The Misconception

Amazon is in financial trouble. They don't  generate any profits, their sales growth is slowing, and they recently raised debt.

My View

Amazon's lack of profits is a conscious decision by management, and the right decision given the opportunity ahead of them. The key questions investors should focus on is not whether they are in financial trouble, but what the company will look like in 5-10 years.

Key Points

• There is a trade-off between profitability and growth
• Amazon is focused on growth because of the huge $3.4 trillion opportunity in front of them
• Amazon's growth focus is further supported by their track record of massive share gains
• As a company focused on growth, valuation should not be based on near-term profitability, but on Amazon's ability to capture share from other retailers.
• Like a startup, Amazon is a risky bet. Valuation balances the upside (Amazon's potential to be the online Walmart of the retail world) with the downside (increasing competition and a business model that may not have much operating margin potential)

Last week, Jeff Bezos described Amazon as a startup at a Business Insider conference. This likely led to a lot of head scratching; it's not often that a company with a $150 billion market cap would describe itself as a startup. However, there's more truth to it than one might initially think. Amazon is a startup in the sense that it is managed like a startup. This has important implications on how investors should measure Amazon's performance and value the company.

The Management Spectrum

Think of company management as a trade-off between growth (sales) and profitability. On the growth end of the spectrum, management invests in building infrastructure and products to gain share within their industry. They do so because they see a significant opportunity ahead for themselves, and they believe that these investments will likely generate better returns than any other use of that cash would. On the profitability end of the spectrum, management tries to expand operating margins and cut costs because they do not see any major growth opportunities for the company. Instead of investing in something that might not generate a return, they believe that the best use of their cash would be to let it fall to the bottom line and to the owners of the business. Generally, young companies prioritize growth, while mature companies prioritize profitability. 

When possible, sales are prioritized over profitability. There is a saying that the higher you are on the income statement, the more important it is. This is because generating sales and gaining market share is usually harder to do and a faster way of increasing overall profit than increasing margins.

Here's an example. Let's say that I own an apparel company that's making $100,000 in profit each year. This is a company with the bare essentials -- a factory, some workers, a website. There's two ways I can take my business. I can either try to make more money by squeezing out costs (maybe getting rid of a few unproductive employees, or finding a cheaper factory) or I can take those profits and invest it into advertising the brand and increasing awareness of my products. The former path would grow my profit directly, but my sales would remain the same. I might choose to do this if I believe I've tapped out the potential revenue streams for my company. The latter path would likely grow my revenue significantly at the expense of near-term profitability. I might choose to do this if I believe I've got many other regions to grow into, or if I believe I have more products to create. For a startup that is just beginning to realize its potential (think Uber), it makes sense to go for the growth. For a mature company in a difficult industry (think Staples), it makes sense to cut costs and focus on profitability.

Amazon's Growth Story

Amazon management sees itself as a company on the growth side of the spectrum. Amazon has invested $9 billion in capex over the last 3 years, which is larger than all but a handful of retailers. Additionally, operating margins have declined by 360 basis points from 2009-2013 despite growing sales by 204% over that time frame.

Clearly, the company is investing heavily in itself. The confusion comes from the company's size -- it's not often that a company would continue to invest heavily when they're generating over $70 billion revenue and are a behemoth in their space.

Should Amazon prioritize growth? The answer depends on what management sees as the growth opportunity for the company. While Amazon is the largest e-commerce company in the U.S., they still have significant room to grow.  Take a look at e-commerce's penetration of total retail sales  (excluding auto dealers and food services) shown below. E-commerce represents just 8% of total retail sales. This is extremely low when one considers what e-commerce penetration should be in 5-10 years. It's not difficult to imagine a future where consumers order half of their purchases online - just think of all the products that you could reasonably buy online without having to go to the store. With a $3.4 trillion brick and mortar opportunity ahead of itself (the red area of the graph), Amazon can make a strong case to continue focusing on growth.

Heavy investments are further supported by Amazon's massive sales growth. Not only is there a significant opportunity ahead of itself, but Amazon is also grabbing more and more of that share each year. Amazon's retail sales in the U.S. have grown from $12 billion in 2009 to $40 billion in 2013. Some investors have brought up the point that sales growth has decelerated over that time frame. However, it's important to remember that sales growth will naturally slow as the company gets bigger and bigger. In fact, 20%+ sales growth for a retailer of Amazon's size is still extremely impressive. Instead of focusing on the growth rate, investors should focus on the dollar gains, which are growing each year (shown in the chart below). Additionally, Amazon's growth rate is further understated by their shifting sales mix from 1P to 3P. I'll detail this added wrinkle at a later date, but for now it's enough to know that their growth rate would actually be higher if the company recognized its sales consistently across its retail business.

Amazon's Valuation is Misunderstood

The implication is that we cannot value Amazon on its net income. If we accept that Amazon should be plowing its profits back into the business, then we can also accept that net income will be depressed by choice. If we accept that net income will be depressed, then we should also agree that valuation should NOT be based on current or near-term earnings per share, as most public companies generally are. If not EPS, what should valuation be based on?

Amazon is a share gain story. As hinted at above, the key to Amazon's success is their ability to capture share from brick and mortar retail stores. Admittedly, the company's valuation is expensive even on metrics based off of sales. However, the high multiple is partly justified by the high visibility into their sales growth, their consistent track record of share gains, and the inevitable retail industry shift towards e-commerce as an alternative shopping channel.

Alternatively, valuation could also be based on Amazon's long-term earnings potential. However, this becomes a difficult exercise on what the long-term potential of Amazon's sales and margin are, and it's made more difficult by Amazon's lack of financial disclosures.

Amazon Is, Like Any Other Startup, a Risky Bet

Note that as a company with a startup mentality, there are significant risks associated with investing in Amazon. While Amazon's rich valuation accounts for its huge potential over time, the stock will also get dinged whenever that potential is questioned. Over the last year, Amazon shares have declined by 19% vs. the S&P 500's gain of 15% as investors have questioned what Amazon will look like in 5-10 years. While I believe Amazon's major investors understand why Amazon is investing heavily in itself, there are questions over:

• Whether the investments dollars are being spent in the right places.
• Whether decelerating sales growth is due to increased competition from brick and mortar retailers, and at what point their sales growth will settle out.
• Amazon's long-term margins and how much recent margin pressure is from management discretion vs. structural issues.

Addressing these concerns are beyond the scope of this article, but are important questions with interesting debates (and I've partly addressed the second question earlier in the post). Let's move the discussion toward these topics and away from their lack of near-term profits.