Retailing giant Amazon.com continues to grow revenue by large amounts. But its operating margin and free-cash-flow metrics are worsening, raising questions about the sustainability of the company’s growth and its investment strategy.
Amazon’s fourth-quarter revenue grew 35%, to $17.4 billion. But its operating expenses — including fulfillment, marketing, technology, content, and sales, general, and administrative — grew faster, at 37%. Those costs consumed 18% of revenue last quarter, 250 basis points higher than a year ago. In addition, head count grew 67%.
Amazon’s spending spree is causing free-cash flow — a source of funds to develop new products, make acquisitions, and pay dividends — to lag. Defined as cash flow minus purchases of fixed assets, free-cash flow fell to $2.1 billion last quarter, down from $2.5 billion a year earlier. Indeed, growth of free-cash flow on a trailing 12-month basis has fallen for six straight quarters.
“All this SG&A and capex requires a leap of faith that it is somehow going to result in growing profitability and growing free-cash flow in the future,” says Charles Mulford, a professor of accounting at Georgia Tech and director of Georgia Tech’s Financial Analysis Lab. “And that’s certainly not what we are seeing now.”
Amazon’s “free-cash profile” — a forward-looking metric developed by Mulford that measures the amount of incremental free-cash flow that can be expected for a given boost in revenue — is also declining. Amazon’s FCP was as high as 18% in the second quarter of 2010, but fell to 13% last quarter, a sizable drop, says Mulford. The best-performing retail dot-com businesses, in comparison, recently posted FCPs in the 20% range.
“Usually when you see revenues grow [as they did for Amazon], you see margins and free-cash profile improve, because it gives the company more flexibility and money to spend without hurting margins,” Mulford says.
It’s unusual for an established business like Amazon to post worsening operating margins when revenue is growing so fast. It’s something you would expect to see early in the life of a company, says Mulford, when it has to spend heavily on capital assets and SG&A.
Amazon’s problem (and CFO Thomas Szkutak’s) is whether the company can reverse course. “I don’t think we are going to see revenue growth increase from here,” Mulford says. “So do they start cutting back on their capital spending and on SG&A? I don’t know. But that’s the only thing that would translate into growing free-cash flow.”
Some experts say growth areas like Amazon Web Services have the potential to boost profitability. Gross margins in that business may be as high as 50%, according to some analyst estimates. “Other revenue,” the reporting category that AWS comes under, grew to $1.6 billion in 2011.
“If some of these other businesses have larger gross margins it might help, but Amazon is already really big — so they would have to generate a lot of revenue [for them] to offset the lower-margin [products],” says Mulford.
The story Amazon tells the market about where all this investment will get them is key, Mulford says. But on Tuesday’s earnings conference call, CFO Szkutak did little to allay concerns, stressing only the growth in the company’s retail and web-services business. (Amazon did not respond to a request for a comment from Szkutak.)
When an analyst asked about the apparent diminishing returns on Amazon’s capital outlays, Szkutak said: “I’m not sure how to answer that, or exactly what you mean. We see a lot of opportunity in front of us.… There’s some pockets of softness or challenges with some of the economic impact, particularly in Europe.… But we’re incredibly optimistic about the opportunity that we have, and that’s why we have invested the way we have.”
For the quarter, Amazon’s operating income dropped 45% compared with a year ago, and net profit fell to $177 million, from $416 million a year ago.