One of the things I love about the work I do is that I get to watch after hours trading. There's nothing quite as exciting, even if you are not in a trade. After closing the regular session down just over $3.00 at $182.30, shares of Amazon.com (AMZN) tanked on the news that the company missed Q1 EPS projections. AMZN touched an after hours low of $170.69, rebounded back into positive territory before whipsawing around a bit more, and ultimately ended after hours lower by about 1 percent. The volatility in Internet stocks sporting lofty valuations continues.
Despite the EPS miss and continued high operating expenses, investors should not worry about the future of the in the air, on the ground, on top of the cloud online giant. This is because, from several standpoints, Amazon is more like Apple (AAPL) and less like Netflix (NFLX).
Given my recent pessimism on his company's future and the way it conducts business, I think it's important to note that I have nothing against Netflix CEO Reed Hastings. I have a somewhat intimate view of all of the excellent work he has done with education in California. Plus, he comes off as a thoughtful guy, who became rich and then introspective before co-founding Netflix. I respect that. With that said, Netflix makes a good compare and contrast with Amazon vis-a-vis expenses.
When I hear Amazon CFO Thomas Szkutak speak about Amazon's CapEx spending spree, I receive the words with confidence. Part of the reason is because Bezos actually speaks about the company's expenditures, telling you exactly what they are going to and how they are getting there. I click away from an Amazon earnings call with absolutely no question about where and how its cash flows. I don't feel like they have anything to hide from investors. They execute an open and transparent process.
Another reason why I have an easier time swallowing Amazon's massive cash outlays is because they actually have a substantial amount of cash. Like Apple, Amazon keeps a war chest. And it's much safer to dip into profits when they are massive and you have a rainy day fund to take from and use as backup. With Q1 operating cash flow of over $3 billion, free cash flow of nearly $1.9 billion, and cash and cash equivalents and marketable securities totaling $6.9 billion, as of March 31, 2011, Amazon builds its business form a position of strength and relative safety and security. If it's sales came to an absolute halt, it could spend, at its current pace -- CapEx for Q3 totaled $315 million, Q4, $328 million, and Q1, $298 million -- for several quarters without empty pockets or the need for some type of infusion. Apple operates from an even stronger position.
Relatively speaking Netflix works from a weak position. For instance, NFLX free cash flow has gone from $8 million to $51 million to $79 million over the last three quarters. It holds cash and cash equivalents and short-term investments totaling $343 million. As for expenses, they are growing and incredibly difficult to pin down. As Wedbush Securities analyst Michael Pachter told me in an email:
It's a black box, I really can't make sense of their spending and reconcile [it] to a particular account. I can assure you that every penny they spend... will work its way through the income statement eventually, certainly within 5 years. I just can't tell you that it goes into content library and then amortizes in a particular quarter.
Amazon does not keep such complex books and what appear to be outright secrets. If you listen to the company's earnings calls -- which they conduct live on the phone with analysts -- there's nary a hint of evasiveness. When they don't tell you something, it's clearly for strategic reasons. For instance, Szkutak would not give any other information on how Prime customers are adopting free online content streaming, other than to say it's going well. He was also somewhat vague on the costs associated with ramping up Amazon Web Services. There's no question, however, about when and how the costs Amazon incurs hit the books. It's no mystery. They could not have been more up front about the hit to the EPS than they were. When somebody has a question about a 50 percent increase here or a few million there on the balance sheet, the question gets asked and answered. This rarely occurs on a NFLX conference call.
Despite it recent stumbles, Amazon Web Services represents another reason to be bullish on Amazon's future in the light of increased expenses. AWS makes up just one of Amazon's several revenue streams. As an online retail outlet, it generates sales through various avenues, ranging from media to electronics to consumer staples. Of course, it has recently upgraded its audio and video offers through its cloud services and streaming for Prime members. And don't forget about the pilot program, Amazon Fresh. While we cannot yet tease out the impact the latter three businesses, if history repeats, they'll be successful. In its relative infancy, AWS, when combined with assorted marketing and promotional activities, co-branded credit cards, and seller programs, such as Amazon Associates, brought in $953 million for Amazon in 2010, according to the company's most recent annual report.
Thanks in part to its diversity, when Amazon spends money, there's less risk attached than when Netflix does. Netflix readily admits its getting set to abandon the DVD rental business, leaving online streaming as virtually its only source of meaningful revenue. It does not "side" activities that bring in hundreds of millions of dollars that can get ploughed back into one or two main drivers or new ventures. It's hardly diverse. As such, it's putting so many of its eggs -- profits and cash -- into one unproven and competitive basket.
Along the same lines, you can make a rather safe assumption that Amazon will make money on its investments. A look at its history of doing so provides proof. With Netflix, it's next to impossible to generate true ROI figures because we really don't know the full extent of their liabilities for the reasons discussed in this article and elsewhere. Therefore, I cannot trust any ROI numbers they provide.
To be fair, it's not Netflix's fault that it has a shorter history than Amazon does. I expect the company to spend money as it ramps up growth. As an investor, however, I also expect them to clearly convince me that they are on a sustainable path. The cards they have put out on the table thus far show off a tenuous proposition at best. The inverse holds true for Amazon.
When Amazon makes a major annoucement I don't walk away puzzled like I did when Netflix plunked down a million bucks an episode for "Mad Men." For instance, launching their cloud offering when they did, practically out of the blue, was nothing short of brilliant. It's worth every penny it might have cost Amazon to ramp things up ahead of Apple and Google (GOOG). With this move, Amazon takes ownership, at least in much of the public's eyes, of the next trendy term -- "the cloud." You could not brand yourself any better than Jeff Bezos did here. Amazon's competition certainly wishes it went first from a marketing standpoint. I don't think Netflix's competition loses much sleep, however, over missing out on "Mad Men."
Obviously, I would stay away from NFLX. It will see $150 before it sees $250. As for AMZN, I would consider playing it in one of three ways. I would only own the stock, long-term, at this moment through dollar-cost-averaging. It can't hurt to take what you can afford, ignore the day-to-day or month-to-month price and invest regularly in one of the world's next blue chip companies. You'll wake up 20 years from now richer thanks to the move.
As I noted ahead of earnings, you could also play AMZN using options. Post-earnings, it's worth revisting the strategy. If you want to own the stock long-term, but find yourself afraid of getting in too high, writing, also known as selling, put options makes sense. Going short a put option equates to being long the underlying stock. To position yourself for the time when the prospects of a strong holiday season for Amazon outweight concerns over expenses, you could select a put with a strike price you would be comfortable buying AMZN at today. If the party you sell the put to exercises her option to sell you 100 shares of AMZN at that price you must buy them. You receive the premium you sold the option contract for in exchange for entering into this contract.
Amazon also works as an excellent swing trade on the long or short side. The peaks and valleys on AMZN's 1-year daily chart, courtest of Schwab's StreetSmart Edge, make this strategy quite obvious. Of course, you can't trade this way by sight alone, so consider studying indicators such as the ones I included on the attendant chart. If the price of the stock is too rich for your blood (it is mine), you can easily execute this strategy with options by buying puts to play the stock short and buying calls to play it long.
Disclosure: Author is short NFLX via a long position in put options. Author may initiate a long or short position, possibly using options, in AMZN or AAPL at any time.