Amazon's (AMZN) US$13.7 billion acquisition of Whole Foods Market (WFM) marks its most significant push into the grocery category, but likely left some investors scratching their heads after more than two decades of building an e-commerce empire without physical stores.
Despite rumours of Amazon being interested in Whole Foods or other physical retailers in recent months, the timing of the announcement caught us by surprise, as we expected the company to further test its other grocery concepts before going all-in with physical stores. Nevertheless, we do see several reasons why this acquisition is more than just a push into the grocery category, and why it can enhance Amazon's wide moat.
First, there is already a high degree of overlap between Amazon Prime members and Whole Foods shoppers, with opportunities to migrate existing Prime members to the Fresh member tier. Second, Amazon adds instant credibility in fresh produce and proteins through Whole Foods' supplier base, something that had been slow to materialize with Amazon's grocery efforts to this point.
Third, Amazon has a new vehicle to meaningfully expand and accelerate its private-label offerings, including its own packaged food and household products, as well as the opportunity to sell Whole Foods' 365 label to existing Prime customers. Finally, Whole Foods' physical locations offer an opportunity to better showcase new Amazon products and technologies.
Overall, we view the price paid by Amazon for Whole Foods -- representing a forward enterprise value/EBITDA multiple of 11 times -- as reasonable, and have raised our fair value estimate to US$1,200 from US$1,050 to account for contribution from the acquisition, new growth opportunities and cost synergies. Our five-year top-line growth forecast increases to 22% (up from 19%) with our five-year operating margin outlook moving to 7%-8% (versus 7% in our previous model). While Whole Foods represents a major shift in Amazon's retail strategies, we believe it could make Amazon even more integral in consumers' lives -- bolstering its network effect in the process -- while becoming a major headache for other retailers.
Amazon keeps delivering on key metrics
Amazon's operational efficiency, network effect, and a brand built on customer service provide it with sustainable competitive advantages that traditional retailers cannot match. As an increasingly vital distribution channel for consumer product vendors, Amazon commands favourable pricing terms to traditional rivals, which will help drive recurring site traffic. Even with more retailers looking to expand online, we believe Amazon will maintain its consumer proposition through the convenience of Amazon Prime's expedited shipping, expanding digital content library and new partnerships stemming from its Whole Foods acquisition. Aided by more than 300 million global active users and recent fulfillment infrastructure, technology and content investments, Amazon owns one of the wider economic moats in the consumer sector and is likely to reshape retail, digital media and enterprise software for years to come.
Key top-line metrics -- including active users (a 15% compound annual growth rate the past five years), total physical and digital units sold (28% CAGR) and third-party units sold (36% CAGR) -- continue to outpace global e-commerce trends, suggesting that Amazon is gaining share while fortifying its network effect. On top of its impressive growth trends, Amazon is gradually building an intriguing margin expansion story, including 3.1% operating margins in 2016.
Amazon's margin expansion is going to be less predictable than its growth trajectory, given the potential for new investment cycles, including international fulfillment infrastructure and content deals, AmazonFresh, tablets and other hardware such as the Echo/Alexa-enabled products, new delivery capacity and technologies, and physical store expansion. Some of the company's capital decisions haven't always yielded strong returns. However, we're optimistic that Amazon can post 7%-8% operating margins by 2021 based on Prime and Prime Fresh adoption and price hikes, segment margins for Amazon Web Services exceeding 30%, fulfillment center scale, third-party sales and improving international profitability.
Without bricks and mortar Amazon builds defensive perimeter
A shakeout among traditional brick-and-mortar retailers is underway, particularly in commoditized categories. With nonexistent customer switching costs and intense competition, we've already seen Circuit City, Linens 'n Things, Borders and RadioShack effectively exit the retail landscape, while names like Barnes & Noble, Sears, the office superstores and a host of other retailers struggle to reverse deteriorating fundamentals. Market consolidation among mass merchants like Wal-Mart Stores (WMT) and Costco (COST) has played a role in this trend, as have direct-to-consumer investments by key original-equipment manufacturers like Apple and Samsung. However, we see Amazon as the most disruptive force to emerge in retail in several decades.
One of Amazon's key advantages is its operational efficiency of its fulfillment and distribution network, which allows Amazon to competitively price with its brick-and-mortar retail peers while still generating positive economic returns. This allows Amazon to generate strong cash flow, which in turn can be reinvested in advertising, customer service, and website enhancements that keep its marketplace robust and customer loyalty strong. In fact, we believe Amazon's brand has come to represent low prices, a wide selection, convenience and superior customer service -- a rare combination among retailers.
Amazon's network effect is predicated on low prices, an expansive breadth of products and a user-friendly interface, all of which attract millions of customers, which in return attract merchants of all kinds to Amazon.com, including third-party sellers on Amazon's Marketplace platform (which represented roughly 50% of total units sold in 2016) and wholesalers/manufacturers selling directly to Amazon. According to our research, the percentage of traffic to Amazon derived from search has fallen in recent years at a time when other online retailers have become more dependent on search. We think this indicates that Amazon is increasingly becoming the starting point for online purchases, akin to a mall anchor tenant. Additionally, customer reviews, product recommendations and wish lists increase in relevance as more consumers and products are added to the Amazon platform, enhancing its network effect.
We like Amazon's chances of competing in digital media, given its sizable customer base, the symbiotic hardware/software ecosystem of its Kindle, Fire TV, Dash and Echo products, and well as intriguing licensing possibilities with Amazon's Echo and other Alexa-enabled voice-recognition products. We still view the Kindle suite of products as customer-acquisition tools that add multiple layers of upside to our base-case assumptions, including additional Prime memberships and engagement levels, accelerating digital media sales, and a positive halo effect on general merchandise sales. We believe Amazon will continue to develop into a formidable player in digital media, given its vast content offerings, inroads into new verticals (including video games) and ability to sell hardware as a loss leader.
We believe Amazon Web Services has similarly developed moat sources from cost advantage, intangible asset and network effect. Amazon's public cloud computing offerings possess more than four times the computing capacity in use than the next 14 largest providers combined (according to Gartner statistics), providing the company with scale advantages and often making it the preferred name for corporations looking to reduce information technology expenditures. AWS generated US$12.2 billion in revenue during 2016, and we forecast average annual revenue growth of more than 30% over the next five years. With recent investments for additional capacity and other innovations, we expect AWS to become an increasingly positive gross margin contributor -- the segment posted 25.4% segment operating income in 2016, and we believe this segment can deliver 30%-plus margins over a longer horizon--because of its highly scalable nature and other services outside of cloud storage, including a network of third-party software providers selling on AWS Marketplace.
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