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Amazon's Aggressive Income Statement

Peter Eavis

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Management at Amazon.com (AMZN Quote) has grown increasingly aggressive in setting key expense and revenue items -- giving the company's earnings a substantial, but possibly artificial, boost.

Last year's operating earnings of $180 million could have been reduced by more than a quarter if Seattle-based Amazon had merely maintained historical levels for income-statement items related to inventory, unpaid customer bills and advance payments to Amazon. To a large extent, these items, which exist at all retailers, are set according to management's own assumptions. Overly aggressive companies have been known to abuse them to make profits look stronger than they are.

One way to test if this is going on is to check whether ratios for these items are in line with historical levels -- and whether any change is justified by developments within the company's operations. At Amazon, there does not appear to be a strong case for assumptions becoming more aggressive. That means Amazon's true profitability could be weaker than it looks, casting doubt on whether the company can meet Wall Street's bullish earnings expectations for 2004.

Amazon spokesman Bill Curry responds: "We never manipulate numbers to influence results."

After a plunge into the single digits in 2001, Amazon's stock has rocketed higher as investors have begun to believe in the company again. But an unexpected earnings miss could, of course, force Amazon's highflying stock into another tailspin. On Monday, Amazon posted a late rally to finish 24 cents higher at $58.30.

Allowances

The numbers in question are arcane, and some of them get disclosed only once a year. But they could still be having a significant impact on earnings. The three items that warrant a closer look are:

• The inventory valuation allowance, which is the reserve the company keeps on its balance sheet to absorb losses from inventory. Amazon decides how much should be added to the reserve, and these additions are an expense item in the income statement.

• The accounts receivable reserve, which the company keeps on its balance sheet to absorb losses from customers who don't pay. At Amazon, the reserve for retail customers is not an issue, because buyers pay up front. Instead, the reserve that requires a closer look is the one that absorbs losses from third-party vendors that use Amazon's site. Additions to this reserve are also an expense item in the income statement.

• The amount of unearned revenue that is bled into earnings, which is in part an issue of timing. Unearned revenue is booked as a liability on the balance sheet. It represents advance payments for goods or services to which Amazon is contractually obligated but has yet to deliver. The company gets to choose how much of the unearned revenue gets fed, or amortized, into revenue each quarter.

When looking at these items, investors won't get a full picture by checking the dollar amount. Instead, they must assess their change in relation to other items. In each case, the relevant ratio has become substantially more aggressive.

Steep Drop

First, the inventory valuation allowance. In 2000, Amazon's addition to the reserve was $31 million, compared to only $23 million in 2002. The drop was even steeper as a percentage of cost of inventory (which is cost of sales excluding cost of shipping). The inventory reserve addition in 2000 was equivalent to 1.81% of cost of inventory, compared to 0.9% for both 2001 and 2002.

If the reserve addition had been kept at the 2000 ratio of 1.81% in 2002, Amazon would have added an extra $23 million to costs in 2002. That is equivalent to 13% of the company's operating earnings.

Amazon's Curry responds that the inventory addition was at an "appropriate level." He says that inventory management has improved over the past few years. He illustrates this by pointing to an indicator called "inventory turns," which measures how many times a year a company sells its inventory. Amazon has increased that turn number to 19 in 2002, from 14 in 1999, Curry points out. Amazon bulls may also point out that the days' inventory outstanding measure (which compares inventory with cost of goods sold and expresses that relationship in days) fell between 2000 and 2002, which is a good thing. This indicator dropped to 17 days in the fourth quarter of 2002 from 21 days at the end of 2000.

Seeing as inventory management has clearly improved, why would it be wrong for Amazon to have let its inventory reserve drop? Simple answer: Amazon's product range has broadened and contains many items, such as consumer electronics, that carry far more inventory risk than books. In other words, it makes no sense that the reserve has slipped, and investors should be wary.

More of the Same

The accounts receivable allowance for vendors shows the same pattern. In 2000, the reserve for these receivables was 0.45% of net sales, compared to 0.2% in 2002. If the 2000 level had been maintained in 2002, Amazon's operating earnings would've been lower by $10 million, or 5.6%. Curry says of the most recent allowance: "That's the appropriate level." That seems particularly unwarranted, because Amazon's use of vendors has skyrocketed since 2000.

Unearned revenue's impact on earnings is slightly harder to track, because it is a revenue number. However, it is not hard to arrive at an estimated impact, by applying a very conservative 25% margin to the unearned revenue. The unearned revenue movements are particularly odd. In 2002, Amazon amortized $135 million of unearned revenue into revenue, but added only $95 million of unearned revenue to its balance sheet. How can it have added more to its earnings than it took in?

Of course, one possible explanation is that it is still amortizing unearned revenue from past years. Indeed, it may be amortizing the value of equities it received as payment from Internet companies in 1999 and 2000. If this is the case, investors must ask how much more of this equity-related revenue it has left on the balance sheet to amortize into earnings. If it is about to be exhausted, which seems likely, the contribution of unearned revenue to earnings could slump.

What is the relevant yardstick for gauging unearned revenue amortization? The most appropriate would be unearned revenue amortization as a percentage of unearned revenue already on the balance sheet, plus additions to that number in the given year. That number rose to 74% in 2002, from 42% in 2000, applying quarterly ratios.

Keeping the 2000 ratios in 2002, unearned revenue would have been $69 million lower. Applying the 25% margin to that sum gives an earnings boost of $17 million, or 9.6% of operating earnings. Curry said the unearned revenue ratio was "appropriate" and advised that Detox look at Amazon's most recent annual report, "which illustrates the ins and outs of deferred revenue period to period." The annual report didn't appear to shed light on the reason for the strange increase in this ratio.

Also odd is the fact that unearned revenue collected is dropping as a percentage of net sales. It fell to 2.4% of net sales in 2002 from 3.7% in 2001. It's hard to see a good reason for a decline of that size. The dark explanation would be that Amazon is booking revenue too quickly to boost earnings.