Amazon's Continued Growth Strategy May Put Pressure On Its Future Finances

| About:, Inc. (AMZN)

While customers should have every reason to like Amazon (NASDAQ:AMZN), investors may want to question a little their seemingly unconditional love for its stock. Traded at almost 20 times its equity book value, Amazon stock commands a valuation premium of close to 1,000% over the general market, given that the average ratio of price to book equity for the S&P 500 currently is less than 3. With substantial earnings growth, all this could have been justifiable. But that is not the case for Amazon, which has seen both earnings decline and reported losses over the last 5 quarters. To a degree, shareholders are forgoing their earnings to subsidize the value afforded to Amazon customers. It may come to a point where the subsidies have to be further supported through borrowing when Amazon's earnings can no longer sustain its high-cost, low-margin business model.

It's certainly admirable when a company can provide its customers with quality goods and services at competitive prices. But such a customer-first business practice is sustainable only if the costs of doing business are controlled at a comparable level. According to Amazon's cash flow statement, annual spending on capital expenditures grew more than 10 fold in the last 5 years from $333 million to $3.8 billion in its bid to expand businesses and get operations on scale. During the same period, sales increased only 3 times based on data from its income statement. With operating and other expenses climbing up in proportion to sales, profits (losses in some quarters) that flowed in could barely keep up with oversized capital investment outflows. A balance between capital requirements and operating results seems inherently unachievable under Amazon's aggressive business strategies that call for continued capital investments and low-margin operations.

When earnings from operations can no longer meet planned capital expenditures, Amazon has to resort to borrowing to make up for the shortfall. Data from the balance sheet show that long-term debt jumped from $255 million at the end of 2011 to over $3 billion at the end of 2012, with the period seeing a reported loss of $39 million. Although cash inflows from financing help meet immediate needs of capital expenditures, substantial debt increases put more pressure on maintaining a profitable operation as payments of interest expense further increase the cost of doing business. Currently, Amazon's debt-to-equity ratio stands at almost 50%, a high debt burden by most standards. In comparison, two of the notable tech giants Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) have a respective debt-to-equity ratio of 14% and 7%. In Apple's case, the debt was incurred only last year to finance dividend payouts and potential share buybacks. For many years prior, Apple incurred neither short-term nor long-term debt.

With debt being part of the capital components, the nature of a company's financial obligation changes. While equity investors can tolerate periods of low earnings or even no earnings in exchange for potential future growth, credit providers expect periodic payments of interest as stipulated and the on-time return of the principal borrowed, regardless of whether or not a company is generating enough profits. For Amazon, as much as it doesn't have to answer investors' call to improve its profitability, it needs to have the financial resources to meet its debt obligations. Amazon's continued lack of profitability can present a challenge to its future financial strength. While Amazon investors can now shrug off earnings concerns in favor of expansions, they must know that the company's inability to generate enough earnings is no joking matter in a debt situation because any difficulty of making scheduled debt payments can directly threaten Amazon's financial health. Investors may want to think twice about Amazon's earnings prospect if the company continues to finance its expansions increasingly with debt.

In addition to its high level of long-term debt, Amazon also uses a lot of current liabilities to help fund its ongoing operations. At the end of its latest quarter, Amazon's accounts payable stand at over $10 billion, while total cash and short-term investments count less than $7.7 billion. To help pay for outstanding bills, Amazon seems to be relying on rolling operation cycles for needed funds, essentially a situation of "living paycheck by paycheck." As to the overall business, Amazon's total assets have grown to more than $31 billion throughout the years, but over 70% of them are financed by debt and liabilities. Total equity has yet to reach $10 billion. While little earnings have contributed to equity growth, total common shares outstanding increased by 1 to 2 million shares each quarter over the last 5 quarters. With Amazon stock's elevated valuation, any additional shares through new issuance, warrants, convertibles or even stock options can bring in substantial amount of additional paid-in capital, countering potential negative effects caused by the company's increased use of debt and persistently low profitability.

Amazon's array of businesses may well be what customers love and many investors cheer for, but like any business operations, they have to be self-sustainable over the long run and eventually bring back returns on investments. Some investment evaluations may overly emphasize on a convincing business story and overlook the nitty-gritty of financial analysis. But in the end, it's the financial numbers that provide the conclusion to any business story.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.