Best Of: It’s the Beginning of an Era for Amazon

By TradeSmith Research Team

Editor’s note: In February 2019, we said it was “the beginning of an era” for Amazon. As 2019 comes to a close, Amazon’s stock price gains are in the neighborhood of 23%, despite a lot of tough publicity over the course of the year. In a bigger picture sense, Amazon is the dominant example of the “disrupters versus the disrupted” phenomenon — and for that reason, the dominance may have only just begun.

Apple became the world’s first company to hit a trillion dollars in market cap by executing brilliantly in the smartphone space. Amazon followed suit, hitting the trillion-dollar milestone roughly a month behind Apple.

But while the smartphone industry has likely peaked — with profit margins and replacement rates coming down as consumers keep their phones longer — the biggest profits for Amazon are still well ahead. Not only that, Amazon is poised to generate mega-scale returns in multiple different industries.

For these reasons and more, Amazon is likely to be worth not just a trillion, but multiple trillions over the next decade or two. The current positioning for Amazon is so powerful and so dominant, the only real threat it faces is a forced government break-up. And even then, a break-up might not be bad.

It is possible, maybe even likely, to see Amazon split itself up down the road into multiple trillion-market-cap companies.

It is hard to state how much potential Amazon holds, but here is one way to think about it. At the time of our writing (February 2019), Amazon has a price-to-earnings ratio above 80. Meanwhile Berkshire Hathaway, the conglomerate founded by Warren Buffett, has a price-to-earnings ratio of 8.

That means the price-to-earnings ratio of Amazon is literally ten times that of Berkshire Hathaway. And yet, if you had to put your life savings into one stock for the next 20 years (not recommended of course), Amazon would easily be the safer bet — even at 10 times the cost.

Why is this the case? Because Amazon is the disrupter, whereas the companies Berkshire owns are an assortment of the disrupted (or the soon-to-be disrupted). Amazon has shown a willingness to disrupt almost every industry it touches, and its advantages just keep getting bigger. As of this writing in February 2019, the growth-and-profit opportunities spread out in front of Amazon look better than ever.

To get a handle on how much Amazon can grow, consider the following metaphor from Jitendra Waral, a Bloomberg Intelligence senior analyst. “Amazon’s end market is 16% of global gross domestic product, excluding China,” says Waral. “To put this in context, if Amazon’s end market was the Empire State Building, it still is on the third floor.”

Amazon has a high price-to-earnings ratio in part because its growth footprint is so global. No other company can claim a credible path to handling transactions worth 16% of world GDP ex-China, or more than half of all e-commerce in the United States.

But Amazon is also valued so highly because its “value per user” is off the charts.

Aswath Damodaran, a professor at NYU Stern and the world’s foremost expert on valuing companies, has done excellent work showing how the value of a user can vary widely from one technology company to another. The connection to user value comes with how much future profit potential that user holds.

The revenue from a Netflix subscriber, for example, is highly predictable but also static. Netflix won’t get more than $11 per month or whatever it charges. Meanwhile the value per user of, say, Twitter will be far lower, because Twitter has no subscription revenue and only moderately profitable advertising options.

Facebook, on the other hand, has a high value per user even though it is a free service because users spend so much time on Facebook, and there is so much data available providing new ways to monetize them. 

Amazon’s value per user leaves other big tech companies in the dust. That is because Amazon can monetize its user base 64 ways from Sunday, in ways that make the user happy rather than irritating them. Amazon has barely scratched the surface here.

If you have an Amazon Prime account — as somewhere around 100 million American households do — consider everything Amazon knows about you from the stuff you buy. It knows your clothing size, your entertainment preferences, your general lifestyle habits, the general demographics of your entire household, and a whole lot more. If you also shop at a Whole Foods, the data set goes even deeper.

Here is one thing Amazon could do with this data: They could run the most profitable health insurance company in the world. How? By using their data set to offer health insurance exclusively to households with favorable statistics. This would allow Amazon-backed health insurance to offer more coverage at a lower cost than everybody else.

Amazon is almost certainly going to do that, by the way (offer bespoke health insurance to select households via big data). It is only a matter of time. They have already teamed up with JP Morgan and Berkshire Hathaway to find better healthcare solutions for the 1.2 million employees of the combined three companies.  

Healthcare is a huge market waiting to be disrupted. Amazon is just now rolling up its sleeves. They recently spent almost $1 billion on PillPack, an innovative pharmacy company, as an appetizer.

As Amazon gets deeper into the healthcare business, it can do a deep-dive forensic analysis of which segments of the healthcare industry are profitable to run as businesses (and which ones are not). Amazon will use its scale and scope to offer low-profit segments as a third-party platform provider — and directly enter the high-profit areas as a competitor.

Healthcare is going to be shockingly profitable for Amazon, on a multi-trillion revenue scale. But that’s not even their biggest new thing. Neither is the cloud, another industry Amazon dominates that is growing like a weed into a multi-trillion-sized opportunity space.

The biggest big new thing for Amazon, as of this writing, is advertising. When you think about it this makes sense. Amazon has a deeper and broader “big data” trove on consumer transactions than any other company in the world. The next closest competitor is a hundred miles behind. Google knows what you tend to search for, and Facebook knows what you like to click. But only Amazon has the data on what you are actually purchasing, and the pattern of clicks that led you to buy.

After a series of experiments, Amazon rolled out its “Amazon Advertising” division in September 2018. Michael Olson, an analyst with Piper Jaffray, predicts the revenue from Amazon Advertising will surpass the revenue from Amazon Web Services (the juggernaut cloud business) by 2021.

That isn’t because Amazon’s cloud business will stop being a monster. It is because the advertising business will be an even bigger monster. And the whole thing works like a flywheel, with different parts of the juggernaut reinforcing each other. Like Amazon’s acquisition of Whole Foods, for example, which gives them a beachhead in grocery delivery and the brick-and-mortar space.

Amazon Prime members who shop at Whole Foods get insane deals in exchange for scanning their codes in, which gives Amazon more big data, which lets them sell perfectly targeted advertising — on behalf of third parties as well as themselves. The flywheel just keeps getting bigger.

Then, too, there is the big data Amazon collects by way of being the world’s biggest e-commerce platform. The millions of third-party providers selling on Amazon now run the gamut from tiny mom and pop shops to global brands like Nike and Apple — the latter two because they have no choice. Amazon has the ability to scrutinize buying patterns and profitability metrics on virtually all of the business that streams through its platform — allowing it to pick and choose the most profitable industries to clone and compete in directly.

This is why it is perhaps likely that, someday, Amazon will break itself into multiple companies (if the government doesn’t try first). Over the long haul, Amazon could have a trillion-dollar market-cap advertising business all by itself. And a trillion-dollar cloud business all by itself. And a half-trillion-dollar e-commerce business all by itself, and so on. If the company ever breaks up voluntarily, it will be based on a sum-of-parts valuation deeming the individual pieces more highly valued separate than together.

We are still only scratching the surface here. But by now you are asking, isn’t there some way to beat Amazon? Isn’t there some other company that could rise up?

The answer is no. Short of a forced dismantling at the hands of government, or a nuclear catastrophe wiping out Amazon HQ, there is essentially no way to beat Amazon now. They are too far ahead in the areas that count. The time to stop them was years ago, and no one did.

Here are some statistics to underscore that point. As Alexis Madrigal of The Atlantic recently reported, Amazon now has 288 million square feet of space across all its properties. Most of that is warehouse space. The total square footage for Whole Foods retail stores is less than 20 million square feet, and the square footage for all of the AWS data centers is less than 10 million square feet.

So, Amazon has nearly 260 million square feet of warehouse logistics space. In the past three years alone, Alexis Madrigal observes, Amazon has added enough new space to match 590 Wal-Mart supercenters. How do you catch up to that? You don’t.

The core business of e-commerce is physical, dominated by stuff that ships and things you can drop on your foot. Amazon spent years and years building out its logistics centers, forgoing profits quarter after quarter, with half of Wall Street wondering whether the CEO might be crazy or Amazon’s investors might be crazy.

Amazon’s management trained its investor base to wait and wait and then wait some more for profits, and then took every penny of revenue it had, for years on end, and plowed it back into huge logistics expansion (of the physical warehouse sort) that was so aggressive it bordered on insane. It was a “dominate or die” type bet; Amazon’s management followed a strategy so risky that either the vision would work out or the company would be crushed.

As we can see now, the vision worked out. But the profit-generating phase is just beginning. When a company like Amazon takes more than two decades (it was founded in 1994) plowing almost every nickel back into reinvestment, and then gets the vision right, the result is another ten to twenty years, at least, of moving toward full realization of the embedded profit opportunity.

It is truly the beginning of a new era — a wildly profitable era — for Amazon. 

TradeSmith Research Team