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Morningstar | Amazon's Top-Line Outlook Raises Questions, but Profit Drivers Remain Strong and Create Optionality

While skepticism about revenue growth trends have been dominating the headlines following the update and weighing on the stock, we still remain confident in wide-moat Amazon's longer-term disruption and free cash flow potential, and we view today's pullback as an opportunity. We're not planning material changes to our $2,200 fair value estimate, as some of the third-quarter upside will be offset by minor adjustments to our medium-term assumptions.

Our five-year assumptions calling for 23% top-line growth and operating margins of 7%-8% remain in place. On revenue, we had always forecast some degree of natural deceleration, with our model calling for revenue to slow from the low 30s in 2018 to the mid-20s in 2019. We had factored in the lapping of the Whole Foods acquisition and the shift to third-party sales and subscription-based services. However, fourth-quarter revenue growth guidance of 10%-20% also reflects accounting changes for Prime memberships, foreign currency headwinds, and potentially some conservatism for holiday competition.

Continuing recent trends, Amazon blew away the high end of its operating profit target for the third quarter, delivering $3.7 billion (6.6% of revenue) versus its outlook for $1.4 billion-$2.4 billion. Amazon is ahead of schedule on the five drivers of margin expansion we've previously identified (AWS, Prime engagement/subscription services, third-party sales, advertising, and technology licensing). AWS engagement/cost-containment remains strong (as evidenced by segment margins of 31%), while Prime and other subscription platforms remain healthy even with the base-fee hike. Advertising is still Amazon's breakthrough story for 2018, and while management shied away from it, we see multiple ways to evolve this business in the future. Wage increases and potential USPS rate hikes lurk as margin headwinds, but we wouldn't be surprised to see Amazon reallocate some of its strong margins and invest in near-term retail growth.

Taken together, we see management's fourth-quarter targets ($66.5 billion-$72.5 billion in revenue, $2.1 billion-$3.6 billion in operating income) as achievable, if not mildly conservative.

Two additional areas stood out to us during the quarter: (1) physical stores and (2) Amazon Business. With respect to Whole Foods, Amazon Go stores (which have expanded to six locations in Seattle, Chicago, and San Francisco), and the "four-star" format in NYC, we're seeing the company's retail strategy come into focus. In particular, we believe these locations help to bring Prime memberships into the real world, driving greater engagement and potentially unlocking new other offline Prime membership benefits (and pricing tiers) in the future.

CEO Jeff Bezos called out Amazon Business in the fourth-quarter press release, noting that it has reached a $10 billion sales run rate across eight countries. While this business unit has had its share of executional challenges--largely tied to the operational differences between individual and business customers--we also see this segment as an increasingly important driver for Prime membership growth and engagement, third-party sales, and advertising services.