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Amazon, A Complete Analysis

Summary

I did a complete analysis of AMZN, and I suggest to sell the stock.

Business analysis.

Accounting analysis.

Prospective Analysis.

Business Analysis

I have analyzed Amazon, that recently became the second trillion company of all times, using Porter's five forces, limiting my analysis to the Amazon online shopping business in the US.

Rivalry among existing competitors

The existing competition is wide and, in some cases, strong. In general, existing competition could be every type of little online store selling the same products of Amazon, but the main competitors are giant retail companies, like Walmart, Best Buy or Target. These companies are adapting to the costumers' needs and are becoming more and more digital, with e-commerce and better technological infrastructure.

Initially, Amazon had the advantage to have a better service, delivering what you wanted in your house in a fast time, but now that the other giants are slowly imitating it, the competition will be more and more focused on the price of the products. Moreover, clients have low barriers to switching from one company to the other, this is crucial and impose many investments for improving the product and the brand in a long-term Amazon perspective. Lastly, the exit barriers are high, these giant companies will not exit the market, continuing to compete in this market also if they have negative returns, stealing market shares from Amazon. Overall, the rivalry among existing competitor is high.

Bargaining power of Suppliers

Given that Amazon’s suppliers are thousands and differ from the small company producing necklaces to established companies with millions of revenues, they can’t really impose higher prices and threatening Amazon. Moreover, given that Amazon makes too much money relative to suppliers, also the integrate forward danger is negligible. Lastly, many companies, principally the smallest, are making much of their revenues via Amazon and probably want to protect it. Overall, the bargaining power of suppliers is low.

Bargaining power of Buyers

Amazon core mission is to give is costumers the best products at the best price, customers are at the core of its business. As said before, clients have a low barrier regarding changing their store, they just need to search the same product on google, check all the available options, and pick the cheaper product, forcing the price down. This happens also because the competitors ‘service is more and more like Amazon's one, creating a price war. Costumers have indeed a high quality of information, but they are not concentered, they are more than 300 million (2017). That said, given the high liquidity of information, the low switching cost and the availability of substitutes the bargaining power of buyers is medium/high.

Threat of Substitutes

The Amazon’s main substitutes are the brick-and-mortar stores, selling the same articles of Amazon. Again, the low switching cost for buyers here is fundamental. Costumer can easily decide to buy an article in the store under their house, rather than wait for two days to receive an article from Amazon. These substitutes “limit” the Amazon revenues imposing price constraints, substitution must be an Amazon priority for their long-term growth (Whole food acquisition probably is their first step in this field). Overall, the threat of Substitutes is high.

Threat of New Entrants

Is true that clients can switch to a new company offering the same services as Amazon without any barriers, but the high brand recognition, the great service and the range of products available are difficult to recreate. It would take years and billions of dollars to create a brand as strong as Amazon and to imitate his technology features. In addition, Amazon benefits from high economies of scale created during these years, new entrants should achieve similar structures to compete, and that is money and time costly. Overall, the threat of new entrants is low.

Accounting Analysis

For doing an effective Accounting analysis I firstly explained the management’s incentive to modify the accounting numbers, then I analyzed the presence of Red Flags. Lastly, I analyzed different major area of accounting policies and made the necessary adjustments.

Management’s Incentives

Managers have incentives primarily for these 5 reasons:

1) To influence stock price

2) Because there is outside pressure to hit earnings benchmark

3) Because there is inside pressure to hit earnings benchmark

4) To influence executive compensation

5) Because senior managers fear adverse career consequences if they report poor performance

Management usually has always some part of his retribution rewarded in stocks. The so-called stock-based compensation, mentioned several times in AMZN 10-K, is used by companies to align the managers with the goal of the company, that could be identified in maximizing the current value per share of the existing stock. Moreover, if managers receive a premium salary only when they reach established goals, this could lead to manipulating the accounting numbers to reach these goals and receive more money. For both reasons, the presence of Bezos as the top-manager is a great obstacle to modify the Financial statement numbers to influence other managers compensations, his main goal is the growth of Amazon, not short-term money.

Red Flags

I did not find any evident sign of really “low” accounting quality, but I am sure that Amazon uses many accounting items to slightly modify the items (using the “immateriality” gimmick discussed in Homework 2) and could modify other area of accounting to report results different from the reality, I will discuss these quantitative red flags in point 3.

Accounting Policy and Adjustments

Revenue recognition

Amazon in its 10-K states: “We recognize revenue from product sales or services rendered when the following four criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, or service has been rendered, the selling price is fixed or determinable, and collectability is reasonably assured.” These four principles are the GAAP principles of revenue recognition. Later in the note Amazon talks about revenue arrangements with multiple deliverables and say:” [multiple deliverables] are divided into separate units and revenue is allocated using estimated selling prices if we do not have vendor-specific objective evidence or third-party evidence of the selling prices of the deliverables. We allocate the arrangement price to each of the elements based on the relative selling prices of each element.” Here management has the important function to estimate the single unit prices, GAAP suggests writing the “best estimate of selling price”. Then the 10-K describes the recognition for Amazon’s services/products. For example, the amazon prime memberships “are also considered arrangements with multiple deliverables”. That said, Amazon is consistent with GAAP revenue recognition policy. Also, analyzing its worsening receivables turnover I think that they could understate them, or they are entering new businesses and have not high bargain power. The understatements could be reflected in the income statement as an increase of earning and net income (and taxes), but a decrease of future earning (“cookie jar” effect). Lastly, I don’t think their credit quality is deteriorating. If the revenue recognized by Amazon is not “real” and should be deferred the adjustment that management should take is: decrease the revenuesàdecrease the COGS= Net income decreases (Net of tax shield effect), on the balance sheet the deferred revenue is recognized (liability), deferred taxed are decreased and other current asset is recognized for an amount = COGS previously reduced, equity is reduced.

Inventory

Given that the Amazon inventory turnover is growing this means that Amazon is using in a better way its inventory, producing more sales for every dollar of inventory. No slowdown in demand is shown by this trend nor red-flags. This is also confirmed by the question 4, Homework 5 in which we analyzed the DIO and the results were that Amazon is improving its inventory management. If the inventory is overestimated, for adjusting it Amazon should take an inventory impairment expanse, that will reduce the net income (after the “tax shield” effect), on the balance sheet this impairment will reduce inventory, increase the deferred tax assets and reducing the shareholders equity.

3.3 PPEs

The worsening Fixed asset turnover could be a telltale sign for PPE manipulation. This seems like a lower efficiency of AMZN in using its assts or could be explained by the new investment made by Amazon (Homework 5, Question 2) for future competitiveness plans. Analyzing the industry, we already noticed that Amazon has different useful life rather than its “competitors”, usually shorter, this create differences for depreciation and for taxes and earnings, boosting the last years of the PPE asset. Lastly, assuming a cost of capital that could be estimated by the WACC at 8.74%, the ROA is consistently lower than cost of capital, suggesting distortion for PPEs. The adjustment if overstated is like the one done with inventory.

3.4 Stock-based compensation

As discussed in Homework 7, Amazon pays many of its employees with stock-based compensation. We don’t know how to evaluate the options, cause the Black-Scholes formula parameters are not given. This could be a distortion on Amazon financial statements, increasing their fair value could lead to an increase in the COGS and “selling general and administrative expense”, decreasing net income and could be reflected to market data through a lower Dilutive EPS.

3.5 Lease

Utilizing the off-balance sheet lease financing (operating) Amazon does not account many Billions of values of assets, using the 1.83% discount rate the “net minimum lease payment” is (this time assuming therefore as a 5-year period, for obtaining similar rent expanses):

(millions of $)

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

Operating leases

2,427

2,376

2,258

2,039

1,813

2387

2387

2387

2387

2387

Present Value

2383.33

2291.26

2138.29

1896.16

1655.6

2140.62

2102.1

2064.2

2027.1

1990.6

Implicit Discount rate

1.83%

Present value of net minimum lease payments

20689.4

If adjusted this would increase the liabilities and recognized the lease asset, modifying different financial ratios, for example Decrease the Asset turnover the ROA and increase the Financial leverage.

Overall, Amazon is reporting numbers that seems to adhere to the reality, we cannot know if they are underestimating/overestimating some of the discussed numbers, but we know that the company is growing and every year more information could be added to this Financial Statement valuation.

Disclosure: I/we 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.