Amazon – a cash-compounding machine that justifies its PE ratio?

Amazon’s stocks are an inimitable example of success, boasting an astronomical PE ratio in the triple digits, despite its reducing operating margin curve. The demand for Amazon’s shares and what seems to be an unprecedented price often inspire headlines that question the validity of its giant status, ‘Is Amazon stock a falling knife?’ and ‘Amazon: why the giant (P/E ratio) must fall – seeking alpha’ are some recent examples of concerns cited. Ted Black’s piece looks at Amazon from the perspective of ownership, and what it is that investors are truly buying into. A recent article by Vestact stated, ‘When buying this company you as an investor are expecting growth in sales for a very long time to come, further you are also looking for a massive earning boost when Amazon slow their infrastructure spend.’ Based on the sentiment, and Black’s piece making note of the genius of Bezos it’s easy to see why Amazon stock carries the seemingly precarious PE that it does. – LF 

Ted Black is a mentor, teacher and writer.
Ted Black is a mentor, teacher and writer.

By Ted Black*

Amazon is twenty years old. To celebrate the milestone, last week’s Economist looked at it in some depth. A striking assumption that emerged from its thoughtful analysis is, “It is hard to compete with a firm whose shareholders do not expect it to make a profit”.

If you judge the company by its income statement, the profits are not only meagre but the 10-year trend is alarming…all the way down from 6% to 1% operating margin last year. Net margin was 0.4% and negative in 2012.

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Do shareholders hang in, as the analysis suggests, because they buy into a long-term, customer-driven vision…that given a choice Bezos will invest in new areas rather than go for profits?

If you look at the company through the eyes of the typical manager, who only uses the lens of an income statement and usually stops at the Gross Margin profit number at that, you might wonder why the capital markets value the firm at almost four times its asset base of $40 billion.

Forget fuzzy visions of the future, what tangible result today keeps them investing?

There was passing mention of Free Cash Flow of $10 billion over five years – a “less distorted measure of profitability than net income which was just $2.9 billion over the same period” is how they put it. That comment gives us a clue on how to view the company from another standpoint – an “owner’s”.

If you got into an owner’s shoes – which the Economist didn’t – you would start with the bedrock Cash Flow statement…just as Amazon does in its annual report…and then the Balance Sheet. Do that and the numbers tell another story.

In a business, you do not get a return on investment. You convert all cash into assets of one kind or another. Therefore, when you get down to assessing everyday operating managers, you can only seek a return on assets they manage (ROAM). It is asset management that matters – not investment management.

The first measure in the ROAM equation is asset productivity. For every $1 of assets, Amazon managers generate $1.90 in sales. Then, going to the cash flow statement, for every $1 of sales they generate 7.4 cents operating profit in cash. Multiply the two numbers and Amazon’s Cash ROAM is 14%. That’s higher than Wal-Mart’s. On the other hand, the theoretical and abstract accounting EBIT ROAM is only 1.9%.

Then there’s the cash-to-cash-cycle…the time it takes from paying to being paid. There are a handful of business basics, but this has to be the #1 business imperative. The compounding speed of the cycle governs how viable and successful a business is. It determines how productive and competitive you are.

The cycle is like a flywheel. Amazon “spins” its inventory flywheel more than 10 times a year and its debtors more than 15 times. The result is a negative cash cycle – creditors cover trading for a month. In contrast, Wal-Mart has a positive cash cycle – it has to fund around two weeks trading.

It goes further. If you believe there is no real profit unless you recover the cost-of-capital, then how does Amazon fare? From the net cash generated by operating managers, you deduct interest and then pay the taxman. Last year’s cash profit after interest and tax was $5.3 billion – not the $274 million shown on the income statement.

Last in the “queue-for-cash” is the “owner”. Given average returns on equity around the world, let’s say his “cost-of-equity” charge is 15%. That means we deduct $1.4 billion leaving a $3.9 billion “economic profit”.  Cumulatively for the past ten years, it amounts to more than $18 billion.

By any standard, that’s not half bad and probably why Bezos sits on a cash war chest of $8.7 billion – again more than Wal-Mart, no mean company, as we know.

What makes it all the more remarkable is that from 2004 Bezos has grown the asset base by 1118%, sales by 980% and the Cash ROAM% has never fallen below 13%. It hit 24% in 2009. Yes, the profitability trends are down but given the huge growth, the results are astonishing.

Bruce Henderson, founder of Boston Consulting Group, defined a business this way: “It is a cash compounding machine or it is nothing, and sooner or later will be swept away.” He may be right or wrong. Either way, Amazon, a brilliant business design brilliantly run is a relentless cash machine.

It is why its managers like to be paid mostly with equity. They truly understand its value, and know how to build it. That’s a good enough reason for their shareholders to keep investing.

 

*Ted Black is a mentor, teacher and writer. Based in Johannesburg, he uses the ROAM Model and a 100-Day Action Project method to develop managers. It enables them to convert fuzzy problems, and opportunities, into high-precision, results-driven projects. The prime goal is fast, measurable, personal and team growth. He has written and co-authored three books as well as many articles for Business Day.

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