amazon q3 2017

Amazon announced its third quarter financial results. And here's the thing:

For the nine-month period, revenues of $117 b comprise, $12 b of AWS, and $105 b of the regular Amazon. That is 40% growth for AWS, and 27% for Amazon. The operations include Whole Foods business post its acquisition.

Operating income was $1,979 m, of which AWS was $2,977 m. What's going on? Yeah, Amazon suffered an operating loss of $988 m. Ok, North America showed profits of $1,144 m, but with a margin of 1.66%. International operations have continued to lose; for nine months, it was $2.1 b. 

While revenues have been growing, its core operations have not been great, yet. I have to say yet, because, the markets are forever willing to bet on Amazon. Its stocks are trading over $1000 per share, making Mr.Bezos, the world's richest along the way. Amazon never ceases to amaze me. 

Let's move to cash, for that is what is counted. At the beginning of the period, it had cash of $19 b excluding marketable securities, and over nine months, it ended with a little over $12 b. That means, it consumed a net cash of over $6 b. This story is not that meaningful. 

So we go first to the operating cash. How much cash did the operations generate during the period? It was positive cash earnings of $6 b. So far so good; collectively, Amazon and AWS generated some cash. This cash belongs to both lenders and common shareholders. Before attributing it to the capital providers though, Amazon needs cash to feed its growth projects, and there are many of those. It consumed $7 b for its capital expenditure. Boom...that is all of operating cash, and some more; now it is short by $1 b. During the period, it also acquired Whole Foods for more than $13 b. Effectively, Amazon's operating business, which from now onwards will include Whole Foods, used over $20 b cash compared to $6 b cash accruals. That is a net negative cash of over $14 b. If we are willing to bet that Amazon will not venture into more acquisitions in future, we can exclude that $13 b as a one off item. The chances are that it will not be the case. Even when we spread that number over say, 3 years, it becomes $4.5 b of annual acquisitions cost. So average annual capital spending would be over $13 b. Put another way, Amazon will have to generate operating cash of over $13 b just to breakeven. To be fair, Amazon did generate $15 b and $17 b for the twelve-month period ended September 2016 and 2017 respectively. Also its earnings are understated due to expensing of its technology and content costs. If we adjust that, its earnings will shoot up substantially. I will come to that later.

But where do its capital providers stand then? Amazon has debt of $25 b on its books. It raised $16 b to fund Whole Foods acquisition. It had to, remember it did not have enough cash. It is another matter that for a growing company like it is, which does not have stable, sustainable cash flows to service debt, increasing debt is not a good idea. But, that damn thing called equity dilution is pervasive...

It is fair to say that Amazon does not have any free cash flows for its shareholders, yet. Yet is the word, for the markets expect the business to do extremely well in future.

There is a goodwill allocation of $13 b, which I am going to ignore despite the accounting anomaly, we have no other choice. And for discussions on how it is an anomaly, I will keep for another day.

Its operating business looks like this: Assets $92 b; liabilities $66 b; that's net assets of $26 b. Then there is cash equivalents of $23 b. Total capital is: $25 b debt; and $24 b equity. Annualized return on capital was 10%, and return on equity was a little over 6%. These are improved figures compared to the prior periods; so the Amazon story is building up, isn't it? 

Now, for equity investors the equation is like this: What kind of returns is the business going to give on its book capital of $25 b? For an expected return of 10%, Amazon operations should generate $2.5 annually, and growing based on retained equity. For 15%, it is $3.75 b.

These numbers are prior to the adjustments due to technology and content costs though. When this is done, both capital employed and operating earnings will go up, and therefore, return on capital will change. For Amazon, it should increase.

For new shareholders, it is a different question. With a total market capitalization of $525 b, what are the expected returns? Even when we apply 52.5 times earnings multiple, the business has to generate $10 b in earnings.

As noted earlier, there is one key adjustment to be made in all this analysis. Amazon spends tons of money on its research and development activities for which the benefits are going to accrue in future periods, but the entire costs are expensed in accordance with the accounting rules. It spent $38 b during the previous three financial years. For 2016, the technology and content costs were $16 b. These costs are to be capitalized ideally and a portion should be amortized each year based upon the number of years the benefits are supposed to accrue. Take your pick; but is Amazon really worth $525 b?

I come back to my original hypothesis: Is Amazon a hype, or is there something we have missed, and the markets have not?

quality stocks, what to expect

Recently a friend of mine forwarded a report presented by an analyst, who is quite popular in the investing community. It was about buying quality stocks and getting excess returns. The key points of the report were: Investors tend to use higher discount rates to bring the estimated cash flows to the present value. All high quality stocks trade at large premiums. And because of that, their expected buy price never comes across. As a result, they miss high returns over the long period. And therefore investors should instead use a lower discount rate. Then they will have a higher present value for their stock; and lo and behold, they can buy the stock, and make make higher returns for a long time. It appeared cool to many, and why not?

I was surprised after I read the report; it was an interesting thought indeed, except there was a catch. The whole idea of discount rate and expected returns was pushed apart, and how. I have written about expected returns in the past. Expected returns are never precise. The aim should be to increase the purchasing power over time, rather than asking for more than what is warranted. CAPM is great, but has its limitations. Although it starts with the right footing, it falters when we come to measuring risk in cash flows, and unnecessarily looks for precision. And so does the concept of margin of safety, which is both overrated and getting more due than it deserves. Perhaps I will have to do a more detailed post on both CAPM and margin of safety.

Value of any business is the present value of its cash flows over its lifetime. We need two things: Cash flows for the entire period; and a discount rate to bring them to present. Simple, profound, but a complicated affair. How do we know what cash our favorite business will throw until its liquidation? The size of cash flows and their timing have a significant effect on present value. Therefore, our estimation task is futile to that extent. This is one reason why it is prudent to stick to businesses which are more likely to be stable over the period of our investment. Stable businesses tend to throw out stable cash flows; so our work is that much easier; but not as easy, because it still involves estimation.

If our cash flows estimation is getting difficult because the business is complex, or is subject to disruptions, or because of some shit, we cannot compensate it with either higher margin of safety (which all value investors do) or higher discount rate (which all other investors do). It doesn't really matter whether you try to eat shit with a spoon or hand, you are still eating shit. Most value investors don't get it.

Once we have our estimated cash flows, we need a discount rate. CAPM provides some framework on that, which is still the best tool available with us. It requires one adjustment though. Let's start with a risk free rate, and say that our investment returns will have to be higher than that. How much higher, is a great question. It is not volatility as measured by beta times equity risk premium. It should rather be based upon qualitative analysis and our own expectations. Short term volatility is investor's best friend for it helps in picking stocks at the right price, and then proves that often markets are inefficient. And yeah, beta is shit; period.

When our expected returns are 15%, we discount cash flows at that rate, and our expected returns will be 15%. In reality though it could be 10% or 25% because of at least two things: One, our estimated cash flows are wrong always. Two, markets can be more pessimistic or optimistic than our own estimates. The key point, however, is that when we expect to make 15%, we discount the cash flows at 15%, not 10%. This is the flaw in the aforesaid report of the analyst.

The guy is making a point that we should discount the cash flows at a lower rate so that we can make returns higher than that over the period. How profound...

What I would do for a quality stock is what I do for not a high quality stock too. A business that is not high quality may have cash flows that are visible for a short period of time. Why shouldn't we use those cash flows and discount them based upon our expected returns over that (short) period? Why should we use lower discount rate for a high quality business when we want much higher returns?

The analyst missed another key point. It is to be able to play the waiting game. What you do is analyze the business, and have a rate of return expected from the stock; and then wait for the markets to offer you a chance to get that. If that means waiting for more time, so be it. There is another way to play this as well. If you think that markets are not willing to give in, and your patience is running out, you can lower your expected returns, discount the cash flows at that rate, and see if the stock can be bought at that price. Again, these decisions are made based upon quality of business and interest rate environment. When risk free rates are 5%, your expected returns can be lower than when they are 10%. Long term interest rates change the course of our expectations.

A better game to play is to check the implied rate of return in the market price, and see if that is suitable for us. If not, we have to play the waiting game, and rely on the market's histrionics. I do know that there are times when markets are too kind to us; and a better investor waits for such times of cuddling.

For quality stocks, we can use lower discount rates for minimum acceptable rate of return, and then say that anything higher is icing. What we cannot do is, use lower discount rate, and then say we want returns higher than that.

The truth is that markets set higher premiums for stocks as long as they remain high quality. That means what we should be doing is look for those stocks that are high quality in terms of business and management, and then discount the cash flows, which are usually large and growing, with a rate, which is higher than risk free rates. And, how much higher is again a great question...

investment in property

I have noted how property prices are a delusion as prices were firming up in 2012. Later in 2013 prices appeared too high compared to cash flows associated with them. And in 2016 I noted that rentals were not aligned with prices in India. Recently, someone asked me why I do not invest in property. This is what I said: 

There are two caveats before I begin though. First is that I am biased towards equities. Naturally, I will banish everything else. But then so is everyone; aren't all biased too? Second, I don't have an edge in the game. My knowledge on property market is limited; and I neither fancy nor am I interested any further.

There are at least five reasons why I don't deal with the property market. 

1) I buy assets based upon an intrinsic valuation that I carry out. For a real property, say an apartment in a building, the cash flows are rentals net of maintenance costs. As noted in my earlier posts, rental yields have been too low in India. With a 2% yield for instance, the investor will have to say a prayer if the expected returns, including capital gains, are to be reasonable. I do not indulge in hoped-based-only instruments. Of course, we need hope all the time in life; we always hope that everything goes well. But while investing, I feel better when the probability of earning expected returns, based upon analysis, is higher, and then coupled with some hope that prices will come along with value at some point. There is always some meaningful work behind hope. 

Dividend yields on quality stocks in India aren't too high either; less than 2%. Yet, I prefer stocks. The reason is that mispricing in equity markets helps us pick stocks at prices we like. I don't find such privilege in property markets. Inefficient equity markets are investor's friend. 

2) Investing in real properties is highly concentrated with no regard for diversification. Usually for me it is not a problem when I have to buy stocks because of the comfort level I get based upon my analysis helped by the price I get to pay. Absent such comfort, property market becomes even more dangerous. For instance, with say, Rs.20 m, I would rather pick five stocks than throw the cash for one single apartment. The hope-based investment becomes prominent, and you will have to desperately seek a greater fool for your expected returns. 

3) The liquidity in equity markets is another reason why I prefer them. It takes time to first find a seller, and then to find a buyer in order to complete a property transaction. Heck, it is too much of a hassle. 

4) Tax regulations are too kind to equities in India, where as of now, there are no taxes on long term capital gains. And dividends are, generally, tax free. The difference could be enormous compared to the property especially when the transaction value is usually large. 

5) Then there is the fifth reason why I don't deal with the property market. I do not know it yet though.

Beware that you can defy equity markets; property markets have the capacity to defy you. The game is on.