- Amazon has historically pursued a revenue growth focused strategy, which is today being questioned by earnings seeking investors.
- Amazon’s reducing cost to revenue leverage amid falling operational efficiencies, questions its reinvestment strategy and high cash burn rate.
- The cost trends in tandem with deteriorating trends in payables will take a toll on Amazon’s cash flow, the prime measure of the company’s performance.
- Our Amazon stock analysis reflects our negative long term outlook on Amazon.
A topic of some of the most heated debates on Amazon (NASDAQ:AMZN) stock has been its PE ratio. The high PE ratio has, at times, been justified by reinvestment into its own business eating into Amazon’s bottomline. The question to be asked is whether or not Amazon’s reinvestment is efficient and is it generating additional growth for the e-tailer? In our earlier post on Amazon’s High PE ratio, we had highlighted how the e-tailer was generating lower absolute sales from its burgeoning investments. Let’s look at Amazon’s efficiency and performance after considering the latest numbers for FY 2014.
People argue that Amazon’s profit margins are wafer thin as they invest so heavily in R&D. The claim is if Amazon did not put so much into R&D (Technology and Content) expenses, the company would be trading at a PE ratio closer to 20, against its current PE ratio in the 1000’s.
Source: Amazon PR ratio chart by Amigobulls
A deeper look at the relationship between Amazon’s expenses and topline growth reveals more startling results. We categorized the expenses under two main heads; Research & Development (R&D) and Selling, General and Administrative (S, G&A) expenses, and here is what we found!
Incremental Sales to R & D Expenses Decline Continues In 2014
Here, we compare Amazon’s incremental sales over the last 10 years to the prior year R&D expenses. R&D expenses are made to generate revenues sometime in the future, and since we do not have any breakup of Amazon’s R&D expenses and projects currently underway, we stuck to the one year forward incremental sales. While this is not exactly right if plotted on a timeline, a clear understanding is that investments should eventually result in incremental sales. Hence we compared the incremental sales to prior year R&D expenses, at a corporate level, and a ratio was calculated over the last 12 years. The results are plotted in the chart below.
The ratio can be viewed as a leverage factor for Amazon’s revenue growth. The ratio has trended down over the last three years, from a high of 8 in 2011 to a new low of 2.14 for 2014. The downtrend is a clear break from a historical range of 5 to 8, which confirms our earlier belief that the ratio is now well on a decline. In simple terms, Amazon’s R&D reinvestment is now paying off lesser and hence investors are justified in demanding earnings growth rather than topline growth. Amazon stock price movement following Amazon Q4 2014 earnings was a clear proof of investor sentiment, with the stock gaining 12% following an earnings beat while missing revenue estimates.
Amazon Revenue To S,G&A expenses Ratio Is On The Rise
Future sales could be a function of current period R&D. Likewise, current period sales are a direct function of selling, general and administrative expenses incurred. Hence we looked at revenue in relation to S,G & A of current period to get an understanding of Amazon’s operational efficiencies. The revenue to S,G & A expenses ratio calculated for the last decade is plotted in the chart below.
Amazon Revenue to S,G&A Chart
The revenue to S,G&A expense ratio has also consistently declined over the last three years. The ratio broke its historical range of 7-8 over the last three years hitting a low of 5.3 in 2014. In simple words, Amazon is generating lower revenue from every dollar spent of S,G&A expenses.
Amazon Cash Flows
“Our financial focus is on long-term, sustainable growth in free cash flow.”
Free cash flow is a direct function of cash flow generated from operations. The cash flow remained positive and growing due to increasing leverage enjoyed by Amazon on its costs, for a major part of the last decade. Also, another driver of Amazon’s cash flows has been its increasing days of payable outstanding (DPO), which had seen an increase for most of the last decade. The payables to cost of sales relationship is charted below.
Amazon Days of payables outstanding chart
Amazon’s ability to keep its creditors at bay has plateaued and the DPO has been falling over the last four years. With Amazon losing this lever to drive cash flows, the impact of Amazon’s cash flow could be disastrous.
Our last measure for Amazon is the inventory turnover ratio. This is a critical metric for any retailer as it measures the operational efficiency. Amazon’s inventory turnover trend over the last 10 years is summarized by the chart below.
Amazon Inventory Turnover Ratio Chart
The inventory turnover trend gives us a clear proof that Amazon’s operating efficiency is falling. A once highly efficient inventory churn rate of 15 times in 2003 has fallen down to 8 times in 2014.
Another key metric Amazon released in Q4 2014 was its free cash flow adjusted for financial lease principal repayments and capital acquired under capital leases. And as we guessed, the numbers are far from encouraging and confirm our earlier belief that Amazon free cash flow is headed for a crash landing sooner or later.
|in millions of $||2013||2014|
|Free Cash flow||2031||1949|
|Free cash flow adjusted for financial lease principal repayments and Capital acquired under capital leases||159||-2194|
Source: Amazon earnings release
It is no surprise that Amazon raised close to $5 billion in 2014 from a debt offering. Well, there will be more of these fund raising rounds as Amazon continues on its cash burning adventures like the Fire Phone.
Amazon Cost Trends Can Lead To A Cash Flow Problem
The trends of lower leverage from R&D expenses and higher S, G&A expenses incurred to generate sales will lead to a dangerous conclusion: A burnout of Amazon’s cash pile and a need to raise additional debt. As long as the above two ratios were on a rise, Amazon’s cash balance was rising as the company’s revenues are mostly collected upfront. This in combination with Amazon’s capital leases and increasing DPO led to an inflated free cash flow being reported.
However with the decreasing cost to revenue leverage, the reinvestment into Amazon will lead to slower revenue growth, directly impacting the cash flow generation. The reducing inventory turnover is an added proof of Amazon’s reducing efficiency and where it is headed.
In Conclusion, Amazon is seeing reducing marginal benefit from the so-called reinvestment into its business. With these trends in mind, Investors are justified in seeking earnings growth, and failure to deliver on this metric over the next few quarters could result in significant pullbacks in Amazon stock price. Amazon’s unproven earnings ability, high valuation multiples, lower cost leverage and reducing operational efficiency make Amazon stock a highly risky bet, which is currently reflected in our Amazon stock analysis.