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Amazon (Buy, $1,100 PO) Stock view: Positive on retail, but street increasingly focused on advertising For Amazon’s retail business, sentiment remains positive despite some modest 4Q revenue weakness vs expectations. We expect the retail business to remain strong in 1Q with stable growth as core drivers (Prime, delivery infrastructure advantage) remain intact. The lack of early tax refund support is a potential 1Q risk, but we would expect any delayed spending to bounce back in March or 2Q. Continued store closures by traditional retailers should aid the online shift throughout 2017. Finally, it appears Amazon has become stepped up advertising on its site, with more sponsored listings, which could be a source of revenue upside in 2017. Amazon had new revenue disclosures in its 10-K, and the ad revenue line significant accelerated in 2016. For AWS, we expect some additional q/q revenue deceleration and q/q declines in margins. We note that AWS growth in 4Q was below our estimates, and the effects of 4Q’s late price cuts should drive additional deceleration in 1Q. Microsoft and Google are well capitalized competitors that are significantly increasing cloud investment (see Battle in Seattle for industry update), so the Street sentiment could shift more cautiously on Amazon on a slight miss. Margins continue to be a risk, but top line trends seem to be the biggest driver of sentiment and advertising optimism has grown. Amazon’s current investment cycle began in earnest in 3Q’16, and we expect the elevated pace of investment to persist through 3Q’17. Margins may see y/y declines given: 1) Ongoing investments in fulfillment center build out (given fulfilled unit growth of 40% in 2016), 2) Digital content and related marketing, 3) Prime benefits (Now and Fresh), 4) Alexa/Echo, and 5} India. We think the Street is constructive on these initiatives, and will move past lower y/y margins concerns if top line growth is stable in 1Q. Key theme/metric(s) for 1Q: AWS growth and 2Q profit outlook We forecast 43% y/y AWS growth in 1Q, down from 47% in 4Q, partially due to the lingering effects of price cuts that went into effect on December 1*. This implies 4% q/q growth v. 9% last quarter. Increased investments in logistics/fulfilment, AWS, marketing, Prime content and others could set Amazon up for disappointing margin guidance vs. the Street’s expectations. However, we think the Street will focus on revenue trends and ultimately view the investments as a long-term positives. Biggest 1Q issues/risks: ¢ 2Q GAAP operating income outlook given increased investments in logistics, India, Prime Instant Video content, as well as expected AWS deceleration * Gross profit growth trends given expense issues and tougher growth comps in 1H17 « AWS margin trends given AWS price cuts and aggressive competition ¢ — International segment performance given investments in India 1Q traffic data points mixed comScore’s US data indicates that Amazon PC user growth has been down 2% y/y in 1Q through February vs. 4Q at -5% y/y. Mobile user growth is up 8% y/y vs. up 9% in 4Q. Amazon’s total mobile and PC minutes were down 5% y/y in 1Q through February vs. up 18% y/y in 4Q; mobile minutes were down 7% y/y in 1Q vs. +18% y/y in 4Q. 1Q items/news: ¢ Logistics investments: Amazon announced a $1.5bn air hub in Northern Kentucky that will host Amazon’s own cargo airline. - AWS outage: AWS had a large outage in early March. Investors will likely focus on the competitive implications of the outage. . Bankof America 14 Internet/e-Commerce | 06 April 2017 Merrill Lynch HOUSE_OVERSIGHT_014900