Amazon Plus Twitch Equals A Whole New Game

| About:, Inc. (AMZN)


Amazon's $970 million purchase of Twitch is the largest deal in the company's history.

Twitch is the world's biggest live streaming video platform.

Amazon shares are down 15% year-to-date, creating a window of opportunity for long-term buys.

Twitch makes Amazon a competitor with Google, Apple and Microsoft for the platform of the future.

It's official. Amazon (NASDAQ:AMZN) bought videogame platform Twitch Interactive Inc. for $970 million this week.

Close to $1 billion is a lot of scratch. But if you're Amazon, and you have growing aspirations in media, gaming and advertising, it makes sense. Acquiring Twitch puts Amazon at number one in live streaming, and number three in online video, right behind Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) in the United States. It also gives Amazon a shot at creating a platform for someday broadcasting events like major league sports, according to Dan Sahar from Qwilt.

But buying Twitch is really about something primal: CEO Jeff Bezos' overwhelming ambitions. With Twitch, Amazon becomes the only industry player with an end-to-end video platform for both user-generated content - via Twitch, and professionally produced content - via Amazon Instant Video. As Sahar pointed out, Netflix and Google do well in one of these areas, but not the other.

A Triple Play: Hardware, Media and Store

Amazon isn't usually regarded as a tech or a media company, but it's well on its way to becoming both. With Twitch, Amazon will have an easier time enticing customers to purchase Kindle Fire, Fire phone or Fire TV smart devices, (available video content plays a big part in many people's decision-making process).

And that's just the start. Once ensnared, Amazon customers will use their Fire device to rent games, music, e-books, apps - more and more of which Amazon plans to produce itself - and they'll buy them through Amazon's store. It's a triple play. Amazon will own the hardware, the media and the store where it's purchased. Can't you just hear the cash register? Ka-ching, ka-ching, ka-ching.

The simple truth is that Amazon is now well on its way to becoming one of the top video providers on the Web. Twitch accounts for nearly 2% of all traffic in the U.S. during peak hours, according to The Wall Street Journal. In fact, Twitch traffic is beginning to swamp the internet. At peak times, here in the U.S., only Google, Apple (NASDAAAPL) and Netflix command more bandwidth.

Still, the acquisition has confused many professional industry observers, because Twitch today is a platform for hardcore gamers to do live-streaming video. For instance, Wedbush Securities investigative analyst Michael Pachter told GamesBeat immediately after the deal went through, "I'm not sure why Amazon bought Twitch. Other than (because) Google wanted it."

For the record, I'm a long-term bull on Amazon for exactly the reason Wall Street and other professional analysts often can't make heads or tails of Jeff Bezos or his company. The CEO of Amazon is much, much smarter than his skeptics.

Book Peddler to Master of the Universe

Jeff Bezos started out in 1995 as a book peddler in his garage in Bellevue, Washington. Within a year, Amazon had grown to 100 employees and racked up $15.8 million in sales. Since then, he has taken over 30% of the total book market, which hit $34.9 billion last year, and 65% of the e-book market, which has been pegged at $7.9 billion.

I've been a book author for twenty years, so I know a little about the book-publishing world. Just a few scant years ago, major publishers saw Amazon as just one more channel for sales. Now, despite the loud and very public spat between Hachette Book Group and Amazon, book publishers now can't live without Amazon's sales and Amazon's market power.

Amazon is getting a lot of bad press over the Hachette dispute, but the Wall Street Journal did a good job of laying it out. Here's the economic story for investors. While books are only a small part of Amazon's business these days, they're significant because they indicate the company's mindset. Amazon grinds down its suppliers to keep its competitive edge.

Publishers are no exception. The battle for who will control book publishing is already over. Amazon won.

Or...if you prefer a more nuanced version, the fight is purely about who has the real power in the relationship, as Forbes has pointed out. Once the dust has settled, the free market will ultimately decide who wins.

The Controversial Case for Buying Amazon

Meanwhile, what's going on with the stock? While Amazon net sales rose 23% in the company's latest earnings report, the company fell back in the red, despite a massive $19.34 billion in revenue. Shares tumbled over 10% in after-hours trading. The operating loss was expected and the reason analyst after analyst downgraded the stock following Q1, including JPMorgan, RBC, Wells Fargo, SunTrust and Citi.

Next quarter will be more of the same. Revenue guidance is $19.7 billion, but a big operating loss is expected, $410 - $810 million. Amazon's stock took a sickening slide last year, and while it's slowly coming back, quarter-after-quarter of profit-less (or worse) growth gets some investors to throw in the towel, while giving others a chance to get in.

Which way should you bet? It depends on whether you understand and agree with Amazon CEO's mindset. Just don't expect expenses to shrink or profits to appear anytime soon. Justifying big expenses and the earnings multiple for the quarter is one of the main goals of a CEO. But Bezos could care less about the quarterly earnings report.

Jeff Bezos has made that clear time and again, ever since his 1997 shareholder letter, when he said: "We will make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions."

Bezos' mindset is ruthlessly long-termed. He refuses to maximize short-term growth in earnings per share, in favor of focusing on growing into the distant future. Amazon is profitable in its retail operations, but it's losing money overall because Bezos can't resist investing in costly new ways to keep expanding the company's reach.

Twitch is just his latest way to plow profits back into growth. As former Amazon employee Eugene Wei explained to Business Insider, Bezos is like a kid who takes the $1 profit from his lemonade stand and uses it to build another stand. Eventually, he has built a lemonade stand on every street corner in the world.

And then he moves humanity to outer space, and starts building lemonade stands in every corner of the galaxy.

Fire: A Key to Amazon's Future

A good example of how Bezos sees his business model is Amazon's first smartphone, the Fire. The knock on the Fire is that the smartphone will surely be unprofitable, considering the lack of profits in low-priced handsets. But Bezos is already selling the Kindle tablet at cost with zero profit impact.

The Fire is a device with a mission. The Fire is all about encouraging consumers to spend more money at Amazon. Its Firefly app can recognize video, music, text, even everyday objects - 100 million of them, according to the company, and then help users buy it from Amazon.

If you're thumb-tied, you can tilt the Fire rather than touch the screen to see different product views in Amazon's shopping cart. An ASAP feature suggests videos based on your viewing habits and caches them to start instantly (after you buy the video, of course).

Amazon's Astounding Revenue Growth

While Bezos' almost megalomaniacal focus on getting consumers to buy more from his company can be annoying, it has paid off handsomely for Amazon shareholders.

The growth numbers for Amazon stock are nothing short of astounding. Streaming music is a recent Bezos' obsession that will extend Amazon's growth even more. Amazon has a huge stake in it with the launch of Prime Music. Russ Crupnick, managing partner of consulting company MusicWatch, pegs Amazon's share of the $2.8 billion digital download market in the U.S. last year at 18%, and at 23% of the $2.1 billion market for CDs. By comparison, Apple's iTunes commands about 67% of digital downloads and doesn't sell CDs.

In other words, Amazon is the only competitor to Apple of any real size in this rapidly growing market.

Consumer Spending and Other Risks

Every company faces risks. One risk to Amazon is a downturn in general retail consumer spending. In the past however, when retailers come under pressure, Amazon sidesteps some of the negativity. They did so in 2013, thanks to the company's absence of brick-and-mortar locations.

Amazon is trading at a huge forward price-to-earnings ratio, but the amount of leverage a company employs and how it uses its revenue can have a large impact on P/E ratios. Amazon invests most of its revenue back into the company, leaving little in the way of earnings. This distorts earnings, and thus the P/E ratio. In addition, Amazon has traded at a very high P/E for 15 years, and that has not affected the stock's price movement.

P/E ratios are (of course) better suited for valuing mature companies than explosive growth companies. Amazon has the potential to produce dramatic earnings if and when reinvestment in the company is curtailed. While Amazon defies many basic stock market metrics, Dana Blankenhorn wrote an interesting article about it recently, saying that a 2-1 price to sales ratio is not unreasonable for what is increasingly a tech stock.

Profits without Prosperity

Jeff Bezos is often criticized for plowing profits back into Amazon, but it's one reason I like the company. We live in a relentlessly short-term minded world. Bezos is one of those rare birds who understand that the best way to be successful in the long run is often to deliberately aim at not being successful in the short term. History shows that the world has been lurched forward mostly by people who weren't looking primarily for the reward of narrow, immediate gain. (Katherine Graham, Walt Disney, James Burke and William McKnight come to mind.)

In line with that, an interesting article just came out in the Harvard Business Review, "Profits without Prosperity."

It's worth a read, but if you're short on time, I'll summarize. Starting in the late 1970s, there has been a growing trend for American companies to cut capital expenditures to boost stock buybacks so they could hit quarterly earnings per share targets.

The HBR pegged the reason as executive greed. Stock-based instruments make up the majority of top executive pay. In 2012, the 500 highest-paid executives in U.S. public companies received, on average, $30.3 million each - 42% of compensation coming from stock options and 41% from stock awards. By increasing the demand for a company's shares, open market buybacks automatically lift the stock's price, even if only temporarily, and significantly increase the CEO's personal prosperity.

That's why since the first half of the 1990s, when it was already viewed as excessive, the compensation of top U.S. executives has doubled or tripled.

The Only Way to Own Amazon - Forever

Obviously, Amazon can be a heart breaker. It once traded at almost $400 a share, and dropped all the way down to under $300 in May.

I'm still accumulating, but I'm also taking to heart Warren Buffett's advice about holding periods. "The preferred holding period for a stock?" he said. "Forever."

Amazon is not a stock to buy for the next five years, it's a stock to buy and tuck away for your kids and grandkids. It's a great company that's going to be even greater in ten or twenty years. Where competitors have seen obstacles, Amazon has offered solutions, pursued market shifts, in fact, augmented, and accelerated them.

Jeff Bezos (love him or hate him) clearly plans to follow his own path and answer to no one. Twitch, Fire, the music streaming service, even the battle with Hachette--they're all part of his grand plan.

A lot of people see Amazon as merely the world's largest online tradesman. I think they're missing the point. Bezos is all about offering game changing solutions that create growth and unseat competitors. At a shareholder meeting in June 7, 2011, he said:

"You just have to place a bet. If you place enough of those bets, and if you place them early enough, none of them are ever betting the company."

Like I said, he's a heck of a lot smarter than his skeptics.

Disclosure: The author is long AMZN, AAPL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.