Recently, I came across an article expressing the view that investing in Amazon (NASDAQ:AMZN) is a bad idea for long-term investors. Even though the author made a brave, contrarian attempt to oppose the common analytical consensus, I truly doubt that his main arguments appropriately addressed the company's actual story.
I used to be a member of the camp of investors who wouldn't buy Amazon's shares due to its unprecedentedly low-profit margin and fierce competition in the retail, shipping, and technology industry. Fortunately, I developed an open mind and recognized that Amazon can be a successful long-term investment even if it does not match mainstream investment tenets regarding earnings multiples and growth.
Why is Amazon's profitability so low? Does it really matter at this point?
Perhaps the most pivotal point in understanding Amazon's business model is to understand its strategy. Contrary to its peers, Amazon is aiming to increase its market share at any cost. Not only does the company make relatively small profits on many of its products and services, but it also often sells some below their production costs. This has been the case for Amazon's Kindle e-book readers and Kindle Fire tablets.
In order to combat its existing competition and ward off new potential industry entrants, Amazon is betting big on innovation. Drone delivery services and checkout-free stores are just a few examples of these bets. If these endeavors prove to be commercially viable, Amazon can attain further efficiencies and improvements in its operational activities.
Amazon's story is all about revenue and operating cash flow growth
Forget profits. The only relevant section of Amazon's income statement is revenue. From 2014-2015, total revenues climbed 20% to $107,006M. As shown in the graph below, quarterly year-on-year revenue growth is both stable and above the industry average.
Geographically, most of Amazon's revenue is generated in the United States (66%), followed by other developed markets such as Germany (11%), United Kingdom (8.4%), and Japan (7.7%). Roughly 60% of total revenue comes from the North America segment, which accounted for 56% of total revenue just two years ago. The share of the AWS (Amazon Web Services) segment on net sales has also increased, which positively impacted the overall profitability of the company since AWS is a high margin service. On the other hand, the international segment currently operates with negative margins.
Looking at Amazon's cash flow, one can clearly spot a strong long-term trend of accelerating cash from operations. This is a vital attribute of every financially sound and well-managed company, and proves Amazon's outstanding ability to steadily collect cash from its regular business activities. Based on the fact that Amazon is a young company, it would be highly inappropriate to use other measures than those derived from revenues and cash flows to assess the company's prospects.
Presumably, the best financial metric for estimating Amazon's intrinsic value is the so-called "Funds From Operations". Although FFO is usually used in evaluating the performance of REITs, it can also serve as a useful valuation metric for early stage tech companies like Amazon.
FFO is a metric calculated by adding non-cash charges, such as depreciation or amortization, to net income, and then subtracting non-operating income and any expenses. To attach a meaning to the metric, look at its correlation to stock price.
Obviously, there is a solid long-term relationship between the two. Moreover, we can get a better understanding by calculating Amazon's Price-To-FFO multiple, which is an alternative to the traditional Price-To-Sales ratio.
Amazon trades at a higher Price-To-FFO multiple than its peers (Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Microsoft (NASDAQ:MSFT), eBay (NASDAQ:EBAY) and Wal-Mart (NYSE:WMT)), but I argue that these companies shouldn't be considered as competitors. Amazon has a highly differentiated business model, which is far different to those of the commonly used peer comparison companies.
While Amazon may seem expensive at first look, realize that the company's business model substantially differs from its peers. With respect to that matter, I believe that any valuation metric and argument which do not relate to revenue or cash flow are irrelevant. Based on the long-term trend of FFO, and the existing relationship between FFO and Amazon's stock price, it is likely that Amazon's shares will continue to appreciate. On the other hand, investors should also keep in mind that outside the U.S., Amazon has been struggling. The flourishing AWS segment partly offsets the losses from the International segment but if Amazon wants to succeed, it will have to find new revenue streams. Despite the challenging business environment, China and India might be key markets. After all, a large company like Amazon should have no borders.
Disclosure: I am/we are long AMZN, GOOG.
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.