October 27, 2017

Stocks rebounded yesterday amid some more favorable earnings reports. Economic news continued good. Unemployment gains, which had spiked right after Harvey and Irma, have fallen back toward historic lows. The ECB said it would cut the rate of bond purchases but might continue the program for longer, a sign that easy money and low inflation are likely to persist in some form for the foreseeable future.

After the close of business last night, there was a series of very strong earnings reports from Alphabet# (formerly Google), Amazon, Intel#, and Microsoft#, four tech giants. To old school investors, safe may still mean names like GE#, Procter & Gamble# and AT&T#. But in today’s world, companies that aren’t proactively pushing as hard as they can to innovate and grow are destined to wither and sometimes die (think Sears).

The problem with Macy’s isn’t Amazon. Its Macy’s. If someone buys a Kitchen Aid mixer on Amazon rather than at Macy’s, it isn’t because Amazon offers a better product. They both offer the same product. Amazon might offer it at a lower price, but that is their choice. It is also likely that some entity other than Macy’s is capable of offering the same mixer at an even lower price than Amazon. No, the reason Amazon wins that sale and Macy’s loses isn’t just price. It’s a whole other set of factors. Amazon delivers it for free. Amazon has a simple no hassle return policy. When I look on Google for Kitchen Aid mixers, Amazon pops up on the first page, not Macy’s. If I am not sure what mixer I want, Amazon offers dozens of choices. At best, Macy’s offers one or two.

Amazon didn’t start with any advantage over Macy’s. It didn’t even exist a generation ago. It wins because it keeps making itself better every day, offering more products, better service and faster delivery. Its web site is better. So is its phone app. Amazon Prime adds services and features for its best customers. Ask Alexa.

Despite Amazon’s great growth and great power, it doesn’t win every battle. It tried to enter the phone business and failed. Maybe someday it will try again, but the reason it failed is that Amazon couldn’t offer a better value proposition than Apple#, Samsung or even Google. It just bought Whole Foods. Supermarket company stocks got killed as a result, but we will see how the battle unfolds. Amazon made a lot of news about how it was lowering some prices at Whole Foods, but those who have tracked the price changes to date see very little overall change. It has dropped some products and added a few others, but I doubt, for now, that you can tell the difference before and after, except for the sudden appearance of Amazon lockers in Whole Food

stores. Indeed, maybe that is the Trojan horse of this deal, the ability of Amazon users to have another set of pickup points for products they buy and, by the way, might pick up a few things for dinner on the way out. With that said, good supermarket chains like Wegman’s are going to watch every little move Amazon tries to make and react. Not only will they react, they should proactively push their own respective strengths, everything from lower prices to differentiated product assortments.

This brings me to yesterday’s news. During the day the St. Louis Post Dispatch noted that Amazon received approvals to set up wholesale pharmacies in more than a dozen states. That sent the stocks of drug store, drug retailers and PBMs (pharmacy benefits manager) down once again. Everyone fears what Amazon can and will do. But as I noted above, one can compete with Amazon as long as one can offer an equal or better value equation. One company clearly in the cross hairs of Amazon is CVS#, both the largest drug store retailer and the largest PBM in the country. CVS has close to 10,000 stores across the U.S. I would bet that everyone reading this letter has a CVS within 2 miles of their home (I concede I will lose a few of those bets, but not many). Obviously, CVS is in a better position to deliver a prescription quicker than Amazon can. As the largest PBM, it has relations with major insurance companies, buying cooperatives and leading employers. It is proactively expanding services (e.g. instore clinics) to both end users and corporate customers. But CVS knows that Amazon is a threat. As a result, also in the news yesterday was a story that says CVS is in talks with Aetna to combine. Such a combined company would certainly be better prepared to equal or even exceed what Amazon might offer. Amazon is very adept at lowering prices, but price alone rarely wins. There is nothing Amazon might sell or offer that a combined CVS/Aetna can’t sell or offer. Might Amazon exert downward pricing pressure on the industry? Of course, it could and it probably will if it moves forward. But price alone isn’t going to be a winning formula.

The point is that really good companies are proactive. There is no guarantee that CVS and Aetna will hook up, and there is no guarantee that whatever CVS will do in response to the Amazon threat might work. But CVS is being proactive, not reactive the way Macy’s has been. It is innovating and changing with the times, adding services to both corporations and retail. These changes may or may not work, and one can only speculate what they might mean to future profits.

We do know, however, that tomorrow’s winners are going to come from the proactive group of companies, not the reactive group. Comcast# lost about 100,000 video customers last quarter to cord cutting. AT&T lost almost 600,000 on a much smaller base. Comcast’s offset was strong growth in its broadband business. AT&T never really built a competitive broadband offering.

There was a time when owning those old rocks of Gibraltar kinds of companies was comforting. I would suggest it is a lot more comforting today to own the disruptors than the distruptees. If there was any doubt, last night’s earnings reports add an exclamation point.

Today Lonzo Ball is 20. Marla Maples is 54. John Cleese is 78.

James M. Meyer, CFA 610-260-2220

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

Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.

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