Amazon: Earnings Were Not Disappointing

| About:, Inc. (AMZN)


While most of the market found Amazon earnings disappointing, there are signals that the results are not disappointing because the value of the underlying business has increased.

The stock remains with a rich valuation, but the underlying business performance suggests that the business is likely to reach the stock value.

The important thing for investors is that the intrinsic (true) value of the business increases over time, and Amazon shows that they did so.

The key metrics that indicate increase in the business value are operating performance, FCF/share (free cash flow per share), and top line growth.

A month ago I published an article about Amazon (NASDAQ:AMZN) earnings and expectations. I mentioned that I was seeing more downside risk to the stock after the earnings report, which happened to be correct. The market didn't like the earnings release because it missed revenues expectations. But the purpose of this article is to analyze the earnings and the prospects of the business going forward. In my opinion, the earnings were not disappointing. I find the numbers to be solid. I also find evidence that Amazon business value is improving over time, which is ideal for stock holders.

Amazon reported total revenues of $107 billion, which means they outperformed their main industry

From my previous article, I exposed a few scenarios about Amazon revenues based on the expectations for the worldwide e-commerce retail industry. I am relying on Statista's forecast for worldwide retail e-commerce sales, which is a reliable source of data. I share my own forecast below.

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While the top line missed sell-side estimates, I find that top line growth was strong. In my opinion, it is strong simply because growth remains above industry-wide expectations. This is the right path for Amazon to fall into, as their main strategy continues to be investing heavily in growth opportunities. It wouldn't be good if Amazon is focused on growth, but they can't grow faster than their industry. Fortunately, that is not the case for Amazon. The top line growth is one of the most important metrics for Amazon, as all global e-commerce retailers are fighting for a bigger piece of market share.

Despite the recent stock price drop, the sales multiple of Amazon continues to be higher than average

After the earnings report, Amazon continues to trade at a higher P/S than its five-year historical average of ~2.1x. Considering that price multiples tend to be mean reverting, this suggests that AMZN stock price continues to carry a premium to historical valuation.

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Despite the premium to historical valuation of the stock, there has been indicators that point that Amazon's business is increasing in value over time

When owning a stock, investors and shareholders should be focused on whether the underlying business value is increasing over time. This is the approach that legendary investors take, such as Warren Buffett. If a business is increasing its intrinsic value over time, then it makes sense to own the business. Of course, there is risk that the price asked for the business is too expensive, but nonetheless the most important metric is that the business value is increasing over time.

There are two positives that can be drawn from the last earnings and annual report, which is evidence that the intrinsic value of Amazon business is increasing over time.

Positive #1 - Reversed the long-term trend in operating margins on the back of AWS and FBA

As part of Amazon business strategy, they offer a service to third party sellers that is called Fulfillment by Amazon (or FBA). The amount of products that were sold through FBA increased by 47%, and now accounts for more than half of all third-party products sold on the marketplace. The increased in FBA is one strong indicator that third-party businesses continue to rely on Amazon marketplace for product placement, as opposed to brick-and-mortar marketplaces such as shopping malls. Almost every major business has an active store on Amazon - such as General Electric (NYSE:GE) and Nike (NYSE:NKE), among others. Investors and consumers know that Amazon is the most popular online marketplace. But the increase in FBA units sold, and the proportion that FBA occupies, provides data validation to the popularity of Amazon.

In addition to validating the popularity of the marketplace, the increase in FBA services provides one important and tangible benefit to the value of Amazon's business, which indicates that the value of the business is growing over time. The key benefit is that the commissions that Amazon charges for providing fulfillment services are higher. Therefore, the more third-party businesses rely on FBA, the more commissions Amazon collects. The increases in FBA, coupled with the high margin AWS (Amazon Web Services), is reflected in Amazon's operating margin, as it has reversed the decline and continued rising throughout 2015. The increases in operating margin is an essential metric to measure the value of the business.

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Positive #2 - Improvement in Free Cash Flow per share

Free cash flow is the most important metric for any businesses because the value of a stock is measured by free cash flow. In other words, the value of a stock is the discounted value of future free cash flows. Hence, the term DCF (discounted cash flow) is heavily used on stock valuation. Free cash flows were $14.9/share in FY 2015, compared to $4.2/share a year ago. This is a very large and important metric to assess whether the intrinsic value of Amazon business is increasing. It is not only relevant to point to the size of the improvement, but also the improvement itself. Given the improvement of FCF/share, coupled with the fact that Amazon continues to dilute shareholders through stock based compensation, this proves that AMZN underlying business has increased its intrinsic value in 2015.

Despite the large improvement in free cash flows, the multiple at which the stock is trading to these cash flows remains rich. After considering the annual results, Amazon trades at a P/FCF multiple of 39x. It's still rich, but better than its previous multiple of 52x before the earnings release. Arguably, the high growth of Amazon business justifies the rich FCF multiple. But in my opinion, and based on the high P/S multiple, Amazon valuation is still a bit stretched.

Investor Takeaways

Investors and shareholders of Amazon should not be concerned about the stock price drop after the earnings. In addition to that, shareholders of Amazon have tangible proof that the value of the business is increasing over time. Both the improvement in operating margins and FCF/share provides evidence that the business value of Amazon is higher now than it was in 2014. Despite the many negative headlines about Amazon disappointing Q4 results, I find the results to be validating that the business is worth more (and not disappointing).

Nonetheless, the expectations that are built into the stock price are also very high. At the current price of ~$587 per share, I still find Amazon to be overvalued. But at the pace that the business is improving in value, there is evidence that Amazon is likely to be worth the price that it is trading today. It might not be worth it now, but in the future is likely that it will be. That is probably why the stock continues to reward investors in the long-run.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.