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Morningstar | Market Fixation on Its Near-Term Revenue Overshadowing Amazon's Dynamic Long-Term Cash Flow Model

Wide-moat Amazon capped off 2018 with strong fourth-quarter results that solidified our views about the company's ongoing shift from purely a growth story to one that better balances cash flow generation through margin-accretive offerings such as third-party services, new Prime membership tiers and subscription platforms, expanded AWS functionality, and advertising (with Alexa licensing offering a potential future contributor). The market continues to pressure the stock due to first-quarter 2019 revenue guidance of $56 billion-$60 billion (up 10%-18% compared with 20% in the fourth quarter), and while we acknowledge that there are legitimate questions about international markets such as India, we believe the more relevant takeaway for investors is that Amazon's 2018 moves make it a more dynamic company with greater monetization opportunities over a longer horizon.

Gross margins improved 180 basis points to 38.1%, which was a bit weaker than trends earlier in the year due to holiday shipping offers, but still reinforce the idea of Amazon as a more consistent cash flow generator. Just two years ago, most investors would've scoffed at the notion of Amazon posting mid-single-digit operating margins, but with gross margin expansion helping to drive full-year operating margins of 5.3% (versus 2.3% last year), we believe our longer-term operating margin target of 8%-9% looks more palatable. Admittedly, management noted that it expects headcount, fulfillment, and AWS investments to accelerate in 2019, but we believe the evolution of Amazon's advertising, third-party services, subscription, and logistics businesses supply it with enough slack to post 6% operating margins for the year.

We're not planning changes to our $2,200 fair value estimate. We expect some volatility over the near future as the market adapts to Amazon's growth/profitability algorithm but ultimately believe the cash flow potential of its evolving business model is too much for investors to pass up.

Examining Amazon's business units in greater detail, we believe AWS was one of the clear high points for the fourth quarter, with segment revenue growing 45% and segment operating margins improving 280 basis points to 29.3% (putting full-year margins at 28.4%). While management didn't provide much transparency about the reason for the margin gains other than a pullback in AWS-related investments relative to 2017, we continue to believe that the market underestimates the longer-term margin potential of this business, even after factoring in greater competition with Microsoft Azure. In the past, we've said that a reasonable margin target for this business was the low-30s, but after factoring in pricing potential for future mission-critical business functions (cybersecurity, Internet of Things) and AWS Marketplace, we now see low- to mid-30s as an achievable goal.

Advertising continues to be Amazon's breakthrough story for 2018, and we continue to see multiple ways to evolve this business in the future. This includes improved functionality (smart recommendations and automation) and video optionality (with management calling out the ad-supported free streaming channel Freedive recently launched by subsidiary IMDB) as examples. We expect advertising revenue to grow more than 50% annually the next five years, with operating margins in the 30%-40% range using Facebook and Google as benchmarks and accounting for some price competition.

New e-commerce regulations in India restricting exclusive product sales, banning the sale of products from vendors that e-commerce companies have an equity interest, and restrictions on discounts are a legitimate concern and will likely result in a modest reduction to our five-year online store sales forecasts for Amazon (which we're forecasting in the low double digits). However, we also believe investors should balance these concerns with increasing evidence that the Prime membership flywheel is accelerating outside of the U.S.--management called out the largest number of Primer member sign-ups this quarter, which we largely attribute to international markets--and helps validate our thoughts about Amazon's international business reaching low-single-digit margins over the next five years.

On the surface, the 3% decline in physical stores sales during the fourth quarter could be interpreted as a sign of integration issues with Whole Foods, and while we believe there have been some missteps as Amazon adjusts to Whole Foods' customer preferences, we chalk up much of the decline to fiscal calendar accounting and mix shift adjustments (Whole Foods online delivery or pickup orders are counted in online sales). Looking forward, we remain intrigued by the potential for Amazon Go stores (which have expanded to almost 10 locations in Seattle, Chicago, and San Francisco), and "four-star" format in NYC, as 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.