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Amazon: One Company To Deflate Them All

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About: Amazon.com, Inc. (AMZN), Includes: EBAY, MSFT, SHOP, WMT
by: Cestrian Capital Research
Summary

Amazon has been eating the world for a good ten years now.

Amazon's deflationary bow wave washes value directly into Amazon's market capitalization.

We believe Amazon will continue to deflate the US economy.

And we believe the valuation multiples and stock support levels are such that now is a good time to go to Buy on the stock.

We sound a note of caution on position size as we run into Q4 earnings.

DISCLAIMER: This article is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this article is not an offer to sell or buy any securities. Nothing in it is intended to be investment advice and it should not be relied upon to make investment decisions. Cestrian Capital Research Inc or its employees or the author of this article or related persons may have a position in any investments mentioned in this article. Any opinions or probabilities expressed in this report are those of the author as of the article date of publication and are subject to change without notice.

Summary

This note is a little long, for which we make no apology. We hope you enjoy it. Stick with the bits that look boring or macro-y, we think they're relevant to the stock at hand.

Our thesis here is that Amazon (AMZN) will continue to build value over the very long term, because it is a major force in depressing GDP growth in the US. If that sounds wrong-headed, it isn't. Post-crisis, American GDP growth has been muted not because of low employment or high interest rates or high savings rates, but, in our view, because of the powerful deflationary effects of the Internet at large and AMZN in particular. We believe that the truly colossal amount of value that AMZN has deflated out of its competitors and suppliers can be found alive and well and sat in AMZN's market cap. And we believe that this trend will continue. The stock has had some headwinds of late - we think they may be clearing, and we think that the stock's valuation multiples have become much more attractive as the company has continued to grow whilst the stock has traded sideways. We don't see the powerful deflationary forces retreating any time soon. We think that's important to understand in this thesis.

So we go to Buy - (Very) Long Term Hold on AMZN. We think there's another decade of value creation ahead.

A Decade-Long Transfer Of Value from Labor To Capital

Here's the story of the very strange economic decade which comes to a close in just a few weeks. Marx would turn in his grave. However, his sometime co-author and patron Engels, scion of a wealthy manufacturing family, would likely lament that his own demise came too early to witness the perfection of capitalism.

Bear with us whilst we walk you through this.

Firstly, here's US real GDP growth every year from 1961-2018, on a cumulative basis. Looks great, right? A nice steady curve up and to the right. A few hiccups along the way, but all in all, it's the American dream in a single chart.

Source: World Bank, Cestrian Capital Research Analysis

Now look a little closer, at the annual change in real GDP. Between the start of the data series in 1961, and around 2005 just before the subprime crisis got ahold, you can see the economic cycles you would expect. Pretty brutal reversals every few years. High highs and low lows. If this were a stock chart you would say - hold on to your hat if you are going to trade this stock.

But look at the post-crisis period, from 2009 to 2018. After a brutal recession, the most negative growth in the 60-year period covered in this chart, growth resumes at between 1.5% and 3.0% annually for a decade. If it were a stock you'd stay it had suddenly become rangebound, having been a wild ride the prior fifty years.

Source: World Bank, Cestrian Capital Research Analysis

So you have to ask yourself - why is this? Why has growth not resumed its normal boom and bust pattern - and in particular, why has it not reached big percentage peaks, as it has in the prior half-century?

Perhaps unemployment has never recovered from the mortgage crisis? High unemployment, low consumer spending, low growth? Nope. Look - unemployment has dropped dramatically in just a few short years.

Source: World Bank

So if unemployment is down so much, that means more money in consumer pockets (since consumers and employees are for these purposes one and the same group of people). And more money in consumer pockets means more spending. And more consumer spending means GDP growth and inflation - right? That's what we've all been taught.

Wrong.

Look - consumer inflation (the blue line) has stayed low since the crisis. It rose a little past 2% last year but you can see the curve flattening off, at a level which would be considered low by pre-crisis standards.

Now, we know that the Fed has a very close eye on inflation and we know it likes to use interest rates to control inflation. The Fed looks to be delivering on the goals it has set for itself. You can see that rates and inflation do bear some relation to one another. Very low rates for a long period of time - very low inflation for a long period of time.

So unemployment is down, interest rates are down (that ought normally to encourage borrowing and spending, driving up GDP growth) - why hasn't GDP grown faster?

Is it the savings rate? Did the American consumer scare themselves in 2008 and decide to take a lesson in prudence from the German or Chinese saver?

Nope. The trend for savings as a % of GDP continues on an overall downward trend since 1970/71. You can see a little alarm for sure post-crisis, but overall, again, if this were a stock chart, you'd say it's in a long-run downward trend.

Source: World Bank

So - why has the US economy not grown faster as it came out of the subprime crisis? The conditions are ripe - unemployment low, rates low to encourage borrow and spend, and fear isn't so high that Americans are storing all their dollars under the bed.

We believe we may know the answer. In fact we believe we all know the answer - all of us - if we just stopped to look at what we spend our time doing all day.

The answer is - the Internet.

Ironically for a project that had its roots in both federal defense and post-hippy counterculture all at the same time, it turns out that the Internet is the most wonderful servant of capitalism that has ever existed. Why? Because it is the most powerful deflationary force we have yet invented.

Marx liked to refer to 'capitalism destroying itself', and if he had stopped to think about it for a little longer, he would have realized that deflation was the most destructive force in capitalism.

Deflation destroys profit margin. It destroys companies as those companies are undercut by low-cost competitors. It destroys jobs as they can be replaced with jobs in cheaper labor-rate countries, or by machines. And whilst this might sound a high-falutin' thing, or a thing done to you by foreigners or some kind of bad people somewhere, it isn't. You deflate the US economy every day. When you buy something on Amazon. Because either it's actually cheaper than from the store, or because you have to spend a lot less money in total on the thing vs. buying it from the store. You don't have to buy gas to get the thing. You don't have to stop being productive in order to go get the thing. You don't buy a coffee and a sandwich from the store, because you aren't in the store. What you're doing is buying something that is probably assembled in a low-labor-rate country (or a low labor rate part of the US), packed in a low-wage Amazon fulfilment center and shipped to you by a low-wage courier. Every step of the way, when you buy a pair of shoes or a piece of electronics on Amazon, you're sucking value right out of the value chain. Deflating the US economy. (And that's before we even consider what you're doing if you're buying a digital product that doesn't require you to pay the guy in the truck to get it to you).

But deflation hasn't destroyed capitalism, it has powered it forward. You love deflation. It means you can buy more stuff, more often. The stock market loves deflation. It means it can keep finding lower-cost companies to invest in, which will destroy the old-line companies and make super-profits along the way. That's the economics of Moore's Law in the tech industry, the economics of packet-switching in the telecom industry, and the economics of reusable rocketry in the space industry. Consumers and investors - they both love deflation.

Marx also said to anyone who would listen that socialism would come to replace capitalism as surely as night follows day. Historical determinism, he called it. The inevitability of capitalism's overthrow by revolutionary socialism. He got that wrong too. That's because he spent far too much time sat in a capitalist's house reading obscure German philosophy and not enough time outside of the house noticing how much everyone loves cheaper stuff. If only Amazon Prime had existed in the 1860s. You watch that Prime subscriber count rise, you know capitalism's going nowhere. And 1-day shipping? Oh man. Now nobody wants to queue for bread.

Now before we trash the guy completely, it has to be said he did get one thing right. Capitalism has a habit of extracting value from labor and transferring it to capital. In other words, poor folk work all day to help rich folk get richer. The answer to which isn't socialist revolution, which just involves making everybody poorer all at the same time. (Source: any and indeed every single time socialism has been tried anywhere in the world, ever). The answer is the American dream, which is to say, work hard and grab your chances to become a capitalist not a laborer.

The last decade has seen a transfer of value from labor to capital like no other. Here's a chart we posted in our recent note on AT&T. It's a great chart so we're going to use it again here.

The orange line is cumulative GDP growth in the US from 2009-2019. Nearly 50% up. That represents the fruits of American labor - and it looks a darn sight better than the same chart in say Europe. Well done hardworking Americans. But the purple line is the S&P500 total return in the same period. That represents one of the largest pools of capital anywhere in the globe. And it's up over 6x the amount of GDP growth.

Now, a whole university of economists can tell us why this is too simple an illustration, and they could be right, but this shows in stark contrast just how much value has been earned by capital (the stock market) vs by labor ("GDP") since the crisis. (Yes, we know GDP isn't a pure measure of labor like coal output or hours worked etc. But it's a good enough measure for our point here).

Let's look now at the value created by Amazon in the same time period.

The Post Crisis Period Has Been Wonderful For Amazon Shareholders - At The Expense Of, Oh, Everyone Else.

There are other deflationary sources in the US economy. Pretty much anything in e-commerce plays a part. But the big kahuna is Amazon. Just look at what a massive catalog of cheap stuff, efficient billing, and rapid nationwide distribution has done for AMZN shareholders. And in particular, look at the value created post-crisis versus that before the crisis.

Source: YCharts.com, Cestrian Analysis.

Before you say "oh, a lot of that is AWS" - what do you think AWS is? It is a deflationary force that depresses the value of other forms of computing, and of the supply chain that it dominates. Companies use AWS because it is cheaper and more reliable than processing compute loads in their own basements. Indeed AWS processes so many compute cycles that it can buy every imaginable contributory component of those cycles (silicon, coolant, power, real estate, staff, coffee) far cheaper than can its customers. So it is deflating those supply industries too.

There's a very famous book from the Internet 1.0 era about eBay (EBAY), called The Perfect Store - it's a good read and you can still find it on Amazon (here). But in truth, Amazon itself has become the Perfect Storm for any industry it touches. This is less to do with Bezos' genius, although he undoubtedly possesses that particular form of madness, and more to do with the sheer force of scale economics. The huge hike in market cap you see above is, in its simplest form, the destination for the value deflated out of everything Amazon touches. Extra, pre-AMZN money that used to be earned by bookstores, publishers, authors, consumer electronics vendors, blade server component vendors, datacenter construction firms, realtors, other retailers, the reduced hourly rate of the workforce who used to have more valuable skills but now have to work in AMZN fulfilment because their high-skilled jobs have gone elsewhere ... the list goes on. All that money is represented by that near-as-dangit-$1Tn you see above.

But Is It Still A Buy?

AMZN shares have lost their way of late. Speaking for ourselves the stock has been very, very good to us over the years - we've owned it on a personal account basis on and off for a long time. It has been the ultimate buy-the-dip stock - it has nearly always rewarded buying in the teeth of market fear and loathing. At the time of publication, we own no AMZN stock because it has been listless for some time. There's lots of reasons for that - AWS has very effective competition from Microsoft Azure, the old-line retailers have made a valiant effort to regain share in the hearts and wallets of the US consumer, tech players such as Shopify (SHOP) have made good inroads into helping retailers not called Amazon become a bit like Amazon, etc. And on top of that, the founder and CEO is engaged in (1) a personal battle with the current US Administration, (2) running a space company, BlueOrigin, which takes a lot of his money and presumably time too and (3) a high profile divorce which we doubt was at a time of his choosing. That's not a good set of dynamics for any CEO, and we do think these factors have taken their toll on the company and its stock.

But when we sit back and look at the very long term, we can't see any reason why AMZN won't continue to prosper. Wal-Mart (WMT) in our opinion just doesn't have the core DNA to beat Amazon in the modern world, and it doesn't matter what kind of hybrid bricks/clicks model that WMT chooses. And a thousand smaller, Shopify'd-up vendors aren't going to combine forces to beat AMZN either. We back the Death Star vs. the rebel alliance on this one.

And we look at that sideways trading of the stock, and the growth of the company, and the fact that they're moving back into investment mode (which historically has been a benefit for AMZN - the company does seem to be astute at capital allocation), and we think - we want to be shareholders again.

Here's why.

Firstly, it looks like there's a line of support now at around $1,750/share. Only the Q4 2018 Fed crisis has pushed the stock below that level in more than a year.

Secondly, the stock is a touch above the 50-day SMA but still a little below the 200-day SMA and we think it has a good chance of moving up so that the 200-day also can act as support. (Again there have been only short periods in the past where the stock has sat below the 200-day).

Source: YCharts.com, Cestrian Capital Research Analysis

Thirdly, look how the (revenue) valuation multiples have come down, and revenue growth seems now to be moving up. We think revenue multiples remain the correct way to value AMZN. We know it can turn on higher margins when it likes, and we believe it will be a long time before market share causes AMZN to mature on the revenue line.

Source: YCharts.com

For all those reasons, we now move to Buy.

Finally, a word on position size. AMZN is not a fun stock with which to game earnings day. It has a habit of swooning during earnings calls. The company doesn't seem to care too much about the beat-and-raise game, and doesn't play it well (or at all) as a result. So speaking for ourselves we intend to take a smaller position following publication of this note, and then see how it goes. We may add a little before Q4 results depending on all the usual factors. But we definitely want cash left over to pick up more following Q4 earnings - either to catch a move up, or to average down in the event of a negative reaction to earnings or guidance.

Cestrian Capital Research, Inc - 28 November 2019.

Disclosure: I am/we are long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We are long MSFT on a personal account basis.

*** NOTE we intend to place a Buy order on AMZN stock on a personal account basis following publication of this article ***