After Amazon (AMZN) reported results last quarter, I called attention to the heavy investments it was making through capital expenditures and capital leases. I posited the view that the operating margin was unlikely to snap back like most analysts and investors expected, as these investments would find their way into the income statement through depreciation.
Amazon came out with their 4Q10 results and 1Q11 guidance yesterday, and the numbers were ugly. Operating income was flat YoY in spite of a 36% increase in revenue, and EPS was up a bit thanks to a lower tax rate and other income. The company also guided to substantially lower operating income YoY for next quarter.
Notably, the company continues to misrepresent their free cash flow (FCF) by ignoring the huge outflow for capital leases. It calculates its FCF for the last twelve months as $2.52 billion. However, it also reported spending $577 million on acquiring fixed assets under capital and build-to-suit leases. Deducting this, FCF is only $1.94 billion. Further, this cash flow includes an add back of $424 million in stock compensation. If you believe that stock compensation is a legitimate and recurring expense (as most reasonable investors would), then you need to deduct this amount to arrive at a measure of FCF that is comparable to GAAP net income. This will get you to $1.51 billion for the last twelve months, 40% below what Amazon calculates. This is still an impressive $3.30 per share, driven by a negative working capital cycle (primarily a big increase in accounts payable).
Amazon is by and large honest in their financial reporting. For instance, it does not highlight a non-GAAP net income number excluding stock compensation and other costs, something even “Do no Evil” Google (GOOG) does. So it is perplexing why they miscalculate an important metric like FCF. Are they deliberately trying to mislead investors, or are they making an honest mistake? If it is the latter, is this causing them to make unproductive investments in the business? For instance, the company calculates its Return on invested capital as 34% using its definition of FCF. However, using true FCF, this is only 20%.
Since Amazon trades at such a lofty EPS multiple, many analysts use a multiple of EBITDA or FCF to value the company. One could argue that their price targets should actually be 40% lower given that the FCF is miscalculated. On the other hand, portraying the actual FCF taking into account capital leases hasn’t prevented Rackspace (RAX) from garnering an arguably much inflated valuation of 60x EPS with zero FCF.
Amazon has now missed consensus EPS estimates for three quarters in a row ex-one time items. Analysts continue to be bullish on the company, expecting margins to increase rapidly in the future. Given that their capital expenditure including capital leases is running at almost 3x their depreciation, this is unlikely to happen any time soon. Fixed assets are up 87% this year, more than twice the growth rate of revenues.
There also may be structural reasons for the margin decline, and I will venture a few: Amazon has bought companies with low (or possibly negative) margins like Zappos and Quidsi. Amazon has entered into new product areas with lower margins than the products they traditionally sold. Amazon is now selling “loss leaders” like the Kindle at subsidized prices.
So what is Amazon’s stock worth? Assuming some margin expansion in the back half of the year, the company is likely to earn $3 in EPS in 2011. Put an aggressive 40x multiple, and you get a $120 stock, with substantial downside from the current price. Of course, in this age of easy money and ample liquidity, perhaps it won’t get there until the next recession comes along. Or it may do what Walmart’s stock did – stay flat for a 10 year period during which revenue doubled and profit tripled. If you are short Amazon’s stock, I would recommend selling some $120 puts a few months out against your short position.
Disclosure: I am short AMZN.