Much of the bull and bear debate on Amazon.com ("AMZN") centers on future growth rates, operating leverage, and the success of new ventures. While these are undoubtedly important factors for consideration when investing in the company, they are inherently difficult to predict. Personally, I know I am not smart enough to predict the future of AMZN with nearly the same degree of precision of the sell-side analysts whose research I occasionally peruse. If you are, feel free to disregard the balance of this article because it will only waste your time.
My goals when allocating my capital are twofold: i) imprecisely estimate the amount of future cash that the security considered for purchase will deliver to me over its lifetime and ii) determine if the price I can purchase the security at provides a wide enough margin of safety to cover potential errors in my calculation. For these reasons, I try to spend much of my time thinking about free cash flow, return on invested capital, and returns on incremental invested capital.
Free cash flows, current and future, are important because on a discounted basis they ultimately determine the present value of a security. Return on invested capital is important because it is the ultimate arbiter of how efficient management is at allocating the capital it doesn't distribute to shareholders to generate more free cash flow in future periods. With that in mind, let's take a closer look at AMZN on these metrics.
Amazon isn't generating much free cash flow. This is typical for a company growing at the rate AMZN currently is, given the perceived growth opportunities. No problems so far. However, it is atypical for a company to outspend its free cash flow by 240% repurchasing stock and still dilute existing shareholders. To summarize, if you owned AMZN shares at the end of 2011, you now have $565 million less net cash and you own the same percentage of AMZN's future cash flows. In other words, AMZN's main accomplishment this year for equity holders was to create an incremental cash liability. Note that cash balances grew on the balance sheet because AMZN was a net issuer of debt and increased accounts payable, which creates a corresponding liability...don't get excited.
Maybe it's just me, but I don't like when a company I own takes all of my free cash flow, or in this case 240% of my free cash flow, and uses it to repurchase gifts given to its employees. If people are upset about President Obama "sharing the wealth," they will have a heart attack upon closer examination of AMZN's stock comp policy. This trend doesn't appear to be abating as AMZN intends to gift its employees $285 million in the first quarter of 2013.
Perhaps we should give AMZN a pass on de minimus free cash flow and Socialist stock compensation policy because they are growing so fast and hiring a bunch of over-educated types who will find ways to allocate capital at super high rates of return.
|Return on 2011 Invested Capital|
|Total assets ($ billions)||25.278|
|Non-interest bearing current liabilities||14.896|
|Total invested capital||10.382|
|2011 operating Income||0.862|
|Normalized tax rate||37.00%|
|ATAX operating income||0.54306|
|Return on invested capital||5.23%|
|Return on 2012 Invested Capital|
|Total assets ($ billions)||32.555|
|Non-interest bearing current liabilities||19.002|
|Total invested capital||13.553|
|2012 operating Income||0.676|
|Normalized tax rate||37%|
|ATAX operating income||0.426|
|Return on invested capital||3.14%|
|Return on Incremental Invested Capital|
|Capital invested between 2011 & 2012 ($ billion)||3.171|
|Incremental ATAX operating income||-0.117|
|Return on incremental invested capital||-3.70%|
Note: I assume a 37% tax rate. I have no idea what AMZN's normalized tax rate is.
Here we see that AMZN's returns on capital are actually declining because they are deploying incremental capital at a negative rate of return. In fact, AMZN invested $3.2 billion in its business over the course of 2012 between capital expenditures and acquisitions, net of depreciation, and generated an incremental negative $112 million in after-tax operating income. This is functionally similar to putting capital in a bank account at a negative 3.7% yield.
I expect that bulls on AMZN will argue that ROIC is depressed because of non-cash stock compensation expense. However, my reply is that stock comp is a real expense because it is diluting existing shareholders. If AMZN wants to arrest this dilution, it will need to expend real cash to repurchase these shares which otherwise would have gone to shareholders. Furthermore, if you are long AMZN, presumably you feel the shares are undervalued in which case the expense stated on the income statement ultimately underestimates the expense on the cash flow statement because these shares will need to be repurchased at a higher price in the future.
Finally, AMZN has a market capitalization of about $130 billion at today's price but only has $13.5 billion invested in the business. Essentially, investors are saying that every $1 that AMZN has invested has a present value of roughly $10. If that is the case, Jeff Bezos is Lebron James and Warren Buffett is Brian Scalabrine. To put these numbers in context, other "capital light" business models like IBM and McDonald's (MCD) have invested capital of $85 billion and $30 billion and market capitalizations of $228 billion and $95 billion, respectively. Coincidentally, these companies are also massively profitable, but I still wouldn't pay $850 billion for IBM or $300 billion for McDonald's.
To summarize, AMZN doesn't generate much free cash flow and the cash flow it does generate, and more, goes to purchasing stock gifted to employees. Additionally, AMZN doesn't have much capital invested in its business and the capital it is currently investing is generating a negative return. As stocks are largely priced off of future earnings potential and future earnings potential is a function of returns on existing capital plus estimated returns on incremental invested capital, this does not appear to bode well.