There was an interesting development on Monday when it was announced that Amazon (AMZN) has filed a registration statement to issue some securities. In what would be the company's first debt offering since 1999, rumors are that the company would look to issue bonds with maturities of 3, 5 and 10 years. The company doesn't have any bonds outstanding currently, and says the bonds will be used for general corporate purposes. Monday's news is very curious, as I have been one lately to criticize Amazon's balance sheet. I'm not entirely sure I'm in favor of this, and it might add more fuel to the short fire.
Balance Sheet Impact
When I detailed Amazon's third-quarter results, I stated that the balance sheet was not looking very good. Because Amazon is primarily a retailer, business can be seasonal so comparing the balance sheet from quarter to quarter doesn't always work. But when comparing Amazon's balance sheet at the end of Q3 in 2012 with the end of Q3 in 2011, there were the following red flags:
- The total of cash and marketable securities fell by nearly $1.1 billion to about $5.25 billion over the 12-month period.
- Working capital went from $2.926 billion to just $513 million.
- The current ratio went from 1.33 to 1.04.
- The debt (liabilities to assets) ratio went from 59.24% to 66.92%.
But there certainly are trends that just don't look good. The following chart shows Amazon's working capital at the end of each quarter. The dollar values on the left are in millions.
Eighteen months ago, at the end of 2011's Q1, Amazon had nearly $3.56 billion in working capital, and as I mentioned above, that number was down to just $513 million at the end of September.
Now if Amazon does in fact issue debt with those above-mentioned maturities, there are two immediate impacts on the balance sheet (holding all else constant). The first would be that the company's cash balance would increase by the debt amount (ignore fees for this argument). The second impact is that long-term debt would increase by the debt amount. So let's say Amazon issues $3 billion in debt. Cash and long-term debt would increase by $3 billion each. But there's the funny part. Because long-term debt is a long-term liability, Amazon's working capital would jump to over $3.5 billion, like I said, assuming no other changes from Q3's end. The cash pile would also increase, and the current ratio would as well, because current liabilities are not affected at all.
So the only ratio of the ones I look at that would be negatively impacted by an issuance of debt would be the debt, or liabilities to assets, ratio. So let's just say for argument's sake that Amazon issued $3 billion worth of debt Monday. For this argument, assume that the balance sheet had not changed since the end of Q3, and that there are no fees or anything associated with this transaction. Cash (total assets) and long-term debt (total liabilities) increase by $3 billion each. Well, overnight, the debt ratio would have gone from 66.92% to 70.76%. That doesn't seem like much, but a year ago it was under 60%. Also, Amazon will start using that cash, but probably won't pay back the debt until it matures. So if you assume that it spends say $1.5 billion (half of it) right away, again for argument's sake, the debt ratio goes above 75%.
The addition of the debt would make the debt ratio instantly worse and it would probably get worse until it starts paying that debt back. Now if you remember how I said the business can be somewhat seasonal, the debt ratio is affected by the seasonality. Generally speaking, over the past couple of years, Amazon's debt ratio has been highest at the end of Q4, and then it drops in Q1. So instead of a chart with a bunch of up and downs, I've changed things up a little. To reduce the impact of seasonality, I've created a 4-quarter running average chart for the debt ratio, as seen below. The logic is simple. I've taken the average total liabilities for the past four quarters divided by the average total assets for the past four quarters. The debt ratio simply is total liabilities divided by total assets, so we're just using averages. So in the chart below for example, the Q4 of 2009 figure does a 4-quarter average from Q1 of 2009 to Q4 of 2009. The final point, Q3 of 2012, includes Q4 of 2011 through Q3 of 2012.
Essentially, the chart above is a moving average, and it's not looking good. Amazon has been criticized for its financials and its balance sheet, and rightly so. Right now, the numbers just aren't looking very good, and the trend is going in the wrong direction.
Declining profitability to begin with
In addition to Amazon's balance sheet getting worse, the income statement isn't doing much better. While Amazon has grown the top line revenue numbers quite well in the past few years, they aren't translating it to the bottom line. The company is making little to no money, and in the most recent quarter, actually lost money.
To show you how bad the margins are doing, I've put together a chart showing the trailing twelve month operating and net profit margins for Amazon. This is not an average number. It is a combination of the quarters, the total operating income for the previous four quarters divided by the total revenue for those four quarters. So for example, the Q4 2009 number below is actually the margins for the entire year in 2009, whereas the Q3 of 2012 number is the four-quarter period from Q4 of 2011 to Q3 of 2012. These numbers are based on the GAAP results, and do not take out any adjustments, such as any gains or losses from equity investments that are always discussed when it comes to Amazon.
I bring up this point because what does debt carry? Interest expense. Now, rates are low and Amazon isn't in current financial trouble, plus it is looking at shorter-term maturities. It isn't expected to float anything like a 30- or 50-year bond here. But go back to that $3 billion hypothetical figure from before. Even at an average of say 2% interest, that's $60 million in pre-tax interest costs. To a company like Amazon that has operating margins of less than 1 percent right now, interest costs will certainly make things worse.
Debt or Equity?
There is an interesting argument to have when it comes to Amazon raising some funds. Should it issue debt or equity? If Amazon issues debt, it will be on the hook for interest payments, plus it will eventually have to pay that money back. The balance sheet will improve in some respects, but the debt ratio would get worse. The good news here is that current shareholders would not face any dilution.
But let's look at the equity side. If Amazon were to raise money through a share sale, those are funds that would never have to be paid back, unless Amazon starts buying back shares, but that is not something it would be obligated to do. The downside here is that current shareholders would be diluted, and many believe the notion that a company selling stock sends a signal that a stock is overvalued.
So think about the equity for a second. At the end of the third quarter, Amazon had approximately 453 million shares outstanding. If it were to dilute shareholders by 2%, it would sell approximately 9 million shares, to use a round number. At Monday's close, that would raise approximately $2.19 billion dollars, before any fees. But that money goes straight to cash and Amazon wouldn't be paying interest. What would the interest costs on roughly $2.2 billion be? I'm guessing somewhere between $35 and $75 million a year, pre-tax. Is it worth it for shareholders to take a 2% dilution hit instead of watching the company potentially pay hundreds of millions in interest? Remember, Amazon's outstanding share count has generally risen in recent years due to executive options and the like, so shareholders have already faced some sort of dilution.
I would personally lean toward the equity side, but that's just my opinion. It would also depend on what the interest rates were, so I can't make a total recommendation without those numbers.
Acquisition of Netflix (NFLX)
I bring this up because there has been a lingering debate over the possibility that Amazon could acquire Netflix. Amazon wants to expand its Prime Video offerings, and with Netflix's foot already heavily planted in this space, many would think Netflix is a logical acquisition target for Amazon. In fact, a recent Netflix rally was due to acquisition hopes.
So when it seems like Amazon may be raising money, you might think that an acquisition is coming. Well, one might be, but I don't think Netflix makes sense for Amazon at the moment. While Amazon could cut out a ton of costs, since it has a lot of overlapping content, I don't think Amazon would want to be on the hook for the billions of dollars worth of content purchases Netflix has. These are the off-balance sheet liabilities that Netflix always refers to. These two firms are competitors, and I don't see how an acquisition would make sense for Amazon. Netflix isn't profitable currently anyway, so why would Amazon spend billions on the company? It just doesn't make sense to me, which is why I think that any funds raised would be better off if used elsewhere.
The issue of debt for Amazon is an intriguing one. Amazon's balance sheet has gotten worse in recent quarters, with working capital projected to go negative in the next quarter or two if the trend continues. The addition of debt would certainly inflate some balance sheet metrics right away, but the debt ratio would increase and get worse as it spends that money. Debt would also incur interest expenses, and Amazon isn't the most profitable to begin with.
I'm not a fan of Amazon raising debt at the moment, because it seems to me that it would have been better off doing it a year ago when its financials were better. With the balance sheet and profitability numbers getting worse, interest costs have probably risen for the company. Monday's announcement doesn't mean that Amazon will definitely raise funds, but it seems likely that it will.
This decision brings up some questions that need to be answered, like what will it spend the money on and should it sell stock instead? For now, I'm leaving Amazon in the short candidate bin because I think the debt issue brings up more problems than solutions, for now anyway. That doesn't mean that you have to go out and short Amazon today, but there seem to be more reasons today why you would want to.
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