Consumer Technology June 14, 2018 Industry Update Prices: 6/13/2018 Brand Amazon - Implications of Company's Private-Label Efforts Industry: To analyze Amazon’s private label efforts, we reviewed where its items ranked in product searches Consumer Technology as a means of gauging their sales. Of the 100 items we analyzed, 24% were ranked first, 56% were in the top 10%, 65% were in the top 20, and 35% were outside the top 20. While encouraged by Tom Forte, CFA the results, we consider Amazon to be in the early innings of its private label efforts, with significant 212-223-5364 opportunities to expand into more products and categories. [email protected] While gathering data, we noticed the increasing prevalence of Amazon’s advertising efforts. Ninety four of the 100 product searches had advertisements. We believe Amazon’s private-label efforts are important to the company for several reasons: • SALES IMPLICATIONS: First, when considering the impact of its private-label sales efforts in a vacuum, we project Amazon has greater than a 25% chance of increasing our near-term sales CAGR by 100 basis points from its private-label efforts. A 100 basis points increase would raise our 2020 forecast to $348.6B from $340.3B for a delta of $8.3B. However; when including its advertising sales, which should benefit from its private-label efforts, we increased our near-term and long-term sales projections by 100 basis points to reflect our confidence in both initiatives moving the needle. • MARGIN IMPLICATIONS: Second, again looking in a vacuum, we forecast the incremental revenue growth would negatively impact our near-term adj. EBITDA margin projection by 35 basis points to 14.4% from 14.8%. We estimate the contribution margin is only higher than its first-party sales, while lower than its cloud computing efforts, advertising, and third-party sales. However, when considering the high contribution margin of its advertising sales, at this time, we are not forecasting margin degradation on the assumption ad-sales related margin gains could offset dilution from its private-label efforts. • CATEGORY PENETRATION: Third, they provide it a means to further penetrate significant categories, such as apparel and groceries. This is important because it needs to expand its efforts in both to sustain its elevated growth rates, especially groceries. • IMPROVE PROFITABILITY: Fourth, it provides the company a means to improve the profitability of its first-party sales, which are much lower margin than third party and its cloud- computing service (AWS). • DRIVING ADVERTISING: ;Fifth, we believe the company’s private-label efforts provide sellers even more motivation to advertise on Amazon, which is an important source of high-margin revenue. • 365 OPPORTUNITY: Sixth, within groceries, we believe its 365 brand is underutilized online and it provides the company an opportunity to expand its physical grocery store footprint to pursue sales from more value-conscious consumers. • M&A: Seventh, we see private label as an important part of Amazon’s M&A strategy of building first and buying second. If it is unable to penetrate markets with private label, such as women’s apparel, we believe it will make acquisitions to do so. For example, we still consider lululemon as an attractive target and additionally see strategic value in Amazon acquiring startup Everlane and privately held Vineyard Vines. • ANTITRUST RISK: In addition, our industry experts suggested Amazon could face antitrust scrutiny if it unilaterally ranked its private-label products first in its natural search results, regardless of their sales performance. • GOOGLE SHOPPING ACTIONS: Lastly, following our conversations with industry experts, we will be closely monitoring the performance of Google Shopping Actions (Google’s latest e- commerce effort to reduce friction between product searches and purchases) to see if it has a negative impact on Amazon’s sales growth. • STOCK RECOMMENDATIONS: Conducting research for this report increased our conviction in our BUY ratings for Amazon, ChannelAdvisor, Overstock, Park City Group, Quotient Technology, and Qurate Retail Group. While it also made us more confident regarding Wayfair’s business model, we continue to see its shares as overbought and are reiterating our UNDERPERFORM rating. Please refer to pages 57 - 58 of this report for detailed disclosure and certification information. D.A. Davidson & Co. Member SIPC D.A. Davidson & Co. TABLE OF CONTENTS EXECUTIVE SUMMARY ........................................................................................................... 3 THE INCREASING VALUE OF AMAZON’S BRAND ................................................................. 8 AMAZON’S PRIVATE LABEL EFFORTS .................................................................................. 9 Category Penetration ............................................................................................................... 11 Category Penetration – Easy Categories ................................................................................. 11 Category Penetration – Millenials............................................................................................. 20 Category Penetration – Difficult Categories ............................................................................. 21 Product Development ............................................................................................................... 26 Product Development – Strengths ........................................................................................... 26 Product Development – Weaknesses ...................................................................................... 26 Advertising ............................................................................................................................... 27 Advertising – Ad Load .............................................................................................................. 30 365 Opportunity........................................................................................................................ 30 Private Label and M&A ............................................................................................................ 32 Antitrust .................................................................................................................................... 33 Google Shopping Actions ......................................................................................................... 35 APPENDIX ............................................................................................................................... 36 2 D.A. Davidson & Co. EXECUTIVE SUMMARY Figure 1. Amazon: Private Label Source: Amazon and D.A. Davidson. Amazon’s Private-Label Efforts – Important for Several Reasons We believe Amazon’s private-label efforts enable it to further penetrate categories (including apparel and groceries), improve the profitability of first-party sales (relative to branded merchandise), and drive high-margin advertising revenues. Further, we see an opportunity for it to advance the online and offline efforts of its 365 groceries private label. Sales and Margin Implications Note, as a result of our research for this white paper, we increased our sales growth projections by 100 basis points per year, given our increased confidence in Amazon’s ability to generate incremental revenue from its private-label AND advertising sales; especially when considering we see its private-label efforts as a catalyst for its advertising. In this section and the next one, we discuss the sales and margin implications specific to its private-label efforts, without consideration of its advertising. Sales Implications Our base-case near-term sales CAGR forecast for Amazon (see Figure 2) is 24.1% with revenue increasing to $340.3 in 2020 from $177.9B in 2017. If Amazon were able to increase its CAGR by 100 points (from its private-label efforts) our new forecast for 2020 would be $348.6B, for a delta of $8.3B. We estimate the likelihood of Amazon generating an incremental 100 basis points of sales growth from its private-label efforts to be greater than 25%. Figure 2. Base-Case Sales Projections, 2014-2027E CAGR 2014- 2017- 2017- ($B) 2014 2017 2020E 2027E 2017 2020E 2027E North American Revenue 50.8 106.1 204.9 326.7 27.8% 24.5% 11.9% International Revenue 33.5 54.3 93.9 139.2 17.5% 20.0% 9.9% AWS Revenue 4.6 17.5 41.5 99.9 55.5% 33.4% 19.1% Total Amazon Revenue 89.0 177.9 340.3 565.8 26.0% 24.1% 12.3% Source: Company reports and D.A. Davidson. Figure 3. Base-Case Margin Projections, 2014-2027E Change (Basis Points) 2014- 2017- 2017- 2014 2017 2020E 2027E 2017 2020E 2027E Amazon 7.2% 11.1% 14.8% 20.0% 392 364 888 Source: Company reports and D.A. Davidson. 3 D.A. Davidson & Co. Figure 4. Sales and Margin Implications: Private Label Base Potential Base Potential Odds 2017- 2017- Upside/ 2020E 2020E Upside/ of 2020E 2020E (Downside) Adj. Adj. (Downside) Achieving Sales Sales Basis EBITDA EBITDA Basis Upside/ CAGR CAGR Points Margin Margin Points (Downside) Private Label 24.1% 25.1% 100 14.8% 14.4% (35) >25% Source: Company reports and D.A. Davidson. By way of comparison, Costco, which in our view operates one of the best private-label efforts, with its Kirkland products, generates approximately 25% of sales from them (excluding its private-label gas sales), or roughly $32.3B on FY17 sales of $129.0B. Working in Amazon’s favor, it offers a much larger selection of merchandise