Financial Research Project – Amazon

The report provides the financial analysis for Amazon, Inc. with regard to opportunities the company presents to investors in the long term prospective. As the company operates in a highly competitive environment, and its business model features high risk levels, the investors base their analysis on а broad range of factors. The report presents a comprehensive examination of financial performance indicators and key business ratios, including margins and ROE, as well as stock performance analysis and concludes with investment recommendations.

Background Information

Amazon, Inc. is a globally recognized leader in the e-commerce industry, providing services to customers, sellers, enterprises, and content creators. Besides the online retail segment, the company manufactures and sells electronic devices, provides services in marketing, promotion, and B2B cloud computing. Founded in 1994 by Jeffrey Bezos, the company has been continuously investing in disruptive innovations, stating its mission “to be the Earth’s most customer-centric company.” The Amazon brand is among the top 50 valuable brands in the world, and the company is consistently taking first ranks in different versions of the most innovative companies lists (Forbes, 2015; Yahoo! Finance, 2015).

Financial Performance Results

The key financial results for the years 2014, 2013, and 2012 are summarized in Appendix A. Appendix A.1 contains data selected from Amazon’s income statements, balance sheets, and cash flow statements. Appendix A.2 contains а comparison of the selected financial indicators and key performance ratios with competitors and with average indicators for the industries according to Amazon’s segments of operation. The data is compared to those of the main competitors in the retail industry (Walmart, Costco, Target) as well as with technological companies (Apple, Google, Microsoft); the industry selection includes all related industries.

The results reflect a broad range of segments covered by Amazon and indicate a significant drawback of any financial analyses for such a complex business. Amazon’s overall performance is influenced by its performance in all specified segments, and the general data give no implication of which segment contributed to the analyzed financial metrics. An overall analysis of the key financial performance indicators is presented below.

Revenue and Net Income

The company exhibited stable growth of revenues in 2014 and 2013, with the growth rate of 20-21 percent, and reached $88.98 billion in revenues. Amazon is in the top 100 global companies by sales figures. However, it fell behind the competitors in both retail and IT/electronic equipment industries in absolute figures. Whereas large retail competitors obtained only modest sales growth due to economic downturn and decreased the purchasing power of their customers, the average revenue growth rates in the retail industry were much higher.

The reported earnings were less stable during the years; the company closed the year 2014 with net losses. This result reflects large expenditures incurred by the company to present innovations and enter new business areas (see more detail in the section). In order to beat these results, the company specifically communicated that profits are not the primary goal of Amazon: “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows” (Amazon, 2014b).

Cash Flow

As Amazon showed worse financial results in 2014 and emphasized that the cash flow is its main strategic goal, there was a number of discussions regarding how the reported cash flow figures correspond to the actual value of the business. Amazon generates more cash flow than EPS; however these figures can prove misleading due to depreciation expenses, stock-based compensations and capital leases, which can inflate cash flows and “make cash flow look positive in the short term” (Trainer, 2014).

Working Capital and Total Assets

The assets and liabilities structure of Amazon is similar to other companies in the retail segment. The competitors manage to create negative working capital due to specifics of their relations with suppliers. Amazon increased its assets and working capital in 2014 as it displayed significantly higher cash flows. Likewise, Apple grew its current assets in 2014. The ratios that describe the effectiveness of asset’s usage will be presented in the sections that follow.

Financial Ratio Analysis

In the next sections several most important financial and performance ratios are described, based on the Amazon reports for the years 2012-2014 (end of period 2014, December 31). It is important to use both horizontal analysis (to analyze the ratios to track the company’s performance over time) and vertical analysis (to compare the ratios to other companies in the industry or business sector). However, industry groups are often too general, and as mentioned above, Amazon operates in several segments. It is a unique company, competing with the traditional brick-and-mortar retailers and at the same time developing non-core business and entering competition with the leading technological companies in the segments of advertising, digital devices, and computing services. It is necessary to note that despite the fact there are some general rules for the ratios, they can be sometimes misleading due to the differences in methodology, specifics of the business model, and the performance of a particular industry. The ratios are presented in Appendix B.1.

Current Ratio

The current ratio is closely related to the concept of the working capital and describes the relation of current assets to current liabilities. The current ratios for Amazon, calculated for the last 3 years, are relatively stable and equal to around 1.12. It is a good value, indicating that the company is able to meet its liabilities in the short term, which is typical for all other retail competitors. However, Google achieves the value as high as 4.8, which is unmatched by any of competitors.

Earnings per Share (EPS)

This ratio is rather controversial as it can be calculated using different base metrics. Generally, it is calculated as the income available for common stock (net income excluding dividends) divided by the number of common shares outstanding. Amazon does not pay dividends and equals a modified version of the indicator, diluted EPS.

Given the fact the company gained no net income in 2014, its current level of diluted EPS is $-0.52. In 2013 it was the positive value of $0.53. As Amazon is stable in its revenues and gross profits, the negative value of net income and EPS is caused by the company’s high operating expenses, which goes in line with its strategy for developing new business segments, continuing experiments in the existing business model and the Amazon’s effort to effectively manage the customer base. Among competitors, Apple took the second place due to high number of shares outstanding.

Price/Earnings Ratio (P/E)

This ratio, along with the EPS ratio, is an important ratio to evaluate the profitability of a company. Due to the fact that Amazon delivered no net income in 2014, the ratio is not calculated for this period. In 2013 the P/E ratio was rather high and equaled 675.55, which reflects a high level of variance in this ratio for Amazon. The average level during the past 13 years was 66.06 (the ratio calculations for other companies and longer-term averages were obtained from the GuruFocus resource). At the same time, other companies in the retail industry exhibit more stable P/E ratios of around 15-30.

This level of volatility is recognized as an inherent risk in the company’s annual report for 2013: “we have a rapidly evolving business model and our stock price is highly volatile” (Amazon, 2014a). Other considerations related to Amazon stock price will be elaborated further in the section related to stock price analysis.

Gross Profit Margin and Operating Margin

Despite a high level of risk related to the Amazon’s business segment, in the last years it has been delivering high revenues. The gross profit margin for Amazon was growing during the last three years and reached 29.5 percent in 2014. Compared to other industries, this is not a very high level (for instance, Google and Microsoft operated with a gross profit margin over 60 percent). Yet it is typical for retail businesses to operate with lower margins due to a high level of competition (Walmart ended 2014 with a gross profit margin of 25 percent). Operating margins along with net profit margins of Amazon were lower than those of its competitors in all the three previous years. Even retail companies, which typically have very low operating margins due to the aggressive price competition, showed margins of 3-6 percent. Some specific measures related to the factors that influence the profit generation of the company are described below.

Return on Equity – DuРont Analysis

The DuPont analysis of return on equity is based on the decomposition of the ROE formula into three components. The decomposition of the standard ROE formula is as follows:

ROE = Net Profit Margin x Asset Turnover x Equity Multiplier.

The analysis brings insights on how “the company is achieving its ROE: increasing margins, increasing inventory turnover, or using leverage” (Jun, 2012). Net Profit Margin describes the operating efficiency component, Asset Turnover shows the efficiency of asset utilization, and Equity Multiplier characterizes the financial leverage. The further formula decomposition is as follows:

ROE = (Net Income/ Sales) x (Sales/ Total Assets) x (Total Assets / Shareholder Equity).

The results calculated for the years 2012-2014 are shown in Appendix B.2. For example, for the FY 2014 (ending December 31, 2014) the DuPont components are as follows:

Net Profit Margin = $-241,000 / $88,988,000 = -2.24%.

Assets Turnover = $88,988,000 / $54,505,000 = 1.63.

Equity Multiplier = $54,505,000 / $10,741,000 = 5.07.

The key component that influences the ROE of Amazon is its net profit margin. The company closed the 2012 and 2014 years with net losses, so the net profit margin is negative. Net profits and related issues of high costs present the key focus areas for Amazon; the expenditures will be analyzed in more detail in the following section. The second noticeable component is the unusually high leverage: the figure increased from 3.97 in 2012 to 5.01 in 2014, which is reflected also in the very high value of net borrowings in 2014 (see Amazon balance sheet data). This goes in line with large capital expenditures.

The asset turnover decreased slightly and was close to the typical levels of other retailers. It could be improved significantly if the company managed to increase sales as stated in its annual report: “We focus on improving all aspects of the customer experience, including lowering prices, improving availability, offering faster delivery and performance times, increasing product categories, service offerings, expanding product information, improving ease of use, reliability, and earning customer trust” (Amazon, 2014a).

Low profit margins are typical for the retail business, especially for the low cost model of Amazon. To compare, in 2014 net profit margins of retail competitors who made profit were 2-3 percent (see Appendix B.3). Combined with high asset turnovers and adequate leverage figures, this allowed Costco and Walmart to reach ROE of 17 to 20 percent.

By contrast, the technological giants featured high profitability margins (20-25 percent, typical for the service industries) and the corresponding ROE values of 35.4 percent (Apple), 13.1 percent (Google and Microsoft).

Other Financial Indicators

The beta coefficients (see Appendix D.3) are calculated in Yahoo reports as monthly stock price changes relative to the market index S&P 500 for the period of 36 months. Given the fact that Amazon operates in several distinct business segments, the comparison with overall industry index does not give any information on how it performed in any particular area. The implications of the stock analysis are elaborated in the following section.

Amazon’s operation in the last years incurred significant operational costs (see Appendix A.1, Cost of Goods and General Selling and Administrative Costs). The costs grew faster than the revenues, which was the main reason for the poor EBITDA and net profit figures in 2014. Besides operation costs, Amazon’s efforts to compete in the new IT services segment are illustrated by its heavy capital investments. Web services gain an increasingly higher share along with the traditional investment in warehouses and retail spaces: “Increases in capital expenditures primarily reflect additional capacity to support our fulfillment operations and additional investments in support of continued business growth due to investments in technology infrastructure, including AWS” (Amazon, 2014a). Amazon’s competition in IT and business services is in the same situation as Google’s “remarkable capex increase” explained by the rapid expansion of the data centers, and Microsoft’s data centers supporting its “cloud and devices strategy” (Ovide, 2014; see chart in Appendix C.1). These investments are often made ahead of actual demand in order to win competition, which represents a major risk of such a strategy. Nevertheless, the company’s stock value shows the support the shareholders have for Amazon’s business development, as it will be explained in the following section.

Stock Performance

Appendix D contains one-year historical charts that present performance of Amazon stock prices against competitors from other industries, mentioned in previous sections. Appendix D.1 compares Amazon to its main competitors in the retail industry (Walmart, Costco, Target). Appendix D.2 compares Amazon with technological companies and electronic equipment providers (Apple, Google, Microsoft).

It can be seen that Amazon stocks exhibited large fluctuations up to January 2015. The announcement of Q4 2014 positive results contributed to the immediate growth of the stock price. The competitors in retail faced similar intermittent trends, except for the Costco company, which performed with a significant positive trend during all the four previous quarters. The comparison of technological companies reflects the position of Amazon as a new entrant: despite growing presence of Amazon, Apple is a clear leader. Microsoft’s shares perform almost symmetrically to Amazon’s, which is related, among other factors, to the worsened market evaluation of Microsoft cloud services vs. Amazon Web Services.

Appendix D.3 contains summary data on one-year stock performance as well as beta coefficients. The data reflects good performance of the last quarter; the price is close to a 52-week maximum. However, Amazon shares feature high risks and are therefore not suitable for analysts relying solely on technical indicators. The overall performance of Amazon business in 2014 leads to a conclusion that the shares were trading too high at the beginning of 2014. Financial results of Q1-Q3 2014 gave reasons to suggest that the stocks were not likely to further increase in value:

We think the market seems to consistently over-price Amazon stock, as investors lay greater emphasis on factors other than financial strength and business fundamentals in their valuation of the company, in our view. Even though Amazon’s profitability has steadily deteriorated over the last 10 years, its stock has appreciated by over 600% and is currently trading at very-high valuation multiples (Trefis Team, 2015).

Due to the fact Amazon stocks exhibit large fluctuations and its business model relies strongly on the disruptive innovations to give results in the long-term horizon, Amazon is mostly considered as a long-term value investment. Investors take into account not only current indicators, but also longer-term outlooks. The stock price was formed under a controversial influence of two groups of investors. The “bulls” relied on the optimistic forecasts based on the long-term innovation premium of Amazon and its extraordinary high brand perception by customers. On the other hand, the “bears” emphasized the press of competition in its traditional media business: “There is a whole lot more competition than in the days when Amazon had raised capital very cheaply” (Fader & Raff, 2014).

In this view, the historical overview for a longer period might give additional insights; the three years horizon is visualized in Appendix D.4. The chart shows that in 2011-2013 Amazon exhibited dramatically higher growth of stock price than its competitors. The stock prices were most likely overpriced at the end of 2013, which coincided with the starting period of weaker financial performance. In the next few months after the results of Q4 2014 were announced, the stock price restored almost to the highest level of the end of 2013. Whether the investors’ positive outlooks will be confirmed with better financial performance in 2015 depends on a large number of external factors and Amazon’s ability to retain the competitive advantage in the next years.

Investment Recommendation

Amazon is an outstanding company with an exceptional history of growth. It is characterized by a highly valued brand, extraordinary customer loyalty and a consistent pursuit of innovations. These unique competitive advantages, although not reflected in the financial statements, form the basis for positive expectations in the long term. However, the complex nature of Amazon’s business model, which comprises a broad range of industry segments as well as a high level of inherent risks imposed by its innovational business model, introduces a certain complexity to the classical investment analysis. In particular, some results obtained by analyzing financials and ratios may be misleading as the company’s reports do not reveal the actual performance of each of the component businesses. As the company competes with a large number of companies both in its core e-commerce retail segment and in the technological industry, it faces numerous influences of various external factors.

Given high fluctuations of the stock prices, resulting from the risks and high unpredictability of the company’s business environment, it is not recommended to consider Amazon’s stocks as a tool to attain earnings in the short-term. Amazon shares tend to be overvalued at the moment, and the high volatility of its stock prices significantly increases investment risks. However, longer performance trends and high capital expenditures combined with Amazon’s historical performance in product development and innovations indicate that Amazon’s stock is an excellent investment opportunity in the longer term, provided that it is combined with other assets in a diversified portfolio.

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