I have written many articles on Amazon.com (AMZN) that have largely focused on its weak financials, shrinking growth and poor metric performance. This article will summarize those prior thoughts and provide one more reason to hate Amazon's valuation: further detail on the concept of the "Amazon Bank" with the addition of new data from 2013 Q1. Amazon's current valuation is ridiculous at every level based upon the information in this article: 2014 Forward P/E: 87, P/Book: 15, PEG (5-yr expected): 5.8, Price to Free Cash Flow (2012): 307x (source: Yahoo! Finance). Besides the valuation, here is the summary of the factors that have me short in Amazon:
- Amazon's revenue per unit is dropping at over 8% per year, thus making shipping cost a higher and higher percentage of each unit, and hence revenue, over time (due to pricing competition, sales tax, and a move to lower priced products).
- Exacerbating factor (1) has been the massive increase in gasoline and oil prices since 2009 (~ 40%). So, the cost of shipping per unit has increased while the revenue per unit has decreased. This has created a double whammy for Amazon in terms of shipping expense per unit (see this article for detail).
- One way reduce the shipping cost per unit when gas is high is to reduce the shipping miles per unit. This pushed Amazon to open extremely expensive distributed fulfillment and logistics centers to minimize the variable shipping cost impacts from factors (1) and (2). While this added fixed cost has reduced the variable cost of shipping to optimize current financials, the overall net impact is very negative on Amazon's income statement and cash flow with respect its last good year of performance (2010). Although they are optimizing their situation to the current reality of on-line pricing trends and fuel expenses, they will never be able to achieve the peak margins they achieved in 2009 and 2010 due to this. Analyst models currently not only expect a return to those peak net margin levels, but they expect Amazon to exceed them significantly in order to support their price targets.
- In order to place distributed fulfillment and logistics centers in needed locations, Amazon had to negotiate sales tax agreements with individual states. This is removing Amazon's 15 year price advantage over the competition. Without this, Amazon will see additional margin pressure.
- As well as hampering profits, items (1) through (4) have severely impacted Amazon's Cash Flow over the past three years as well. To counter this, Amazon had to borrow $3 billion late last year from the debt markets to keep its current ratio above 1.0, and has also essentially opened a bank where they have used the timing of payments in working capital to generate much needed cash flow. Amazon has in effect borrowed $4.6 Billion over the past four years from suppliers and customers by collecting cash up front for services, payments or products it has yet to provide. More below for detail on this $4.6 Billion and where it has come from.
- The Law of Big Numbers is catching up to Amazon as its traditional product lines and market are not providing the growth Amazon needs to maintain is cash flow to fund operations. Their solution has been to "go horizontal" and add on new businesses at a break neck pace to supplement their growth. The impact from this can be seen in the cost of inventory and fulfillment. Both are growing much faster than revenue, as the additional SKU's (and fulfillment centers themselves) add significant distribution, logistics and fulfillment complications and expenses. Inventory Days will continue to expend (see chart below) as SKU's and number of fulfillment centers increase.
- Amazon's revenue per customer is in decline for the first time in its history. Amazon's growth had been driven by huge increases in revenue per customer over the past 15 years, and now that has not only stopped, it has reversed. This has pushed Amazon to spend a significant amount of money on acquiring new customers through expensive loyalty programs and the entrance into new markets (i.e. China). Amazon is not profitable with its current middle and upper class US/European customers, so the expansion into lower income markets will prove challenging.
The Bank of Amazon: Amazon has generated $4.6B in Free Cash Flow since 2009 by expanding its timing of payments metrics.
As I pointed out in an earlier article, Amazon has burnt cash ($1.4B) selling products and services from 2008-2012. The company has remained solvent by stretching out payments to suppliers, growing an unprofitable Prime business that supplies cash up front for losses later, and by expanding its gift card business. While all three provide cash in the short-term and create significant liabilities going forward (it has to be paid back with either cash, inventory or operating expenses), the first two actually reduce earnings by accepting lower margin in order to borrow short-term cash at zero interest. I should point out that there normally is no issue in generating cash from working capital in a growing company, but the question investors should be asking themselves is why is Amazon so aggressive in taking losses in order to do it? The answer is because they have to; their balance sheet is that tenuous. That should make any long investor nervous.
Amazon offers incentives in the form of lower commissions and fees to its partners and negotiated terms with their suppliers in order to push out payables. While you could argue this is a good thing for Amazon to have this negotiating power, comparisons show that Amazon's competitors, like eBay (EBAY), now offer significantly better terms which Amazon will have to deal with. At almost 72 days payable, it will be very difficult to continue to expand this number to generate cash without losing business. The expansion from 59.0 to 71.8 days over the past four years has generated a cumulative $1.6B in Cash Flow.
Accrued expenses is the current amount of cash received for products and/or services that have yet to be rendered over the next twelve months. Amazon accrued expenses are largely made up of Amazon Prime membership fees, gift cards receipts and AWS service premiums. At the end of Q1, Amazon had $5.416B in accrued expenses. Amazon accrued expenses have grown significantly since the end of 2008 from 17.3 days of revenue to an amazing 27.3 days of revenue. That means that Amazon has already collected almost an entire month's worth of revenue up front as pure cash, without any of the expenses. Amazingly, my analysis shows that Amazon Prime and gift cards can sustain an operating loss as long as they add new members fast enough to grow accrued expenses larger than the loss. This is an interesting strategy, as the loss keeps taxes at zero, even though they generate cash. This fits with CEO Jeff Bezos' strategy of growing free cash flow, and not caring about profits.
Long-term liabilities are the same as Accrued Expenses except it is the amount of cash received for products and services due beyond twelve months. While that eliminates Prime memberships, it does include gift cards and AWS services. At the end of Q1, Amazon had $2.573B in long-term liabilities. Amazon long-term liabilities have grown since end of 2008 from 8.7 days of revenue to 14.3 days of revenue. Interestingly, this metric has shrunk a little from its peak of 17.1 days in CY12 Q1. This could be a hint that AWS revenues will start to slow soon (it is now a year later) as Amazon signs long-term service contracts with its customers. Not included in these numbers is the $682 million of long-term digital video commitments Amazon keeps off of its balance sheet that is helping to drive its Prime membership.
Net Cash Position
Amazon currently has $4.9B in net cash (blue bars in the figure below) with a current ratio of 1.138 (current assets less current liabilities). If we total the cash generated since the start of 2009 from expanding days payable, accrued expenses days of revenue and long-term liabilities days of revenue we would get $4.6B. Without the expansion of those financial metrics, Amazon would have nearly zero net cash after Q1 (red bars in the figure below).
Inventory Days Trend
Amazon has always prided itself on fast inventory turns and held it quite steady up until 2010, when days of inventory started growing sharply. As discussed earlier this is most likely due to the expansion of SKU's and fulfillment centers needed to both grow the company and keeps costs down. This metric should continue to pressure free cash flow going forward, as Amazon has stated it will continue to build out new fulfillment centers and introduce many new product lines.
After examining Amazon's business and its past 5-year financial statements in detail, it is clear that Amazon's operations, given the current market realities, could no longer generate the cash flow needed to sustain its business. Due to this Amazon has gone to the debt markets for a $3 billion loan and created profit destroying incentives to generate cash flow that its suppliers, partners and customers have taken advantage of. Based on competitive metrics, these incentives' leverage appear to be near their limit, and Amazon may struggle generating the required cash needed to operate the business in the near future. This would imply either a secondary offering or additional debt may be on the horizon.
Amazon's 10Q tells us quarter after quarter that their "financial focus is on long-term, sustainable growth in free cash flow." Jeff Bezos has also told us that operating margin percentage is not important, that its free cash flow that really counts. Based on the information in this article it is clear that Amazon has taken this approach in building the company, and there is nothing wrong with that. My issue is that if you model future free cash flow in accordance with financial trends, competition, markets, strategy and what they have told us and then apply a reasonable discount rate, the current market valuation is massively disconnected from reality (by more than a factor of 2).