Can Amazon really justify a $1 trillion valuation?

Can Amazon really justify a $1 trillion valuation?Last week, Amazon’s stock price crossed the $1,000 threshold. In the process, its market capitalization nearly reached $500 billion.

And of course, the next question was, when will Amazon become the world’s first trillion dollar company?

Let’s look at Amazon’s financial performance, and see what might have to happen to make the company worth a cool $1 trillion.

Amazon’s revenue and profitability since 2008

The chart below shows Amazon’s revenue and various measures of profitability since 2008. Revenue is the blue line, and maps to the left axis. The profitability metrics are orange bars, and map to the right axis.

Wee see a consistent increase in revenue, from $19 billion in 2008 to $136 billion in 2016, for a compound annual growth rate (CAGR) of 28%. But the progression of profitability isn’t nearly so clean. We see annual increases in 2009 and 2010, followed by decreases through 2014, followed by increases in 2015 and 2016.

Amazon revenue and profitability metrics since 2008

Operating income is the the left-most orange bar for each year. For some perspective, operating margin, which is operating income divided by revenue, maxed out at 4.7% in 2008. It recovered to 3.1% in 2016. So even the largest orange bars for many years are only in the low single digit percentage points of total revenue. That gives you an idea of just how tight Amazon’s margins are. It’s not a terribly profitable company.

Why do we care about profitability? Because that’s ultimately how companies generate value. We don’t care about revenue when it’s entirely consumed by costs. It’s the difference between revenue and cost that matters. With profitability in mind, let’s look at Amazon’s cost structure.

Amazon’s cost structure since 2011

The chart below shows Amazon’s operating costs and operating income as a percentage of total revenue since 2011. One thing immediately jumps out at us: Amazon’s costs are dominated by cost of sales. That makes sense, given that Amazon is predominantly a product sales company. (In 2016, 70% of Amazon’s revenue came from product sales.)

I only showed percentages explicitly for Amazon’s four largest cost buckets:

  • Cost of sales
  • Fulfillment
  • Marketing
  • Technology and content

The other percentages are so small, including operating income, that I don’t even show the numbers. Again, Amazon’s margins are tight.

Amazon operating costs and operating income since 2011

The clearest trend is that Amazon’s cost of sales is decreasing with time, as a percentage of total revenue. We can also see that the next 3 largest cost buckets (fulfillment, marketing, and technology and content) are all increasing.

That has been Amazon’s great profitability tension: decreasing cost of sales, versus increasing fulfillment, marketing, and technology and content costs. From 2011 through 2014, the latter 3 cost buckets “won”, growing faster than cost of sales declined. In 2015 and 2016, though, cost of sales “won”, falling faster than the other buckets grew.

Why is cost of sales declining so quickly, as a percentage of total sales? The next chart tells us the answer. The blue line shows us net product sales, as a percentage of total sales. That line is going down. The solid green line shows us cost of sales, as a percentage of total sales. That line is also going down. But the dashed green line is going up, which shows us cost of sales as a percentage of net product sales.

In other words, the reason cost of sales has declined so much, is that product sales comprise a smaller and smaller share of Amazon’s revenue. Product sales are still the dominant source of revenue, contributing 70% of total revenue in 2016. But product sales contributed 87% of total revenue in 2011. Amazon is ramping up its service business, which means total revenue is growing more quickly than cost of sales. That’s why we see cost of sales decline, as a percentage of total revenue.

Amazon cost of sales versus total sales and net product sales since 2011

Modeling Amazon’s future revenue and profitability

The usual disclaimers apply here. Anyone can build a model showing anything they want. Plug in some numbers, loosely describe them as reasonable, and off you go.

If I want to show Amazon’s worth $1 trillion, I can build a model for that. If I want to show Amazon’s worth half of what it’s valued at today, I can build a model for that too. No model is gospel. They’re just a bunch of numbers that will definitely be wrong, no matter what.

With those disclaimers in mind, let’s proceed. We’ll use Amazon’s 2016 income statement as our baseline. Here’s my assumption about revenue: I’ll assume Amazon’s revenue growth declines 10% each year, starting with the 28% CAGR from 2008. In other words, I assume revenue grows 28% in 2017, 25% in 2018, 23% in 2019, and so on, until it reaches a terminal 2% growth rate.

I’ll assume Amazon’s net margin is a steady 20%. (Net margin is net income divided by total revenue.) That’s generous, to say the least. Amazon’s 2016 net margin was 1.7%. Its highest net margin since 2008 was only 3.7%. But Apple and Microsoft both consistently produce net margins around 20%. I’ll assume Amazon can flip a switch, and get its cost structure in line with these other massive players.

Finally, I’ll assume a discount rate of 3%. I’m just trying to adjust for the time value of money, by converting Amazon’s future net income dollars into today’s dollars.

Under these conditions, how long will it take for Amazon to deliver $1 trillion of net income in today’s dollars? It’ll take until 2029. At the end of its 2029 fiscal year, Amazon will have delivered $1.06 trillion in this scenario. That’s 13 years of future performance, since we use 2016 as a baseline.

What happens if we assume Amazon only delivers a net margin of 10%? It’ll take until 2036 for Amazon to deliver $1 trillion of net income in today’s dollars. And 10% net margin is still over 2.5 times the profitability that Amazon has shown for any year since 2008.

Forecast of Amazon's cumulative, real net income

Putting these forecasts in context

We know Amazon isn’t worth $1 trillion today. So analysts on the whole don’t believe in the forecasts we just built. That’s not surprising, particularly given that we forecasted a huge improvement in profitability over anything Amazon has reported in the past.

How difficult is it to forecast the next 13 years? Let’s look at how Amazon’s management described the business in its 2004 annual report:

Amazon.com, Inc., a Fortune 500 company, opened its virtual doors on the World Wide Web in July 1995 and today offers Earth’s Biggest Selection. We seek to be Earth’s most customer-centric company, where customers can find and discover anything they might want to buy online, and endeavor to offer customers the lowest possible prices.

Here’s how management described its “strategy”:

Our business strategy is to relentlessly focus on customer experience by offering our customers low prices, convenience, and a wide selection of merchandise.

Compare those statements with how Amazon’s management describes the company today:

…we serve our primary customer sets, consisting of consumers, sellers, developers, enterprises, and content creators. In addition, we provide services, such as advertising services and co-branded credit card agreements.

That’s how long 13 years is, in the world of technology. In 2004, Amazon was exclusively an online marketplace. The word “Kindle” didn’t appear in that year’s annual report. Amazon Web Services (AWS) was barely a twinkle in management’s eye:

We continually invest in several areas of technology, including our seller platform; A9.com, our wholly-owned subsidiary focused on search technology on www.A9.com and other Amazon sites; web services; and digital initiatives.

That’s the challenge, when we try to project performance of technology companies 13 or more years in the future. We’re basically hoping there’s some sort of spark that exists today, that when nurtured, will open whole new markets in the future. That’s the only way you can continue to rack up double digit revenue growth year after year after year.

And unfortunately, the chance that any single company has that spark is vanishingly small. Amazon’s past 13 years are the outlier. A rational person would expect some sort of reversion to the mean. But maybe Amazon is different.

Amazon’s lack of profitability keeps it from being a trillion dollar company

Why is Amazon not already a trillion dollar company? I think it’s primarily because of its weak profitability. The company certainly has demonstrated revenue growth, with a CAGR of 28% since 2008. It has grown the revenue of its most lucrative segment, services, by 47% annually since 2011. The top line numbers are there.

That brings us to profitability. Again, Amazon’s best net margin since 2008 was 3.7%, which came in 2009. In 2016, after years of exceptional revenue growth, particularly in the services segment, Amazon reported a net margin of 1.7%. In 2015, net margin was 0.6%, and in 2015, net margin was negative, at -0.3%.

Amazon’s management will argue that the company is investing in itself. The only way to sustain its revenue growth is to invest heavily in its infrastructure. And that’s a good argument. But large competitors like Apple and Microsoft have ten times the profitability of Amazon, delivering net margins around 20%, when Amazon delivered 1.7% in 2016.

If Amazon is to become the world’s first trillion dollar company, it’ll need to display growth in profitability that does not too badly undercut the growth in revenue. That’s a delicate walk. I can’t imagine Amazon’s management even cares about this totally arbitrary $1 trillion market cap figure. But directionally, the path for Amazon is clear. Ease off the revenue growth ever so slightly, really ramp up the profitability growth, and the sky is the limit for its valuation.

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