they decide to sell the book for 22.99 -- guess what -- I'd probably buy it in the bookstore.

    You see, their huge sales and market dominance are dependent on their low prices. If they raise their prices, sometime down the road, they will lose business. THEY HAVE NO MOAT. Let me say that again. THEY HAVE NO MOAT. They have scads of competitors. They are no more efficient. The Internet simply does not allow the kind of branding and moat building that the brick and mortar world allow. Amazon is simply willing to forgo profit to build market share but it is a fool's (sic) market share -- a market share that will evaporate the moment they raise prices.

    Buying such a company at 100x earnings is simply a last fool (sic) in endeavor -- you might make money simply because there are bigger fools. But, ultimately, the stock is worth maybe $25/share at most in the real world and ultimately, that is where it will land.

  • Report this Comment On December 08, 2011, at 5:05 PM, Thuddd wrote:

    I agree with accelerando about the moat, or the absence thereof, but the $25/share price is a little harsh. I might consider Amazon shares at $30-$40.

    I frequently shop Amazon, but I seldom buy Amazon. This year's on-line purchases are running about eight to ten to one non-Amazon to Amazon dollar-wise. Christmas presents so far are zero for Amazon. Shipping costs are also zero, so far. No Prime bill for me.

    I don't get it. How in the world can Amazon grow into this $100B market cap, never mind increase in price? What would that scenario be? And why is the old "Amazon's earnings are being depressed by the massive investments the company is making to fuel its torrid growth." being repeated here on the Fool, again. Earnings are earnings, whether they are spent on massive investments, or not. Massive investments are capitalized and depreciated, not expensed, e.g. they do not reduce earnings. And what's with not reporting kindle sales-telling the SEC in their filings that those sales were "not material". Is this a big boy company, or some half-baked start-up? It's sure priced like a big boy company. Smell test? And don't get me started about how the report "cash".

    Joe, this is really bad advice. Nice company, but I can't see how Amazon can ever be what is expected of it. That being said, I too have been watching this company for over a decade, and I was convinced that it would be another internet roadkill in the early years.

  • Report this Comment On December 08, 2011, at 5:39 PM, SkippyJohnJones wrote:

    At 100x earnings, isn't the eventuality of reduced spending / increased margins already priced in? Isn't the Fire already assumed to be a runaway, permanent, profitable success?

    The stock has never been cheap, but I buy growth stocks in the hopes of appreciation. It's hard to imagine the company's earnings taking off any time in the next 12-24 months. They are nowhere near done with the strategy of infrastructure growth. The top line will surely grow, but I don't see Bezos taking his foot off the pedal any time soon (he professes a minimum 7 year horizon). With this in mind, should investors wait for the price to be bid up to 125x earnings? 150x?

    When earnings do start to come, how can the multiple not be compressed? At that point, the vision will start to be realized; speculative growth investors will move on to something else. Tech stocks with understandable businesses and predictable cash flow don't get massive valuations. Reference Cisco, Microsoft, Apple, Oracle, Google, and plenty of others. Eventually a business grows into its share price, or the share price tumbles. Amazon is an anomaly in that it gets the valuation of a startup tied to a mega-cap. Perhaps Facebook will enjoy the same status when it declares, but then Facebook is still a very young company. Amazon has walked this tightrope for 16 years - 14 as a public company.

  • Report this Comment On December 08, 2011, at 7:38 PM, dougjhawk wrote:

    True that about Amazon!

    I think it was Warren Buffett who said something like "invest in what you know and what you know." (or maybe my dad told it to me...anyway, he would've gotten it from reading about Buffett).

    I use Amazon every month --- books, Keurig coffee pods --- and they always come through for me. Never a bad experience.

    If I could scrap together some spare change from the piggy bank, I'd invest.

  • Report this Comment On December 08, 2011, at 9:22 PM, FoolsAreTools wrote:

    The legion of Amazon fanboys here are clearly in love with the company. What they don't mention--other than their embarrassed admission that the valuation is high--is that the company has flaws--some so serious that they will ultimately bring the valuation in line with other retailers:

    -a state sales tax loophole that will almost certainly end, thereby decreasing their margins

    -formidable competitors who will focus more effort and price competition to steer business away from Amazon. (Walmart.com, Apple, B&N.com, Staples.com, etc.)

    -a customer service department that is not especially satisfying (Ever return a product on a multi-item order that included free $25 shipping? Or do you need help with a Kindle Fire problem? Good luck!)

    -inconvenient wait-times for shipping if you are not a Prime customer.

    In the end, dazzling increases in revenue do not matter. It's all about sustainable increases in earnings. See an Econ 101 coursebook for details.

  • Report this Comment On December 09, 2011, at 1:46 AM, ikkyu2 wrote:

    I don't own AMZN because of the valuation - it's too high. I have been steadfastly refusing to buy shares at this high valuation.

    Since 1994.

    However, just because I was wrong for the last 17 years doesn't mean that the P/E ratio will never come down to Earth. On the contrary - it surely will. And, I've already proven to my own satisfaction that I don't know when it will - so why would I buy here?

  • Report this Comment On December 09, 2011, at 12:06 PM, ServusDei7 wrote:

    Valuation is way too high. P/E over 100 is definitely not sustainable, and the share price will come down, even if earnings continue to go up. This was true of Microsoft.

    Also, this company is definitely not tier 1. It was losing money as recently as 2002 so it has not proven itself capable of generating consistent earnings yet. The profit margins are too low, so it is easy to drift into the red. ROE is also not impressive. There is simply not moat here. Even Tier 3 is too generous for Amazon.

  • Report this Comment On December 10, 2011, at 3:58 PM, smartalecc5 wrote:

    FoolsareTools:

    -a state sales tax loophole that will almost certainly end, thereby decreasing their margins

    You realize the tax will not affect their "margins" at all? Margin is the profit made per item. They just collect the tax and give it to the gov't. It doesn't affect the amount they make per item. If you were to say that the increased prices would decrease demand and hurt Amazon's economies of scale adcvantage then I'd agree with you.

    -formidable competitors who will focus more effort and price competition to steer business away from Amazon. (Walmart.com, Apple, B&N.com, Staples.com, etc.)

    Sure there will be increased competition but competing on price is not something many companies are able to do. Including apple in your list.

    -a customer service department that is not especially satisfying (Ever return a product on a multi-item order that included free $25 shipping? Or do you need help with a Kindle Fire problem? Good luck!)

    Amazon strives to be the #1 customer oriented company in the world. I would say its one of their compettive advantages. Have you ever received an email a week after you bought an item saying "The price dropped and we're going to give you the difference". Staples.com sure hasn't done that for me.

    -inconvenient wait-times for shipping if you are not a Prime customer.

    Hence why they are pushing Prime and adding more value by adding streaming services. Additionally, w/o Prime its still comparable to other outlets. How many other websites say "you need to order in the next 13 minutes to get it by this exact date."?

    In the end, dazzling increases in revenue do not matter. It's all about sustainable increases in earnings. See an Econ 101 coursebook for details.

    I think you need to consult an economics coursebook buddy. I'm long Amazon and you should short it. We'll see who's laughing in ten years.

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