amazon, the year that was

Amazon is worth $695 b now. It was available at $364 b in the first quarter of 2017. That's a massive jump. What caused it? Well, the same factors that caused it to increase from $15 b in 2007 to $78 b in 2012. Markets have been very forgiving for Bezos for all his long term stories. Every year I look at Amazon, and say, too much. Now it is a little $695 b, and much. 

Revenues for the year grew 30% to $177 b; they were $14 b in 2007. 

Revenues have been growing each year in double digits; the lowest growth rate was 19% in 2014. The 5-year compounded annual growth is over 23% and the 10-year is over 28%.

In 2017, it earned $6.27 in earnings per share, which is its best recorded number. Yet, the market is willing to price it over 230 times earnings. That is one way to look at it. 

Leases

If you capitalize its non-cancellable leases, the per share earnings for 2017 drops to $5.62. But then its debt increases by the present value of its lease commitments of $19 b. Lease asset is created, and depreciation and finance charges are taken to the income statement.

Advertisements

Amazon spends over 3% of its revenues on advertisement and promotions, after all it is a retail business. In the last 10 years, the total spend has been $26 b; for 2017, it was $6.3 b. If you consider that the benefits of these costs should accrue over a period of say, 3 years, you should capitalize these costs. Capital asset is created, and depreciation is taken to the income statement instead of the actual advertisement spend each year. 

The combined effect of leases and advertisement costs adjustments increases the earnings per share for 2017 to $10.31.

Research and development 

Amazon is in retail business alright. But at its core it is a technology company, which has disproportionate spends on technology and content.

It spent $22.6 b in 2017, which is over 12% of its revenues. In the last 10 years, Amazon spent over $78 b on technology and content. Naturally, the benefits of these costs should accrue over a period of time in future rather than in a single year. If you capitalize these costs, which you should, you create a capital asset again, and depreciate it over the period of its life, say 3 years. Consequently, depreciation is taken to the income statement instead of the actual spend.

We have made three adjustments to the books now: leases, advertisement, and research costs. The combined effect of these increases the earnings per share for 2017 to $30,94; much better than the book values. 

This is how the adjusted earnings per share look over the years compared to the book values.

Even operating margins look better.

Return on equity and capital are respectable.

Now the adjusted PE multiple is 46 times rather than 230 times book earnings. Will this make Amazon a better buy? That depends upon how much free cash flows the business is able to throw out each year. 

In 2017, there weren't much of free cash flows because of Amazon's acquisition of Whole Foods for $13.2 b. Even if we consider $15 b of free cash flows to firm, which it has never earned till date, Amazon is priced at more than 46 times. 

When I do a DCF with 15% revenue growth rate until it reaches sort of a mature state, I find the current price of $1442.82 too much even when I use an expected rate of return of 8%. The price is too high when I do a simple FCFF projection over the next 10 years, and apply a multiple at year 10. 

The 8% path

However, there is one way which can give Amazon investors a return of 8% over the next decade. That is when it earns an adjusted EPS of $125 compared to $30 now, and trades at 25 times those earnings at year 10. For that to happen, the revenues should grow to $719 b and net margins should be 8.42%, and there should not be any dilution in equity. The math is simple, but the path to that? There is a consolation that Walmart had revenues of $485 b in 2017. 

If you want returns more than 8%, you should seriously hope that the markets remain more patient than ever even after a decade from now, hoping that Jeff Bezos vision of long term value is yet to come, and boy will it come.

The operations

Amazon has a mix of operations.

Its AWS business has been growing faster than its retail business. And its contribution to the operating profits is predominant.

As always, its international business has been losing money primarily because of advertisement and research spends. 

Interestingly, assets employed on its segments reveal much.

On $18.6 b assets, AWS earned operating profits of $4.3 b; whereas, its international operations lost money on similar assets employed. Of course, these are accounting numbers prior to lease, advertisements, and research adjustments.

AWS is not retail
In fact, I wonder what AWS is doing inside a retail business. It would be far better if Bezos spun off AWS business as a separate entity which is basically into cloud computing. Instead of Amazon owning it, let Bezos and other shareholders own it separately so that AWS is not consolidated as a subsidiary of Amazon. We will then know the water levels Amazon retail is treading upon.

Capital employed
Amazon's capital adjusted for leases, advertisement, and research costs is estimated at $76 b equity and $64 b debt. From $140 b capital, we can back out excess cash of $31 b and arrive at operating capital of $109 b.

This will not give us total capital employed by Amazon to date. My estimate for that is: $27 b book equity; $44 b book debt; $19 b lease debt. Add to this $90 b, accumulated depreciation on its assets of $50 b, and we get $140 b. With a cumulative advertising costs of $30 b and research costs of $90 b, we have a total estimated capital employed by Bezos amounting to $270 b to date. Backing out debt, equity contribution is $207 b. Of course these are estimates, but give us a fair idea.

So then it is $207 b historical equity compared to $695 b current market prices.