Amazon Looks Undervalued

Despite several busy weeks highlighted by the proposed acquisition of

Fulfillment, marketing, and technology/content expenses continue to run at a higher clip than a year ago, which would be a concern if there wasn't evidence that the network effect supporting Amazon's ecosystem remains strong. We see this in the acceleration in third-party seller revenue (up 37.5%, suggesting Amazon is becoming an indispensable channel for third-party sellers), paid units (accelerating to 27%), and subscription revenue (up 51%, signaling consumers are becoming more engaged on the Amazon platform).

The more important takeaway for investors is that we see signs that the building blocks of longer-term free cash flow growth assumptions may be evolving and becoming more durable, lending further credence to our wide moat rating. Our medium-term operating margin assumption of 7%-8% has long been a function of Prime memberships, third-party sales, and Amazon Web Services, with advertising and Internet of Things/licensed technology offering upside.

We believe these pillars are intact--supported by 130 basis points in gross margin expansion--but also becoming more dynamic. For instance, Whole Foods will give Amazon various ways to engage with Prime members (and drive higher membership fees), while adding brands like

We plan to adjust our 2017 operating margin outlook to 2%-3% (versus 3.1% a year ago) and raise our top-line forecast to around 25%. Over the next five years, we expect average annual revenue growth of 22% and still see operating margins of 6%-7% operating margins as achievable. As such, we don't plan to change our $1,200 fair value estimate and view shares as undervalued.

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