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?