Is Amazon the new Standard Oil?

Peter Garnry

Head of Equity Strategy

Last Tuesday, Amazon reached a market value of $1 trillion, joining Apple in this exclusive club for giga-cap stocks. Amazon has now delivered a total return to shareholders since its IPO of around 39.8% annualised, which is an impressive accomplishment. The bigger question is whether Amazon will be allowed by regulators to double again. On Friday, the New York Times ran an article about a young law student, Lina Khan, who in early 2017 published a scholarly article in the Yale Law Journal called Amazon’s Antitrust Paradox. Here she lays out what might come next in regulating technology companies. As we have been arguing since last year, technology companies are the most interesting industry in the global equity market but they come with an important regulatory risk that by nature is negative for profitability.

A new Standard Oil rises

Since last Tuesday, Amazon’s market value has dipped below $1trn again but using the more rightful metric called enterprise value (market value + net debt, essentially what you have to pay for acquiring a company) Amazon commands the top spot in global equity markets with an enterprise value of $971bn with Apple taking the second place with $939.7bn. As the NYT article argues, the current antitrust framework dates back to the 1970s and focuses on consumer welfare. If a company increases consumer welfare, it is not doing any harm. Lina Khan’s scholarly article, however, goes back to arguments used in the 1940s after World War II, thus broadening the scope of antitrust regulation away from just consumer welfare.

On the surface, Amazon (despite its enormous enterprise value) looks small with only a 4% US retail sales market share. Amazon’s revenue was $208.1bn in the last 12 months and is expected to reach $286.2bn in 2019. This compares with Walmart’s $510.2bn in revenue in the last 12 months. Focusing on these aggregate numbers, Amazon does not look like a threat. Indeed, many consumers only see the good side with low prices constantly being pushed upstream to consumers while downstream is where Amazon exerts its power.

Amazon’s four key businesses are cloud, e-commerce, Amazon Prime, and voice home devices. New York University marketing professor Scott Galloway has shown through research in his L2 company that Amazon has dominant market share in all four businesses. The cloud business is essentially powering the global Internet business and here Amazon is dominating massively. Some estimates that Amazon’s US cloud business is five to six times larger than that of number two-ranked Google.

While Amazon only has a 4% retail sales market share, it has a whopping 44% in online commerce which is where most businesses are focusing their growth, and e-commerce will continue to take market share against physical sales. Surveys suggest that companies are indicating that they often feel they cannot do business without using Amazon for distribution. This is market control, despite what the aggregated numbers say.
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Source: l2ink.com
If we go one notch deeper into Amazon’s business, it becomes clear that Amazon has almost achieved full dominance in several key online businesses. For instance, of all batteries sold online Amazon has a 97% market share. If you are a seller of batteries and you are seeing growth in online sales while physical store sales are flat, then you would obviously like to expand online. But here you will meet Amazon and its near-total dominance.

Guess what, you are not in control of negotiating the price on batteries.

This is probably the most important insight into Amazon. Forget the headline numbers: deep below, Amazon basically controls a few large retail categories. On top of that, when you also control a vast cloud infrastructure empire, you indirectly control a large part of businesses across many industries. 
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Source: Jumpshot
The comparison between Amazon and Standard Oil is increasingly being made. Standard Oil was the giant US refinery business that in the last decades of the 19th century gobbled up many competitors through aggressive acquisition offers using their own shares. If competitors declined, Standard Oil would just lower prices below production costs in the geographical area where the competitor was operating. Standard Oil used its balance sheet and other profitable refining businesses to subsidise the price cut, eroding the health of the competitor’s business until they agreed to be acquired.

Over time, Standard Oil branched out of its narrow refinery business through vertical integration into controlling logistics etc. This is exactly the same strategy Amazon is currently pursuing with building up its own logistics business. Vertical integration ensures that any business process that is not sourced from the market, and that you can produce cheaper internally, lowers operating costs which you use to slash prices even further, strengthening your position in your final markets.

Lina Khan lays out arguments for why some of Amazon’s business could be viewed as an essential utility for the economy and thus should be allowed to be accessed on nondiscriminatory basis. This is how former Danish state-owned telecommunication company was forced to allow new mobile communication competitors onto its network at prices that ensured profitability for new entrants into the industry. Over time, this created more competition and lower prices. In Amazon’s case, prices are already low creating direct consumer benefits. But the larger question for regulators is whether the cost of Amazon is showing on other places in the economy, offsetting the visible effects in retail.

Scott Galloway goes even further in an antitrust critique published in Esquire that argues for increasing regulation on Amazon, Apple, Facebook, and Google. We are definitely not antitrust experts but our aim with this analysis is to present what we think is the key risk to Amazon and other major technology companies: the winds are blowing in the direction of more regulation. As we know in the financial industry, it is a long journey but over time it will constrain the business.

The flipside of the regulatory risk is obviously enormous earnings power. Amazon generated $9.2bn in free cash flow in the last 12-months. While many other companies in the world generate more in free cash flow, it is the future trajectory that’s mind-blowing. Amazon is expected by Wall Street to grow its free cash flow to $26.4bn in 2019, showing that the company has reached an inflection point where its economies of scale are now powering strong profitability.

As the price below shows, the market is currently buying into positive growth story and placing little weight on the regulatory risk.
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Amazon share price (five years, source: Saxo Bank)

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