August 2, 2017

Stocks continued to rise after a strong report on July manufacturing reinforced the conclusion that the U.S. economy is on solid footing. While construction spending fell, it was all due to a sharp drop in government construction spending. Some of that is seasonal; some due to the lack of any fiscal initiatives to date in the Trump administration. With so much bad news surrounding the White House lately, President Trump is tweeting regularly about record highs in the Dow. While it is hard to say that the Trump agenda to date is responsible for higher earnings, low interest rates, lack of inflation and a weak dollar, when one can’t repeal Obamacare, and political pressures are heating up around the world, taking credit for record stock market prices is only a modest stretch to demonstrate how he is making America Great Again.

This will be a big week for economic data, culminating in the labor report on Friday. So far, the data is right in line with expectations. The one very obvious weak spot is auto sales. Easy financing pulled demand forward last year into this year. Now everyone who deferred buying a new car in the recession has done so. There is no sign whatsoever that the auto industry is headed for a repeat of 2008-2009, but annual sales of about 16-17 million vehicles, plus or minus, is probably a stable and reasonable target for the next few years. Most of the recent weakness has been in fleet sales and hybrids. SUVs, trucks and crossovers are doing fine. With the consumer showing signs of spending once again, with housing doing OK, and with manufacturing healthy, our economy is now back on track, growing at an annualized rate of 2%+.

As earnings season winds down without any disturbing changes in the economy to talk about, I want to switch this morning and talk about Amazon. Let me start and make it clear that I have no intention of making any recommendation on the stock price. According to analyst consensus, Amazon will earn about $18.50 in 2019 and it currently sells for about $1000 per share. It’s a great company and all that but, as investors, we buy stocks and not companies. I can’t get my hands around making an argument to buy a stock at over 50x earnings two years from now, especially a company that already has a market cap approaching $500 billion. I will leave valuation and stock recommendations to others.

Instead, I want to talk about what Amazon represents, and what it means to our economy. Right now, everyone thinks Amazon can take over the entire economic world if it so desires. Recently, it said it might start selling Kenmore appliances. Immediately, Home Depot, Lowes# and Whirlpool# fell 4% each. Whirlpool even makes Kenmore washers and dryers. Why would they suffer? Remember, Kenmore is the house brand of Sears, a company that is in such bad shape that its accountants question its ability to remain, a going concern. Amazon said it might put more emphasis on auto supplies, and every auto supply retailer stock cratered. Same for the supermarkets after Amazon agreed to buy Whole Foods. Forget that Whole Foods accounts for less than 1% of supermarket sales in the U.S. As far as everyone is concerned, if Amazon wants something, only the scraps will be left for everyone else to divide.

This isn’t the first time we have witnessed this phenomenon. Not long ago, it was Wal-Mart# that would crush everything in its path. Many years ago, Toys ‘R Us was going to do the same in its niche. Today, it is struggling to survive.

Without saying it explicitly, what people are really saying, is that Amazon executes retailing better than anyone else and, therefore, until someone does a better job than Amazon, it can continue to capture share, almost at will.

Doing a better job doesn’t simply mean selling at the lowest price. Indeed, it is rare that Amazon’s prices can’t be beat someplace on the Internet or even in some conventional stores. Wal-Mart, for instance, competes very well against Amazon on price. But superior execution is about far more than price. It is about service. In the Internet world, it is about making it easy for customers to find everything and buy what they want as simply as possible. If I know what I want, I can go to the Amazon web site and complete the transaction in less than 60 seconds. Try that on macys.com. It means reliability. It means easy returns with no questions asked. It means innovation. Look how the Kindle changed book reading.

Amazon can’t do everything. I never thought of buying a bag of ice on the Internet. Amazon is trying to sell fresh food, but it is probably beyond its scope to become the most efficient high quality purveyor of fruits, vegetables and fresh meat. I have no intention of buying fresh bagels there either. Appliances puzzle me as well. Obviously, the Amazon website will be the forward-facing front for sales of Kenmore appliances. But appliances are heavy, they still have to be delivered and installed, and, over the years, they require service. Granted Amazon can arrange all of the above using Sears existing network to deliver and service products, but I don’t see the competitive advantage. Competition will match price because it will have to. Differentiation is the key. I see it in general merchandise. I see the value of Prime to Amazon customers. But some products just don’t fit the mold.

Customization isn’t a logical strong point either. You aren’t going to get duplicate keys made on Amazon. But with all that said, what Amazon has done for years now is perfect a highly efficient logistical system to deliver millions of products from its warehouses to your doorstep. While it can do it all itself today, Amazon is also both a front and back end to independent merchants who want to pay and take advantage of Amazon’s web presence and its efficient ability to move product and collect payments. Finally, its Prime service for loyal customers keeps them coming back to Amazon for almost everything (but not ice and keys!).

In short, Amazon has built a better mousetrap.

But, we live in a wonderful capitalist society with plenty of money and innovation. Others see what Amazon has done and they have emulated them. Amazon seemingly sells everything. Most of its competitors sell more narrow selections in vertical markets like Warby Parker for sunglasses or Casper for mattresses. Niches are suddenly appearing everywhere from no-wedgie men’s underwear to half-sized bras. If you can develop a unique brand and match Amazon’s ease of use and delivery time, you can succeed. None of this is slowing Amazon, at least not yet. But if Amazon is going to continue to grow and dominate, it must get even more efficient and build an even better mousetrap. That is why it constantly experiments. Look up. Is that an Amazon drone making your delivery?

Amazon moves quickly. What brings companies down so many times is that too often the reality that size brings with it bureaucracy and slower speed. Before you know it, some upstart one ups the innovator. Amazon today, however, shows no signs of slowing down.

What does this mean for conventional retailers? For most, it means big trouble. Big retailers are already entangled by their own layers of bureaucracy. When they focus and increase their speed, they think they are moving fast, but they aren’t. They may improve their value and service, but so far, most aren’t able to close the gap with Amazon. Some can, however, and others are trying. Good examples among big name retailers in this regard are Wal-Mart, Home Depot and Best Buy. Some have their own protected niche and appear immune, at least for the moment. Louis Vuitton comes to mind.

Amazon by its very presence has made life easier for all of us, not just because it executes well, but because it is forcing everyone who sells goods and services to do it less expensively and with better service. It doesn’t matter whether I am talking about a department store or a wholesale plumbing supply house. Amazon is also singularly responsible for our ability to make our dollars go further. They set the standard and others followed. Anyone selling anything who is still doing business the same way they were five years ago is probably losing market share. In sum, Amazon and all its Internet offspring have lowered prices, increased service and moved products faster than ever before. You can call it whatever you want, but I’ll call it both deflationary and productivity enhancing.

Today Kristaps Porzingis is 22. Mary-Louise Parker is 53.

James M. Meyer, CFA 610-260-2220

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# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

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