Financial Analysis of Amazon.Com, Inc. 2012 Annual Report

AMZN

Company Overview

Amazon is a Fortune 100 company, recording over $61 billion in revenue in the 2012 fiscal year, with a net loss of $39 in that period. The company is a retailer, operating almost exclusively online. Amazon runs a large family of retail websites, several of which are the market leaders. The flagship site Amazon.com is ranked as the #11 website in the world in terms of traffic by Alexa, which itself is an Amazon subsidiary (Alexa.com, 2013). Amazon is the dominant player in online retailing in several countries, including the U.S., the UK, Germany and Canada (Myslewski, 2013).

Amazon was founded in 1994 and is based in Seattle. The company has always focused its efforts on online retailing. Initially, Amazon was focused on books and music, but very quickly began to branch out into other retailing fields. Today, Amazon has a very broad product range, and including its partner retailers it offers millions of different products through its suite of websites. Amazon was founded in the earliest days of the Internet, before it was a mass market medium, and this allowed Amazon to gain first-mover advantage in the online retailing sector. This advantage occurred not only because Amazon was able to build a strong brand in online retailing, but because the company was able to develop technologies that put it ahead of all other competitors in online retailing. Johnson (2010) notes several facets of Amazon's innovation, including the development of new markets and finding new ways to profit in old markets. Amazon's customer relationship management software in particular has been a key success factor (Business Week, no date).

Despite its strong market position, Amazon faces an uncertain operating environment. The pace of technological change in online retailing is rapid, and the space is occupied by companies with strong bricks and mortar presence. Among other major online retailers are Wal-Mart, Apple and Staples, all with significant store networks. Amazon therefore competes against firms by specializing in online, and must maintain technological advantage in order to maintain the advantage that its strong brand and competitive positioning have given it. Amazon's brand has been ranked by Interbrand (2012) as the 20th-most valuable in the world, but Amazon will need to maintain its technological competitive advantage in order to retain this strength.

In recent years, the U.S. economy has struggled, but Amazon did not share in those struggles. Revenue growth has been strong and steady in the past five years, increasing from $19.16 billion in 2008 to $61.0 billion in 2012. Amazon saw a loss last year, however, something it had not been close to in the previous four years. This was the second consecutive year of declining profits. Part of the role of financial analysis is to better understand the dynamics that lead to results like this. By investigating the financials of Amazon, it will be easier to determine why the company's profits have fallen so dramatically in the past couple of years. Operating income has declined in the past couple of years, indicating that at least part of the problem comes at the cost level for the company, but its income tax was also considerably higher in 2012 than in previous years. The first step will be to conduct a thorough review of the financial statements.

Review of Financial Statements

There are several different ways to break down financial statements. The first is through horizontal analysis, which compares recent performance against past performance. Vertical analysis is a means by which changes in percentages of items on the income statement and balance sheet can be identified. These changes will identify some of the changes in the company's finances over time. Finally, ratio analysis will provide further depth to understanding Amazon's financials, and can be used in combination with horizontal and vertical techniques.

Horizontal Analysis

Horizontal analysis compares current results to past results in order to get a sense of trends. Starting with Amazon's income statement, the horizontal analysis for the past three years looks as follows:

Amazon Income Statement

Horizontal Analysis

2012

2011

2010

2009

Total Revenue

61093

48077

34204

24509

COGS

45971

37288

26651

18978

Gross Profit

15122

10789

SGA Exp

R&D

Operating Income

60%

76%

Income Tax

Net Income

-39

-4%

70%

The horizontal analysis reveals a number of things. The top line, revenue, has seen impressive growth over the past three years, steadily increasing. The cost of goods sold has increased at roughly the same rate as the revenue, with just a slightly lower rate of increase in 2012. This is important, because it indicates that any pressure on earnings is not coming from the company's gross margin. What this means is that Amazon has been able to maintain its pricing power over both suppliers and consumers, and may have even increased its pricing power in 2012. The strength of the company's brand and its market share have allowed it to maintain margins. It is expected that as the company grows it should be able to get volume discounts from suppliers, and it is possible that this has happened in 2012. The other implication of this finding is that Amazon's profit problems are more likely to be internal, since bargaining power does not appear to be an issue.

Indeed, both the major expense categories have grown faster than sales over the past three years. Selling, general and administrative expenses are at 318% of 2009 levels; research & development expenses are at 368% of 2009 levels. Both of these figures represent higher growth than has been experienced on the total revenue side. As a result, while gross income has grown faster than revenue, operating income has declined. It is worth nothing that in 2010, the increases in expenses were not significantly different than the increases in revenue. It is only in the past two years that expenses have increased rapidly. There are a number of potential factors for such increases. The emphasis on technological innovation and maintaining industry-leading technology might explain why Amazon has increased its R&D expenses so quickly. Further, the company's move into tablets with the Kindle has represented a slight shift in business model that could also have resulted in significant R&D increases. While income tax is higher than it used to be, it has not grown as rapidly as revenue. However, it has grown faster than operating income, which is the basis for tax calculation. An increase in tax beyond the increase in operating income has to be disconcerting for management and investors.

A horizontal analysis must also be conducted on the balance sheet. This is as follows, for the past three years:

Amazon Balance Sheet

Horizontal Analysis

2012

2011

2010

Cash

11448

Receivables

Inventories

Current Assets

21296

17490

13747

PPE

Intangibles

1955

Total non-Current

11259

Total Assets

32555

25278

18797

Payables

13318

11145

Current Accrued

Total CL

19002

14896

10372

LT Debt

39.8%

other non-current

Total non-Current

Total Liabilities

24363

17521

11933

Total Equity

The horizontal analysis of Amazon's balance sheet shows that total assets have increased 73.2% in the past two years. Of these, the biggest growth lines have been plant, property and equipment (192.5%) and receivables (112%). However, the increase in total equity has been slower than the increase in total assets. This means that the value of the company has not grown as quickly as its asset base. Equity growth has been a fairly meager 19.3% over the past two years. This is not entirely surprising, since the company lost money last year and has seen two years of decreasing profitability. Amazon has therefore financed its recent growth primarily with debt. Long-term debt has increased 381% in the past two years, the fastest rate of growth of any balance sheet line item. The growth in debt specifically pertains to the 2012 fiscal year, where Amazon added $3 billion in debt. This was the company's first debt issue in a decade, and was done in part to take advantage of very low financing rates, with the highest rate on the debt being 2.5% at the time of issue (Mead, 2012).

Vertical Analysis

Another major form of financial statement analysis is the vertical analysis, which compares line items to a baseline item. For the income statement, revenue is the baseline item and for the balance sheet the total assets represent the baseline item. The vertical analysis data for Amazon's income statement is presented here:

Amazon Income Statement

Vertical Analysis

2012

2011

2010

Total Revenue

61093

48077

34204

COGS

45971

75%

37288

78%

26651

78%

Gross Profit

15122

25%

10789

22%

22%

SGA Exp

16%

14%

13%

R&D

7%

6%

5%

Operating Income

1%

2%

4%

Income Tax

1%

1%

1%

Net Income

-39

0%

1%

3%

This analysis shows the slight decrease in cost of goods sold more clearly. It also highlights the increase in expenses. The percentage figures illustrate that the selling, general and administrative expenses increased from 13% in 2010 to 16% of revenue in 2012. The R&D expense increased from 5% of revenue in 2010 to 7% in 2012. These figures might not seem like much -- just 3% - but the operating income in 2010 was just 4% of total revenue. This means that operating income declined to just 1% of total revenue in 2012, a very fine line that is close to a loss. Combined with the increase income tax, Amazon slipped from profit to loss over the course of two years, just on the increase in the two major expense line items. If the growth in selling, general and administrative expense and the growth in research & development expense cannot be curtailed, the company will continue to lose money, even though it is holding or improving its gross margin.

The vertical analysis technique can also be applied to the balance sheet to analyze how each line item has changed as a percentage of total assets over the years. The vertical analysis of the past three balance sheets for Amazon is as follows:

Vertical Analysis

2012

2011

2010

Cash

11448

35.2%

37.9%

46.6%

Receivables

10.3%

10.2%

8.4%

Inventories

18.5%

19.7%

17.0%

Current Assets

21296

65.4%

17490

69.2%

13747

73.1%

PPE

21.7%

17.5%

12.8%

Intangibles

7.8%

1955

7.7%

7.2%

Total non-Current

11259

34.6%

30.8%

26.9%

Total Assets

32555

25278

18797

Payables

13318

40.9%

11145

44.1%

42.8%

Current Accrued

17.5%

14.8%

12.3%

Total CL

19002

58.4%

14896

58.9%

10372

55.2%

LT Debt

9.5%

1.0%

3.4%

other non-current

7.0%

9.4%

4.9%

Total non-Current

16.5%

10.4%

8.3%

Total Liabilities

24363

74.8%

17521

69.3%

11933

63.5%

Total Equity

25.2%

30.7%

36.5%

The vertical analysis of Amazon's balance sheets reveals a few things. The first is that there has been a significant increase in the non-current assets from 26.9% of total assets in 2010 to 34.6% in 2012. Most of this growth has come from the plant, property and equipment line, which has increased from 12.8% of the balance sheet to 21.7% of the balance sheet in two years. The offsetting decline has come mainly from cash, which still has grown significantly. However, cash as a percentage of the balance sheet has decreased. That said, it is hard to argue that Amazon needs $11 billion in its bank account, so if there are opportunities to spend that cash on plant, property and equipment and earn a better return, then Amazon should pursue those opportunities. It is worth considering, that if Amazon has spent some of that money on R&D in the past few years, but the results of that spending are still not on the market, then Amazon may yet earn a strong ROI on that increased spending. When it does, perhaps its profits will increase again, but that is entirely speculative. The key is that Amazon is spending some of its cash to increase its fixed asset base, but at this point profits have not increased as the result of that spending.

Ratio Analysis

Ratio analysis is a technique where a company's financial statements are broken down with different ratios, and these ratios are analyzed in order to better understand the information that is contained in the financial statement. There are several different categories of ratios -- liquidity, financial leverage, asset management, profitability and market value ratios being the most important ones.

Liquidity ratios are based on the balance sheet and measure the firm's ability to meet its pending debt obligations for the coming year. The three main liquidity ratios are the current ratio, the quick ratio and the cash ratio. The current ratio is defined as the current assets divided by the current liabilities. This was 1.12 last year. The quick ratio is the current assets less the inventories, divided by the current liabilities. For Amazon, this is 0.80. Both of these figures are healthy, as is the cash ratio of 0.6. Amazon has no pending liquidity issues, and in part that explains why the company was able to borrow $3 billion at rock bottom interest rates last year.

The financial leverage ratios include the debt ratio and the long-term debt-to-equity ratio. A third ratio in this category, times interest earned, is not possible to calculate because Amazon just issued its debt and therefore did not pay a full year's interest on that debt last year. The debt ratio for Amazon is74.8% and the long-term debt-to-equity ratio is 37.6%. The first of these figures is relatively high, but Amazon is still considered to be a growing company. Moreover, most of the company's liabilities are in accounts payable, which are current liabilities. The relatively low amount of long-term debt indicates that Amazon has good long-term financial leverage and is at fairly low risk of problems due to debt load.

The asset management ratios include things like total asset turnover and inventory turnover. For a retailer, inventory turnover is a critical ratio, because unsold inventory often must be cleared as a discount. It is important to move inventory through the company as quickly as possible to recognize revenues from all goods that have been purchased by the company. The inventory turnover ratio is the COGS / average inventory. For Amazon in 2012, this was 8.3x, for an average inventory life of 43 days. This is a decent number, but not great. Two years ago, when the company hit a peak net profit over $1 billion, the inventory turnover was 9.88 times, or 37 days. A decline in inventory turnover is a sign of weakness, although in this case tempered by Amazon's ability to maintain margins.

The total asset turnover reflects the ability of the company to generate sales from its asset base. The formula is the revenue / average total assets. The total asset turnover this past year was 2.11 times, which is a decent number. Two years ago at the time of peak profit, Amazon had a total asset turnover of 2.09, so there has been little change in this performance metric, even as the company has increased its total assets significantly. It is positive that even if the inventory turn has decreased in the past couple of years, total asset turnover has not.

The profitability ratios indicate the company's profit position. The gross profit and net profit are two major examples of this type of ratio. The gross profit last year was 24.8%, and this is higher than it was two years ago when the company was at its most profitable. The gross margin in 2010 was 22.3%. The net margin, however, is lower. The company lost money in 2012, so the net margin was 0, whereas two years ago Amazon had a net margin of 3.3%. The erosion of the company's net margin is one of the most pressing financial concerns for Amazon.

The market ratios do not reflect the performance of the company, but rather the reaction of the stock market to this performance. Thus, market measures reflect market sentiment, introducing another variable to the financial analysis. One on hand, introducing a fuzzy, irrational variable like market sentiment makes little sense if one is to understand the actual performance of Amazon, but on the other hand the company's managers are beholden to the interests of shareholders. This is especially true for a company like Amazon that does not pay dividends to its shareholders -- growth in the share price is one of the metrics against which management will be evaluated. Using the P/E ratio is tricky, because the price is updated continually, whereas earnings are not. The market does not know the earnings of the company at the end of the fiscal year, for example, and only can adjust to those earnings a few weeks later when the earnings are announced. Thus, it is best to examine the current P/E for Amazon, which MSN Moneycentral lists as negative. This is because the denominator, the earnings, remain negative at this time. The market, however, believes that the lack of profitability is temporary, hence the fairly high market value for the company's shares. Another measure is the price to book value, which is presently $297.90 / 19.11 = 15.6. This is a fairly high number, implying that the market sees strong growth continuing in the foreseeable future for Amazon. The market clearly feels that Amazon's market position is strong, and that it will continue to dominate technologically in its industry in order to maintain that strength even as more bricks and mortar companies turn to online retailing in order to fuel growth.

Overall, the ratio analysis indicates that Amazon is a healthy company. There are some points of concern that have been highlighted, specifically with respect to the recent increase in costs that have not translated into increased revenue, but overall Amazon is a healthy company. The market seems to realize that the company is in great shape as well, giving it a high price/book ratio and a high price despite a lack of earnings in the short-run.

ROE DuPont

The DuPont analysis is intended to illustrate where the company's return on equity is coming from. The three constituent numbers are the profitability, the operating efficiency and the degree of financial leverage. The profitability is non-existent at Amazon, which neuters the DuPont analysis, since the result is 0 * 2.09 * 1.33. It is known that the gross margin, however, is fairly healthy, as is the asset turnover and that the degree of financial leverage is relatively low. However, ROE has "return" as the numerator, and the return is nothing right now. If there was a return, the operating efficiency and the profitability would share responsibility, as the company has a fairly normal debt to equity ratio. The lack of return on equity right now directly relates to the negative net margin, as the other variables are both positive.

EVA

The economic value added metric seeks to highlight not the return on equity but the return after the cost of capital has been taken into the equation. The formula for EVA is net operating profit -- (capital * cost of capital). The capital employed is the book value of equity plus book value of debt, less cash, so for Amazon is $21.107 billion. The cost of capital for Amazon is the weighted-average cost of capital. The weights are .748 debt and .252 equity. The cost of debt is, based on the recent debt issue, is 0.65% for short-term. The cost of equity, using the capital asset pricing model, is as follows:

Ramzn = Rf + ?(Rm), or 0.383 + (0.81)(7) = 6.053%.

This gives a WACC of (.252)(6.053) + (.748)(0.65) = 1.52 + 0.48 = 2.00%. The capital times cost of capital is therefore $422 million. The net operating profit is negative, so the company lost economic value, that is the economic value was subtracted rather than added.

Review of Policies

Amazon's debt policy is sound. The company has a somewhat high level of debt, but most of that is operating. It took out long-term debt mainly because rates were low -- it did not need the cash. Further, most of that debt is at a fixed rate. When rates increase, this money will be very low cost. Thus, the capital structure is also fairly healthy, as long as Amazon does not take on too much more debt. There is some debate about the merits of the dividend policy. Amazon does not pay dividends, but is sitting on $11 billion in cash. Presumably at some point, it will need to pay its shareholders. However, the current investment in R&D is quite high, and given the short technology life cycle in the industry, Amazon likely would prefer to maintain its cash cushion, in particular as it must fend off well-financed competitors like Wal-Mart. Thus, Amazon's financial policies are sound for a company of its position, finances and industry.