Amazon Is Tier 1

"And, by the way, the bulk of the billions in Berkshire Hathaway has come from the better businesses ... And most of the other people who've made a lot of money have done so in high-quality businesses."
Charles Munger

At Tier 1 Investments, a Motley Fool Rising Star Portfolio, I seek out and invest in elite businesses. These include companies with the most valuable brands, best management, superior products and services, and strongest competitive advantages. I call these businesses Tier 1 enterprises, and Amazon (NAS: AMZN) fits that description perfectly.

A dominant brand
Founder and CEO Jeff Bezos chose the name "Amazon" well. Rather than choosing a name that would have made it difficult for the company to expand beyond books and CDs, Bezos chose a name that signifies Amazon's massive scope and growth potential, and Amazon's product line now includes just about everything under the sun. "Amazon" has become a trusted household name that holds the dominant mindshare among consumers when it comes to Internet shopping, and I believe that one day Amazon could very well earn a place in consumers' minds as the place to shop. After years of torrid growth, Amazon's brand is now one of the most valuable in the world.

Superior products and services
Amazon consistently ranks at the top of the list in terms of customer satisfaction. The numbers bear this out. Amazon's sales surged a staggering 41.6% in the past year, as Amazon's core retail operations continue to gain share from its bricks-and-mortar competitors. In addition, Amazon's ultra-popular Kindle line of products dominates the e-reader industry with a market share approaching 50%. And the new Kindle Fire, while not technologically superior to Apple's (NAS: AAPL) iPad, is positioned to command a lion's share of the low-end tablet market at a hard-to-beat $199 price point.

A deep and expanding moat
Amazon has several extremely strong competitive advantages. The fact that Amazon doesn't have to maintain physical store locations gives it a lower cost structure that its traditional retail competitors, such as Target (NYS: TGT) or Best Buy (NYS: BBY) , which Amazon then passes on to its customers in the form of lower prices. Amazon is also able to offer a wider selection of items for sale than could be housed even in the giant storefronts operated by these big-box retailers. And although it has recently come under political pressure, Amazon benefits from the tax-free shopping experience its customers enjoy in most U.S. states. These are advantages that traditional retailers simply cannot match.

Beyond these more obvious benefits, Amazon is expanding its moat through its Amazon Prime program. For $79 per year, Amazon offers free two-day shipping for all orders placed by those who join this program. And although at first it may seem like a strange combination, Amazon also offers free Internet video streaming of more than10,000 movies and TV shows as part of the deal. This puts Amazon in direct competition with Netflix (NAS: NFLX) , the current market leader in video streaming.

Netflix has a broader selection of movies and TV shows, but at $79 per year, Amazon's offering comes out to less than $6.59 per month, a 17% discount to Netflix's $7.99 monthly subscription fee. Throw in the free shipping feature and you can begin to see why the number of Prime members is growing at 20% per year. But the advantage to Amazon is not the recurring revenue stream Prime provides, which is low-margin at best, but the incentive it gives its customers to make more of their purchases through Amazon. Once a person plunks down $79, they're going to want to get their money's worth. This helps explain why Amazon customers are believed to more than double their purchases on Amazon after they join Prime.

The Kindle Fire should only help to expand the value of Prime, and in turn the value proposition of shopping through Amazon. The device gives customers another way to enjoy the video streaming feature, and helps to make it even more convenient to shop on Amazon's website or through its mobile app. And as an incentive to purchase a Kindle rather than Apple's iPad or Barnes& Noble's (NYS: BKS) Nook, Amazon Prime is offering a digital-book lending service for Kindle owners.

With each new feature Amazon adds to Prime, the service becomes more valuable to its customers, making them more likely to renew. And the more "sticky" Prime becomes, the more purchases consumers are likely to make through Amazon. With the launch of the Kindle Fire, Amazon now stands to control one more part of its customers' purchasing experience. That strengthens the core of Amazon's competitive advantage: value and ease of use.

Simply stated, Amazon's website offers customers the ability to shop from one centralized location that offers lower prices on an unmatched selection of goods, with free shipping and tax savings, from a brand that consumers trust. That's a tremendous recipe for success.

Visionary leadership
I love founder-led businesses. Especially ones with passionate leaders who manage their business for the long term with an unwavering focus on the customer experience. I believe Bezos fits that description perfectly. Bezos has managed Amazon's staggering growth through the boom years of the late 1990s straight through the bursting of the tech bubble and on to today, while staying a step ahead of larger competitors such as Wal-Mart (NYS: WMT) . What's more, Bezos owns nearly 20% of Amazon's shares, currently worth more than $17 billion. To say that Bezos' interests are aligned with shareholders' is an understatement.

Risks and why I'd sell
Amazon faces many external threats. Several formidable competitors are gunning for the company's market share in multiple businesses. Retail behemoth Wal-Mart has been ramping up its online business, and offers customers the ability to shop in person and pick up or return items at its stores. Furthermore, with Amazon's entry into the tablet market, Amazon is now going head-to-head with tech titan Apple and its ultra-popular iPad. And Google (NAS: GOOG) is rumored to be developing a Prime-like service of its own.

These are top-tier companies and not to be taken lightly, but I believe Amazon's competitive advantages are strong enough for Amazon to compete successfully, and win, in many of these areas. However, if these rivals do more harm to Amazon's business than I anticipate, I'll recommend selling Amazon.

I will not deny that Amazon's shares are expensive. At more than 100 times earnings, Amazon is much more richly valued than most stocks I will purchase in the Tier 1 portfolio. But I've been following Amazon for over a decade, and the stock has never looked cheap. Quite simply, this is a superior business of which I want to own a piece. And although shares look expensive now, I believe they will be worth much more in the future.

Amazon's earnings are being depressed by the massive investments the company is making to fuel its torrid growth. There will come a time when Amazon dials back these capital expenditures, and when that happens, Amazon's cash flow will explode. I can't say for certain when that will happen, but to put a long-term value on the business, I look to Wal-Mart's $200 billion market cap, which I believe Amazon will ultimately surpass.

The Foolish bottom line
Amazon is one of the best companies in the world, and with the current share price down about 20% from the highs of the year, I believe now is a great time to buy. This is the type of opportunity I look for at Tier 1 Investments, and so tomorrow I will be buying shares and adding Amazon to my Rising Star portfolio.

Next steps:

  • If you'd like to follow along with Tier 1 Investments as I build out the rest of my portfolio, keep checking back in with my Rising Star page, which is updated with all of my buy recommendations.

  • Keep track of Amazon's share price and breaking news by adding Amazon to My Watchlist.

  • And finally, you can follow me on Twitter @Tier1Investor.

At the time thisarticle was published Joe Tenebruso manages a real-money Rising Star Portfolio for The Motley Fool and is an analyst for the Fool's Million Dollar Portfolio and Income Investor premium services. Joe has written puts on Apple.The Motley Fool owns shares of Google, Apple, Best Buy, and Wal-Mart Stores. Motley Fool newsletter services have recommended buying shares of, Wal-Mart Stores, Netflix, Apple, and Google. Motley Fool newsletter services have recommended creating a diagonal call position in Wal-Mart Stores; writing covered calls in Best Buy; and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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