3 Things Amazon.com, Inc. Investors Need to Know

By Markets Fool.com

Shares of Amazon.com have soared over the past month as the market continues to value Amazon based on extremely optimistic assumptions. The argument that Amazon produces loads of cash flow, making up for its lack of net income, is something I've taken on in previous articles about the company's extensive use of capital leases and how the cloud computing business is a giant money pit.

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Here are a few other things about Amazon that investors need to know.

Amazon's marketing spending is exploding
Given that Amazon has become the first place that many people go when buying things online, particularly for the tens of millions of Amazon Prime members, it would seem as though Amazon wouldn't need to spend huge sums of money on marketing. However, not only is Amazon's marketing spend exploding, but it's also growing faster than revenue.

Chart created by author; data from Amazon.

Where are all these marketing dollars going? According to Amazon's 10-K, the increase in marketing spend over the years has gone primarily to online marketing channels, such as search advertising, as well as television advertising. Amazon is spending a tremendous amount of money driving people to its site.

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It seems like this shouldn't be necessary. While Amazon doesn't disclose the total number of Prime members, analyst estimates go as high as 50 million. This may be an optimistic figure, but Amazon has stated that there are "tens of millions" of Prime members in the past. Estimates for how much the average Prime member spends vary: RBC puts it at $538 annually, while Consumer Intelligence Research Partners puts it at $1,500 annually.

Tens of billions of dollars are coming in through Prime members each year, a significant chunk of Amazon's total revenue, presumably without much prodding via advertisements. While some of Amazon's marketing spending is likely going toward trying to grow the Prime user base, the company's efforts are getting less effective over time, with an increasing percentage of revenue going toward marketing each year.

As both a percentage of revenue and in absolute terms, Amazon vastly outspends Wal-Mart, Target, and Best Buy when it comes to marketing. Wal-Mart manages to spend just 0.5% of its revenue on marketing, and this stingy advertising budget has been a trait of the company throughout its history.

Amazon's starting to near department-store levels of marketing as a percentage of revenue, even though it doesn't have department-store margins. Great retailers don't need to spend heavily on marketing to persuade people to buy things -- Costco doesn't even have a marketing budget, for example. But that's clearly not the case at Amazon.

A rising gross margin?
Over the past few years, Amazon's gross margin has been expanding. After hovering around 22%-23% from 2006-2011, gross margin reached 29.5% in 2014, rising in each of the past three years.

If Amazon's only business was retail, this would be a great triumph, as it would signal that the company was able to pass off higher prices to its customers. But Amazon has been growing two businesses rapidly in the past few years, its third-party marketplace and Amazon Web Services, and this growth has caused Amazon's gross margin to become decreasingly relevant.

Why? Here's what Amazon counts when determining the cost of sales:

Cost of sales consists of the purchase price of consumer products and digital media content where we record revenue gross, including Prime Instant Video, packaging supplies, and inbound and outbound shipping costs, including sortation and delivery centers, and related equipment costs.

Cost of sales doesn't include fulfillment for either the retail business or the third-party business, which totaled $10.8 billion in 2014, and it doesn't include depreciation from Amazon Web Services, which is counted instead under technology and content spending. This means that the third-party business and the cloud computing business operate at very high gross margins, skewing the gross margin for the entire company.

The fact that the gross margin has grown over the past few years tells investors absolutely nothing about the core retail business. A more relevant number would be the operating margin, which has been in decline since 2011.

Growing interest payments
In 2014, Amazon paid $210 million in interest payments. While this is only 0.24% of the company's revenue, it completely erased the meager operating profit Amazon managed for the year.

Over the past five years, Amazon's interest payments have been growing, thanks to both an increase in debt and the heavy use of capital leases to finance billions of dollars in capital investments.

Chart created by author; data from Amazon.

All signs point to a continuation of this trend. As I pointed out in my article on Amazon's capital leases, Amazon's true free cash is extremely negative, with the company not bringing in enough cash to pay for all of its initiatives. Amazon sold $6 billion in bonds in December, and if heavy spending continues, more debt offerings are inevitable. These new bonds will carry annual interest payments of around $240 million.

The capital leases also carry interest payments, and as long as Amazon continues to grow its cloud computing business, its use of capital leases will continue to rise. As the percentage of revenue dedicated to interest payments rises, it will become more difficult for Amazon to post a real profit.

Amazon's heavy spending is starting to catch up to it, and the finances of the e-commerce giant are looking increasingly precarious.

The article 3 Things Amazon.com, Inc. Investors Need to Know originally appeared on Fool.com.

Timothy Green owns shares of Best Buy. The Motley Fool recommends Amazon.com and Costco Wholesale. The Motley Fool owns shares of Amazon.com and Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.