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Good morning. Treasury yields ticked higher again yesterday, and once again, stocks didn’t like it much. I’m starting to wonder if there is some technical reason for the bond rout that goes beyond “higher for longer” fears. Email me your market structure/conspiracy theories: firstname.lastname@example.org.
Amazon may not be a monopoly, but investors sure hope it becomes one soon
Yesterday, the Federal Trade Commission sued Amazon, alleging that tactics fundamental to the company’s online retail business are illegal. The market didn’t much care.
Amazon’s shares were down a bit over 4 per cent, but it was a bad day for markets generally and for tech stocks in particular: the Nasdaq was down a per cent and a half and Apple by more than 2 per cent. And Amazon had been trending down recently, losing 9 per cent of its value over the previous week and a half.
Why the indifference? Part of it is that everyone knew the FTC suit was in the works, and part of it is probably down to the FTC’s lack of success in other recent lawsuits. Arun Sundaram, of CFRA Research, captured the indifferent market response in a note to clients:
The FTC, under the leadership of Lina Khan, has not shied away from undertaking challenging cases, even when the odds of success are low . . . it will be a lengthy and uphill battle for the FTC . . . the FTC could have a tough time defending its stance that Amazon’s current business practices are harmful to consumers. Overall, we see low risk of major structural changes at Amazon. We keep a Buy opinion.
I have no estimate of the lawsuit’s chances of success. Even supposing it is doomed to failure, however, it is important for Amazon investors. The lawsuit accuses Amazon of being an anti-competitive monopoly. Right now, it may or may not be one. But the growth assumptions encoded in Amazon’s share price suggest that Amazon might well become one in the future.
Some background. Lina Khan, the FTC chair, rose to fame because of a paper she wrote while at Yale Law School, “Amazon’s Antitrust Paradox”. The paper challenged a dominant school of US antitrust jurisprudence.
Since the 1970s, the so-called Chicago School, led by the late judge Robert Bork, reduced the scope of antitrust law almost completely to consumer protection. To simplify: so long as prices were low and products were available, the competitive structure of an industry was not a legal problem, the Chicago School held. Mergers that integrated industries vertically — uniting suppliers, manufacturers and distributors — were once considered a threat because they allowed companies to export dominance from one sector to another. Not so, said the Chicago School: vertical mergers increased efficiencies and brought prices down. Undercutting the prices of smaller competitors to drive them out of business was not a problem, either, because such behaviour is economically irrational and therefore rare.
Khan argued that the Chicago School fell down when it came to platform companies such as Amazon and Uber. For one thing, the platform companies had demonstrated that pricing at or below cost was indeed a sustainable way to gain market share. Further, platforms provide the basic digital infrastructure that competitors and near competitors need to grow, and could use that as leverage to stifle competition. As a result, if antitrust regulators wait until prices were being manipulated, they are too late:
Focusing primarily on price and output [as the Chicago school does] undermines effective antitrust enforcement by delaying intervention until market power is being actively exercised, and largely ignoring whether and how it is being acquired . . . disregarding the market structure and competitive process that give rise to . . . market power . . . restricts intervention to the moment when a company has already acquired sufficient dominance to distort competition
The standard response to anyone who says Amazon has too much power in online retail is simple: “They have everything, it’s cheap and convenient, customers are happy, what’s the problem?” It’s a very strong response. Khan’s reply was that over time, platform companies would become dominant enough to increase prices and manipulate rather than meet customer preferences.
Which brings us to the part of Khan’s paper that is directly relevant to markets. She argued that investors were more than willing to tolerate years of low profits from platform companies, and suggested they did this precisely because they foresaw monopoly profits in the future:
One might dismiss this phenomenon [of investing in persistently unprofitable platform companies] as irrational investor exuberance. But another way to read it is at face value: the reason investors value Amazon and Uber so highly is because they believe these platforms will, eventually, generate huge returns. As one venture capitalist recently remarked . . . “I don’t see any cleaner monopoly available to buy in the public markets right now.” In other words, that these platform companies are undertaking consistent, steep losses and still generating strong investor backing suggests that the markets expect Amazon and Uber to recoup these losses.
While investors have unambiguously endorsed and funded online platforms’ quest to bleed money in their race to draw users, antitrust doctrine fails to acknowledge this strategy.
The strategy outlined in Khan’s paper is given concrete form in the FTC lawsuit. It alleges that over time, Amazon has made its services worse by jamming more and more ads to the top of product search results and rapidly increasing fees to third-party sellers on its platform. The declining service quality would normally create room for a competitor, but Amazon pre-empts this by punishing third-party sellers on its platform who sell products at prices higher than are available elsewhere on the internet. Violators see their products made invisible in search results. This makes Amazon prices, which include rising Amazon fees, a floor for the market. Furthermore, any seller who wants to be included in the Prime discount program must use Amazon’s logistics service for delivery, making it impossible for another warehouse and delivery program, which might form the kernel of an Amazon competitor, to compete and grow.
I don’t have any assessment of these arguments, and even if Amazon works the way the FTC says it does, I don’t know how much it hurts customers. The question that interests me is whether investors assume that Amazon will eventually dominate the online market, raise prices and rake in monopoly profits.
Here are the last two years of revenue, operating profit and earnings per shares at Amazon, along with consensus Wall Street estimates from the next five years (estimates from S&P Capital IQ):
Investors are paying 58 times this year’s estimated earnings for Amazon. Part of the reason they are willing to do this is because — if Wall Street is to be believed — revenues will continue to grow at their current level and, more importantly, because margins are set to double in less than four years.
Part of this is down to hopes that Amazon’s non-retail business — cloud computing — will continue to grow rapidly at high margins. But it is worth noting that growth in that business has slowed, and its margins may have plateaued. A big increase in margins in the US retail business, which have moved between zero per cent and 3.5 per cent in recent years, has to be an important part of the investment case for Amazon. Amazon retail, capital-intensive and low- margin, has still not become the business investors have waited for all these years. And it might never become that business, if the industry remains as competitive as it is now.
Amazon might not feel like a coercive monopoly now, and may not be one. Will it be one when its retail margins are much higher? Will getting to those higher margins entail even more aggressive manoeuvres to harvest profits from third-party sellers and customers? Even if Amazon wins this case, its antitrust problems might not be over.
One good read
Why global stock exchanges can’t compete with the US, and what to do about it.
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