What First Quarter Earnings Mean For Amazon Investors

About: Amazon.com, Inc. (AMZN)
by: Damon Verial

Amazon's Q1 2019 earnings have been cited as disappointing, but I found them more optimistic than pessimistic.

Management sentiment predicts Amazon stock to rise at a normal pace, and investor sentiment predicts a bolstering effect on novel information releases (e.g., news events or earnings).

A gap-based dip-buying strategy produces excess returns and can be further leveraged via options.

Amazon (NASDAQ:AMZN) reported Q1 2019 earnings last month, but the response was underwhelming. The stock dropped slightly in response, and some investors claimed that the top is nearly in for this stock. I looked over AMZN's earnings and found them neither impressive nor dire.

Sentiment Analysis

More importantly, sentiment - which explains more than actual quarterly EPS and revenue changes in post-earnings price movement - returned to average. Average is not bad, but sentiment did drop quarter over quarter, by 20%. This, however, is still not all that bad, as year over year, sentiment is flat and equal to the market average.

From a sentiment analysis perspective, we should expect neither excess returns nor underperformance in AMZN's stock over the coming quarter. Let's take a look at some of the statements flagged by my sentiment analysis from this quarter's report. These forward-looking statements contributed to the sentiment drop but were, nonetheless, overall positive, as they usually are for this company.

The most interesting aspect of the earnings report was Amazon's statement that the company is benefiting from investments up to 20 years ago; the company employed a long-term investment outlook in logistics and fulfillment to where it is easily able to provide products to the consumer in two days' time. Now, the $800M investment to bump that time to one day is beginning to see fruits, and Amazon expects one-day delivery to become standard this quarter. From a quantitative perspective, that's a 50% speed increase.

I see this as the most important change in the company in recent years. Amazon began its one-day delivery system two years ago here in Japan, a country with less than 5% the surface area of the United States. In two years, Amazon was able to make such a system possible in a country with many more logistical issues.

This is a huge boost in convenience for customers and will doubtless lead to more sales and revenue.

Second, as per "disappointing" guidance, Amazon admits that guidance tends to be rather unreliable for this company in particular because of the scale of the company and the various macro issues over which the company has no control:

"Our results are inherently unpredictable and may be materially affected by many factors, including fluctuations in foreign exchange rates, changes in global economic conditions and customer spending, world events, the rate of growth of the Internet, online commerce and cloud services, and the various factors detailed in our filings with the SEC."

The guidance given tends to be based on past trends and not much speculation. Conservative investors should see this as bullish, as offering overly optimistic guidance tends to bring large drops to the stock when expectations are missed. This is likely a factor in Amazon's lower-than-average volatility in this sector; AMZN's volatility is under half that of similar stocks in this sector, including Wayfair (W), Lands' End (NASDAQ:LE), and Overstock.com (OSTK).

Amazon has also stated that it will continue to invest in its tertiary businesses, such as digital video. This business fails fast, so whenever a side project is started, investors should tentatively see it as a bullish catalyst.

The company is also doing well in the cloud, seeing half of its profits from this sector. I have written much on this subject in the past, stating that Amazon Web Services will likely remain leader for B2C cloud services, while Microsoft (MSFT) will likely overtake the enterprise sector. I still hold this to be true, but AMZN has made some important developments in the enterprise side, such as by partnering with Volkswagen (OTCPK:VLKAF), Ford (NYSE:F), and other automotive enterprises:

"I'm particularly happy about the Volkswagen alliance that we've joined up with them to power their Volkswagen Industrial Cloud. That's going to integrate more than 30,000 facilities and 1,500 suppliers and partners in Volkswagen's global supply chain over time. We have deals going with Ford on powering the cars of the future, Lyft, Gogo, a lot of really good customer wins in the quarter."

Some Amazon bears have expressed fears of economies of scale becoming diminishing returns as Amazon matures. Management has made clear that this is not the case, at least not yet:

"It's more than kind of leading through excess capacity. We have some really, really impressive gains and efficiencies in both the warehouses and also the data centers."

Acquisitions continue to create potential bullish catalysts. However, management is cautious to express too much tangible upside in this regard:

"PillPack, we're probably around 6 months or so in since that acquisition closed, and continuing to support them in their mission and learn from them certainly. So no real update on that, but excited about the potential there to be sure."

Overall, Amazon's sentiment was net positive. The 20% drop quarter to quarter should be read as a return to normal after the expected excess returns implied by last quarter's earnings sentiment. All things being equal, we should expect stock growth at a normal Amazon pace, a la May 2018, rather than the rally that began in January 2019:

(Source: Stockcharts.com)

The price action described by the average sentiment periods in AMZN shows general upward momentum with large down days. Buying on down gaps at market open tend to produce the highest ROI and should be enacted by traders, dip-buyers, and dollar-cost-averagers. Seventy-three percent of down gaps fill (area gaps) within the day.

How to Play

As AMZN is expensive, options tend to be preferable to stock. Option traders should ensure that their option strategies have a theta of under 6.0 to ensure profitability over time. Statistically, bullish option plays with theta values above 5.8 will see profitability from the rise in the underlying disappear because of time decay.

In addition, AMZN's bumpy history displays a rather reliable statistical trend. During times of low past returns, AMZN tends to mean revert, giving excess future returns. At this point, AMZN is set to give an excess return of nearly 5%.

AMZN's cognitive dissonance profile is also bolstered. The stock posts excess returns on positive news and drops less than expected on bad news. This implies strong investor sentiment, which itself can act as an upward pressure source for the stock.

Gap Trade

Finally, we have a gap in Amazon:

(Source: Stockcharts.com)

These area gaps are of the same type. I backtested them to find they produce an annual ROI of 24% when traded in the long direction for the optimum holding period versus risk, which is seven days. Here is the result of this strategy:

(Source: Damon Verial; data from Yahoo Finance)

Hence, drawdowns tend to be short-lived. With AMZN having dipped twice after earnings, we can see these as dip-buying opportunities. Sentiment implies that AMZN should perform as per its average performance, which is highly bullish relative to the market, and so I recommend dip-buyers and gap traders use this opportunity to go long via the following strategy:

  1. Sell 1x Aug16 $1,840 call
  2. Sell 1x Aug16 $1,830 put
  3. Buy 2x May24 $1,850 calls

This strategy puts the risk/reward curve in your favor. You receive a credit for opening this strategy, allowing you to get paid for being long AMZN over the next seven days, when the gap is expected to close. As AMZN does not pay a dividend, this strategy is also superior, when the long calls are rolled over, over time.

Happy trading.

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.