Coho Capital shareholder letter for the second quarter ended June 30, 2016.

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H/T Beren

Dear Partners,

Please find your quarterly statement attached. Coho Capital rose 2.2% during the second quarter and returned 3.3% through the first half of the year. This compares to an increase of 1.9% for the S&P 500 during the quarter and 3.8% for the first half of the year.

The global rout in equities earlier this year enabled us to deploy capital opportunistically and upgrade the portfolio in the process. Most significant, we jettisoned two long-term holdings: GM warrants and Fiat, and established a new position in Amazon.

A combination of loose financing, increased productive capacity, and an acceleration in sales incentives, eroded our confidence in the strength of the current auto cycle. Over a holding period of 2.5 years we made 26% on GM Warrants and doubled our money on Fiat.

Amazon is a business we have long admired. As an Amazon Prime customer for more than a decade, we have observed Amazon’s increasing share of our wallet. We have always wanted to own the business within Coho Capital but uneven profitability and a lofty valuation have kept us away. A 29% reduction in market cap earlier this year prompted us to analyze Amazon with a fresh lens. We purchased shares at an average price of $562 and Amazon now represents our largest position.

Our research uncovered what we perceive to be one of the most dominant moats in all of business, led by a visionary CEO with superlative capital allocation skills. Despite passing $107 billion in sales last year Amazon’s growth is accelerating. With large fixed costs and a rapidly scaling top-line, we believe Amazon is at an inflection point for margin expansion. Further, the company’s cloud business represents an opportunity that could someday be worth more than Amazon’s e-commerce business.

Coho Capital – E-Commerce

Amazon is most well-known for its e-commerce segment, which has more than 304 million global users (19% compound annual growth rate over the past five years) and a 41% share of online commerce. The next largest competitor is Best Buy with a 2.7% share. And yet despite its dominant position, Amazon continues to grow faster than the competition – capturing 60% of total US online sales growth in 2015, according to Forrester Research. Amazon’s competitors are at such a significant disadvantage in selection and pricing one could argue that Amazon’s e-commerce business has no credible competition.

Despite Amazon’s dominant position within online commerce, the company has years of explosive growth ahead. It may be surprising to some, it was to us, that e-commerce stills represents less than 10% of all retail spending. According to the US Census Bureau, e-commerce sales represented 7.8% of all domestic retail sales as of March, 2016. Rates of penetration are even lower internationally at 7%.

What to Expect When You’re Inflecting

It is interesting to note that growth within technological products and services tends to see a dramatic acceleration at around 20% penetration levels. This is what is known as the “S-curve.” Both smart phones and notebook computers reached a material inflection point once market adoption hit 20%. Contrary to how Wall Street typically prices growth companies, it is later-stage rather than early-stage growth that should be most highly valued. Once the S-curve has been breached, growth can be explosive. For example, digital music took a decade to reach 20% penetration but leaped to 50% in just four years. We are not there yet, but many will increasingly view the idea of driving all over the city to fill a shopping basket as an archaic exercise.

With Amazon’s domestic infrastructure largely in place, we expect margins within the company’s e-commerce segment to inflect materially higher as operating leverage continues to ramp.

Amazon Prime

Consider the following business:

  • Approximately 30% of US online shoppers have a membership.
  • Over 63 million members exist worldwide.
  • Membership numbers are up 50% on a global basis during each of the last two years.

Amazon Prime is a cornerstone of Amazon’s growth strategy as Prime customers tend to spend more and embed themselves more deeply within the Amazon eco-system. According to Consumer Intelligence Research Partners, Prime members spend $1,100 a year compared to $600 for non-prime customers. For long-term Prime members, the numbers are even more compelling with those using the service for 7-10 years spending 8-10x more than non-Prime members.

Prime members are spoiled by Amazon with free shipping, unlimited photo storage and streaming of music and video. Amazon’s ever-widening collection of free Kindle books, podcasts, music, Fire TV, Prime video, game playing, and now voice assistance through Alexa, are powerful inducements for Prime customers to stick around. As CEO Jeff Bezos put it, “If you’re not a Prime member, you’re being irresponsible.”

It would appear that Prime benefits, as well as higher switching costs incurred through engagement with Amazon’s digital services, do indeed inspire loyalty. According to Amazon, four fifths of Prime members who signed up for the service a month after it launched in 2005 are still with the company. More recent vintage renewal rates are even higher with 96% of customers that have been with Prime for two years choosing to renew for a third. It is easy to see why Amazon showers Prime members with benefits, for the lifetime value of these customers is very rich indeed.

From a competitive standpoint, the panoply of perks offered by Amazon is impossible to match. Firms can offer free shipping, but little else in the way of consumer inducements. Of course, no one can deliver free shipping at Amazon’s unit costs so Amazon grinds the competitive screws tighter.

As an investor, one of the most valuable things one can find in a business is latent pricing power. Amazon Prime has latent pricing power in spades. At the end of 2014, Amazon raised Prime prices by 25%. Few businesses are capable of passing on such dramatic price increases without suffering from consumer churn. Yet, the next year domestic Amazon Prime members rose by 25%.

At $100 a year, Prime represents an extraordinary value. We envision a future where consumers will view the convenience and benefits of Prime as an essential element of eliminating friction in their lives. When you consider the average consumer pays $100 a month for their cable bill, an annual Prime payment of $150-$200 does not seem far-fetched.

With 110 million (expected by yearend) members paying annual fees of $100, Amazon has an $11 billion stream of recurring revenue at its disposal.

Like Costco, we expect Amazon to monetize its Prime members in myriad ways such as credit cards, travel, group buying discounts and car buying. It is not hard to envision a future in which Prime members utilize a Prime card to secure discounts in offline services and products such as dining, hotels, air travel and merchandise. In fact, it was announced today that Prime members would enjoy discounts on their student loans through a partnership with Wells Fargo.

If You Can’t Beat Em, Join Em – Amazon Marketplace

After twenty years of building an arc for a flood of online commerce, the rest of Amazon’s competitors are patching up leaky row boats. In fact, with Amazon so far ahead of the competition it makes little sense for small and mid-tier retailers to

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