Amazon Addendum

In my last post I pointed out two things regarding AMZN:

1) It appeared as if AMZN had dropped capital spending below the rate of depreciation, and...

2) Their R&D spend had ramped up dramatically. I also pointed out that if this R&D spending were capitalized and written off over three years then the company still isn't very profitable, they really aren't growing and their returns on investment were probably non-existent.

I used these two items as an example of what the central bank policy of ZIRP has brought us. There isn't any way to earn a return on your invested capital and many businesses, AMZN excepted, are giving up.

My perusal of AMZN's balance sheet was where I picked up (1) above, A friend has since pointed out that AMZN is now heavily using a form of capitalized leasing for much of its capital spending. The result is that the line item for this doesn't appear separately in their cash flow statement, but the equipment does show up in their balance sheet. The lease payments for this run through the income statement. In short, AMZN's capital spending is far higher than what their cash flow statement reveals.

Obviously, this makes (1) above untrue.

Unfortunately, for AMZN shareholders, this means that AMZN's return on investment is substantially below what I assumed in my previous post. AMZN's R&D and incremental capex spend is higher than what I had assumed and this is further pressuring their ROI.

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

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.

Central Banks Cannot Create Investment Via the Printing Press

Richard Duncan, a former World Bank employee, has posted an article that discusses his belief that QE is a form of debt cancellation that will allow governments to leverage up and make new growth inducing investments.

http://www.richardduncaneconomics.com/qe-is-debt-cancellation/

The Duncan argument runs as follows:

1) Central banks create money from thin air and buy government debt.

2) As governments owe money now to the central banks, and since central banks return all of their proceeds to the government, governments actually become less leveraged as central banks print.

Conclusion: This means that governments can really lever up now and invest in things that will create growth for the future in combination with central bank money creation from thin air.

The problem with this argument is that the second premise is demonstrably false. When central banks buy government debt, they issue a new form of debt, currency. This currency is also debt. Look at any central bank balance sheet and you will see it show up as a liability, just like every other form of debt.

Currency is slightly different from government debt in that it doesn't have a maturity date or pay interest. It is zero coupon perpetual debt. Nevertheless, it represents the same kind of claim on goods and services as the government bond. That is, $1000 in cash has the same purchasing power as a bond that sells for $1000. Nothing has really changed with the central banks money creation gambit, except for one small wrinkle.

Unfortunately, the small wrinkle completely destroys Duncan's conclusion that central bank printing will allow us to create new investment for future growth.

When central banks print money from thin air and buy bonds, they artificially push interest rates down. That is, to induce the holder of the bond to sell to them, the central bank must bid up the price of the bond above where it would normally trade, driving down the interest rate associated with the bond.

There is a funny thing that happens to the rate of savings when you do this however, it falls. As the central bank shifts the supply curve of money to the right, we see that rates will fall, all else being equal. This means that the interest rate is now below the equilibrium rate for the supply and demand for savings. This induces people to save less and consume more.

We can see now that Duncan's prescription of more central bank printing will bring about the exact opposite outcome of what he believes will happen. There will be less savings and investment available with more central bank printing. Investments require savings as someone somewhere has to defer consumption of their output in order to be able to lend it out so that the workers erecting a plant, or software coders creating an app or actors and technicians filming a movie can be paid and survive until the fruits of their labor are completed and their investment can start to earn a return.

Duncan, like most economists, confuses cash with savings. They are not the same thing. Savings, deferred consumption, is required for actual investment. Cash gives you a claim on that savings, but it not only doesn't create savings, the creation of cash destroys the incentive to save. Cash creation causes less investment, not more as Duncan hopes.

Duncan's argument is the equivalent of saying that central banks can create output, that they can just print up barrels of oil, employee retraining systems and jobs. They, of course, can do no such thing. Their money creation from thin air actually destroys future output (less savings means less growth) and creates malinvestment (malinvestment being a topic for another time).

Think about it like this, if money creation from thin air creates investment opportunities as Duncan proposes, why is the rate of savings and investment so weak? Why don't business invest more with the free money?

The reason that they don't is that they couldn't even if they wanted to as the savings doesn't exist at this level of consumption given the artificially low interest rates. If you want more savings and investment, you need higher rates and, therefore, less central bank printing. Duncan has it all backwards.

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

Larry Fink's Muddled Thoughts

Larry Fink, CEO of the world’s largest asset manager, has sent a letter to the CEOs of the 500 largest companies in the U.S. admonishing them for returning too much capital to shareholders.

The New York Times story on this tells us that Mr. Fink believes that such activity is detrimental to investors and the companies themselves. He believes that everyone is thinking too short-term, that we have become a “gambling society.”

Well, Mr. Fink is correct, there does exist a capital allocation problem in the world today. The problem is that Mr. Fink is chastising the wrong groups.

  

Investors and businesses alike have an incentive to maximize their own profits. When interest rates are set at zero, as they are today in the U.S. and below zero in much of the rest of the world, it is quite impossible to get these two groups to focus on the long-term.

  

When central banks peg rates at artificially low levels, two things will happen:

First, savings will fall. At artificially low interest rates, savers have less incentive to put off consumption.

Second, investment rates will naturally decline with the decrease in the savings rate. Also, the natural reaction of businesses to artificially low rates is to reduce investment. Since businesses will invest to the point where marginal cost equals marginal return, with interest rates set at zero, the marginal return on investment will also be zero. There is no incentive to invest. In fact, without savings, they couldn’t invest even if they wanted to.

This is why businesses want to return capital to shareholders. Business and people are reacting rationally to the interest rates forced upon them by central banks. There is no point to saving and investing if returns are set at zero. At an interest rate artificially set at zero, you will get neither savings nor investment.

Mr. Fink does not properly recognize who the culprit is in our live for today, gambling culture. It is the central banks that have created the mess. Everyone is forced to deal with the state planners and their arbitrary and foolish interest rate edicts.

Given that he doesn’t understand the problem, Mr. Fink moves on to proposing the wrong remedy.

Mr. Fink’s solution to our problem is to adjust the tax code. He wants to increase the tax rate on holdings of less than three years to the ordinary income tax rate, whereas today we tax holdings of longer than one year at a lower capital gains rate.

Mr. Fink states this, “would create a profound incentive for more long-term holdings and could be designed to be revenue neutral.”

It would do no such thing. Without a higher, market-based rate of interest, savings levels will be artificially low. Remember, if returns are set at zero, there will also be no income to tax. Taxes are not the driving factor here. If you want more investment, eliminate the Federal Reserve. Let the market determine rates.

The New York Times seems to believe that Mr. Fink’s asset management business has something to gain and little to lose via these suggested changes to tax policy, as they tend to hold investments for some time.

I suspect that Mr. Fink’s real concern is, or at least it should be, that his business is tremendously threatened by the choices that people and businesses are making today. Mr. Fink’s business is managing the savings of people and investing those savings in businesses. If there is no savings, and businesses liquidate, there will not be much for Mr. Fink or his employees to do in the future. Societal capital is being liquidated and Mr. Fink’s business is, therefore, under threat.

No one can rationally allocate capital in this environment. Savings and consumption patterns are being massively distorted by central bank interest rate policies. No one knows the real demand for their products, where they should be sourced from, where they should find the capital to produce them or if they should produce them at all.

Under such conditions, I am certain that corporate CEOs are paying too much to buyback their shares, but they feel forced into this situation because they know that returns on capital that they may invest in plant and equipment are guaranteed to earn zero. They are being as rational as possible given the information that they have been provided by the artificially driven financial markets. Additionally, the real capital, savings, required to increase investment does not exist. Even if executives were to heed Mr. Fink's plea, they couldn't comply.

They think their current cap rate on share buybacks is maybe 3%, and this far exceeds the zero percent that they will earn if they reinvest in their businesses. Share repurchases also push share prices up, and this is not something that too many shareholders, other than Mr. Fink, complain about. Unfortunately, the three percent is also overstated since they will certainly see returns fall in the future as they continue to liquidate their businesses. In the minds of CEOs this is a problem for tomorrow, however.

Central banks have created quite a mess, and tax policy cannot fix it. There can be no rational capital allocation or an increase in the amount of savings and investment as the interest rate required to produce such a result is being massively suppressed by the central banks.

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