Amazon, Inc.

, Part II
Profitability and Ratio Analysis

Name(s):_________Shuting Qin________________________________

Use this Word document to respond to each case question and submit to Canvas.

1. What accounts on the income statement are changing the most? What is happening to
Amazon’s gross margins? What is happening to Amazon’s net income margin? What about
Walmart – do you see as much change?

Net income is changing the most. Amazon’s gross margins has been increasing year over year
from 2015 to 2018, Amazon’s net income margin also grew year over year from 2015 to 2018,
especially rising dramatically by 153% from 2017 to 2018.

By contrast, Walmart’s gross margins remained constant from 2015 to 2018, however, Walmart’s
net income margin has been decreasing year over year from 2015 to 2018.

2. What accounts on the balance sheet for Amazon are changing the most? Why do you think
these accounts are changing? Is this consistent with what we discussed in Part I of the case?
There are only three non-equity balance sheet accounts which changed by more than 4
percentage points for Walmart. One event changed all three accounts – what happened?

Retained earnings of Amazon is changing the most, which is consistent with what have been
discussed in Part I of the case. This is primarily due to Amazon’s acquisition of Whole Foods on
August 28, 2017; 4 months of Whole Foods revenues (Aug. 28-Dec. 31) are included in Amazon’s
income statement in 2017, and a full year of Whole Foods revenues are included in Amazon’s 2018
income statement. For WMT, Property and Equipment, net, Goodwill, and retained earnings
changed by more than 4 percentage points, which is related to WMT’s acquisition of “Flipkart”.

3. Is the increase in Amazon’s ROCE in 2018 due to an increase in ROA, Leverage, or both?

The increase in Amazon’s ROCE in 2018 is due to an increase in ROA, since ROA increased from
3.5% to 7.7%, and there was a small decline in leverage.

4. Compare the change in Amazon’s ROCE in 2018 to the change in Amazon’s ROA. Why is the
change in Amazon’s ROCE so much higher than the change in its ROA?

The change in Amazon’s ROCE is much higher than the change in its ROA, since the leverage is
as high as 300%+, which will amplify the increase in ROCE which can be decomposed into the
product of ROA and Leverage.

5. By contrast, Walmart’s ROCE dropped in 2018. Is this caused by a decrease in ROA, Leverage,
 Amazon, Inc., Part II: Profitability and Ratio Analysis

or both?

The drop of Walmart’s ROCE in 2018 is caused by a decrease in ROA, since ROA dropped from
6.0% to 4.1%, and there was a slight increase in Leverage.

6. Amazon’s and Walmart’s ROAs went in opposite directions in 2018. Were these changes
caused by changes in Profit Margin, Total Asset Turnover, or both?

The changes of Amazon’s and Walmart’s ROAs in 2018 were mainly caused by the changes in
Profit Margin.

7. How has Amazon’s revenue mix of product sales vs. service sales changed in recent years?

Online stores (1st party sales) contributed the most revenue in 2018 (53%), followed by 3rd party
seller services (18%) and AWS (11%). The percentage of sales from online stores has declined
from ≈ ¾ in 2015 to ≈ ½ in 2018, while the % from each other group has increased.

8. What accounted for the substantial increase in sales from physical stores in 2017? In 2018?
What is “distorted” about the growth rate in sales from physical stores in 2018?

Amazon entered the brick-and-mortar retail business with the acquisition of Whole Foods on
August 28, 2017. (10-K: Item 1. p. 3). Therefore 4 months of Whole Foods revenues (Aug. 28-
Dec. 31) are included in Amazon’s income statement in 2017 (explaining the increase from 0%
in 2016 to 3% of the revenue mix in 2017), and a full year of Whole Foods revenues are included
in Amazon’s 2018 income statement (contributing to the increase from 3% to 7% in 2018).

9. What product/service group (besides physical stores) has the highest growth rate in 2018?
What revenue stream is driving this?

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The growth rates of Online stores, Physical stores, Third-party seller services, Subscription
services, AWS, and “Other” in 2018 are 13.5%, 197.1%, 34.1%, 45.7%, 46.9% and 117.2%,
respectively. Therefore, we can see that, revenue from physical stores grew the most in 2018
(197.1%), due primarily to the acquisition of Whole Foods during 2017 described above. Revenues
of “Other” (mostly advertising revenues) grew 117.2% in 2018, coming from a relatively small
base. AWS, already a large contributor to revenues in 2016 and 2017, is growing rapidly at 46.9%
in 2018, as is Subscription Services (45.7%). The sales of online stores are growing at the slowest
rate (13.5%), compared to 34.1% revenue growth for Third-party seller services.

10. BONUS QUESTION: Part of the growth in the “Subscription Service” line item is driven by
an accounting change. What is it? [Hint: See pg. 48 of the 2018 10-K for a description of
Amazon’s accounting policies for revenue recognition.]

The ASU adopted by Amazon on January 1, 2018, is primarily related to the unredeemed portion
of its gift cards, which are recognized over the expected customer usage period rather than
waiting until gift cards expire or when the likelihood of redemption becomes remote. The
recognition and classification of Amazon Prime have been changed, which were accounted for
as a single performance obligation and recognized ratably over the membership period as service
sales from 2018. Previously, Prime memberships were considered to be arrangements with
multiple deliverables and were allocated among product sales and service sales.

11. Is there a trend in the gross profit % (“gross margin”) reported in Amazon’s common size
income statements? How is Amazon’s gross margin affected by the change in revenue mix of
product vs. service sales? [Hint: What is the gross margin percentage for services-based
revenues?]

There is a gradual increasing trend in the gross margin reported in Amazon’s common size income
statements. The proportion of sales from products has decreased in recent years, whereas the
percentage of service sales increased. Compared with product sales, services have higher gross
margin, which contributes to the increase in Amazon’s overall gross margin.

12. Is there a trend in Amazon’s operating income % (“operating margin”)? How did the
operating margin change in 2018?

Amazon’s operating margin increased from 2015 (2.1%) to 2016 (3.1%), followed by a decrease
in the year of 2017 (2.3%), and then rose significantly in 2018 (5.3%). Compared to 2017, the
operating margin increased by 3.0% in 2018, with an 130% rate of growth.

13. Compare the mix of revenues and gross margins of Amazon vs. WMT. Do the differences in
gross margins make sense in light of their different mix of businesses, products and services?
In particular, consider the following: what is Walmart’s biggest merchandise category? Using
what you know about that segment, are margins expected to be high or low for Walmart’s
largest merchandise category?

The gross margins of Amazon are higher than that of WMT, which is related to Amazon and WMT’s
different mix of businesses, products and services. For instance, Grocery is Walmart’s biggest

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merchandise category. The gross margins of grocery are expected to be low due to the fierce
competition in the market, which could be a reason of WMT’s lowerer gross margins.

14. Compare the total operating expenses (excluding COGS) as a percentage of sales of the two
companies. What type of expenses contribute most to these differences?

Amazon’s total operating expenses (excluding COGS) as a percentage of sales are higher than
that of WMT, the differences are around 10%-14%. SG&A and Fulfillment expense contribute
most to these differences.

15. Compare the operating margins from the common size income statements of the two companies.
Recall from the analysis of Amazon’s operating margins, the operating margin on Amazon’s
AWS segment was by far the highest of its three segments. To better understand the operating
margins of Amazon vs. WMT, use the segment disclosures data to calculate Amazon’s
operating margin for North America and International only (i.e., excluding AWS and corporate
overhead allocations). How does this adjusted value compare to WMT’s 2018 operating
margin?

We can see from the common size income statements, the operating margins of Amazon increased
from 2.1% to 5.3% over these years, whereas the operating margins of WMT decreased from 5.0%
to 4.3% over the same periods. After excluding AWS and corporate overhead allocations, we can
get the adjusted new operating margins of Amazon (showed in the following table). It is obvious
that the adjusted operating margins are lower than the previous ones which include AWS, and the
adjusted operating margins of Amazon are lowed that the operating margins of WMT. Therefore,
we have reason to conclude that the high operating margin of AWS segment contributes
significantly to the overall operating margins of Amazon.

2016 2017 2018

North America
Net sales 79,785 106,110 141,366
Operating expenses 77,424 103,273 134,099
Operating income 2,361 2,837 7,267
Operating Margin 2.96% 2.67% 5.14%
International
Net sales 43,983 54,297 65,866
Operating expenses 45,266 57,359 68,008
Operating income (1,283) (3,062) (2,142)
Operating Margin -2.92% -5.64% -3.25%
Consolidated
Net sales 123,768 160,407 207,232
Operating expenses 122,690 160,632 202,107
Operating income 1,078 (225) 5,125
Operating Margin 0.87% -0.14% 2.47%

16. Which operating expenses do you expect to grow less rapidly than sales (i.e. have a significant
fixed cost component)? The excerpt below from Amazon’s MD&A may be helpful:

Fulfillment is expected to grow less rapidly than sales, since it has a significant fixed cost

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component.

17. Compare the Accounts receivable turnover and collection periods of Amazon and WMT in the
most recent year. How are these measures interpreted? What additional sales-related
information would enable more meaningful measures? What business line(s) do you think the
A/R are primarily related to for Amazon?

The Accounts receivable turnover of Amazon (16.54 and 15.61, respectively in 2017 and 2018) is
much lower than that of WMT (87.40 and 86.48, respectively in 2017 and 2018). The collection
periods of Amazon are 22.1 days and 23.4 days, respectively in 2017 and 2018; by contrast, the
collection periods of WMT are 4.2 days in both 2017 and 2018, which is about 1/5 of the collection
periods of Amazon.

Both Accounts receivable turnover and collection periods measure how quickly the firm collects
its receivables from its customers. Faster collection means higher turnover and fewer days. Longer
times could indicate difficulty collecting or strategy to extend more credit to drive sales.

In my opinon, AWS is primarily related to the relatively low Accounts receivable turnover and
long collection periods of Amazon.

18. Compare the inventory turnover and holding period (also called “Days in Inventory”) of
Amazon and WMT in the most recent year. How are these measures interpreted? Is the relative
similarity of these measures surprising to you?

The inventory turnovers of Amazon are 8.14 and 8.38, respectively in 2017 and 2018,
correspondingly, the holding periods of Amazon are 44.8 and 43.6, respectively in 2017 and 2018.
The inventory turnovers of WMT are 8.60 and 8.75, respectively in 2017 and 2018,
correspondingly, the holding periods of WMT are 42.4 and 41.7, respectively in 2017 and 2018.
We can see that, Amazon and WMT have similar inventory turnover and holding period. Such
similarity isn’t surprising to me.

19. Both Amazon and WMT have seasonal businesses, with demand elevated in the 4th quarter.
How can seasonality distort the estimated inventory turnover and holding period? How could
you adjust for such seasonality? Also, what is the fiscal year end month of the two companies?
How does this difference potentially affect the fiscal year-end balance of inventory
considerations?

Companies may maintain excessive inventories at certain times of the year, in preparation for a
“seasonal sale” of high demand. As a result, an inventory turnover and holding period measured
at this time as opposed to after the season will be radically distorted. Such seasonality could be
adjusted by using an average monthly inventory instead of beginning and ending inventories.

The fiscal year-end month of Amazon is December, whereas the fiscal year-end month of WMT is
January of next year. Amazon’s fiscal year-end balance of inventory is supposed to be lower than
WMT’s, since companies usually have the lowest inventory in the end of year.

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20. Compare the fixed asset turnovers of the two companies. How is the fixed asset turnover
interpreted? How do you expect the requirement to report operating leases on the balance
sheet beginning in 2019 to affect the fixed asset turnover of Amazon? Do you expect such a
large effect on the fixed asset turnover of WMT? Explain.

Fixed asset turnover can be interpreted as: how much sales $ are produced for each $ of fixed
assets, which can be used to measure a firm’s efficiency in generating revenue from its fixed-asset
investments. The fix asset turnovers of Amazon decreased from 4.56 to 4.21, from 2017 to 2018;
whereas the fix asset turnovers of WMT increased from 4.37 to 4.55, from 2017 to 2018.
The fixed asset turnover of Amazon is expected to decrease after reporting operating leases on the
balance sheet. The fixed asset turnover of WMT is also expected to be affected like this.

21. If Amazon continues to invest in AWS and AWS continues to become a larger portion of
Amazon’s sales, how would you expect Amazon’s total asset turnover to change over time?

Amazon’s total asset turnover is expected to decrease, since AWS has the lowest asset
turnover among the segments, if AWS accounts for a larger portion of Amazon’s sales, it will
reduce the total asset turnover of Amazon.

22. Note that total asset turnover uses sales as the “flow” account, while inventory turnover and
accounts payable turnover uses cost of goods sold. Why do you think these ratios use different
flows in their calculations? Related, does AWS have inventory? Does AWS have COGS?

Inventory turnover and accounts payable turnover uses cost of goods sold because COGS reflects
the total cost of producing goods for sale and excludes retail markup, whereas sales usually
include a markup over cost. Dividing sales by average inventory and average accounts payable
inflates inventory turnover and accounts payable turnover. However, the total asset turnover ratio
measures a company’s ability to generate sales from its assets, it should be calculated by
comparing net sales with average total assets.

AWS segment assets primarily consist of property and equipment and accounts receivable and
does not have inventory. AWS have COGS.

23. ROCE of Amazon in 2018 of 28.3% is considerably higher than the ROCE of Walmart of 8.9%.
Is this due to higher ROIC, higher effect of financial leverage, or both?

ROCE of Amazon in 2018 is due to both higher ROIC and higher effect of financial leverage
compared with WMT.

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24. Although Amazon’s traditional ROA is lower than Walmart’s ROA in 2016 and 2017,
Amazon’s ROIC is higher than Walmart’s in all three years. What distinctive feature of
Amazon’s business model explains the difference in rankings for ROA vs. ROIC in 2016 and
2017?

Amazon is getting cash in before paying suppliers, which means that # Days inventory on hand +
# Days to collect receivables < # Days to pay suppliers. This approach to management of working
capital contributes to cash from operations. Typically, as retailers grow, cash from operations is
reduced by investments in working capital (e.g. increases in inventory and accounts receivable,
only partially offset by increases in accounts payable.) However, Amazon’s business model allows
for increases in accounts payable that exceed the increase in inventory and accounts receivable,
which results in a higher ROIC.

25. Although the traditional Total Asset Turnover for Amazon is lower than that of Walmart in all
three years, Amazon’s Net Operating Asset Turnover is higher than Walmart’s in all years.
What distinctive feature of Amazon’s business model explains the difference in rankings?

Sorry, I have no idea about this question and need to get the explanation in class.

26. Is Amazon’s higher ROIC in 2018 relative to Walmart due to higher ROOA, higher effect of
Operating Liability Leverage, or both?

Amazon’s higher ROIC in 2018 relative to Walmart is due to both higher ROOA and higher effect
of Operating Liability Leverage.