Up Almost 70%, Amazon Still Needs To Get These 3 Issues Under Control

  • Amazon's domestic business is doing fantastic, can it get its international division moving in the same direction?
  • Amazon Web Services is one of the company's main growth engines, but it must keep up the pace.
  • The use of capital leases by Amazon to fund its expansion has to be brought under control, otherwise real earnings and cash flow growth will be hard to achieve.
up_almost_70_percent_amazon_still_need_to_get_these_issues_under_control

To say that Amazon.com (NASDAQ: AMZN) has been one of the better performing stocks of 2015 would be an understatement. Just when everyone thinks they have the company figured out, Bezos and company rewrite the rulebook. The stock hasn’t been "cheap” by normal valuation measures for a while. That being said, analysts expect massive EPS growth between the end of this year and next. In order for this type of growth to happen, the company has 3 challenges it needs to take care of.

A double-edged sword

To put into perspective the dominance that Amazon’s domestic business enjoys, we have to compare the company to a few of its competitors. WalMart (NYSE: WMT) is the retail king that Amazon wants to knock off its throne. In the online world, one of the few real competitors that is left is eBay (NASDAQ: EBAY). Though Wal-Mart sells actual goods, and eBay essentially helps sellers, a customer at any time can choose to buy online, or in store, between the three companies fairly easily.

Wal-Mart’s domestic business reported sales up almost 5% year-over-year, and the company gained 16% more online revenue versus last year. By comparison, eBay’s domestic gross merchandise volume (GMV) is a better indicator of its comparison to traditional retailers. EBay’s GMV on the domestic front increased by just 2% last quarter.

Amazon reported overall domestic revenue increased by more than 25%, and if we exclude media sales, general merchandise and electronics grew by an even more impressive 31%. As impressive as Amazon’s domestic business results are, the same can’t be said of its international division.

The first challenge Amazon needs to overcome is, the company must find a way to profitably run its international business. Amazon has reported a negative operating margin from its international operations in four of the last five quarters. For investors thinking the problem is a matter of scale, international sales already represent more than 32% of Amazon’s overall sales.

By comparison, Wal-Mart reported international sales increased 2.8% annually excluding currency, and recorded a positive operating margin. EBay reported international GMV increased by 8% ex. currency. Amazon’s International division reported international sales increased by more than 20% ex. currency, yet it had a negative operating margin.

The bottom line is, Amazon needs to examine its pricing strategy overseas. Maybe it is time to sacrifice some growth for profits. This strategy is working domestically, and seems like the next logical step.

Fast growth must be maintained

To say that Amazon’s Web Services (AWS) division is growing at an impressive rate is an understatement. With just under $2 billion in sales that increased year-over-year by more than 80%, this is the clear growth driver for the company. Even more important is the AWS division reported an operating margin of more than 20%, which is far better than Amazon’s 2% overall operating margin.

However, the division’s profitability was called into question on the company’s conference call. Carlos Kirjner-Neto of Sanford Bernstein & Co LLC said, “if I add your capital leases and CapEx that suggests AWS capital intensity is at least 80% if not much higher.” The CFO’s response to the question, “the ability to fund AWS? No comment specifically on that.”

The challenge with AWS’s operating margin is realizing this does not include capital leases (which we will look at in a minute). It’s one thing to be proud of cutting prices multiple times a year, but Amazon must walk the line of profitability and growth very carefully. Any slowdown in AWS’ growth rate would be devastating to the stock.

When is $4 billion in free cash flow actually a negative number?

The third challenge that Amazon must find a way to overcome is, its use of capital leases. The company relies heavily on capital leases as opposed to traditional capital expenditures to fund its expansion.

When investors see that Wal-Mart generated $5 billion in core free cash flow in the last six months, they can pretty much take that to the bank. In the same way, eBay’s $170 million in core free cash flow in the last three months is a pretty solid figure.

Amazon went out of its way to tout that, “Free cash flow increased to $4.37 bil. for the trailing twelve months, compared with $1.04 bil. for the trailing twelve months ended June 30, 2014.” In the last three months, Amazon generated almost $9 billion of core operating cash flow (net income + depreciation + stock based compensation). If we subtract the company’s $4.6 billion in CapEx, we get free cash flow of about $4.4 billion.

Unfortunately, Amazon also spent $4.7 billion during this time on capital leases. Including this expense, $4.4 billion in free cash flow is not only gone, but the company actually is negative about $300 million. Amazon increased its CapEx spending by 7% annually, but its capital lease payments increased by more than 70%.

The ,bottom line is, Amazon is doing a fantastic job managing and growing its domestic business. The company needs to apply some of these lessons to its international and AWS businesses as well. International has to be able to run profitably, and AWS needs to move away from using huge capital leases to fund its growth. Amazon has a bright future ahead of it, but if the company can’t resolve these challenges, generating huge profits will be nearly impossible.

Image Copyright: xxlphoto / 123RF Stock Photo

Chad Henage owns no positions in any of the companies mentioned, and has no plans to initiate any positions in the next 72 hours.

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  • I do not have any business relationship with the companies mentioned in this post.
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