Amazon's Cash Flow Potential Too Good to Pass Up

Wide-moat Amazon AMZN capped off 2018 with strong fourth-quarter results that solidified our views about the company's ongoing shift from purely a growth story to one that better balances cash flow generation through margin-accretive offerings such as third-party services, new Prime membership tiers and subscription platforms, expanded AWS functionality, and advertising (with Alexa licensing offering a potential future contributor). The market continues to pressure the stock due to first-quarter 2019 revenue guidance of $56 billion-$60 billion (up 10%-18% compared with 20% in the fourth quarter), and while we acknowledge that there are legitimate questions about international markets such as India, we believe the more relevant takeaway for investors is that Amazon's 2018 moves make it a more dynamic company with greater monetization opportunities over a longer horizon.

Gross margins improved 180 basis points to 38.1%, which was a bit weaker than trends earlier in the year due to holiday shipping offers, but still reinforce the idea of Amazon as a more consistent cash flow generator. Just two years ago, most investors would've scoffed at the notion of Amazon posting mid-single-digit operating margins, but with gross margin expansion helping to drive full-year operating margins of 5.3% (versus 3.5% last year), we believe our longer-term operating margin target of 8%-9% looks more palatable. Admittedly, management noted that it expects headcount, fulfillment, and AWS investments to accelerate in 2019, but we believe the evolution of Amazon's advertising, third-party services, subscription, and logistics businesses supply it with enough slack to post 6% operating margins for the year.

We're not planning changes to our $2,200 fair value estimate. We expect some volatility over the near future as the market adapts to Amazon's growth/profitability algorithm but ultimately believe the cash flow potential of its evolving business model is too much for investors to pass up.

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