We live in a world characterized by slow economic growth and the stock market is trading at moderately above average multiples. You can’t just rely on buying stock in a good company and depending on 3% economic growth to drive sales higher. If the overall economic pie is growing slowly you need to find companies that are grabbing a bigger share of the pie. Companies like Amazon.
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For example, here is a chart showing retail sales excluding gasoline and food. The trend has been growth (above the black line) but growth that is slowing ever so slightly.
This Friday I became a believer in Amazon.
I wasn’t in the past. The company is insanely hard to value. It reinvests a huge portion of its cash flows in growing for the future so it’s devilishly hard to tell exactly how profitable some of its businesses are. Owning the stock is also the mark of the devil as far as many value investors are concerned. A business trading at a high multiple and growing fast, why owning that stock is heresy!
Amazon’s absolutely stellar earnings report, in particular it’s retail strength, in the face of a weak retail environment combined with the fact that the company is entering the pharmacy business and CVS’s panic response by offering to buy Aetna finally put me over the edge.
Rather than bore you with financial models and spreadsheets let’s talk about Amazon in terms of something that’s fun. Will it become the first trillion dollar company? Inflation and economic growth make it inevitable we will eventually have a company worth a trillion dollars and we are close enough to make it worth talking about.
Here are the contenders, the top ten largest companies in America. You can see we are close!
|Company (Ticker)||Market Cap|
|Berkshire Hathaway (BRK.B/BRK.A)||$463B|
|Johnson & Johnson (JNJ)||$381B|
|JP Morgan Chase & Co (JPM)||$358B|
|Exxon Mobil Corp (XOM)||$354B|
|Bank of America (BAC)||$293B|
*Sorry, it’ll always be Google to me I’m not participating in renaming it Alphabet.
If we are right about Amazon being a good investment it will be growing fast. But rather then talk about things in terms of share price, or profit margins, or “boring” things it’s much more fun to frame things in how can a company reach a trillion dollars.
Apple is obviously the closest and has perhaps the best shot. But, the company reached a saturation point in its main markets and there is a real risk of consumers keeping phones longer and stretching out the phone upgrade cycle leading to stagnant or falling growth. Of course, if the latest iPhone is a hit it might be able to be the first trillion dollar company.
Google is next closest. The company is growing at double digits and has a long growth runway ahead as more advertising moves online. In fact, maybe I lied. Maybe Google is my pick to become the first trillion dollar company. It’s close. But, the company doesn’t really have any truly game changing on the horizons, just more of the same (but that same is great). Plus, I felt like writing this newsletter about Amazon.
Microsoft has benefited from firing Steve Ballmer and transitioning their business focus to the cloud. Like Google there is nothing truly exciting on the horizon just more of the same great growth. Facebook is interesting. Growth is high but given all of the recent revelations about their incorrectly calculated user metrics and proliferation of fake accounts I think the company may have a day of reckoning with advertisers in the future and reported metrics may be worse than the company discloses.
We’ll see. The rest of the list is just boring companies. Good companies, but boring. The banks aren’t a threat. We just had a consumer debt bubble end so I don’t see another one starting and while interest rates rising will help net interest income it’s not going to *triple* the company’s value. Berkshire Hathaway is huge conglomerate and insurance company but not a fast grower at this stage. Johnson & Johnson is a great company but health care already consumes 18% of GDP, there’s not much more room for the health care industry to grow at above average rates. Exxon Mobil? Sure, oil prices could recover and double the value of the company but after that there isn’t much else to drive shares higher.
So, how can Amazon be the first company to a $1T market cap?
Well, let’s look at some things they are pursuing.
Amazon Prime Video. They can spend more money on content and become the next Netflix! Well, it’s true that cable sucks and the industry is ripe for disruption. It’s also true that Netflix is valued at $86B and that can add a pretty big chunk to Amazon’s market cap if it can build something that’s valued similarly. Except I’m not sure it’s such a great business. Netflix is attracting ever more subscribers by creating and licensing ever more content. The company is spending $6B-7B a year now on content and losing ever increasing amounts of money. More worryingly the business does not really seem to be showing signs of scaling (on a cash flow basis). I’m not really excited about the prospects of Amazon just shoveling even more money at creating content and hoping somehow it’ll eventually be a hugely profitable business.
Amazon has also been beefing up its logistics and supply chain and there are worries (if you own Fed-Ex or UPS stock) that Amazon was going to build their own delivery network and muscle out UPS and Fed-Ex. It’s hideously expensive to build a global delivery network and Amazon only accounts for about 4.5% of UPS’s and 3% of Fed-Ex’s package volume. If Amazon somehow was able to build a delivery network that was on par with those companies it’s still not worth very much to shareholders. With UPS valued at about $105B and Fed-Ex at $62B that’s about a $7B opportunity (4.5% of UPS, 3% of Fed-Ex) for Amazon, if that. It’s a lot of money to spend and not a lot of value would be created (if any at all, Amazon may not have the package volume to make “last mile” delivery profitable). That does not excite me.
What about auto parts? Auto parts retailers have been killed over the past year, partially from falling sales due to cyclical factors and partially due to fears about Amazon. Well to truly compete with those retailers Amazon would need to build out same day capable delivery. That means thousands of locations across the country. Even then what is the total opportunity? At the beginning of the year O’Reilly, AutoZone, and Advance Auto Parts were valued at a collective $58B. The industry is extremely fragmented and it’s doubtful Amazon could just waltz in and grab a huge market share. Could it disrupt it enough to make the auto parts retailers bad stock investments? Sure, that’s possible. But the market is just too small and competitive to get me excited about the opportunity there.
What about groceries? Americans spend $800B on groceries so at least the market is big enough to matter. I’m still not excited though. In June Amazon bought Whole Foods. First, grocery is an intensely competitive, low margin business. Second, I’m not sure what problem Amazon is going to solve for consumers. Various companies, including Amazon, have offered delivery and online ordering with little success. The big pain points I’ve found in talking with consumers are finding quality meats, quality produce, and cheap bulk items all at the same location. For instance, growing up my mom would shop at three different stores. Today, my wife and I, as a higher income couple are less concerned with price and more concerned about convenience. My wife’s biggest complaint is finding a store with the quality and the assortment she wants. Grocery is a big market sure, but what is Amazon going to do better that consumers want? Plus, let’s say Amazon absolutely kills it in grocery and puts Kroger out of business. That’s still only $27B in market cap (Kroger’s value prior to everyone panicking, perhaps justifiably, about Amazon buying Whole Foods). Grocery does not excite me.
That brings us to prescription drugs. Boy, do Americans spend a lot of money on drugs. $450B or so to be exact. And, boy, does the prescription drug market suck. When Pfizer manufacturers the drug you get prescribed it goes from Pfizer to a wholesaler like McKesson. McKesson buys in bulk and then holds the inventory hoping prescription drug prices will rise. (Just like real estate in the early 2000s, prices go only one way – up. Except now sometimes they don’t.) Individual pharmacies then buy their inventory from McKesson.
But wait, there’s more! The drug you got prescribed, it’s on pharmacy Tier 2 Bronze Level of your insurance company’s formulary so you pay a $50 co pay and they pay the $278.13 balance. What is that, how did that happen, who decided that? Enter the Pharmacy Benefit Managers (PBMs), these companies determine what drugs cost what and are on what tier and what can be substituted for what. They are full of corruption, self dealing, kickbacks (legal and otherwise) and just general shenanigans. They are so opaque not even the insurance companies that contract with them know everything that is going on. The whole “getting the drugs from Pfizer to your doorstep” experience is awful and ripe for disruption.
Even more interesting is just how valuable the space is. In the table below you can see our estimate is that the entire pharmacy space is worth $426B in market cap.
|All others ex-CVS||$50B|
|CVS Health (83% pharmacy)||$68B|
|Walgreens Boots Alliance (~75% pharmacy)||$49B|
|All others ex-PBM owned retailers||$153B|
|Total disrupt-able market cap||$426B|
If Amazon can become a major player, and do things better and cheaper, when it comes to the pharmacy arena it can add a lot of value to the company. What if it becomes the leader in each category? That’s a sweet $137B opportunity!
In the end it doesn’t really matter what specifically happens. As long as the market is a) big enough to matter and b) ripe for disruption then we should see substantial value created for Amazon shareholders.
Add in the already high growth from Amazon’s retail and AWS operations and $1T in market cap could be attainable.
Will Amazon beat Google to $1T? Who knows, but we own both and it will be a fun race!
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Article by Ben Strubel, Strubel Investment Management