Sunday, January 20, 2013

How Valuable Are Amazon’s Intangible Assets?

The income tax portion of Amazon’s 10K filing for fiscal year ended December 31, 2011 reads:
The effective tax rate in 2011, 2010, and 2009 was lower than the 35% U.S. federal statutory rate primarily due to earnings of our subsidiaries outside of the U.S. in jurisdictions where our effective tax rate is lower than in the U.S. Such earnings primarily relate to our European operations, which are headquartered in Luxembourg ... We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. These reserves are established when we believe that certain positions might be challenged despite our belief that our tax return positions are fully supportable. We adjust these reserves in light of changing facts and circumstances, such as the outcome of tax audits ... We are under examination, or may be subject to examination, by the Internal Revenue Service (“IRS”) for the calendar year 2005 or thereafter. These examinations may lead to ordinary course adjustments or proposed adjustments to our taxes or our net operating losses. In addition, while we have not yet received a Revenue Agent’s Report generally issued at the conclusion of an IRS examination, we have received Notices of Proposed Adjustment from the IRS for the 2005 and 2006 calendar years relating to transfer pricing with our foreign subsidiaries. The notices propose an increase to our U.S. taxable income that would result in additional federal tax expense over a seven year period beginning in 2005, totaling approximately $1.5 billion, subject to interest.
Amazon’s effective tax rate was 31.2% for 2011, 23.5% for 2010, and 21.9% for 2009. Reuters provides more on this IRS transfer pricing challenge:
Online retailer Amazon Inc is fighting the U.S. Internal Revenue Service over a $234 million international tax bill, a dispute similar to others in which the agency has struggled to collect corporate taxes. The case, filed on Dec. 28 in U.S. Tax Court in Washington, has implications for other technology companies with software assets that may prove difficult to value for tax purposes … Amazon argues that the IRS is overestimating the value of Amazon’s “intangible property,” which includes computer software, trademarks and marketing assets, according to the court filing … The IRS relied on an estimation method that was overturned in a 2009 court decision involving Veritas Software Corp, now part of Symantec Corp, Amazon said. The Veritas decision was a stinging loss for the IRS, prompting corporations to be more aggressive in fighting the IRS over transfer pricing.
Some excellent reporting from the Bureau of National Affairs provides even more details with respect to the transfer of intangible property from the US parent to its Luxembourg affiliate - Amazon Europe Holding Technologies SCS – back in 2005. While Amazon claimed the value of the European rights to their intangible assets was less than $217 million, the economists hired by the IRS are claiming the value was $3.6 billion. These economists are relying on an application of the discounted cash flow method based on assumptions that Amazon are now challenging. While the representatives of Amazon are claiming that this $3.6 billion valuation estimate based on this particular application of the discounted cash flow approach is above the fair market value – let me submit any reasonable application of the Market Capitalization approach would suggest that the IRS expert is being conservative. Some might be shocked that the IRS is asking for so little as at the current stock price just over $272 a share, the market value of equity exceeds $120 billion. OK, the Market Capitalization approach would have one deduct the relatively minor amount for book value of equity and add any the book value of intangible assets, which would make the value estimate just under $120 billion. With sales in 2011 at $48 billion, the value to sales estimate is well over two. But we also need to remember that the valuation date was closer to the end of 2005 when sales were running around $8.5 billion per year and the Market Capitalization approach was closer to $20 billion. Yes – Amazon has experienced considerable sales growth and a large increase in its market value over the past seven years. We also need to remember that the Luxembourg entity did not receive the U.S. rights to the intangible assets. With US sales running at 55 percent of worldwide sales takes a large chunk of this $20 billion. And I’m sure the lawyers for Amazon will argue that not all of the bundle of intangible assets in the foreign region was created by the US parent given this statement:
Amazon discovered that it could not “simply re-launch the Amazon.com website in foreign countries” but rather, had to launch sites that were “specifically tailored to the browsing practices, purchasing habits, and language and cultural preferences” of its European market. It also needed to develop new technology to support those sales.
Even so – the $3.6 billion estimate put forth by the IRS expert’s discounted cash flow model still appears to be conservative in comparison to any reasonable application of the Market Capitalization approach. Of course, taxpayers often argue that their market valuations reflect irrational exuberance. It is true that Amazon’s operating margin was a mere 5 percent so its market valuation reflected an incredibly high price-earnings ratio. But also remember that Amazon has experienced very high growth during the past 7 years. Which is interesting in light of the other complaint about the IRS expert’s discounted cash flow model:
This disparity in valuation, according to the petition, reflects in part the company's determination that the pre-existing intangibles had a limited useful life of seven years or less, whereas IRS presumed that the intangibles had a perpetual useful life ... The discounted cash flow was based on the projected profits of the European websites from 2005 to 2011 and a terminal growth rate of 3.8 percent.
Given the high current price-earnings ratio, one could readily argue that the market is expecting a much high growth rate than 3.8 percent post 2011. Unless one wants to continue to argue that the current stock price of $272 a share is again reflecting irrational exuberance. Does Amazon management really want its tax attorneys to claim their shareholders are paying way too much for their shares in the company?

1 comment:

malyn said...

Hi Guys, I found a Website to perform Discounted Cash Flow Model calculations, no need to do those calculations on the Excel file anymore, check it out:
http://turnkeyanalyst.com/2013/09/19/cloud-based-discounted-cash-flow-analysis-tool/