On the Difficulty of Profitably Growing a Business in a World of 0% Interest Rates

Amazon’s share price catapulted another 14% higher on Friday. The shares added more than $25 billion of market capitalization in a single day. AMZN’s market cap. now stands above $200 billion and, by the way, they are still losing money. AMZN is the proverbial “spend money now, make a big profit later” growth company.

I have noticed another nice little oddity about this growth company: they are now expensing more in terms of depreciation than they spend on capital expenditures. This is extremely rare behavior for a company whose shareholders expect it to grow future profits at a maniacal rate so that the exorbitant share price can be justified.  Growth companies have, by definition, lots of great high return investment opportunities.

I pointed this out to a friend of mine and he said, “Yes, but they are spending nearly $10 billion per year now on R&D (Technology and Content in Amazon’s income statement)." 

This is true, with the inference being that the company’s current business would be wildly profitable without this expense and they have plenty of profitable investments still in front of them.

To find out how expensing R&D upfront impacts AMZN’s operating income, I went back and adjusted their 2012-2014 income statements by capitalizing R&D and writing it off over three years. This adjustment, roughly, increases reported operating profits by $2.5 billion in 2014, $1.8 billion for 2013 and $1.4 billion for 2012.

This would result in adjusted operating profits of ($ billions):

2014  $2.7

2013  $2.5

2012  $2.1

AMZN’s massive $15.8 billion spending spree on R&D over the past two years could only push adjusted operating profits up by $600 million, the type of return a passbook savings account might have earned in the past. Last year’s massive $9.3 billion spend (investment) pushed operating profits up just $200 million. Yes, the spending of the last two years is expected to have impact in 2015, and beyond. My point, however, is that this is not a very profitable company and, even if you capitalize R&D, they aren’t growing very fast.

Investors must assume that the ROI will improve dramatically at some point in the future because deploying capital at such a pitiful ROI means that it will take AMZN forever and a day for its profitability to grow into its valuation. If we include the Austrian concept of malinvestment to AMZN’s investments, it is quite likely that AMZN is losing money on its R&D spending.

But just how likely is it that ROIs will improve in the future if interest rates remain pegged at zero? Unlikely. If businesses invest down to the point where marginal costs equal marginal returns, growth in operating profits will be very tough to come by.

Already, AMZN has dropped capital spending below its rate of depreciation, and their current bet is that R&D will offer better returns. This analysis suggests not. Amazon is a business that would cost you $200 billion to buy, it generates an adjusted operating profit of just over 1% of this figure and they are spending furiously on R&D and getting precious little to nothing to show for it.

It is very difficult to profitably grow a business over time with rates set at zero. I am not here to pick on AMZN, I am here to pick on AMZN’s shareholders who are, IMO, far bigger fools than AMZN management and the central banks. Yes, the central banks have fostered this mess, but nothing says that investors of the world must participate.

 Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.