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The Amazon Problem

Written by Briton Ryle
Posted March 11, 2019

Value is a funny thing...

The most valuable company in the world right now is Google (or Alphabet, if you wanna get technical — personally, I don't see why we need extra names for companies, it just confuses things), with a market cap just shy of $800 billion. 

A few months back, it was Amazon, when it was the first to break that magical $1 trillion barrier (founder/CEO Jeff Bezos also became the world's richest man around the same time). Both Apple and Microsoft are close enough to keep things interesting. 

Rounding out the top 10, there are two Chinese companies — Tencent and Alibaba — as well as Buffett's Berkshire Hathaway, Facebook, JP Morgan, and Johnson & Johnson.

If you want to talk biggest company by revenue, it's Walmart, with over $500 billion in sales. (Walmart is also the world's third-largest employer, with 2.3 million full-time employees — just behind the 2.5 million people "employed" by China's People's Liberation Army).

If we exclude five oil companies and China's State Grid, the remaining top revenue companies are Toyota, Volkswagen, and Berkshire Hathaway. 

Are you seeing a pattern here? 

What I see is that the companies that take in the most cash money from sales of their products are not considered to be the most valuable companies from an investment perspective.

There's a good reason for this: profit margins. Google makes 22 pennies in profit on every dollar it takes in. Walmart makes 1.3 pennies. For investors, it's the profits that put food on the table. That's why Walmart is "worth" just $300 billion, while Google is $800 million. 

Another observation about those lists: The most valuable company in the world is the one that figured out how to turn the internet into one big store. Think about it. If you send someone an email (from your Gmail account) saying you need new shoes, guess what happens? You start seeing webpage ads from Nike and Target about shoe sales. God forbid you actually google "new shoes" — you'll be seeing those ads for the rest of your life...

The Real 1% 

From an overall economic standpoint, Target is far more valuable to our day-to-day lives than, say, Facebook. Target sells clothes and food. Maslow's hierarchy of needs doesn't say anything about posting pics of your dinner or reposting fake news stories. 

The stock market says Facebook is worth $480 billion and Target is worth $40 billion, even though Target produces 50% more revenue and employs 10 times as many people. 

Again, it's about profits. Facebook makes $20 billion in net profit a year. Target makes about $3.5 billion. 

I've been thinking about all this a lot because of the whole "death of retail" thing that's been going around for the last five years at least (thanks, Amazon)...

So I wonder: How much do people really care where they buy stuff? Seems to me most shopping is a value proposition. Where do I get the quality I want for the right price?

And now that you have Google, Facebook, and Amazon telling you constantly where to get what you want at the price you want, the playing field is about as level and competitive as it's ever been. 

Add in the fact that e-commerce has siphoned off 10% of retail sales, and that's why we have come to a life-or-death scenario for retailers. With profit margins as slim as they are, there simply is no margin for error for the Targets and Walmarts of the world. Strategies have to be airtight.

Because if you attract just 1% fewer shoppers, it could cut your profits by 10–20%. That is simply amazing. It's that 1% that gets Target a price target hike, while Nordstrom gets downgraded. 

Luck or Skill? 

About that persistent theme that Amazon is killing retail — is it really true?

The facts are that e-commerce has now taken about 10% of the entire $5.7 trillion retail market. And Amazon has about 40% of the e-commerce market. That works out to about 4% of all retail for Amazon. (For comparison's sake, Walmart would weigh in just under 10%.)

That's a pretty good performance for Amazon. But is it safe to assume that Amazon's growth continues until it's as big as Walmart? And then it keeps taking market share until it's twice as big as Walmart? 

This seems unlikely to me. Now, granted, I'm old and grumpy. For the most part, I don't shop online. When I need socks, I go to Marshalls so I can be sure that I like the thickness of the material (for a while it was Adidas, now it's Under Armour). 

Right now, I'm operating on the premise that the perfect retail strategy involves an optimal mix of physical locations and online strategy.

Now, we don't know exactly what that balance is. But we do know two things. One, brick-and-mortar retailers have over-invested in the bricks and mortar. Some are too far gone (like Sears and 100 others) and have already declared bankruptcy. Some (like J.C. Penney) are teetering on the brink (note that Dollar Tree is closing hundreds of Family Dollar stores). 

The other thing we know is that Amazon has ridden a perfect wave of internet growth to become a serious player. But now what?

Amazon bought Whole Foods. I'm hearing they wanna open up more grocery stores, maybe some actual retail stores, smaller convenience stores...

In other words, just as traditional retailers are focusing more and more on e-commerce (Kroger just announced a $3 billion investment that will knock 2019 EPS down by about 5–10%), Amazon is going to focus more and more on bricks and mortar. 

Seems risky. The Targets and Walmarts of the world have been operating stores for decades. Amazon? Not so much. Right now, investors seem to be assuming that Amazon's success with e-commerce will carry over, no prob. But long-term leases, property ownership, and management — this is new territory for Amazon. 

I find it hard to believe it will all be smooth sailing for Bezos and Co.

But the thing is Amazon can weather some storms. Because while net income was around $10 billion in 2018 (good for a P/E of 40), Amazon R&D spending was $28 billion. That's more than Apple and Facebook — combined. 

And I'll tell you something else: A good portion of that money goes right to a few under-the-radar companies that handle many of Amazon's mission-critical operations. Amazon's going to invest billions for its next phase of growth. These little beauties will be the big winners.

Even better, these companies are the ones that pay out as Amazon grows. They've paid out billions already, and there's still time for you to get in on the next round, coming March 15

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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