There are about 10 weeks left in the quarter. To fill out my Top 10 list for 2013, I plan on posting one pick each week for the next ten weeks. If you're interested in how my previous Top Ten lists have performed, here is the record.
My first (and favorite) pick for my new Top Ten list is Amazon. The quirks of GAAP accounting have contributed to a lot of confusion and misperception about Amazon, which has, in turn, created quite a buying opportunity. As I'll explain below, Amazon's real revenue growth is higher than reported in their financials. In fact, the actual sales base is 50% larger than reported revenue. I'll also tell you how profitability is likely to look in a few years.
Here's the crux of the problem: Amazon revenue is comprised of both (1) Gross sales: for 60% of merchandise sold, 100% of the revenue is reported, and (2) Net sales: for 40% of the merchandise sold (through third party sellers), only 15% of the revenue is reported in the revenue line.
Another way to look at it: Some revenue (60%) is reported like Wal-Mart (which reports gross sales) and some (40%) is reported like Ebay (which reports net sales).
Per GAAP, the difference in accounting treatment is based on whether or not Amazon has inventory risk.
Here's how it works: You buy a $100 tent from Amazon. If Amazon has inventory risk (they're responsible for returns, etc.), they report $100 in revenue and $15 in gross profit. If Amazon sells you the tent and it ships direct from the manufacturer, they report only a $15 "royalty" (my term) as revenue, which falls straight to the gross profit line as $15 in gross profit.
Though Amazon's reporting is consistent with GAAP, it has led to numbers that aren't very useful. That's because the ratio of gross to net sales has changed in a material way (and continues to change). Comparing a 60/40 mix to the 70/30 mix of three years ago is comparing apples to oranges; it results in all sorts of data distortion, such as a gross margin that's jumped from 21% to 27%. On an apples-to-apples basis (revenue adjusted to reflect 100% of sales), the gross margin has been stable at 15%.
Because the ratio of gross-to-net sales has changed, Amazon's true sales growth is not evident in the GAAP numbers. (Over the last 5 years, the number of sales reported on a net basis has increased by one-third). By my calculation, on a rolling 12-month basis, Amazon's true gross sales have been doubling every 2 years since 2006. Based on my estimates, gross merchandise sales have increased from $13.5 billion in 2006 (GAAP revenue was $10.7Bil, with 30% of sales being reported net), to what I expect will be $97 billion this year, or about 50% more than the $64 billion that will be reported pursuant to GAAP.
Why are true gross sales important?
Armed with a calculation of true gross sales, an analyst has data that is comparable to prior periods, regardless of what the gross-to-net sales ratio happens to be at any particular juncture in time. It's also possible to build a model for the future that doesn't require a guess as to what the gross-to-net sales ratio will be. In my view, the model appears to be evolving toward a 15-17% gross margin/4-5% operating margin potential on total merchandise sales. That does not factor in growth in Amazon Web Services, which at 2% of revenue is small, but its 75% gross margin capability and high topline growth will eventually require it to be reported separately (not under "Other Revenue").
I'm of the opinion that, despite what will be close to $100 billion this year in total merchandise sales, this is a company that has several years of growth in front of them. Amazon is tackling a $10 trillion global retail market and it's not clear at this point how much of it can be captured.
But this much is clear: Management has moved very aggressively over the last two years to gain share by doubling its workforce, ratcheting up spending on technology and marketing by 80%, and building out distribution centers. The G&A expense line, however, remains less than 1% of true gross sales, suggesting this company has powerful margin leverage that's yet to be unleashed. Bears say that such margin leverage won't be unlocked anytime soon - and they're right. Count me among the bulls that doesn't mind waiting.