Amazon

Amazon.com Inc. 

The graph of revenues per share (red line) shows that the revenue per share have grown at a very strong and steady rate (compounding at an average 27% per year in the ten years shown). The book value per share has grown at a high rate but that is mostly due to the sale of shares (largely through options and also in acquisitions) at very high multiples to book value, it is not very much due to the retention of earnings. GAAP earnings per share have increased but remain very low in relation to the $1196 share price. It is certainly possible that GAAP earnings understate the true economic earnings due the following: Marketing costs are expensed as incurred although they will benefit future periods. Technology and content costs are expenses although Amazon indicates that much of this is research and development that will benefit future periods. Unlike most companies, Amazon builds up cash because its customers pay for products before Amazon pays its suppliers and Amazon PRIME and Web Services customers make upfront cash payments, arguably some of this growing cash is equivalent to earnings even though it is liability. Unfortunately we have no basis to calculate adjusted earnings.

Amazon.com Inc.
RESEARCH SUMMARY
Report Author(s):  InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  The Author(s) hold no shares
Based on financials from: Dec ’16 Y.E. +Q3 ’17
Last updated: 27-Nov-17
Share Price At Date of Last Update: $1,195.83
Currency: $ Canadian
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): Sell at $1196
SUMMARY AND RATING:  The graph of revenues per share (red line) shows that the revenue per share have grown at a very strong and steady rate (compounding at an average of an astounding 27% per year in the ten years shown). The book value per share has grown at a high rate but that is mostly due to the sale of shares (Almost entirely through the exercise of options and with some issued in acquisitions) at very high multiples to book value, it is not very much due to the retention of earnings.  It seems likely that GAAP earnings per share substantially under state the true economic earnings due to the expensing of large amounts of technology staff costs and also marketing costs which are likely creating long term value but we have no basis on which to calculate earnings. GAAP earnings per share have been erratic and remain low in relation to sales.  The Value ratios based on GAAP earnings would indicate a Sell. Management quality appears very high but management has shown little or no interest in achieving significantly higher GAAP earnings. The insider trading signal is somewhat negative. The company itself has not bought back any shares since 2012. Executive compensation is high but not a concern given the size of the company. The outlook for revenue growth is strong but it is not clear when that will translate into earnings that are high enough to support the stock price.  Amazon has strong competitive and cost advantages. Amazon is a powerful and game-changing company that is worth watching. But based on the available accounting numbers we cannot rate this a Buy. Amazon’s book value of equity is $25 billion while that equity is valued on the stock market at $591 billion. Amazon has therefore created $566 billion in market value. This is based on the assumption that future earnings and cash flows will justify this value. The stock may well continue to rise with sales and sharply increasing profits but we simply can’t justify the valuation with the available accounting numbers. Overall we would rate this as a Sell. It should be considered a speculative stock. Those with large gains should consider cashing out at least some of the gain (just as Jeff Bezos has consistently done). Nevertheless, the shares could certainly continue to rise and some may wish to hold it but should be aware that its reported earnings do not appear to justify the stock price.
DESCRIPTION OF BUSINESS: (Last updated from fiscal 2016 results) Amazon.com Inc. is an internet-based company. Major revenue sources include i) the sales of products as an online retailers (electronics, books and general merchandise) ii) facilitating others to sell their products through Amazon for a service fee, iii) the sale of proprietary electronics that it manufactures (Kindle, Fire Tables, FIRE TV and Echo) and iv) the provision of web-based storage and services to businesses (Amazon Web Services). The company indicates that it is guided by four principles. 1. Customer obsession rather than competitor focus, 2. passion for invention, 3. commitment to operational excellence, and long-term thinking. The employee count was 341,400 full and part time at the end of 2016 (not counting temporary workers and contractors). In 2016 revenue was 9% from Amazon Web Services (AWS) 59% from North America (excluding AWS) and 32% from international (excluding AWS). Amazon Web Services accounted for 74% of operating profit, International accounted for minus 31% of operating profit and North America accounted for 56% of operating profit.
ECONOMICS OF THE BUSINESS: The GAAP earnings are far too low to support the price to book ratio of 23 times. But the company  has purposely priced low and has not pursued GAAP profits as such. We suspect that the underlying economics are strong.
RISKS: See annual report. The biggest risks are likely technology and competition.
INSIDER TRADING / INSIDER HOLDING: The top officers have a history of selling under automatic sale plans. This is understandable and provides little signal since they are paid almost entirely in stock options. They basically have to sell shares to obtain money to live on. Still, the constant selling has to be considered to be a somewhat negative indicator.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand and predict (marginal pass at best  as it is large and complex and getting more so), has favorable long-term economics due to cost advantages or superior brand power (pass due to tremendous brand power and economies of scale), apparently able and trustworthy management (pass), a sensible price – below its intrinsic value (fail or unable to determine), Other criteria that have been attributed to Buffett include: a low  debt ratio (pass), good recent profit history (pass) little chance of permanent loss of the investors capital (possible fail) a low level of maintenance type capital spending required to maintain existing operations excluding growth (pass)
MOST RECENT EARNINGS AND SALES TREND: GAAP earnings per share growth in the past four quarters, starting with the most recent  (Q3, 2017) was 0%, minus 78%, 38%, and 54%. Revenue per share growth in the past four quarters, starting with the most recent, (Q3 2017) has been 31%, 23%, 20%, and 21%. Revenues per share grew by 25% in 2016 and in 2015 grew by 16% and in 2014 grew by 20%. Therefore the revenue per share trend is very strong. Earnings per share grew 292% in 2016.  The earnings per share trend was very strong at the end of 2016 but turned negative and flat in the latest two quarters.
INDUSTRY SPECIFIC STATISTICS:
Earnings Growth Scenario and Justifiable P/E: The P/E ratio of 304 is pricing in tremendous growth in earnings and/or suggests that current earnings are vastly under-stated.
VALUE RATIOS: Analysed at a price of $1196. The price to book value ratio is ostensibly very unattractive at 24 times. Based on GAAP earnings the trailing P/E is exceedingly unattractive at 305!. The P/E based on analyst projected earnings is also extremely unattractive at 150 and suggests and earnings growth of 100%. It may be the case that GAAP earnings are vastly understated due to expensing vast amounts of technology spending and some marketing expenses that is in reality creating an enduring asset but we have no basis on which to make the adjustment. I am not sure that free cash flow (operating cash flow less cap ex) is a substitute for adjusted net income but the stock is trading at 73 times that figure. There is no dividend. The GAAP ROE is relatively modest at 9%. The growth in revenue per share has averaged 22% per year in the past five years ending 2016 and was 25% in 2016. Earnings per share growth figures are not very meaningful due to volatility and a low base. These ratios, in isolation, would justify a rating of Sell.
SUPPORTING RESEARCH AND ANALYSIS  
Symbol and Exchange: AMZN, U.S.
Currency: $ Canadian
Contact: ir@amazon.com
Web-site: www.amazon.com
INCOME AND PRICE / EARNINGS RATIO ANALYSIS  
Latest four quarters annual sales $ millions: $161,154.0
Latest four quarters annual earnings $ millions: $1,926.0
P/E ratio based on latest four quarters earnings: 304.5
Latest four quarters annual earnings, adjusted, $ millions: $1,926.0
BASIS OR SOURCE OF ADJUSTED EARNINGS: No adjustments were made
Quality of Earnings Measurement and Persistence: Given that Amazon has a P/E of 305 it is important to consider if the true economic earnings are higher than the GAAP earnings.  It is very possible that a large amount of the technology and content expenses and marketing expenses should really be capitalized as they create long-lasting value and in that sense earnings may be significantly under-stated. In addition, Amazon’s receives cash from customers before it has to pay its suppliers and also receives upfront cash from Prime customers. THis cash is offset bya liability but given that the cash grows continually, should some of this be considered a form of earnings?
P/E ratio based on latest four quarters earnings, adjusted 304.5
Latest fiscal year annual earnings: $2,371.0
P/E ratio based on latest fiscal year earnings: 247.4
Fiscal earnings adjusted: $2,371.0
P/E ratio for fiscal earnings adjusted: 247.4
Latest four quarters profit as percent of sales 1.2%
Dividend Yield: 0.0%
Price / Sales Ratio 3.64
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio:                                       23.96
Balance Sheet: (last updated Q1, 2017) Amazon is clearly valued for its earnings potential and not its assets. However it is instructive to understand the balance sheet and how the asset growth has been financed.  Assets consist of 27% cash and marketable securities, 13% inventories, 9% accounts receivable 40% property and equipment (of which about a third is land and buildings – much of which is in reality leased but capitalised and the rest is software and equipment) 5% goodwill and 5% “other”. These assets are supported on the liability and equity side of the balance sheet as follows: 23% accounts payable, 16% accrued expenses (some of this is lease payments due within one year, some is gift cards outstanding and some is for current debt and retirement obligations and other expenses accrued) 7% unearned revenue (apparently mostly PRIME membership fees) 10% long-term debt, 18% other long-term liabilities (mostly lease obligations which offset the capitalised lease assets), and 27% share holder equity of which only 29% is retained earnings and 71% is paid in money from share owners (likely mostly from stock option exercise money). This is clearly a strong balance sheet. What is very interesting is that company has financed itself to a good degree through accounts payable, gift cards and the unearned revenue of PRIME memberships and web services paid for in advance. As long as these amounts continue to grow over the years they effectively are never paid back in the net and amount to a perpetual interest free loan to finance assets. A huge amount of equity has come in through the issuance of stock options. Assets have grown faster than equity.
Quality of Net Assets (Book Equity Value) Measurement: Net equity is probably conservatively stated in that the assets are strong and there is  a modest amount of liabilities that are relatively soft including deferred income taxes and unearned revenue. However, with the company valued at 23 times book value, the reliability of the book value per share figure is unimportant.
Number of Diluted common shares in millions:                                 494.0
Controlling Shareholder: Updated spring 2017. Founder and CEO Jeff Bezos owns 16.9% and effectively controls the company. He has sold shares over the years but also receives shares as options. Vanguard owns 5.3%.
Market Equity Capitalization (Value) $ millions: $590,740.0
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 21.4%
Interest-bearing debt as a percentage of common equity 100%
Current assets / current liabilities: 1.0
Liquidity and capital structure: The company has very good liquidity and a strong balance sheet.
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: 9.1%
Latest fiscal year adjusted (if applicable) net income return on average equity: 14.5%
Adjusted (if applicable) latest four quarters return on market capitalization: 0.3%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
5 years compounded growth in sales/share 21.9%
Volatility of sales growth per share:  Strong and Steady
5 Years compounded growth in earnings/share 29.0%
5 years compounded growth in adjusted earnings per share 29.0%
Volatility of earnings growth:  Volatile
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Yes for revenue, no for earnings
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 14.5%
More conservative estimate of compounded growth in earnings per share over the forecast period: 15.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 20.0%
OUTLOOK FOR BUSINESS: It seems clear that Amazon is going to continue to grow its revenues at a high rate for a number of years. It is not clear when this will translate into a reasonable GAAP profit.
LONG TERM PREDICTABILITY: Given its brand name and scale, it can be predicted with confidence that Amazon will continue to grow its sales at a high rate. It is not clear however when this will result in GAAP earnings that are high enough to support the share price.
Estimated present value per share: With a GAAP P/E of 305, it appears that the current earnings are too low to form a basis for an intrinsic value calculation. It seems very likely that earnings are higher on an adjusted basis but we have no basis on which to calculated adjusted earnings.
ADDITIONAL COMMENTS  
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. Barriers to entry (pass, scale provides a barrier to entry). No issues with powerful suppliers (pass). No issues with dependence on powerful customers (pass), No potential for substitute products (pass) No tendency to compete ruinously on price (fail, although Amazon seems to bring this on itself). Overall this industry appears to be attractive to Amazon as the established large incumbent.
COMPETITIVE ADVANTAGE: Amazon’s scale, brand name and ambitions are advantages. It has cost advantages over traditional retail outlets, although shipping costs offset that to some degree.
COMPETITIVE POSITION: We don’t have the figures, but Amazon clearly has a leading competitive position in online retailing and also in cloud web services.
RECENT EVENTS: In Q3 2017 Amazon acquired Whole Foods for $13.7 billion. Amazon continues to add greatly to its products, services and geographic reach. In the past couple of years Amazon has generated ongoing subscription fee revenue from its PRIME (and related) service as well as Amazon Web Services for business. It is expanded into video creation and streaming and music streaming.
ACCOUNTING AND DISCLOSURE ISSUES: The disclosure seemed overly focused on changes from the prior period with very little discussion of profitability.  GAAP earnings may be understated due to the fact that a large amount of technology expenses including research and development efforts and also certain marketing expenses and the expenses to obtain PRIME customers will clearly benefit future years but these expenses are entirely deducted to reduce current earnings. Also the depreciation expense on software may be overstated if the software will last longer than the amortization period. If earnings are vastly understated then the accounting has not done its job due to excessive conservative on the part of management and/or accounting rules. The balance sheet is quite condensed with not very good disclosure and break-out of some items.
COMMON SHARE STRUCTURE USED: Normal, one vote per share.
MANAGEMENT QUALITY: Led by founder Jeff Bezos, management has to be considered to be excellent in most respects. An area of concern is an apparent lack of focus on profitability. Or possibly an accounting approach that has vastly under-stated earnings. Bezos argues that free cash flow per share is most important. We agree. But he appears to have an incorrect view that stock options should not be seen as a reduction from profits and from the cash flow that accrues to investors. Management treats cash flow resulting from increased payables and from gift cards as the same as cash flow resulting from earnings.  This becomes a form of “float” and has helped to finance growth. Management has at times shown little or no interest in increasing profits, although profits have increased recently. Growth appears to be the goal.
Capital Allocation Skills: Amazon appears to have shown good capital allocation skills by repurchasing shares at attractive prices in 2012 and prior to that. The company has not repurchased any shares since 2012 and that seems wise.
EXECUTIVE COMPENSATION: (Updated for 2016 compensation) The founder and CEO, Jeff Bezos, takes essentially no compensation ($81,840 per year).Compensation for the other four names executives is fairly generous but consists almost entirely of stock options. Base salaries $175,000 but total compensation up to $35 million. Executive compensation is not a concern given the size and value of the company.
BOARD OF DIRECTORS: Warren Buffett has suggested that ideal Board members be owner-oriented, business-savvy, interested and financially independent. Amazon has 10 directors who collectively appear to be well qualified.  Several of them may have accumulated much of their wealth trough Amazon as each director as from several million up to $86 million in Amazon shares. This sharpens their interest but makes some of them less independent. Directors also receive about $800k in compensation. This may be well deserved but does impede their independence.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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