Amazon (NASDAQ:AMZN) has one of the most misunderstood business models today because it doesn't play by the accepted rules which optimize financial metrics such as earnings per share. Unlike its bricks-and-mortar competitors Costco (NASDAQ:COST), Target (NYSE:TGT), and Walmart (NYSE:WMT), Amazon deliberately seeks to maximize its long-term future investible cash flows even at the cost of current profitability. But does that choice serve shareholders over the long term? Should investors be jumping on the Amazon bandwagon or should they keep their money in the established methods of doing business? An intriguing answer emerges from the following five charts .
The first chart reveals the compound annual growth rates of the four companies' sales from 2010 to 2013. Amazon is growing sales at an astonishingly faster pace than the other three with an annualized growth rate three times higher than that of even robustly growing Costco, while Target and Walmart are growing their sales roughly in pace with inflation. This clearly indicates the ample growth opportunities Amazon has available to capture if it can get there before others do.
Investible cash flow growth
Retail companies grow by building storefronts and/or warehouses and filling them with merchandise to sell to consumers. The cash available to internally fund such expansion of buildings and inventory without recourse to debt, as Amazon is doing, is the cash flow from operations with the change in inventory added back in. I call this the "investible cash flow", the money available for commitment to capital expenditures and expansion of inventory.
Operating cash flow comes up short for our purposes because it subtracts the funds the CEO has allocated to expanding inventory; but inventory expansion is integral to the capital-allocation decision we are trying to get our arms around, so we don't want it removed. Free cash flow is even worse because it also subtracts the funds the CEO has allocated to expanding the facilities in which the additional inventory is stored and sold. These two items, inventory and capex, are the very things we are after; and we want to see how much capital the CEO has available before any is allocated to them. Investible cash flow fills the bill.
The next chart compares the companies' compound annual growth rates of investible cash flow over the past three years.
Both Amazon and Costco are growing investible cash flow at impressive rates; Target and Walmart, in stark contrast, have seen declines in their cash flow available for investment in growth opportunities.
Committing to growth
Having investible cash flow is one thing, but it must be invested in growth to, well, grow the company. This next chart illustrates the annual growth of investments in capital expenditures and inventory. Both Amazon and Costco have dramatically grown their investments over the past three years, while Walmart has pulled back slightly as its cash flow slid.
Money well spent or money wasted?
Investing in growth is only worth it if the payoff exceeds the company's cost of capital. Otherwise the company is destroying value and should simply return the money to the shareholders. The next chart shows the amount of investible cash flow each company earns from its invested capital, which I define here as total assets minus non-interest-bearing current liabilities.
Again Amazon stands out remarkably with a return well above that of Costco, which put in a good second place; Target and Walmart lag. One note of caution with Amazon, however, is that its return has fallen from 55% two years ago. The culprit is a steady rise in its, albeit superlative, working capital. This is something to keep an eye on as its future unfolds.
Valuation on cash flow
By standard valuation metrics, Amazon trades at a lofty premium; even stalwart Costco has consistently sold at a premium value. To understand Amazon, however, one must value it by cash generated, as Bezos himself does. The final chart illustrates how the story changes when you value each company in this manner, comparing apples to apples, using the ratio of enterprise value over investible cash flow. Suddenly both Amazon and Costco appear reasonably priced for their respective growth rates.
Amazon and Costco: Two ways to invest
Amazon is growing sales and investible cash flows at breathtaking speeds for a retailer, and the cash flow it earns on its invested capital is remarkable. With such demonstrated growth opportunities in front of it, who wouldn't want their money invested at a 40% annual return? Bezos may be pursuing an unorthodox business model, but his company is bringing in huge sums of additional money for each dollar it invests. For those who prefer to invest in companies that transform how business is done, Amazon is attractively priced at 20 times cash flow.
Costco is the big surprise. Using a more orthodox business model, it too is growing briskly with excellent cash returns on its capital. Better still, its valuation of 12 times cash flow shows no premium over its stagnant peers, Target and Walmart. For those who prefer to invest in established business models, Costco is a steal at these prices.
Both Amazon and Costco are growing prosperously through their own unique business methods; that makes each a good candidate for long-term investment.