Tag: growth investing

Amazon and the problem with reported earnings

Amazon and the problem with reported earnings

Amazon share price has recently broke $3,000 per share and is currently trading at a lofty P/E of 147x. In fact, the company often trades above 80x P/E. Merely looking at the earnings would deter most value investors from owning Amazon.

Building on our income statement series on gross profit margins and marketing expenses, Amazon is the poster boy for not giving a hoot about reported earnings. Here is what Bezos have to say:

Bezos has an incessant focus on the Amazon’s long term prospect. He emphasized a high return on invested capital (ROIC) by reinvesting relentlessly to become the market leader. He understands that for growth to deliver long-term value, the ROIC must be sustainably high.

Amazon build up its moat by spending aggressively on research and development (R&D). R&D expenses include developing new products and infrastructure to enhance customer experience and improve process efficiency:

Looking beyond reported earnings

When we look at Amazon’s operating income, it looks rather mediocre. In 2014, the company made a meager $178 million in operating income on the back of $88 billion in sales. Giving it a razor-thin operating margin of 0.2%.

Adding R&D expenses into operating income would paint a drastically different story. In 2014, Amazon spent $9.2 billion on R&D. Adjusting for R&D expenses would give the company an operating margin of 10.6%.

This is a consistent trend for Amazon over the years. On the surface, the operating margin continued to linger below 6% even in recent years. Adjusting for R&D expenses, we can observe that the margin has actually exploded upwards to 18%.

This is largely due to higher margins segment third-party seller services (3P) and Amazon Web Services (AWS) operating segment rapid growth. This is the result of their aggressive investments in R&D earlier.

Capacity to suffer

The “capacity to suffer” is key because often the initial spending to build on these great brands in new markets has no initial return. Many companies will try to invest smoothly over time with no burden on currently reported net income, but the problem is that when you are trying to invest in a new market, smooth investment spending really doesn’t give you enough power to make an impression. You end up letting in a lot of competition that will drive down future margins. 

Tom Russo, Gardner Russo & Gardner

Capacity to suffer” is a term coined by Tom Russo and its a key trait I look for in companies. Companies that have the capabilities to look beyond short-term Wall Street expectations. Family controlled businesses or founders who have a majority of the voting rights are a commonplace to look for such businesses.

Amazon could have appeared very profitable if it wanted to. By pulling the plug on R&D expenses which drove growth and strengthened the company’s moat. But that’s not how Bezos does things. It always boils down to achieving growth and sustaining a high ROIC.

Here is my favorite statement from Bezos this year:

The problem with GAAP earnings

For digital companies, its economic engine is built on the back of R&D, brands (i.e. marketing efforts), customer relationships, software, and human capital. These intangible investments are akin to the traditional industrial company’s hard asset investments – factories, buildings, and machinery.

For the traditional hard asset investments, expenses are recognized over its useful life. A machinery that cost $10,000 would reduce the current year’s earnings by $1,000. This expense recognized over its useful life of 10 years. Recognizing that wear and tear reduces the value of these assets over time.

However, for the digital company, investment in its economic engine is not capitalized as assets. Instead, they are treated as expenses and charged in entirety towards the current year’s earnings. Despite intangible investments generally having multi-year benefits, or in certain cases, enhance in value over time.

When a firm engages in R&D, marketing, software development, or training employees, it must charge these long-term value-creating expenditures the same way it recognizes general expenses such as office space rents in the current year period.

In short, there is a mismatch between the value delivered and the timing of recognizing the expenses. Also, these intangible benefits are not recognized as assets on the balance sheet.

Take Amazon for example, its value increases as it onboard more sellers, which in turn attracts more customers as it offers a great range of products and vice versa. Its value growth is driven by the network in place, not by increments of operating costs.

Hence, the most important thing for digital companies is to invest aggressively in its early years to achieve market dominance and command a “winner-take-all” profit structure.

Here is a short excerpt from Marcelo Lima’s 2Q 2018 letter to Heller House fund clients:

“Winner-take-all” structure

Since 1996, Amazon has grown revenue at a 50% compounded annual growth rate (CAGR). Even at its current size, adjusted operating income (excluding R&D expenses) grew at 28% CAGR for the past 5 years.

The eventual profitability is a result of continuous investment into the company’s economic engine to achieve market dominance in e-commerce and cloud (i.e. AWS).

For SaaS companies, many have spent years and tons of capital growing despite producing meager accounting profits or are running losses. They are profitable though, when evaluated in terms of unit economics, and when they stop investing every dollar generated into further growth (i.e. once market dominance is achieved). A good example would be Adobe.

In our next article, we will discuss how to analyze SaaS companies unit economics by looking at two important metrics – Customer Lifetime Value (LTV) and Customer Acquisition Cost (CAC).

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Conclusion

Where the key value driver of a company is in intangible investments, investors need to look beyond reported earnings. Especially for innovative companies in their early stage as they invest heavily in growth. Compressing their earnings and balance sheet assets.

Finding the next multi-bagger by understanding operating expenses

Finding the next multi-bagger by understanding operating expenses

Earlier, we have covered the first 3 lines of the income statement – revenue, cost of goods, and gross profits. This allows us to calculate the gross profit margin (GPM), which measures pricing power and production efficiency. We also went through some of the common misconceptions about GPM.

Today, we are going to move further down the income statement – operating expenses. I pay special attention to this segment because this is where you can identify the characteristics of the next 100 baggers. Operating expenses include:

  • Selling, general, and administrative costs (SG&A) – Salaries of headquarters staff, marketing expenses, and utilities bills.
  • Research & development (R&D) – Salaries of staff doing R&D and its consumables used in developing new products.
  • Depreciation – Fixed assets expenses recognized over time. E.g. A laptop costing $3,000 will be charged as $1,000 in depreciation expense over 3 years. Think about it as expensing it over its useful life.
  • Amortization – Recognizing the impairment of intangible assets.

    Update: Our friends from MoneyWiseSmart shared that the impairment of goodwill over 40 years has changed. It is not compulsory for companies to amortize goodwill over 40 years. Companies may opt for it to be evaluated for impairment on a periodic basis. If it is not impaired, the value will be carried on the company’s books indefinitely.

We are able to derive operating profits by subtracting the above expenses from the gross profits.

Operating profits = Gross profits – SG&A – R&D – Depreciation & Amortization

Dividing operating profits by revenue, we will obtain the operating profit margin (OPM). The OPM gives us clues as to how the management is managing operating costs compared to past years and compared to its competitors.

Reported earnings vs true earning power

As usual, we are going to use case studies to understand these concepts. Reported earnings of high growth companies are often misunderstood by investors. Current earnings do not equate to real earning power.

Companies that are growing rapidly often reinvest heavily and their earnings are distorted as a result.

Earnings are the reported numbers. But real earnings power reflects the ability of the company to earn high rates of return on capital and grow at a high clip.

Companies that are able to generate high returns on capital and grow rapidly often will enjoy a big share price increase from multiple expansion and earnings growth.

Monster Beverage

Adapting from Chris Mayer’s 100 baggers, investing $10,000 in Monster Beverage would return $1,000,000 in 10 years. This is the essence of 100 baggers, the stock returning 100 fold your original investment. If held for 18 years it would have returned more than $7,000,000 (700 bagger!).

Monster copied Coca Cola’s playbook. By adopting a capital-light business model – focusing only on marketing and branding. They have no in-house manufacturing and outsourced their bottling business.

At the start, Monster spent a disproportionately large percentage of its revenue on marketing (i.e. SG&A). The company understood that they needed to develop their competitive advantage by building up Monster’s brand and rapidly eat up market share.

Scaling and building its moat

There are several reasons why Monster focused relentlessly on expanding market share and building up its brand:

  • Economies of scale in marketing – Less advertising dollars are required to sell additional Monster drinks as it becomes increasingly popular.
  • Lower distribution costs – Offer less discounts and distribution partners may offer concessions to retain Monster Beverage.
  • Operating leverage – A dollar increase in sales will result in a multiple fold increase in earnings due to fixed cost.

Monster aggressively ramp up its marketing efforts. We are able to see that the marketing team grew by almost 7 times within 5 years. The net sales per marketing employee stayed stable, suggesting that the company did not over-hire.

Monster’s investment in marketing paid off. As net sales increased more than 6 fold, from $96.5 million to $605.8 million within 5 years! We get net sales by subtracting promotions (e.g. discounts we see at the supermarket) from gross sales.

Lollapalooza effect

As the Monster brand gains awareness and experience rapid growth, the benefits of rising bargaining power, and operating leverage kicks in:

  • Increasing net sales/gross sales – Less promotions (discounts) were required to be given to retailers.
  • Rising gross profit margins – Copackers and distribution partners offered concessions to retain Monster as their client.
  • Rising operating margins – Due to operating leverage, operating income rose 32 fold! From $5.3 million to $171.3 million over 5 years. We can also observe this from the jump in operating margins.

This combination of positive factors stated above created a Lollapalooza effect. Investors watching the Monster story play out had until 2004 to jump on this ride before it begins its ascent.

Warren Buffett on marketing expenses

Buffett covered this topic extensively in his 1999 letter to shareholders. GEICO, the low cost car insurer owned by Berkshire Hathaway increased its spending on marketing from $33 million in 1995 to $242 million in 1999.

Buffett explained that he does not care if marketing expenses depress current year earnings. As long as the value of the brand outweighs the cost in the long-run. This is vastly different from most companies that are concern about Wall Street’s estimates. And would cut back on expenditure which increases the size of the moat.

He further illustrated that it probably wouldn’t cost this much to maintain GEICO’s brand position. However, with a large Total Addressable Market (TAM), the benefits from gaining scale was huge. GEICO had approximately 4.1% market share of the auto-insurance market back then.

Limitation of accounting

Accounting rules require companies to recognize marketing expenses, R&D, etc as they are incurred. For example, GEICO spending $242 million in marketing would reduce its pre-tax profits by the same magnitude.

This is despite such expenditure providing benefits that goes beyond one year. Brand names such as Coca-Cola, Nike, etc spent huge dollars on marketing. As a result, they dominate consumers’ minds and we favor these products over others when making our purchasing decisions.

As investors, we have to analyze the company’s operating expenses together with management’s strategy explained in conference calls and annual reports. It helps to ask ourselves these questions:

  • Are the earnings depressed because they are aggressively spending to build up the company’s moat?
  • Is the TAM huge compared to its current market share?
  • Are the benefits of the company’s expenditures reflected in operating metrics such as higher sales, rising gross margins or operating margins (over time)?
  • These must be evaluated in conjunction with the strategies laid out by management in the annual report and conference calls.

Our next article will discuss R&D expenses with Amazon as the case study. At first glance, Amazon looks like it has razor-thin operating margins. Diving deeper, it was actually a result of Jeff Bezos reinvesting a large portion of earnings back into the business to increase the size of the company’s moat.

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P.S. I strongly recommend Chris Mayer’s book 100 baggers to understand the essence of investing in high-quality compounders.