Amazon: Stock Price Tracks Culture.
Q2 2024 Update
No time to read the update? Watch/listen for free:
Edited by Brian Birnbaum.
Stock prices track culture.
In my original Amazon deep dive, written in January 2023, I explain why Amazon’s free cash flow was set to soar to new record highs. As you can see in the graph below, the thesis has been proven correct. But what’s interesting is the mental model that led me to this conclusion, which I used to in turn to advise that family members make a big purchase of Amazon stock near the $100 level. Simply put, I understood that free cash flow per share would hit record levels because Amazon’s culture remained largely intact.
In my recent Costco deep dive I explain how they have succeeded by executing and improving the same operational algorithm for decades. They’ve simply focused on delivering more value to customers at a lower real price over time and this has equated into enormous earning power, to the delight of shareholders. In reading all Amazon shareholder letters from 1998 to 2023, I understood that the essence of this algorithm is culture. Everyone in the company lives and breathes the mission. While we cannot predict exactly what actions they will take, the odds of them succeeding over time are appealing.
Costco therefore serves as additional proof, together with my successful picks to date, that validates the mental framework I teach in my Tech Stock Goldmine course. Similar to Costco, Amazon is constantly compounding the key value drivers of its business: selection, convenience and price competitiveness. The decline in free cash flow in the 2020-2022 period depicted in the previous graph came as a result of Amazon investing heavily in its distribution network to supercharge these three aforementioned pillars. Qualitatively, therefore, Amazon was doing the right thing.
In 2022 the market punished Amazon for taking this decision, with the stock price falling over 50% from late 2021 highs, sacrificing its operating margin, free cash flow production, and stock price to create long term value. Although the decline in FCF was startling, I saw Amazon’s investment as a sign of a strengthening rather than declining culture, which includes heavy CapEx cycles leading to step functions in value.
As depicted below, Amazon’s history is littered with instances of leveraging CapEx to improve selection, convenience, and price. Throughout each of these cycles over the last two decades, Amazon’s operating margin and free cash flow levels have dwindled in the short term, only to then reach all time highs late-cycle. Neither investors, pundits, nor customers know ahead of time the nature of the coming CapEx cycle. Yet their focus on relentlessly expanding selection, convenience, and price competitiveness has gotten them to record free cash flow levels once again.
The take-home message: stock prices track culture.
No one can predict the future, but we can bet on higher probabilities. Culture breeds investment vehicles that are likely to successfully overcome obstacles and take the right actions to enhance their earning power. When I talk about what I believe certain tech companies will evolve into years and even decades down the line, I’m simply isolating dynamics that I see playing out at present and extrapolating their likelihood of playing out over the long term. In this manner, for example, I see Spotify evolving into an audio search engine and Palantir into a platform that connects digital twins. Not to mention other verticals that multifaceted compounders–also known as “spawners”–may produce.
Andy Jassy’s elevation to CEO infused uncertainty, exacerbated by Jeff Bezos’s departure from an everyday role. Two major data points convinced me that Andy Jassy was and is a solid custodian of the Amazon culture: his first letter to shareholders and the graph you see below. In his letter I was able to appreciate his comprehensive understanding of Amazon’s philosophy, and his management of AWS suggests he’s capable of translating these principles into action across the entire company. By the time he took over as CEO in July 2021, AWS was clearly Amazon’s profit engine and he was the man responsible for that.
What most caught my attention during 2024’s Q2 earnings call is Andy Jassy’s remarks about internal models that enable them to calibrate capacity with operating income. If they deploy too much capacity, this eats away at operating income and therefore free cash flow. But if they don’t deploy enough capacity, this upsets customers and erodes the company’s earning power. Indeed, I had no idea that Amazon has developed algorithmic models to help them manage this complexity.
These models exemplify how investors don’t need to be aware of a company’s every single action. Far more important is an understanding of its culture sufficiently enough to maintain confidence in their execution. Here’s what Andy Jassy said about the models during the call:
So most companies deliver more capacity than they need. However, if you actually deliver too much capacity, the economics are pretty woeful and you don't like the returns of the operating income.
And I think you can tell from having -- we disclosed both our revenue and our operating income in AWS that we've learned over time to manage this reasonably well. And we have built models over a long period of time that are algorithmic and sophisticated that land the right amount of capacity.
And we've done the same thing on the AI side. Now AI is newer. And it's true that people take down clumps of capacity in AI that are different sometimes. I mean -- but it's also true that it's not like a company shows up to do a training cluster asking for a few hundred thousand chips the same day? Like you have a very significant advance signal when you have customers that want to take down a lot of capacity.
Moat strength tracks network frequency.
In doubling its size, Amazon also decided to regionalize its distribution network. Per Andy Jassy’s remarks during the Q2 2024 call, this promises, ultimately, to increase the frequency of the network–or in other words, how often people shop at Amazon:
But at the same time, we found a number of other areas where we believe we can take our cost down while also improving the customer experience. One of the great things about regionalisation was it not only took our cost to serve down, but it meaningfully changed the speed with which we're able to get items to customers.
As Amazon delivers a broader range of SKUs within 24 hours, customers come to rely on Amazon for more of their daily needs. This naturally increases Amazon’s revenue per customer, but also has the ultimate effect of strengthening the moat. By dropping prices per every increment in selection and speed (ultimately a form of convenience), Amazon makes it harder for others to compete. As the frequency of the network increases, the difficulty in competing with Amazon increases disproportionately.
I hear Andy Jassy talking about this for the first time during the Q2 2024. Increasing ARPU (average revenue per user) and, most importantly, the defensibility of the operation should accelerate the profitability of the e-commerce business going forward:
As we lower our cost to serve, we can add more low ASP selection that we can support economically, which coupled with our fast delivery, puts Amazon in the consideration set for increasingly more shopping needs for customers.
Services begin to outpace products.
In the Amazon deep dive I also pointed out that services were set to become the most important component of Amazon’s income statement. Since Q1 2023, services have grown from 55.26% of all revenue to 58.39%, as you can see in the graph below, with products now accounting for just over 40% of total revenue. What’s particularly interesting about this trend is that Amazon’s gathering data on three core components of the economy via its digital services: developers via AWS, companies via its 3rd party services, and consumers via Echo. The financial rewards from then training AI models on this data and leasing them out to the world could surpass the revenue from all its current operations.
Amazon is simultaneously building out a Generative AI stack, which Andy Jassy commented on again during the Q2 call. The stack has three layers: one to help folks build models, another to manage all the complexities involved in training (Amazon Bedrock) and deploying them, and lastly one to run applications (Amazon Q). The most immediate result from this stack is not only more revenue on the computing side, but a personal shopping assistant called Rufus. When asked about the potential of Generative AI during the Q2 2024 earnings call, Andy Jassy said the following:
Generative AI especially is quite iterative, and companies have to build muscle around the best way to solve actual customer problems. But we see so much potential to change customer experiences.
We see it in how our generative AI-powered shopping assistant Rufus is helping customers make better shopping decisions.
While the above requires time to crystallize into profit, Amazon’s revenue from advertising continues to grow rapidly and will likely reap sooner rewards. In the graph below, you can see how total advertising revenue compares to AWS revenue. It’s become increasingly meaningful for Amazon, magnified further by its high margins. In the Q2 call Jassy explained that advertising is a key component of profitability in the North America segment and,best of all, that this is just the beginning:
For perspective, we've added over $2 billion in advertising revenue year-over-year and generated more than $50 billion in revenue in the trailing 12 months.
[…]
Sponsored ads drive the majority of our advertising revenue today and we see further opportunity there. Even with this growth, it's important to realize we're at the very beginning of what's possible in our video advertising.
With ads and prime video, the exciting opportunity for brands is the ability to directly connect advertising that's traditionally been focused on driving awareness, as is the case for TV, to a business outcome, like product sales or subscription signups.
That last comment from Jassy points to what I would term performance branding. Traditionally, marketing dollars have applied either to branding or performance marketing, the former consisting of creating brand awareness, the latter optimizing for a specific goal–i.e., ultimately, a service or product sale. Amazon’s opportunity is in combining the two to offer a value proposition not available anywhere else and that, in essence, promises to give advertisers a better overall return on their marketing dollars.
Going forward, much of Amazon’s incremental CapEx will likely be directed towards AI. Much like with other technological trends, there is no guarantee that the enthusiasm will not go through ups and downs. However, the north star for Amazon investors should be whether the company continues to expand on its three core value drivers across its business and whether the company remains faithful to its values or not. This time around, this simple approach has worked, with the stock up 184.7% since I indirectly purchased Amazon (advising close relatives to buy), in line with my analyses of other excellent companies.
Incidentally, the above mental framework seems also to explain why investors capitulated on Netflix stock in late 2023, only to then see it bounce back 288% from the lows to date. You can read the update on my Netflix deep dive below. I look forward to studying these two companies in order to continue iterating my mental framework.
This is also the same mental model behind my Meta call, although I did not invest in the company. In late 2022 the market punished Meta for investing heavily in AI servers. The market thought for some time that Zuckerberg was betting the house on the Metaverse and the narrative gained traction. But this was not the case and again, due to the ongoing cultural optimization of the company, Meta has emerged far stronger.
The Meta case is particularly insightful because in the subsequent quarters Zuckerberg mentioned repeatedly the importance of a culture that ultimate leads them to iterating faster than competitors and how this keeps them ahead. You can read my Meta deep dive below:
Until next time!
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Antonio, keep this free pls... great content, huge alpha!!!
Great stuff