Question

Watching Amazon Flows

Seattle- Market gurus warn us of companies with losses and rising debt. one of those companies, however, is Amazon.com the largest U.S. Internet retailer. Jeff Bezos, founder and CEO of Amazon, started the company in his garage. "The first initial start-up capital for Amazon.com came primarily from my parents, and they invested a large fraction of their life savings," recalls Jeff. "My dad's first question was, 'What's the Internet?'... He wasn't making a bet on this company or this concept. He was making a bet on his son."

Jeff has grown Amazon from an online bookstore into one of the world's largest online retail stores to compete with the likes of Walmart and Target. Amazon's income and liabilities for the past four years follow:

($ millions) 2011 2012 2013 2014
Net Income $631 $(39) $274 $(241)
Liabilities 17,521 24,363 30,413 43,764

Interestingly, while Amazon reports negative income and rising debt, the market sees the company in a positive light. Financial publications such as Forbes named Amazon the 6th "Most Innovative Company in the World" and ranked it as the 13th "World's Most Valuable Brand."

Given Amazon's losses and debt levels, is the market failing to incorporate this? Is there something else that the market is focusing on?

Lets dig a bit deeper. Amazon's financial statement reveal rising sales, narly doubling over the past four years. Although costs exceed slaes in two of the recent four years, the growth in revenues foretells a positive future. Further, Amazon has pursued sizeable investments in research and development --to the tune of $9 billion in 2014 alone, which could yield large future payoffs. Finally, there are its cash flows, which are depicted here:

($ millions) 2011 2012 2013 2014
Operating CF $3903 $4180 $5475 $6842
Investing CF (1930) (3595) (4276) (5065)
Financing CF (482) 2259 (539) 4432

A key here is its operating cash flows, which have increased 75% over the past four years... an impressive trend! In addition, its large investing cash outflows are what we expect from a growth company. Also, its relatively small financing cash inflows suggest that much of its expansion is self-funded (a positive finding).

It is clear that analysis of Amazon requires examination and interpretation of its cash flows. Moreover, while there is risk in investing in a company with high research and development outlays, the market often sees such outlays as a precursor to sales and income growth. While only the future can reveal the success or failure of such cash outlays, it is clear that the market utilizes cash flow numbers in predicting the future and for stock valuation. "We earn trust with customers over time," insists Jeff. "And that actually does mazimize free cash flow over the long term."

Review the chapter's opener involving Amazon.com and its founder, Jeff Bezos. (UP ABOVE)

Requred

1. In a business such as Amazon, monitoring cash flow is always a priority. Even though Amazon now has billions in annual sales and sometimes earns a positive net income, explain how cash flow can lag behind net income.

2. Amazon is a publicly traded corporation. What are potential sources of financing for its future expansion?

Answer 1

Summary: One has to recognize that Amazon's story is all about revenue and cash flow growth, and that earnings are currently irrelevant.

Perhaps the best valuation metric for Amazon is FFO (funds from operations), a widely-used measure for assessing the value of real estate investments.

While Amazon trades at a high Price-to-FFO multiple, its still a good investment.

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.