Last Thursday, Amazon (AMZN) reported first-quarter 2012 earnings. Despite a 35% drop in year-over-year profit, a $0.28 EPS beat (vs. $0.07 expectations) caused investors to tack on $13 billion to Amazon's total market cap.
Financial blog ZeroHedge noted the following:
Only problem is that the EPS, which was $130 million equivalent, was based on $41 million in actual net income from continuing operations, or $0.09. Hardly the stuff sending stocks up 10% in after hours. What's accounting for the balance? An after-tax adjustment amounting to $89 million coming from equity-method investment activity, or the oldest accounting trick in the book, which alone added $0.19 cents to the EPS number, or about 95% of the entire EPS beat.
So, while net operating income still would have beaten expectations of $0.07, it was hardly the blowout quarter that the headlines are proclaiming. The "accounting trick" was Amazon saying that the net income of its equity investments (stocks) added $0.19 to its own income. For example, if my company owns one share of Apple (AAPL), I can say my company actually earned $35 last year thanks to Apple's own operating profits.
This was an interesting time to use this type of creative accounting, considering the company's operating margin again declined to a razor-thin 1.4% and guidance for the second quarter was pretty disappointing. Net sales are expected to be between $11.9 billion and $13.3 billion, or to grow between 20% and 34% compared with the second quarter of 2011. Operating income (loss) is expected to be between $260 million and $40 million, or between a 229% decline and 80% decline compared with the second quarter of 2011.
Amazon will most likely incur a loss for the second quarter of 2012, though revenues are expected to grow substantially year over year. However, is revenue growth going to result in meaningful earnings and cash flow growth? It should also be noted that cash on hand declined from $5.3 to $2.3 billion, a net decrease of $3 billion. This rate of cash burn, for one quarter nonetheless, is quite worrisome.
According to the press release, return on invested capital for the first quarter of 2012 was 12%, a 50% decline from the first quarter of 2011, when ROIC was 24%. Furthermore, year-over-year free cash flow growth was negative 39% for the trailing 12 months.
Projecting Future Earnings and Cash Flow Streams
If massive capital expenditures are only temporary, then the company's current revenue growth should result in massive earnings when the capex spending slows, correct? Amazon currently generates about $50 billion in annual revenues, on operating margins that have declined every quarter since the first quarter of 2011. Margins currently stand at 1.4%, down from last year's 3.6%.
Amazon has never been, and never will be, a high-margin business. While investments today may improve long-term margins, gains will be minimal. Current profit margins are also not unique to the last year or so. The five-year average net, after-tax profit margin from continuing operations is 2.7%.
Based on estimates for 27% EPS growth over the next five years, the result is $1.85 billion in net income at the end of those five years (based on TTM net income of $561 million). On historical margins of 2.7%, Amazon would need revenues of $69 billion to achieve net income of $1.85 billion. Is that possible? I'd say it's more than likely, given recent revenue growth of 30%.
So the market is probably expecting revenue growth over the next five years to be about 30%. It had better be, otherwise valuation is way out of whack. 30% annual revenue growth for another five years would be historical, but for our purposes, we'll assume it will happen.
Revenue at the end of that time period would be a staggering $185 billion, about $60 billion more than Apple generates today. On margins of 2.7%, net income would come out to roughly $5 billion. Assuming there are still 450 million shares outstanding in 2017 (pretty unlikely), we are left with a final calculation of $11 bucks per share. At current prices of $220, Amazon would be valued at 20 times earnings in 2017. This assumes no price appreciation in five years. Surely, after a decade of 30% annual revenue growth, a tenfold EPS increase in five years, and the simple law of large numbers, an earnings multiple of 20 would be difficult to justify.
What kind of annual return would you like to receive from holding Amazon's stock? On a risk-adjusted basis, I wouldn't settle for anything less than 10%. If I'm going to buy a company trading at 200 times earnings, I had better be compensated pretty well. With 10% annual gains, the share price would be worth $355 in 2017, trading at 33 times earnings. If 20 is hard to justify, 33 is simply blasphemous.
Conclusion
The above calculation assumes revenue growth of 30% annually for the next five years. Is that possible? I guess, but you had better be using a very large discount rate if you're assuming revenue growth that aggressively.
At current prices, even if the underlying company performs a miracle and produces unparalleled growth rates, the stock will, at best, not budge over the next five years. If you toss in a conservative discount rate, the net present value of the company becomes far cheaper, depending on how you'd like to calculate that.
Amazon, as a fundamental investment, is horrific. When you get down to the present value of the company, the market is simply failing to account for any sort of a discount, and is prematurely pricing the stock at an aggressive five-year revenue growth rate of 30%. At best, the company is fully valued. My earnings forecast doesn't even include the fact that Amazon's online sales are likely to be taxed heavily in the future.
Finally, management's decision to focus on gross profit margins, shy away from discussing perpetually low margins, elaborate on second-quarter projected losses, and tack on $0.19 per share screams "spin job" to me. And it only adds to my worries about the long-term outlook for the company's shares.
Though the shares may seem ripe for shorting, I'd actually advise not to do so. You might catch some good spots to short at the upper bound of the stock's range, but over the long term there's not a huge catalyst for a decline in the share price. Over time, the stock will simply underperform the market by a wide margin.
