AMZN - Amazon.com Inc.

[JAllen]

:D

Arguably the guy that knows the most about how much digital video content costs said that AMZN was 'losing' $500M-$1B per year two years ago. 

 

Do we agree that this is an expense regardless of any amount capitalized?

 

"Hastings says he generated those numbers based on the value of the content deals that Amazon won when the two companies competed head to head. "

 

 

Did AMZN have to do this or was it designed to make Prime and AMZN more desirable for customers in the future?

 

http://allthingsd.com/20121116/netflix-ceo-amazon-losing-up-to-1-billion-a-year-on-streaming-video/

 

But then shouldn't two years later the company be MORE profitable if the argument was that they were growing into the expense? 

 

 

No, they continue to INCREASE this number to make it more attractive!  It's not necessarily a one or two year investment - they are twenty year investments.

 

 

Two years ago they were losing up to $1bn on this product and they have grown since then so they should be at least $500-$1bn more profitable today (or at least a good portion of that they as they grow into it).

 

Remember that they're not necessarily charging for access to the Prime video content, or at least not as much as it costs them.  The digital video is bundled with Prime.  AMZN was getting $79 for access to this content AND a whole bunch of other stuff with non-trivial expenses that are also growing, like unlimited free shipping.  I ordered from AMZN 42 times in 2012 and if other peoples' estimates of order delivery cost of $5-$10 in shipping are correct AMZN had something like $300 of shipping costs attributable to me.  They only got $79 from me that year.  Some people get FREE books every month which cost AMZN more than they charge normal users for - like $15-$20  per book to the publishers from AMZN (this is a very interesting subject in itself, how they sell most or all Kindle books for less than they cost and also I don't know how much AMZN must pay the publishers for a monthly rental, but it's greater than zero), so AMZN gets $79 but for users that consume a book each month they very well may have lost money on that Prime sub from books alone, not to mention how much in shipping that sub might have cost AMZN that year.

 

I think that until one understands the extent AMZN of customer friendliness and how it gives tons of benefits away, you won't understand why they're not making a ton of money now.  And when you fully understand this customer-friendly approach, how unique it is and how they've managed to create something that no one else comes close to, it becomes easier to see what AMZN could turn into over a number of years.

 

But J, that's exactly my point!  All these things are going into the customer experience.  You can't stop spending on them without reducing the customer experience - so how do you shift to profits? 

 

 

People are increasingly using the service and will continue to do so as they add more benefits like Prime audio.  Consumers are shifting their shopping towards AMZN at a greater than e-commerce growth rate.  The gross margin received from actually buying things will continue to grow resulting in a profitable relationship.  That gross profit minus Prime benefits equation results in a profitable individual customer relationship.  It's mainly the new products, services, FCs and AWS infrastructure they are adding that I believe are obscuring that underlying profitability. 

 

 

There's no argument I'm aware of that says that AMZN's long-term, run-rate operating expenses will be greater than WMT's - not with being way more automated, capital light by not owning retail real estate and a higher percentage of sales that are digital.  And with gross margins of 28% that will hopefully continue to expand, AMZN will be quite profitable.

[dwy000]

The higher gross margins are likely due to the AWS and other service offerings not the products (which is why the company says its a poor metric to judge them by).

 

Your point goes to the crux of the disagreement. You believe they can start to turn profits without raising prices or doing anything differently. I don't see any indication that is possible and don't think they can. And if they change anything growth will grind to a halt (it's easy to grow when you give things away free).

 

I think this new phone is interesting.  My personal guess is that they have lost so much money giving the kindle fire away at cost that they realized they couldn't do that for the phone too. So now they're charging a "competitive" price for it and I haven't heard anyone who thinks it will be successful.

 

By the way you didn't get to my question on how you are valuing the stock today without knowing when they plan to shift gears and focus on profits.  Is $320 a value?  Is $400?  $500?  What is intrinsic value when you don't have a time frame to profitability?

[JAllen]

If they pay a billion dollars in cash to the studios in a year for the right to display content to their users, they expense that much even if they capitalized it initially.  They can't show video to Prime subs without expensing something for that year.  I guess that the capitalized content is probably only self-produced content.

 

I don't think that's accurate.  From the 10K they indicate they recognize an asset for the content and a corresponding liability and then amortize the asset into cost of goods sold over the life of the contract's window of availability.  So if they pay $300M for years of rights that is capitalized and amortized into COGS over the 5 year window.  It's not all expensed upfront, only the proportional amount related to the expected revenues earned off it.

 

 

Yes, the amount amortized/expensed in a year is a portion of the total contract amount.  They capitalize the some initial total contract amount and then amortize it a portion of it each year.  I'm not sure we're disagreeing on anything.  Hopefully we both agree that paying studios for content is an expense that is recognized each year, whether they capitalize an amount initially or not and that they pay the studios each year for a bunch of digital video content that is given away to Prime members.  I haven't focused on how much is capitalized because we're not really talking about the balance sheet here - just expenses - because everyone seems to be focused on headline-income numbers and not cash flow and growth spending.

 

 

You can get an idea of how much AMZN spends on digital video by assuming AMZN spends 50%+ of what NFLX spends on content because the two offer comparably sized libraries.

 

 

Annualized the most recent quarter for NFLX, NFLX is spending $3.5B on content this year.  This digital video content licensing is the single biggest knowable expense that I consider to be a growth expense for AMZN.  They're spending billions on it and are mostly giving it away to Prime Members.  This expense alone could be 2% of revenue.

 

 

You can look at the recent AMZN-HBO deal which is $300M over three years.  So this will be a $100M expense for a few hundred movies and shows.  AMZN offers tens of thousands of movies and TV shows - this stuff is expensive. 

 

 

To understand these digital video expenses better I suggest looking at STRZA - we spent a lot of time on STRZA during the spinoff last year - they discuss the content and various accounting issues and costs associated with licensing digital video content extensively.  The moral of the story is that this content is super expensive regardless of the accounting.

[JAllen]

The higher gross margins are likely due to the AWS and other service offerings not the products (which is why the company says its a poor metric to judge them by).

 

Your point goes to the crux of the disagreement. You believe they can start to turn profits without raising prices or doing anything differently. I don't see any indication that is possible and don't think they can. And if they change anything growth will grind to a halt (it's easy to grow when you give things away free).

 

I think this new phone is interesting.  My personal guess is that they have lost so much money giving the kindle fire away at cost that they realized they couldn't do that for the phone too. So now they're charging a "competitive" price for it and I haven't heard anyone who thinks it will be successful.

 

By the way you didn't get to my question on how you are valuing the stock today without knowing when they plan to shift gears and focus on profits.  Is $320 a value?  Is $400?  $500?  What is intrinsic value when you don't have a time frame to profitability?

 

 

I don't have a specific intrinsic value - I believe it's going to continue to grow and that the current valuation is nothing like 300X earnings.  You can use EV/FCF which takes you down to 50X and if you believe that a few percent of revenue are further obscured by spending than it's 20-30X.  And because they can grow rapidly for a decade or two the returns will be something like growth rate minus multiple compression.  Because we won't sell for a long time we won't pay any taxes until then making the pre-tax equivalent return 1.6X the CAGR from now until we sell and the final after-tax return, if we ever sell, closer and closer to the CAGR the longer we hold it.  But of course AMZN's growth will slow from the low thirties it's growing now over the coming years - so higher returns in the next few years and slowing down over time.

 

 

I'm hoping they will be able to buy back significant slugs of the stock once every five years or so, or during times of distress like they have twice in the past as well.

 

 

You can note that I wasn't writing about AMZN when the stock was at $400 but began to when it fell to $300.  I haven't bought any over $310 or so.

[Palantir]

Dwy, why are you using net income to determine profitability and not cash flow?

[dwy000]

I'm not (or not intending to). I much prefer free cash flow as a measure of earnings power (after adding back stock based comp).  Not sure it changes the argument much here though, especially over time as all capitalized expenses get amortized over time. 

[dwy000]

J - sounds like you think intrinsic value is somewhere between today's price and $400? 

 

Where are you getting EV/FCF of 50x??  FCF is about $2-$2.5bn (and that's without the $1.4bn of stock dilution) and EV is closer to $150 bn.  Are you using your theoretical FCF if and when they shift the business model?  Because you the further adjust that 50x to 30x for the same reason.

[JAllen]

J - sounds like you think intrinsic value is somewhere between today's price and $400? 

 

 

I don't think that.  What discount rate are you using?  Intrinsic value is different for each investor.  I think that at $400, the investor's return will be lower than someone that bought it at $300, that's about it - it's more desirable now - that's why I'm writing here now.  I'm not expressing an opinion on what the intrinsic value is, and I don't on basically all of our stocks - I just believe each of their intrinsic values are higher.  In other words I believe the returns from holding them will be way higher than the market returns and should fare well next to the historical super-investors long-term returns (i.e. > 20%).

 

 

To me it would be a mistake to assume all of the various things one would have to assume.  I just believe the stock will go way higher over the next decade.  What was the intrinsic value of WMT in 1984 or MSFT in 1992 - it didn't matter - you just bought and held on.  What was the intrinsic value of BRK in 1985?  Did it matter at what price you bought that year?  Maybe you wanted to not buy it after it ran up tons in the last six months - just like now for AMZN.  You could just slowly add more over time.

 

 

What I do believe are the following:

• AMZN's EV/FCF is <30X (assumes minimum $5B current FCF or only 4.5% FCF margin, lower than WMT's; 8% FCF margin, lower than AMZN's historic FCF margin would result in less than 20X EV/FCF multiple)
  
• AMZN has a top-five-in-the-world-management-team at the helm
  
• AMZN's N. American retail business has a reasonable chance of plateauing 15X larger
  
• Other businesses that AMZN has first-mover advantage in are very large (books, media, cloud-computing)
  
• FBA/exchange business is one of the best businesses in America with very high returns on capital
  
• Perfectly rational capital allocation (large share buybacks during distressed times) and ultra-long-term perspective are VERY unique, valuable and are themselves competitive advantages
  
• AMZN's rapid expansion obscures much FCF and GAAP profit
  

[JAllen]

Here is the final AWS versus U.S./IBM opinion cross-posted from the IBM thread:

 

http://regmedia.co.uk/2013/11/08/amazon_v_ibm_cia_2013.pdf

 

Anyways, it's surprisingly accessible for a large legal document.

 

Some of my favorite parts are:

• "Amazon had a higher price, but the agency determined that Amazon’s technical proposal was sufficiently superior to IBM’s proposal to warrant a significant price premium."
  
• "IBM’s Scenario 5 ... was mis-priced. . . . Instead of following the directions which stated “Assume 100% duty cycle on all virtual machines associated with this scenario,” IBM calculated and proposed a cost for a single run through of a single 100TB data set. This resulted in a grossly under-priced dollar figure for scenario 5 of IBM’s proposal"
  
• "In sum, AWS’s offer was superior in virtually every way but price, and IBM’s advantage in that area was likely not as great as IBM attempted to make it appear."
  
• "AWS’s offer was superior, and the outcome of the competition was not even close."
  

[dwy000]

J - sorry but that doesn't  make sense.  You feel the return is justified at $300 and too low at $400 but you don't calculate an intrinsic value?  Sounds like you have an intrinsic value in mind and $400 is close to it.  If you believe it's just rocket growth at any price then even $400 is a steal.  To get as precise to say that the returns at $400 are too low then you must have a value in mind, right? 

 

Sounds like you follow more of a growth investor strategy than value (which is buying $'s for less than a $). 

 

The EV/FCF isn't 30 today. EV is about $150bn and FCf is $2.5bn (before subtracting stock based comp).  The 4.5% FCf margin doesn't exist today except in theory. The company even calculates FCf in the 10K

[JAllen]

J - sorry but that doesn't  make sense.  You feel the return is justified at $300 and too low at $400 but you don't calculate an intrinsic value?

 

 

Returns at $400 will be "lower" than at $320, not "too low".  I'm confident that returns from this price range will be way higher than the market over the next decade.  Of course a lower price is better and $320 is lower than $400. 

 

 

One would need a discount rate to discount any future price back to estimate a current intrinsic value and to make lots of assumptions about all of the moving parts - yours maybe different than mine.  I stated my beliefs that are sometimes implicitly assumptions above.

[JAllen]

Does anyone disagree with any of the following assertions?

[*]AMZN purchases digital video rights from studios

[*]AMZN pays the studios cash each year for these rights (regardless of any intangible asset on BS that is created upfront)

[*]AMZN's very large content library costs somewhere in the range of $1-$3B, probably in the middle of this range this year because it is comparable in size to NFLX's library, which is $3.5B

[*]The amount AMZN pays to studios in any given year is an accounting expense

[*]Because this amount is an expense and not an investment in a tangible asset such as a FC, this outgoing cash flow is an operating cash flow.  This payment is just like any other purchase from other suppliers

[*]Because the amount paid to content studios is a current year expense, operating income is reduced by the amount paid to the studios + any revenue allocated to digital video

[*]AMZN doesn't charge directly for access to this content - it gives access to it away to Prime subscribers and allocates some portion of total Prime revenue to these digital video costs

[Palantir]

It's all about how you phrase it. :D

 

Amazon is a tax-efficient compounder, run by an owner-operator with his entire net worth invested in the firm, who has a very long-term view. It has a well known brand, a defensible franchise and an economic moat, whose operations create float.

[Liberty]

http://www.peridotcapital.com/2014/06/profitless-amazon-myth-lives-on-thanks-to-lazy-financial-media.html

[dwy000]

Does anyone disagree with any of the following assertions?

[*]AMZN purchases digital video rights from studios

[*]AMZN pays the studios cash each year for these rights (regardless of any intangible asset on BS that is created upfront)

[*]AMZN's very large content library costs somewhere in the range of $1-$3B, probably in the middle of this range this year because it is comparable in size to NFLX's library, which is $3.5B

[*]The amount AMZN pays to studios in any given year is an accounting expense

[*]Because this amount is an expense and not an investment in a tangible asset such as a FC, this outgoing cash flow is an operating cash flow.  This payment is just like any other purchase from other suppliers

[*]Because the amount paid to content studios is a current year expense, operating income is reduced by the amount paid to the studios + any revenue allocated to digital video

[*]AMZN doesn't charge directly for access to this content - it gives access to it away to Prime subscribers and allocates some portion of total Prime revenue to these digital video costs

 

I'd disagree with a couple of technical points (all based on 10k).

- the amount paid to the studios is not an accounting expense.  The amount is capitalized and then amortized into expense based upon the anticipated related revenue stream related to those rights.  The expense is the amortization.  Any excess paid in cash in a given year vs the amortized amount is put on the balance sheet.  So cash flow doesn't necessarily match expense.

- the expense is amortized into COGS so goes to gross margin not operating expense

- Amazon doesn't charge Prime members for the access.  They do charge non

Prime customers for access.  A portion of Prime income is allocated to this and a portion to delivery revenue.

[JAllen]

I'd disagree with a couple of technical points (all based on 10k).

- the amount paid to the studios is not an accounting expense. 

So COS isn't an expense?  If it isn't an accounting expense, what is it?

 

From the 10-K: "Cost of sales consists of the purchase price of consumer products and digital content where we are the seller of record, including Prime Instant Video"

You say 'is not an accounting expense' but below you say:

The expense is the amortization. 

 

What do you mean?  Do you not believe that amortization is an expense?

Any excess paid in cash in a given year vs the amortized amount is put on the balance sheet.  So cash flow doesn't necessarily match expense.

 

Can you point me to where it discusses this?

- the expense is amortized into COGS so goes to gross margin not operating expense

 

Doesn't matter if operating expense or COS, still reduces income and cash flow.  Do you disagree?  Would income and/or cash flow have been higher or lower if they didn't give access to Prime subs to the video content?

-Amazon doesn't charge Prime members for the access.  They do charge non

Prime customers for access.  A portion of Prime income is allocated to this and a portion to delivery revenue.

 

A portion of Prime revenue is allocated to purchases non-Prime members make?  How can that even be possible - allocating revenue to revenue?  Can you point me to where it says this?

 

There's Prime and there's digital video purchases.  Reed Hastings said AMZN was losing $.5B-$1B two years ago; do you really think he was talking about digital video purchases and not Prime?  How would AMZN be losing money on selling access to this video? 

Do you disagree that AMZN doesn't directly charge Prime members for access to a large video library?  Would income and cash flow have been higher or lower had they not?  These are simple questions.

 

You didn't really say whether or not you disagree with any of my assertions (nor has anyone else I should point out) - you just nitpicked at them in a confusing (at least to me) manner, which suggests you're being disingenuous.  Can you answer any of my questions above?

[dwy000]

Maybe I'm not wording it right but you are twisting or confusing my comments. 

 

1.  COS is obviously an expense.  What I said was the cash paid to the studios is not an expense.  The point being the cash amount paid to studios does not necessarily equate to the amount expensed that year.  If they pay HBO $300MM upfront for a 3 year contract, they don't expense $300MM upfront.  They capitalize it and then expense it over the estimated revenue stream generated during the contract period.  This is not a difference of opinion this is accounting.

 

2.  Of course I believe amortization is an expense.  Hence my comment "the expense is the amortization".  The point being the amount expensed through the income statement each year is the amortization amount from the point above not necessarily the amount capitalized.

 

3. From the 10K:

"Content Costs:  We obtain digital video content through licensing agreements that have a wide range of licensing provisions and generally have terms from one to five years with fixed payment schedules. When the license fee for a specific movie or television title is determinable or reasonably estimable and available for streaming, we recognize an asset representing the fee per title and a corresponding liability for the amounts owed. We relieve the liability as payments are made and we amortize the asset as cost of sales on a straight-line basis over each title’s contractual window of availability, which typically ranges from six months to five years. If we are unable to reasonably estimate the cost per title, no asset or liability is recorded and licensing costs are expensed as incurred"

 

Also in Other Assets which includes "digital video content, net of amortization"

 

4. No it doesn't matter whether it's expensed to COGS or opex (which is why I keep going on about their gross margin growth being less relevant than operating margins).  I was clarifying the accounting - from above it goes into COGS. The bottom line doesn't change either way.

 

5.  Again, you confused my point on Prime.  You said that they don't charge for the content, they give it away to Prime users.  My point was that they do charge some peopel for the content - they charge non-Prime users.  Prime users get it free. 

 

6.  I never said a portion of Prime revenue is allocated to purchases by non-Prime users.  Where did you get that???  I said a portion of Prime revenue is allocated to COGS for digital products and a portion to delivery.

 

 

I'm not sure what you're getting at with all of this.  At the end of the day the company is paying for digital content that they are giving away to Prime users.  That's not a point of argument.  It's a fact that any Amazon user could tell you (and now Amazon is paying for music content and giving that away free to Prime users too). 

 

At the end of the day the company has very little Free Cash Flow per share (as defined by the company itself).  They have no intention of changing their business model and indicate they expect existing level of costs and capex to continue.  You believe this will miraculously turn around for no reason despite a lack of evidence of it or the stated intention of the company to keep spending.  The accounting minutae above doesn't change any of this.

[JAllen]

http://mobileopportunity.blogspot.com/2014/07/the-real-meaning-of-fire-phone.html

 

 

"Amazon everywhere. Futurist Paul Saffo put it this way: “Firefly allows Amazon to invade every store in every mall on the planet and turn it into a de facto showroom for Amazon” (link). I’d go even further. I’d say Firefly is an effort to turn the entire world into an Amazon store.

If Amazon makes that phone first, it takes another big chunk out of Walmart and Target and eBay and every other retailer out there, physical or virtual. If someone else makes it first, Amazon itself is in mortal danger."

[jtvalue]

Bill Nygren, a noted value investor, just purchased AMZN in his concentrated Oakmark Select fund

 

http://www.oakmark.com/Commentary/Commentary-Archives/2Q14--Bill-Nygren.htm

[Grenville]

Bill Nygren, a noted value investor, just purchased AMZN in his concentrated Oakmark Select fund

 

http://www.oakmark.com/Commentary/Commentary-Archives/2Q14--Bill-Nygren.htm

 

I'm a fan of AMZN, but remember that this noted value investor had 13% of his fund in WaMu.

[JAllen]

Bill Nygren, a noted value investor, just purchased AMZN in his concentrated Oakmark Select fund

 

http://www.oakmark.com/Commentary/Commentary-Archives/2Q14--Bill-Nygren.htm

 

 

"So if you buy a $100 item on amazon.com from a third party, Amazon is only allowed to show about $13 of revenue, nearly all of which is gross profit.  For third-party sales, Amazon is effectively functioning as the mall owner, collecting a percentage of sales as rent.  Amazon earns less gross profit on that sale than an average retailer would, but it is also a much lower risk endeavor.  For that reason, we think a dollar of third-party sales should be worth about the same as a dollar that Amazon sells directly."

The FBA/third-party business is the most overlooked part of AMZN IMO.  It is an awesome business and the reason sales are 'only' growing 23% while gross profit is growing 33%.  Like the paragraph below points out, sales would be much higher if AMZN sold more than 60% of units itself. 

"It gets interesting when we adjust our cap-to-sales ratio comparison to include estimated gross third-party sales.  Instead of selling at twice the ratio to sales of the average bricks–and-mortar retailer, Amazon is selling at only 80%.  So, relative to gross sales, Amazon's stock would have to increase 25% to be priced consistent with the very companies whose survival Amazon is threatening.  On that metric, Amazon has never been cheaper."

Can't say I agree with him about every retailer deserving 2X sales regardless of other factors.  WMT isn't growing and is the lowest margin so it deserves a discount for instance.  What does AMZN deserve?  Time will tell.

"In an asset–lite business like Amazon, however, most growth spending gets directly expensed to the income statement, creating a much larger immediate reduction in income.  We believe that if Amazon sharply curtailed its growth spending so that it only grew at the rate other retailers grow, it could produce similar operating margins.  But we don't want them to do that.  We believe that management is maximizing value by investing heavily for super-normal organic growth.  So, yes, Amazon is a rapidly growing business.  But at this price, we believe it is also a value stock."

 

 

 

Hmm, sounds familiar.

[JAllen]

 

 

Here's the letter AMZN sent the FAA requesting the FAA grant it the first commercial exemption, using Congress-granted authority from the FAA Modernization and Reform Act of 2012.

 

http://www.regulations.gov/#!documentDetail;D=FAA-2014-0474-0001

 

"Amazon shares Congress’s goal of getting small aerial vehicles (a.k.a., small unmanned aircraft systems, or “sUAS”)"

 

 

AMZN is:

• "Testing a range of capabilities for our eighth‐ and ninth‐generation aerial vehicles, including agility, flight duration, redundancy, and sense‐and‐avoid sensors and algorithms;"
  
• "Attracting a growing team of world‐renowned roboticists, scientists, aeronautical engineers, remote sensing experts, and a former NASA astronaut."
  

Imagine what these sUAS will do to shipping costs if/when they are commercially approved.

 

 

I'm thrilled that AMZN is investing our money into endeavors like sUAS, not TAXES.

[JAllen]

While I'm spamming everyone with AMZN drivel, how about I post one of my favorite AMZN charts again?

 

 

This presents a difficult counterpoint to those who say AMZN HAS to have lower prices that it's competitors, as it already has a more gross profitable relationship with its customers than all discount retailers and even some non-discount retailers with gross margins consistently increasing and nearing 30%.  AMZN has already moved outside of the discount-retailer box and has developed a rapidly-growing exchange-business ( Channel Advisor reports clients experienced SSS growth of 34% in Q2), FBA, my favorite part of AMZN because of its light capital-intensity and competitive-advantage-inducing effects on greater Amazon.

 

 

 

[Laxputs]

Keep the drivel coming.

[dwy000]

what do the operating margins look like if you overlay them on the same chart?