Amazon Financial Analysis: Revenue, Ratios & Investment Review

Company Overview

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

Amazon was founded in 1994 and is headquartered in Seattle. The company has always focused its efforts on online retailing. Initially, Amazon concentrated on books and music, but very quickly began to branch out into other retail fields. Today, Amazon offers a very broad product range, and including its partner retailers it provides millions of different products through its suite of websites. Amazon was founded in the earliest days of the Internet, before it became a mass-market medium, and this allowed the company to gain first-mover advantage in the online retail sector. This advantage arose not only because Amazon was able to build a strong brand in online retailing, but also because the company developed technologies that put it ahead of all competitors. Johnson (2010) notes several facets of Amazon's innovation, including the development of new markets and finding new ways to profit in established ones. 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 brick-and-mortar presences. Major online competitors include Wal-Mart, Apple, and Staples, all of which maintain significant store networks. Amazon therefore competes by specializing in online retail and must maintain technological advantage in order to preserve the edge that its brand and competitive positioning have provided. Amazon's brand has been ranked by Interbrand (2012) as the 20th most valuable in the world, but Amazon must maintain its technological competitive advantage to retain that strength.

In recent years, the U.S. economy struggled, but Amazon did not share in those difficulties. Revenue growth was strong and steady in the past five years, increasing from $19.16 billion in 2008 to $61.0 billion in 2012. Amazon recorded a loss in 2012, however — something it had not come close to in the previous four years — marking the second consecutive year of declining profits. Part of the role of financial analysis is to better understand the dynamics that produce results like these. By investigating Amazon's financials, it becomes easier to determine why the company's profits fell so dramatically in the past two years. Operating income declined over that period, indicating that at least part of the problem lies at the cost level, but income tax was also considerably higher in 2012 than in previous years. The first step is to conduct a thorough review of the financial statements.

Review of Financial Statements

There are several ways to analyze financial statements. The first is horizontal analysis, which compares recent performance against past performance. Vertical analysis identifies changes in line items as percentages of a baseline figure on the income statement and balance sheet. Finally, ratio analysis provides further depth and can be used in combination with horizontal and vertical techniques.

Horizontal Analysis

Horizontal analysis compares current results to past results in order to identify trends. The horizontal analysis of Amazon's income statement for the past three years reveals a number of significant findings. Revenue — the top line — has seen impressive and steady growth. The cost of goods sold has increased at roughly the same rate as revenue, with a slightly lower rate of increase in 2012. This is important because it indicates that earnings pressure is not coming from the gross margin. Amazon has therefore been able to maintain its pricing power over both suppliers and consumers, and may have even improved it in 2012. The strength of the company's brand and market share have allowed it to preserve margins, and it is possible that volume discounts from suppliers contributed to this in 2012. The implication is that Amazon's profit problems are more likely internal in origin, since bargaining power does not appear to be an issue.

Indeed, both major expense categories have grown faster than sales over the past three years. Selling, general, and administrative (SG&A) expenses reached 318% of 2009 levels, while research and development (R&D) expenses reached 368% of 2009 levels. Both figures represent higher growth than total revenue experienced. As a result, while gross income grew faster than revenue, operating income declined. It is worth noting that in 2010 the increases in expenses were not significantly different from the increases in revenue; it is only in the past two years that expenses have increased rapidly. The emphasis on technological innovation and maintaining industry-leading technology may help explain why R&D expenses rose so quickly. In addition, the company's move into tablets with the Kindle represented a shift in business model that could also have resulted in significant R&D increases. While income tax is higher than in prior years, 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 exceeding the increase in operating income is disconcerting for both management and investors.

The horizontal analysis of Amazon's balance sheet shows that total assets increased 73.2% in the past two years. The biggest growth lines were plant, property, and equipment (up 192.5%) and receivables (up 112%). However, the increase in total equity was slower than the increase in total assets, meaning the value of the company has not grown as quickly as its asset base. Equity growth was a fairly modest 19.3% over the past two years — not entirely surprising given that the company lost money in 2012 and experienced two years of declining profitability. Amazon has therefore financed its recent growth primarily with debt. Long-term debt increased 381% in the past two years, the fastest rate of growth of any balance sheet line item. This growth was concentrated in the 2012 fiscal year, when Amazon added $3 billion in debt — the company's first debt issue in a decade, 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

Vertical analysis compares each line item to a baseline: revenue for the income statement and total assets for the balance sheet. The vertical income statement analysis shows a slight decrease in cost of goods sold as a share of revenue — from 78% in both 2010 and 2011 to 75% in 2012 — while highlighting the increase in expenses. SG&A expenses increased from 13% of revenue in 2010 to 16% in 2012. R&D expense increased from 5% of revenue in 2010 to 7% in 2012. These shifts may appear small, but in 2010 operating income was just 4% of total revenue. The combined effect of these expense increases drove operating income down to just 1% of total revenue in 2012 — a very thin margin that is close to a loss. Combined with the higher income tax burden, Amazon slipped from profit to loss over the course of two years solely on account of the increases in SG&A and R&D expenses. If growth in these two expense lines cannot be curtailed, the company will continue to lose money even while holding or improving its gross margin.

The vertical analysis of Amazon's balance sheets reveals that non-current assets increased from 26.9% of total assets in 2010 to 34.6% in 2012, driven mainly by the plant, property, and equipment line, which grew from 12.8% to 21.7% of the balance sheet. The offsetting decline came primarily from cash, which still grew in absolute terms but fell as a percentage of total assets. That said, it is difficult to argue that Amazon requires $11 billion sitting idle; if opportunities exist to deploy that cash in plant, property, and equipment for a better return, Amazon should pursue them. It is also worth considering that if Amazon has invested some of that cash in R&D in recent years, and the results of that spending have not yet reached the market, then Amazon may still earn a strong return on that investment. The key point is that Amazon is spending cash to increase its fixed asset base, but profits have not yet increased as a result of that spending.

Ratio Analysis

Ratio analysis breaks down a company's financial statements using various ratios to illuminate information that is not immediately apparent from raw figures. The most important ratio categories are liquidity, financial leverage, asset management, profitability, and market value.

Liquidity ratios are based on the balance sheet and measure the firm's ability to meet its near-term debt obligations. The current ratio — current assets divided by current liabilities — was 1.12 in 2012. The quick ratio — current assets less inventories, divided by current liabilities — was 0.80. Both figures are healthy, as is the cash ratio of 0.60. Amazon has no pending liquidity issues, which helps explain why the company was able to borrow $3 billion at very low interest rates.

Financial leverage ratios include the debt ratio and the long-term debt-to-equity ratio. A third metric, times interest earned, cannot be calculated because Amazon only recently issued its debt and did not pay a full year's interest in 2012. The debt ratio for Amazon is 74.8%, and the long-term debt-to-equity ratio is 37.6%. The first figure is relatively high, but Amazon is still considered a growth company. Moreover, most of the company's liabilities are in accounts payable, which are current liabilities. The relatively low level of long-term debt indicates that Amazon has sound long-term financial leverage and is at fairly low risk from its debt load.

Asset management ratios include total asset turnover and inventory turnover. For a retailer, inventory turnover is a critical metric, because unsold inventory often must be cleared at a discount. Moving inventory quickly is essential to recognizing revenues on all goods purchased. The inventory turnover ratio (COGS divided by average inventory) was 8.3 times in 2012, implying an average inventory life of 43 days. This is a decent but not exceptional figure. Two years earlier, when the company recorded a peak net profit of over $1 billion, inventory turnover was 9.88 times, or 37 days. The decline in inventory turnover is a sign of weakness, although it is tempered by Amazon's ability to maintain margins.

Total asset turnover reflects the company's ability to generate sales from its asset base (revenue divided by average total assets). In 2012 this was 2.11 times, compared to 2.09 two years earlier when profitability was at its peak. There has been little change in this metric even as the company significantly increased total assets, which is a positive sign.

Profitability ratios indicate the company's profit position. The gross profit margin was 24.8% in 2012, higher than the 22.3% recorded in 2010 at peak profitability. The net margin, however, declined sharply. Because the company lost money in 2012, the net margin was effectively 0%, compared to 3.3% in 2010. The erosion of the net margin is one of the most pressing financial concerns for Amazon.

Market ratios reflect not the company's operating performance but the market's reaction to it, introducing a layer of sentiment into the analysis. Managers at Amazon are beholden to shareholders, and this is especially true because Amazon does not pay dividends — share price appreciation is the primary metric against which management is evaluated. The price-to-earnings (P/E) ratio is listed as negative on MSN Moneycentral because earnings remain negative. The market, however, appears to view the lack of profitability as temporary, hence the relatively high share price. The price-to-book ratio was approximately $297.90 / $19.11 = 15.6, a high multiple implying that the market expects strong growth to continue in the foreseeable future. The market clearly believes that Amazon's competitive position is robust and that it will maintain technological dominance even as more brick-and-mortar companies expand into online retailing.

Overall, ratio analysis confirms that Amazon is a healthy company. The principal areas of concern are the recent cost increases that have not yet translated into higher revenue, but both the fundamental financial metrics and market sentiment suggest the company remains in strong shape.