How Amazon Gets That $1 Trillion Valuation

By Will McHale

Over the past two decades Amazon has pioneered the e-commerce revolution, leading retail away from brick and mortar to the internet, to online marketplaces. From its humble beginnings as an online book retailer, the company has expanded into innumerable other categories and now offers over 480 million SKUs in the United States alone.

Amazon’s founder and CEO, Jeff Bezos, has publicly stated that he wants Amazon to become the everything store. To achieve this dream, innovation has been a critical component of the company’s journey to date.

In 2005, Amazon introduced Prime, a subscription service that gives users access to free two-day shipping, seeking to answer one of the biggest hassles of online shopping: the cost and time involved with shipping the order.

Amazon redefined the economics of the book industry with the introduction of the Kindle in 2007. The e-book platform democratized the publishing process allowing authors to self-publish, providing previously unimaginable access to readers by removing the barrier of the publishing house.

Recently, the company’s key driver of growth has been Amazon Web Services, which offers a suite of cloud computing services that make up an on-demand computing platform.

These innovations, along with many others, have propelled Amazon to remarkable financial success. Company-wide revenue in 2016 surpassed $135 billion and the online shopping giant’s market capitalization has soared to $400 billion.

Moving forward, we’ll explore how the company’s next leg of growth, Amazon Business, may lead the company to become the first ever to surpass $1 trillion in market capitalization.

Amazon Business is rapidly becoming a major player in the business-to-business (B2B) e-commerce space. In 2016, the division topped $1 billion in revenues and the company indicated it has more than 300,000 customers. Prentis Wilson, VP of Amazon Business, recently stated that the segment is growing 20% month over month and maintaining this pace even as the division scales.

As noted in my previous blog post, “Why Marketplaces Will Reign Supreme,” we believe Amazon, has the potential to continue to take significant share from incumbents and disrupt the massive and highly fragmented B2B supply industry. Amazon’s economies of scale allow for fierce price competition and the company’s logistical expertise enables just in time product delivery to meet critical customer demands.

The B2B market is enormous. According to the research firm Frost & Sullivan, the B2B market is expected to reach $6.7 trillion in sales by 2020. Of that total, online sales are expected to account for 12%, according to estimates by Forrester Research.

In the below revenue build, we project Amazon capturing about 5% of the total market and 35% of the e-commerce market over the next five years. Assuming a breakdown of 50/50 between market place revenue and traditional linear Amazon-supplied revenue and a take rate in line with Amazon’s core business, we project the 2021 revenue opportunity to be $76.4 billion.   

Building a $76 billion business is certainly no small task. However, we believe this is feasible for several reasons.

First, the industry is highly fragmented. As discussed in our recent white paper and in more detail in Modern Monopolies, fragmentation is often a characteristic of industries ripe for a platform to emerge and dominate. Supply fragmentation makes comparison difficult and reduces price transparency. A central marketplace benefits customers by reducing transaction costs and centralizing pricing competition.

Second, Amazon’s Business marketplace functions as a highly scalable platform capable of growing at very high rates over an extended period of time. In a finance context, the law of large numbers posits that as a company grows it becomes harder to sustain a given growth rate.

For example, it is easier for a company to grow revenue 50% from $10 million to $15 million than it is to grow 50% from $500 million to $750 million. In the former, the company needs to sell an additional $5 million of goods versus an additional $250 million for the later.

That could mean 50 times more inventory moving from the company to customers. However, for a platform like Amazon’s Business Marketplace the growth formula is different.

Amazon can grow by adding suppliers to its marketplace and by those suppliers selling more goods through the marketplace. This multiplicative effect enables this platform business to sustain very high growth rates even at extraordinarily large absolute numbers.

Layering our projections about the growth in Amazon’s B2B business onto Wall Street analyst estimates, we can create a 5-year forward earnings model. We project B2B accounting for 30% of the total cumulative revenue growth over the next 5 years. On the operating income line, we model 100-200 basis points lower margins in the B2B business versus Amazon’s core retail segment.

This is a reasonable assumption given the price competition and necessary investment needed to win market share. (Note: Amazon does not break out B2B as its own segment in its financials. We do so here to illustrate its importance in driving overall revenue growth.)

With our 5-year estimates, we can now construct an analysis of Amazon’s future potential valuation. Since 2014, Amazon’s shares have largely traded between 17x and 25x consensus forward EBITDA estimates:

Given that growth will slow as B2B and the rest of business continues to mature (no one can evade the Law of Large numbers forever), it is reasonable to assume that Amazon will trade at the lower end of that range between now and 2021.

Below, we examine valuation potential for multiples ranging from 17-20x.

All the scenarios above produce a $1 trillion dollar market cap by 2021. In the more optimistic scenarios the company eclipses this mark by 2020. The 2021 projections equate to a 21%- 25% compound annual return for shareholders.

 

Not bad, Jeff. Not bad.

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