It seems like an eternity ago that Amazon (AMZN) was above $2,000 a share and was the second US publicly traded company to hit a $1 trillion market cap. In reality, it was a mere two months ago. Since then, the market has taken a tumble, with Amazon falling particularly hard, losing about a quarter of its value to sit at around $1,600 a share.

During that time, Amazon released its third quarter earnings. There was a lot to like:

• Earnings per share was $5.75 versus an estimate of $3.14
• Operating income was $3.7 billion versus an estimate of $2.1 billion
• Total revenue increased 29% year over year
• Amazon Web Services (AWS) sales increased 46% year over year
• Their “other” category, which seems to be mainly comprised of their advertising business, increased a whopping 123% year over year

So why did the market react negatively to the news? It largely seemed to be due to weak fourth quarter guidance. Wall street was hoping for $73.79 billion in revenue whereas Amazon guidance was in the range of $66.5 billion to $72.5 billion in revenue: a difference of about 2% for the high end of their range. Call me crazy, but the resulting 10% drop in the stock price seemed like a bit of an overreaction to me. I’m still a huge believer in Amazon over the long term. Some perspective is also in order. Even with the recent huge drop, Amazon is still up around 30% for 2018. I would be seriously considering adding to my position if Amazon weren’t already the largest position in the Freedom Portfolio.

As of the writing of this post, Amazon is a Babylon 5 level holding and is the largest holding in the freedom portfolio. It is also the second best performer to date in the freedom portfolio. I initially purchased my shares of Amazon for $256 a share in April of 2013. Shares are currently trading near $1,600, which is an increase of around 480% and a huge outperformance over the S&P 500 during that time (see the flat-looking blue line below).

Amazon is the company that I have the highest conviction in and I believe it has a truly enviable combination of high upside and low risk. Below, I will lay out the reasons I love Amazon as an investment, along with potential areas of concern and conclude with the P.A.U.L. score.

Pros

Leadership

I’m not sure there is a more universally respected businessperson alive than Jeff Bezos. His singular vision has managed to propel Amazon from a tiny online seller of books to a global behemoth with a market cap of $1 trillion (although it has given back a lot of that lately). His obsession over customer satisfaction and his Day 1 philosophy are hugely responsible for the success that Amazon has seen. I can’t imagine somebody I would rather have leading the company that is my largest holding. 

E-commerce dominance

When it comes to United States e-commerce sales, Amazon is completely dominant with close to a 50% market share. The next closest competitor doesn’t even have double digits. Even scarier? They’ve been gaining market share. Accounting for 50% of e-commerce sales might make it seem like there’s not much room for growth, but consider that even with that dominance, Amazon still only accounts for 5% of total retail sales in the US. There is still a lot of opportunity for Amazon to grab a larger market share of total retail sales, especially if they start expanding their physical store presence.

AWS – Amazon Web Services

It feels like I’ve been hearing about things “moving to the cloud” for decades. In recent years, it finally seems to be happening, and Amazon is one of the leaders. Amazon Web Services now provides the majority of Amazon’s profit, which allows them to keep their margins small in their e-commerce operations while still investing heavily in new ventures. IBM (IBM) spent $34 billion to acquire Red Hat and one of the major narratives was that it was an attempt to play catch up in cloud computing. That should give you an idea of the opportunity that the cloud represents, and Amazon is one of the leaders.

Prime

While Amazon Prime is beneficial in that it provides consistent recurring revenue for Amazon, the perhaps less obvious benefit is how it helps to lock people into the Amazon ecosystem. There’s plenty of music streaming services, but why choose Apple or Spotify over Amazon Music if you’re already a Prime member? Want a smart home device? Being a Prime member might be a tie-breaker when deciding between competing Google or Apple products. 

Streaming Video

While Netflix is the big name in the streaming video space and the clear leader, Amazon is certainly no slouch. While their originals haven’t quite earned the same critical acclaim as Netflix yet, they’re well positioned to continue to ride the wave of cord-cutting and the transition to online video streaming.

eSports

Speaking of online video streaming: One of the big trends that I have been keen on following is eSports, where people watch other people play video games the same way they watch players play football or baseball. A few years ago, Amazon bought Twitch, one of the leading video game streaming sites. While it’s difficult to say how much it might be worth now, there have been some estimates that say it could be worth $20 billion in the very near future. While eSports is still in the early innings in many ways in terms of recognition among the general public, it already has some surprisingly large numbers associated with it in terms of prize money and viewership.

Traditional Sports?

Amazon has bid on the 22 regional sports TV networks that the justice department has forced Disney (DIS) to sell as part of their takeover of Fox assets. With the entire entertainment industry in flux due to cable cutting, video streaming and the entrance of deep-pocketed tech companies, live sports could be something else that gives Amazon an advantage over the traditional media companies going forward. Paired with eSports, this kind of live entertainment could also give Amazon a leg up over Netflix in the future.

Whole Foods

While on the surface it would seem to be an odd pairing, the Whole Foods acquisition opens up a lot of possibilities for Amazon. Americans spend a lot of money on groceries, and if Amazon can develop a better way for people to buy groceries, it gives them another massive opportunity. They’ve already been experimenting with grocery stores without checkout lines. That doesn’t even touch on the opportunity for grocery delivery or a meal prep service like Blue Apron.

Amazon Delivery Services

Speaking of delivery, Amazon has also started working towards their own delivery service. In fact, just today I saw two Amazon Prime delivery vans on the road and a week or so ago I drove by a parking lot lined with dozens of them. It’s not necessarily their biggest opportunity, but it is an important one. Amazon spends billions of dollars on shipping a year. Getting more involved in delivery gives them greater ability to control shipping costs and greater quality control over shipping as well. I’m also hoping it is one step closer to the drone delivery service they teased us with a few years ago.

Connected Home

Everybody probably knows about the Amazon Echo family of products and Alexa, but Amazon hasn’t been content to stop there. Did you know Amazon has an Alexa powered microwave? While some of these ideas might seem ludicrous, and I’m sure many will end up failing, it’s worth reflecting on just how far we’ve come in terms of the connected home. Just a decade ago, this type of voice interaction with digital assistants seemed firmly in the realm of sci-fi, like the computer from Star Trek. Now, it seems a whole lot more feasible. I’m by no means a cutting edge adopter of smart home technologies, but I recently tried out a few smart plugs to go with my Echo Dot at home. Now, instead of having to manually plug in Christmas lights all over the house, I can simply say, “Alexa, turn on Christmas lights”, and all of the lights magically turn on (accompanied by Christmas music if I wish). It may seem like a small thing, but the kid in me still found it pretty magical, and I can’t wait to see what’s next.

Advertising

Can you name the top digital ad sales platforms in the United States? I imagine most of you would guess Google/Alphabet and Facebook. Some of you might even get Microsoft and Verizon. And because I’m asking the question here, I’m sure you’re expecting Amazon to be up there, but would you have expected them to be 3rd? This is a huge opportunity for Amazon because it’s such a high margin business and because they have so much information on customers who are often on their site because they’re ready to buy. That’s invaluable for marketers.

India

China has been largely closed off to Amazon thanks to some strict Chinese government regulations which have favored domestic companies. However, India’s massive population and growing economy presents an opportunity which could be just as big, if not bigger. Amazon seems to recognize this, and has been investing billions of dollars in their operations there. Amazon doesn’t have nearly the dominance in Indian e-commerce as it does in the US, as Amazon and the Walmart backed Flipkart are basically tied for first. However, 

Cons

Bezos stepping down

Just as Bezos’ leadership is a big benefit for Amazon, it’s only fair to also count the possibility of him someday leaving as a potential risk as well. Bezos is only 54 years old, which is relatively young (especially compared to 88 year old Warren Buffett), and he has shown no indications that he is thinking of stepping down anytime soon. However, Bill Gates stepped down as CEO of Microsoft at the age of 45, so being young is no guarantee against leaving a business. Bezos also notably has other interests, such as space flight company Blue Origin, the Washington Post, and now also his Day One Fund. I don’t see Bezos leaving Amazon anytime soon, but at the same time, it wouldn’t completely shock me to see him step down to a smaller role in the next 5 years. Will Amazon continue to be as relentlessly innovative when that happens? Hard to imagine it will.

Government intervention

I’m old enough to remember when people were terrified that Microsoft was an all powerful monopoly that was going to dominate the world for forever because they bundled Internet Explorer with Windows. While that might seem silly now, it didn’t stop the government from suing Microsoft and there was a real concern at the time that the government might force Microsoft to break up. There haven’t been many serious rumors about the government taking action against Amazon, but it’s hard to ignore just how intensely the President seems to dislike the world’s wealthiest man. Amazon has also come under attack from the left as well. Amazon’s percentage of total retail sales is probably small enough to keep them safe for now, but it’s a situation worth keeping a wary eye on. Concern over government action might’ve played a role in why Amazon decided to place one of their new locations (hard to call it a headquarters when there’s three of them) so close to Washington DC.

Foreign competition

Amazon is a big deal in the United States, but it’s had more mixed success overseas. As mentioned above, Amazon is in a pitched battle with Wal-Mart (WMT) owned Flipkart. In Latin America, they’re playing catch-up to fellow Freedom Portfolio-er Mercado Libre (MELI). In China, Amazon has virtually no presence at all. Furthermore, there are some pretty big Chinese companies like Alibaba (BABA) and JD.com (JD) which could conceivably compete with Amazon quite effectively outside of their own home markets. Ultimately, the biggest threat to Amazon might not come from domestic competitors, but foreign ones.

P.A.U.L. Score

Protected: 4

As mentioned above, Amazon has a pretty unassailable lead in the e-commerce space which is continuing to grow. Their growth into other areas like video streaming, tablets, and Alexa-enabled devices just continues to grow their ecosystem that people get more and more attached to. It’s difficult to see how anybody disrupts them in those areas anytime soon.

At the same time, Amazon isn’t invincible. Microsoft has made big gains in the cloud computing space and Amazon hasn’t been nearly as dominant overseas. Therefore they get a good, but not perfect score.

Alternatives: 5

You may recall in my explanation of the P.A.U.L. System that I used Amazon as the textbook example of a company that has not only a proven track record of trying to new things, but also a lot of optionality going forward as well. Amazon does so many things, but there’s still so much more it could do. They’re just starting to dip their toe into physical stores or fully automated grocery stores. Maybe in the future they get into meal kits or food delivery. They’ve started working on their own delivery service. Could drone delivery be in the future? Amazon has gotten into movies and music and TV shows, along with streaming eSports, so why not get into video games? The possibilities almost seem endless.

Understandable: 4

Despite being involved in so many different businesses, I find Amazon to be relatively easy to understand because they all largely work on the same basic model of finding ways to make things easier/cheaper/better for the customer and making money that way. 

Long Runway: 5

As mentioned above, while Amazon dominates the US e-commerce market, they’re still a small player in terms of total retail sales. As people get more comfortable with ordering stuff online and as Amazon gets more and more efficient with reducing the time from order to doorstep, I have to imagine their market share for total retail sales will rise. The Whole Foods acquisition and expansion of physical stores should only accelerate things.

What’s more impressive than the long runway ahead of them for total retail sales in the US, though, is the sheer number of other runways they have in front of them in other areas. Amazon’s eSports and cloud computing and streaming video offerings should only continue to expand and the opportunities in India and the connected home seem like they are still in their infancy. I can’t think of any other company that has so much opportunity in front of them in so many different areas than Amazon has.

Total Score: 18

An incredible score, considering the max is 20. Truly a score befitting my only Babylon 5 level holding. Amazon has certainly taken it on the chin recently, along with all of the FAANG stocks, but I’m still a big believer. If it wasn’t already my largest holding, I would certainly be thinking about adding to it here. It’s hard for me to imagine a world where, 5 years from now, Amazon isn’t a dominant player in some way.