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Amazon: Built For Greatness, Not Built For Profitability
Sep. 19, 2017 1:35 PM ET|18 comments| About: Amazon.com, Inc. (AMZN)
Joshua Mou
Joshua Mou
Dividend investing, growth at reasonable price, long-term horizon
(42 followers)
Summary
Amazon has disrupted the retail and cloud-computing industries.
Retail and Amazon Web Services are gaining significant market share.
CEO Jeff Bezos has built a company to improve the customer experience, but he has not built a profitable company.
As it is structured today, Amazon cannot increase profits to match its current market valuation.
Introduction
Chief Executive Officer Jeff Bezos laid out his business philosophy very clearly in his 2016 Annual Report. He has structured Amazon.com (AMZN) to always be in “Day 1.” Companies in the Day-1 stage of existence are disruptive, innovative, risk takers, and quick decision makers. They avoid cruise control. They sacrifice profits in return for growth. Bezos states very clearly that he never wants his company to reach Day 2, with established processes to generate profits and to sustain existing business—a company that can run on autopilot.
Amazon has many attributes of an early-stage growth company. Sales are growing rapidly. Market share is increasing. Their disruptive force is felt throughout the retail industry, and their cloud computing service is a major player. But, one significant difference between Amazon and a typical growth company is that a growth company has the goal of eventually becoming profitable. After 22 years of existence, the company is still not structured to make significant profits.
Amazon: Great For Consumers
Consumers and small retailers have enjoyed several paradigm-changing retail transformations since Amazon.com opened for business in July 1995. Some of the most significant, in my opinion, are Amazon Marketplace, Amazon Prime, online customer reviews, Amazon Web Services, and Fulfillment By Amazon.
From the perspective of the consumer, Amazon Marketplace brings an unprecedented number of products to all customers within its reach. Consumers have access to products offered outside of their geographical region. And, most of those products are priced competitively. There are now fewer opportunities for retailers to take advantage of regional pricing inefficiencies or lack of competition, because customers can quickly look up and access similar products on Amazon.com. Amazon Prime adds convenience to transactions, which allows many customers to avoid trips to other retailers—both physical and online retailers. Personally, Christmas shopping used to be a dreaded task for me. Now I can avoid holiday traffic, mall parking lot battles, and the ignominy of being one of those guys walking around on Christmas Eve in the J.C. Penney’s women’s accessories department looking for slippers or a purse for my mom. This change, alone, has made my life more convenient and much less humiliating.
Amazon.com’s customer review system is a gem that draws traffic to their website. The realm of product reviews has expanded to almost anything that can be delivered in a van. These reviews have made a tremendous difference to shoppers who like to scrutinize every purchase. For instance, someone once recommended that I clean the debris from my woodworking files with a card file. So, I opened my Amazon phone application and was able to compare important attributes of card files that I did not know were important attributes, for a product that I did not even know existed five minutes prior. Two days later, all my files were clean thanks to my new card file—which is similar to a wire brush with a stiff wooden handle, in case you were wondering. Imagine ten years ago, there would have been almost no easily accessible text about woodworking card files, much less a review from one of the dozen or so people in the USA who still uses one. Traditional product reviews tended to be in magazines or paid subscriptions, and often these reviews were influenced by advertisement dollars. Or, reviews used to be written by a technical expert after only a short bench trial. Amazon.com reviews have more of a word-of-mouth style that is very attractive to end-users. As the go-to source of product reviews, Amazon draws many purchases that used to go through sales staff in physical retail stores.
While big-box stores are trying to fend off Amazon, Fulfillment By Amazon has opened the doors to worldwide retailing for many small retailers. Mom-and-pop shops can now carve out a portion of the retail market by using Amazon’s online portal and international distribution network. Geography no longer restricts the customer base for retailers that have a single—or even no—storefront. Little to no upfront capital is needed to use Amazon merchant services, which removes that common obstacle to scaling up a business. Amazon has also legitimized the concept of buying online from unknown companies, as customers can count on Amazon to provide good customer service and to provide guarantees on products. Through Amazon, almost no one flinches anymore when ordering card files from small retailers, even if they have goofy names, because Amazon customer service will fix any issues if the tool was not up to par. One thing that has surprised me the most about online shopping is the high standards for customer service. Most online stores now have to compete vigorously on reputation and customer ratings. Rarely do I see a store with less than 95% customer satisfaction. And, rarely have I been disappointed by an online purchase, as a poor reputation dries up sales almost instantly.
Amazon Web Services (AWS) has also played a pivotal role in transitioning enterprise technology infrastructure to the cloud. This gives companies the ability to scale up computing capacity, storage, and applications with little capital upfront. Companies can now access services such as computing, data storage, management tools, analytics, and artificial intelligence. These are resources that most companies would not be able to afford to build on their own. Yet, these companies can now improve their marketing, technology, and sales with AWS. The pace and scale of growth in AWS are evidence to me that many find it to be a valuable service.
Amazon.com was not the first online retailer, nor was it the first to publish product reviews, nor was it the first cloud provider. But, their level of execution and their scale has created a significantly more efficient retail and cloud computing landscape. Old-line retailers and tech companies are scrambling to improve their offerings in order to keep pace. New companies dare to enter the fray, only if they can match this current high standard. What comes next for an investor is to see how this great company can profit from its business.
Amazon: Big Money
One look at the price chart for AMZN will show that there is a lot of money that has been made on the stock.
ChartAMZN data by YCharts
The stock has had an incredible run that looks like it could continue for a lot longer. Traders love this stock for good reason. It has long-term momentum, a heavy following, high revenue growth, and a CEO that shoots for the stars—and hits them. I have great respect for good stock traders. Traders can make money, and possibly a lot of money. They bet on their predictions of stock price movements and timing. Their discipline requires great skill, constant attention, and tons of moxie. What I want to dissect in this article is the other perspective—the investor perspective—of Amazon.
Whether preferring growth or value, eventually all investors are betting money on the profitability of a company and the resultant recognition by the market of the company’s intrinsic value. Therefore, my analysis that follows here will focus primarily on profitability.
Operations
Amazon earns revenue through three primary business segments that generated a total of $150.1 billion in sales over the last twelve months.
North America Retail Sales: $88,476 million (59% of sales) 2Q17 Trailing Twelve Months (TTM)
International Retail Sales: $47,119 million (31% of sales) 2Q17 TTM
Amazon Web Services (AWS): $14,529 million (10% of sales) 2Q17 TTM
The two larger segments are what most consumers recognize the most—online sales in North America and online sales outside of North America. Online sales include revenue earned from products sold by Amazon, fees earned from other sellers using Amazon’s website or fulfillment centers, and membership fees from Amazon Prime members. Amazon Web Services is a cloud-computing platform, used by many organizations, that provides computing power, data storage, networking, and databases.
Finances
Balance Sheet
At the end of 2Q17, Amazon’s market capitalization was $462 billion. Total Long-term liabilities stood at $24.0 billion. Total Stockholders Equity stood at $23.2 billion.
Debt to market cap percentage = 5.2%
Debt to Equity Ratio = 1:1
Cash & Cash Equivalents on June 30, 2017 = $13.2 billion
I consider the debt to be manageable for such a fast-growing enterprise. Current assets of $41 billion cover current liabilities of $40.5 billion, which is adequate.
There are debt maturities due in 2017, 2019, and 2021. And, each of those debts is for $1 billion. This is a manageable schedule. One thing to note is that the long-term debt portion of total long-term liabilities is about $7.7 billion and has been trending slightly downward. The rest of the total long-term liabilities is made up of a category called Other Long-Term Liabilities. This category is responsible for all growth in Total LT liabilities. A large part of Other LT Liabilities is the increasing use of Capital Lease financing for the purchase of equipment. These leases will play a significant role in free cash flow discussions to follow.
Revenue
Amazon is growing overall sales at a rate of 24% year over year on a trailing-twelve-month basis (TTM). For 2Q17, North American sales increased 27% y/y, International sales increased 17%, and Amazon Web Services sales increased 42%.
Earnings
Amazon makes no attempt to hide their poor earnings history. Second quarter 2017 earnings for the company came in at $1.9 billion or $3.94/share for Trailing Twelve Months (TTM). With a stock price per share of $974.19 as of market close on September 18, 2017, that works out to a PE ratio of 247.
If Amazon's earnings stayed at the same level, then it would take 247 years to earn back an investment made today. If someone bought the whole company and took it private at the current market cap of $471 billion, AND IF the company doubled its earnings every year for the next 9 years, the return on investment would only be 8%. That would be an insane growth rate for a decidedly average return. I would bet that most investors could easily find a company that could bring an average return, but with a more achievable growth target. Jeff Bezos recognizes that an earnings analysis cannot justify his company’s valuation. Therefore, he emphasizes cash flow metrics to evaluate the business.
Cash Flow
Amazon’s cash flow numbers are more encouraging. For 2Q2017, TTM Operating Cash Flow was $17.9 billion, +37% year-over-year (yoy) growth. Free Cash Flow for the last twelve month period was $9.7 billion, +26% yoy.
Free Cash Flow, a non-GAAP financial measure, is the money left over from Operating Cash Flow after the company completes capital expenditures. This number helps investors because it represents the money available to increase shareholder value. Free cash flow can develop new lines of business, enhance current business, pay dividends, buy back stock, or pay down debt. Amazon is currently valued at 49 times current FCF, which is more palatable compared to the PE ratio.
Capital Leases
There is a caveat to the strict calculation of Free Cash Flow. Amazon structures the purchase of some equipment and buildings as Capital Leases, which do not factor into FCF. At the end of 2016, there were a total of $9.4 billion in capital leases—not insignificant. Fortunately, Amazon calculates an adjusted free cash flow figure that accounts for payments on these leases.
Amazon Investor Relations did not answer my inquiry about exactly what was being leased. Therefore, there was a bit of sleuthing needed to deduce what Amazon got for those leases. Amazon’s 2016 Annual Report described the use of capital leases by saying, “Certain of our equipment, primarily related to technology infrastructure, and buildings have been acquired under capital leases.” Looking further into the report on page 57, Note 7—Commitments and Contingencies, one can see that 91% of the capital leases were due over the course of three years. Buildings are not typically paid off or rented for only three year periods, so that does not appear to represent the bulk of those leases. Within technology infrastructure, servers have a typical supportable lifespan right around three years, exactly the length of those capital leases. Nine billion dollars worth of servers is probably too much to be for internal company use. The only other reason for Amazon to buy this much tech infrastructures is for AWS operations. Amazon subtracts the payments on their capital leases in the same way that they would subtract the cost of capital expenditures. Adjusting for capital leases, gives an adjusted free cash flow of $5.8 billion for year-end 2016 and $5.5 billion for the most recent quarter of 2Q17 TTM. This takes the current price/adjusted-FCF ratio way up to 87. By this measure, the company is still very expensive.
The company also reports a different adjustment to free cash flow that it titles Free Cash Flow Less Finance Principal Lease Repayments and Assets Acquired Under Capital Leases.
This number takes traditional free cash flow, then subtracts finance lease principal repayments, then subtracts the cost of property and equipment acquired under capital leases AS IF those assets had been purchased with cash. The first adjustment for finance principal repayments is the amount that Amazon pays each year on buildings that it leases. These finance leases have a duration of around ten years, and the leases total less than $200 million annually. The second part of the adjustment is the big one. Those capital leases mentioned previously, pay for a large segment of property and equipment that is not accounted for within capital expenditures. Amazon recalculates these acquisitions as if they were purchased with cash, then it subtracts that cost from free cash flow, as if that cost were part of capital expenditures. Because this makes up the bulk of this adjusted FCF number, investors can look at this figure as what FCF would be if capital lease obligations had been counted as capital expenditures. But, it is different from the other—Table 6: Free Cash Flow Minus Capital Lease Payments—because it converts capital leases to their full cash value as opposed to just counting their current payments. Notice that this adjusted FCF drops substantially in 2Q17 TTM to $1.49 billion. Using this measure of adjusted FCF, the price-to-FCF ratio is a whopping 318! This is because Property and Equipment Acquired by Capital Leases grew much higher in the quarter than in previous quarters.
Will Amazon Ever Generate Significant Profits?
Amazon is a very low-margin business. Low-margin businesses can be very profitable if they can turn over--sell--a lot of product rapidly and if they can control expenditures. Amazon does sell product rapidly. But there are a few things that keep this company from earning profits.
Amazon has a reputation as a low-price retailer, which gives it a significant advantage in sales. They keep prices low, partly, by eliminating the cost of carrying physical retail stores. But, they also sacrifice profitability to keep prices low. Their easiest route to increased profits is to increase prices. But I do not think that they could ever raise prices without losing one of their primary sales advantages.
Amazon also has high corresponding expenses and a heavy need for reinvestment to maintain and grow those sales. Shipping is very expensive, and shipping costs increase proportionally with sales increases. When Walmart (WMT) or Target (TGT) increase sales in their stores, their transport costs are very low because they ship in bulk by truck and train. Selling one item versus selling ten items does not change the shipping cost very much to those retailers. Amazon, however, must add the cost of delivery service to a customer’s front door for every single sale. And, there is the cost of packaging for every single sale. The expense difference between one sale and ten sales is huge for Amazon. Amazon does not enjoy the economy of scale, in this situation.
Fortunately for the company, Amazon Prime memberships offset most of the cost of shipping. In 2016, Amazon began reporting revenue from membership fees, which was $6.4 billion for the year. Net shipping cost for that year was $7.2 billion.
The fact that memberships help to offset the cost of shipping, is a huge win for the company, because free shipping makes it more convenient to shop at Amazon than at either a physical store or another online retailer. However, this emphasizes the company's cost structure compared to other membership-based retailers. Take Costco (COST) as a comparison. They ship in bulk to warehouses, just like Amazon. They sell with low margins, just like Amazon. They have a membership fee, just like Amazon. But, they do not have to pack or ship their products, so those membership fees flow directly to the profit line. Comparing the income statement for Amazon and Costco, they both made $2.3 billion in 2016. Removing membership fees, Amazon would be operating at a $4.5 billion loss and Costco would be approximately flat on profit. So, for Costco, membership fees are pure profit. While for Amazon, membership fees are critical for saving the company from a loss.
The company touts Amazon Web Services as the profit center that will eventually take the company to the profit promise land. AWS had 2Q17 TTM sales of $14.5 billion with resulting operating income of $3.6 billion. The resulting AWS segment operating margin was 24.7%, which is the best operating margin of the three business segments.
Turning back to a previous issue, Amazon has been making significant equipment purchases for AWS that do not show up in their operating expenses. They acquire servers and equipment using lease-to-own seller financing—the aforementioned capital leases. It appears that these capital leases are paying for equipment that supports ongoing operations versus equipment that grows their operations.
Notice in Chart 10 that the annual cash cost of Property and Equipment Acquired by Capital Leases has jumped substantially within the last year. Last year happened to coincide with the three-year anniversary of Amazon’s first significant use of capital leases. Amazon Web Services is also growing, but not nearly as fast as acquisitions from capital leases. The company is not only buying new servers for new business, but it is also replacing currently operating servers. If AWS continues to grow, then in 2020, they will be spending $8 billion a year replacing servers that are in use today, plus buying more for growth which will incur even more recurring expenses. At least a large portion of the capital leases should be viewed as a recurring operational expense. It is obvious that the capital leases are swallowing up all AWS profits.
Adding the annual payments on capital leases to the AWS operating expenses brings AWS solidly into the red.
Fortunately, the adjusted profit margin is stabilizing into the negative 2-4% range versus the negative 29% in 2014. It remains to be seen if AWS operating income will eventually catch up and surpass the expense of capital lease obligations, but it seems doubtful based on its huge recurring expenses. International retail is running at a loss. And, North America retail only has a profit margin of 2.4%. But at this point, AWS does not appear to be any better than the other two business segments.
Conclusion
CEO Jeff Bezos has brought Amazon.com to the point of barely breaking even. He is very innovative in bringing intangible value to the consumer and to the business world. And he has done a tremendous job of balancing his company's revenues and expenses on the knife edge of profitability. But none of his initiatives are set up to be profit centers. Herein lies part of his genius and his competitive advantage: He does not care about profit. And, no traditional business is willing to make that sacrifice in order to compete in an already difficult industry. That is a moat that even the best bridge builder will not cross.
There is no doubt that the Amazon of today has tremendous long-term value. I am sure that it will be bigger and better in ten years. However, its value will probably not come by way of profits. It will never grow into its price-to-earnings ratio, because the earnings will never catch up.
Can investors use $150 billion in sales to justify a $471 billion market valuation? Possibly. But sales only have value if they translate to profits. Can investors use Amazon's book value of $48.36 per share to justify current valuation? The market currently values AMZN at 20 times book value, and it is hard to imagine a scenario in which these assets generate 20 times their current value.
My opinion is that Amazon must be valued on the basis of its benefit to society. What would it cost to replace the services that Amazon provides? What is the value of the competition it brings to the retail and computing industries? What would people pay to recreate the convenience and accessibility that it provides? These values are subjective and are very difficult to quantify. At this time, I think that AMZN is a stock for trading, not for investing.
I began researching Amazon with little knowledge of its finances and business strategy. My research has taught me a lot about the company, and I have reached a conclusion about its suitability in my portfolio. However, I look forward to a robust conversation in the comment section. I have found great value in the collective knowledge and in the variety of perspectives within the SeekingAlpha community. I would count myself fortunate if someone changes my opinion on the subject and helps me make more money. The comment section is now open.
Disclosure: I am/we are long TGT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. |
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发表于 2017-9-19 14:45:07
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