Amazon.com (NASDAQ:AMZN) has just posted earnings, and as usual it did even worse than expected and again guided down for the next quarter (Q3 2014). However, what's really surprising is the magnitude of the guide down. Here's the relevant quote from the press release:
Third Quarter 2014 Guidance
• Net sales are expected to be between $19.7 billion and $21.5 billion, or to grow between 15% and 26% compared with third quarter 2013.
• Operating loss is expected to be between $810 million and $410 million, compared to $25 million in third quarter 2013.
• This guidance includes approximately $410 million for stock-based compensation and amortization of intangible assets, and it assumes, among other things, that no additional business acquisitions, investments, restructurings, or legal settlements are concluded and that there are no further revisions to stock-based compensation estimates.
The implications of this guidance are tremendous. The midpoint guidance for revenue growth is +20.5% year-on-year. That's not very surprising. However, what's truly surprising is the magnitude of the operating loss predicted by Amazon.com. I will only focus on the high end of Amazon.com's guidance, but still, this is what it implies:
- First, it implies a massive EPS loss for the quarter of around $1.00 per share, down from the current expectations for a loss of $0.07. So losses are now expected to be more than 10x larger. This implication flows from the fact that to the $410 million operating loss at the high of the guidance range, we have to add the impact of further P&L items such as those from financing costs, equity losses at LivingSocial and earnings taxes from jurisdictions where Amazon.com can't avoid taxes;
- Second, the loss predicted for Q3 2014 is so much larger than expected, that it's likely that we'll see the consensus for the entire 2014 driven down to $0 at best, from $1.05 right now.
Again, Amazon.com shows how unbelievable it is that its stock is trading at a $160 billion market cap purely on the back of fairy tale after fairy tale.
The gross margin fairy tale
One of the things which has been used to promote Amazon.com stock is the tale about how gross margins are improving. This is both misleading and dishonest. Anyone with a modicum of honesty would point out that Amazon.com accounts for AWS and 3P (third party commissions from marketplace sellers) at 100% gross margin, and then includes the true variable costs of these activities lower in the P&L, in the "technology" cost line (AWS) and "fulfillment" (3P).
Thus, when AWS and 3P are growing faster than the overall Amazon.com, the posted gross margin percentage has no way not to increase, no matter what's happening to Amazon.com's overall profitability.
Indeed, many analysts then continue to expect "leverage" from those cost lines which, due to being victim to the same mechanics inflating stated gross margin, have no way of not increasing faster than overall revenues. This is, again, misleading or dishonest.
The 'profits will come later' fairy tale
Based on the glorious past where Amazon.com managed to post significantly higher operating margin, analysts keep hoping that somewhere down the line Amazon.com will again regain those margins. Were such to happen in the presence of much higher revenues and the bottom line would necessarily be much larger as well.
But thing is, the Amazon.com which had much higher margins in the past was intrinsically different from the Amazon.com of today and the future. Back then Amazon.com was 2/3rds Media and 1/3 EGM. Now it's the precise opposite. Even just assuming unchanged margins for Media and EGM, this change in sales mix is enough to explain the entire drop in Amazon.com's profitability. Indeed, this change in sales mix allows me to say that Amazon.com's lack of profitability is structural.
The latest earnings and guidance once again confirmed this theory - Amazon.com's CSOI profitability continues to go slowly lower, as predicted.
Free cash flow is imploding, too
As I also predicted, the next problem which Amazon.com will face is the disappearance of free cash flow. In this latest quarter, the TTM measure of free cash flow dropped another $400 million, and now stands at barely $1 billion. The next quarter is sure to see a further drop. Soon, this measure will probably hit $0.
One of the drivers of this new problem is AWS. As Amazon.com said, while AWS saw massive price cuts, it also continued to see a massive increase in usage. Well, a massive increase in usage translates into a massive need for further capex. It will be this capex, along with the decreased overall profitability, which will ultimately compromise Amazon.com's free cash flow, which is about the last measure anyone can hang on to - and even that measure would barely justify a share price 80% down from where it stands today.
Amazon.com's earnings report brought more of the same, but it's becoming obvious that the stock is not worth anything close to the price it trades at. It will require more and more fantasy to continuing believing even in a price of ½ its present market capitalization.
Amazon.com's lack of profitability is structural and obviously so. Next, we'll see the disappearance of Amazon.com's free cash flow. Also, Amazon.com's balance sheet is again becoming problematic and it's likely that Amazon.com will issue more debt soon.
Disclosure: The author is short AMZN. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.