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The Economic Moat of Amazon

Warran Buffett always remind us that many of his long term holdings in Berkshire Hathaway were bought not at the cheapest price. In fact, chart wise they would have looked expensive.

However, the great thing about the businesses he bought is they have features that make them able to earn great cash flow for a prolong period.

So much so that such a good company he is willing to pay fair or even moderately above fair value for it.

Such companies should typically have high Return on Assets (ROA) or Return on Equity (ROE). Not only high, but a history of consistently high ROA and margins.

How do they do that? Because of certain economic moats.

Amazon at 179 times earnings

Vitaliy Katsenelson, a CIO whose known for his value investing methodology, has this article in Institutional Investor on why amazon may be worth 179 times earnings.

He cites Josh Tarasoff’s opening presentation in VALUEx conference where Josh discusses the features of Amazon

Josh’s take on Amazon was that it changes the way we shop. Our normal brick and mortar shopping habits are simple: We go to stores every so often, where the merchants have performed their “black art” of merchandise selection, trying to maximize their limited real estate to have the highest appeal to the average shopper (to be more precise: the shopper with the largest wallet). Amazon doesn’t try to appeal to the average shopper or to the wealthiest one, it appeals to the most important shopper — you. Its merchandising strategy is simple: Supply everything! With the Internet and thus Amazon being on our smart phones, tablets, PCs, etc., we can shop on Amazon whenever we realize we need something — instantl

This is basically substitutes taking place and disruption in old world model.

Amazon is habit-forming for younger generations and habit-changing for older ones. This way to shop will gradually become embedded into the DNA of younger generations. A few days ago I needed an iPhone car charger. I didn’t add it to my mental shopping list of things to buy next time I go to Best Buy, I simply fired up the Amazon app on my iPhone and bought it. I almost cannot think of a second website where I’d go if I needed to buy something. I might Google it if it was an expensive item; if not I’d just go directly to Amazon.

Habits will change, but the reason they are called habit is that its hard to change. And that makes it a very unfair advantage.

Amazon’s brick-and-mortar-free cost structure puts it at a competitive advantage against other retailers. The thing I find very refreshing about Amazon is that it allows its competitors to post their merchandise on the Amazon website — they can even do so at lower prices if they like. If a customer buys the competitor’s product, Amazon still makes a commission on the sale. Though we’ve been conditioned by Amazon to think of this as a normal way of doing business online, think about how this would look in the brick-and-mortar setting. Imagine Kohl’s allowing Target to put its pair of Nike shoes right next to Kohl’s pair of the same shoes, at a lower price.

Cost is not the most durable advantage, unless in special situations where you can be the lowest cost but your competitors can never copy you due to these advantages.

Web has brought us the power to compare. The crazy thing about Amazon is they are the market leader in terms of online retailing, but they also innovate so that they get to earn from it as well.

Moat narrows and widens and in Amazon’s case, you probably have to think out of the box when you analyze and value them. Their competitors are no slouch in disrupting the market place.

Would love to hear your thoughts on this.

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wee

Thursday 2nd of August 2012

I would not disagree with most of the other points by the writer.

wee

Thursday 2nd of August 2012

Drizzit

Somehow I am not yet convinced that Amazon has the durable cost advantage compared to the big box retailers if we factor in the shipping cost, the sales tax (which currently is not imposed on online transactions), and the decent profit margin that it needs to earn over the long run (currently, Amazon is sacrificing profit margin for market share). But I would agree its going to eventually take significant sales away from big box retailers, especially those that do not adapt.

Also, I find Jeff Bezos to be extremely critical to Amazon. The stock market believes in him, and hence accorded Amazon a 170x PE. Any lesser mortal would not be able to do the same, and if the share price of Amazon does not hold, sooner or later Amazon will be forced to increase its profit margin. This is especially so since they employ stock based compensation.

I would love to hear your thoughts.

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