- After reporting its Q1 earnings, Amazon's share price fell 14% on Friday, the biggest one-day drop since July 2006.
- It reported an unexpected loss in the first quarter and revenue growth was the worst since the dot-com bubble burst in 2001.
- In particular, its free cash kept deteriorating, especially after accounting for its lease obligations.
- AWS is a bright spot, posting 57% YoY growth in profits and announcing a landmark agreement with Nasdaq.
- However, even after the large price correction, the stock is still valued at a substantial premium given its current fundamentals.
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Amazon.com (NASDAQ:AMZN) was caught in a perfect storm last Friday after its 2022 Q1 earnings report. Its shares fell 14%, the biggest one-day drop since July 2006, after the earnings. On monthly basis, it plunged 23.8% in the month of April, the biggest monthly decline since 2008. Such a dramatic market reaction was caused by a mix of factors, some intrinsic to AMZN's business fundamentals and some extrinsic (such as the inflationary environment and the renormalization of consumer demand to pre-pandemic levels).
In this article, we will only address the factors intrinsic to AMZN's business fundamentals, particularly its cash flow, its lease obligations, and its AWS growth prospects. Overall, the business reported its first consolidated net loss in years. Its operating cash flow decreased to $46.3B TTM, compared with $66.1 billion for TTM ended December 31, 2020, a whopping 30% drop. Consequently, its free cash flow (“FCF”) decreased to a negative of $9.1 billion TTM, compared to a positive $31.0B the TTM ended December 31, 2020. Despite management’s repeated emphasis on prioritizing free cash flow, the deteriorating trend is concerning. After correcting for its lease obligation, its FCF had been a positive $20B in Q4 2020, then it turned almost cash flow neutral in 2021 Q2 and Q3, and to negative $22.3B in the current quarter.
AWS is a bright spot, posting large YoY growth both in the top (37%) and bottom lines (57%). AWS maintained its customer migration momentum. It announced a landmark agreement with Nasdaq with the goal of becoming the world's first fully enabled cloud-based exchange. Management expects infrastructure spending to grow in 2022 in large part to support the rapid growth within AWS. Despite the large growth potential in AWS, we are concerned about the cash flow to support its infrastructure spending, as detailed next.
Free Cash Flow And Lease Accounting
In Q1 2022, its operating income decreased to $3.7 billion. Compared to the $8.8 billion operating income a year ago, the decrease represented a 60% drop YoY. The large drop was partially caused by external factors beyond AMZN’s control, such as the pandemic, the subsequent war in Ukraine, and also surging inflation costs. Although, note that in terms of its net loss of $3.8 billion in Q1, it included a pretax valuation loss of $7.6 billion from the common stock investment in Rivian Automotive.
Nonetheless, the large decrease in operating income creates large financial pressures on its infrastructure investment, both in terms of CAPEX and lease obligations as elaborated next.
Most of us are familiar with the FCF calculation in the following way,
FCF = operating cash flow - capital expenditure.
In AMZN’s case, it also reports another version of FCF (mostly due to new accounting rules effective in 2019 and due to AMZN’s large financial lease obligations). And this version is calculated in the following way,
FCF = operating cash flow - capital expenditure - Finance Leases – Other Financing Obligations
As commented by its CFO Brian Olsavsky:
As a reminder, we look at the combination of CapEx plus finance leases. Capital investments were $61 billion on the trailing 12-month period ended March 31. About 40% of that went to infrastructure, primarily supporting AWS, but also supporting our sizable consumer business. About 30% is fulfillment capacity, primarily fulfillment center warehouses. A little less than 25% is for transportation. So, think of that as the middle and last-mile capacity related to customer shipments. The remaining 5% or so is comprised of things like corporate space and physical stores.
Now as you can see from the following chart, its FFC after adjusting for its lease obligations is even more concerning. It has been a positive $16.8B and turned to almost zero in 2021 Q2 and Q3 (cash flow neutral). And it kept detreating from there. It was negative $20B in 2021 Q4 and reached a negative $22.3B in Q1 2022.
It is debatable whether a negative FCF is absolutely a bad thing or not, especially for a growth stock. For one thing, it certainly shows Amazon still finds many growth areas to invest heavily. However, a negative FCF of more than $20B is sizable even for a juggernaut like AMZN, especially when its AWS growth requires continued heavy infrastructure investments, as detailed next.
AWS Growth And Infrastructure Spending
AWS has maintained its growth momentum. It has been growing 34% annually over the last two years. And it has grown 37% year-over-year in the first quarter in total sales and 57% in operating income. Furthermore, the AWS segment kept receiving new commitments and migrations from customers across many industries, including T-Systems, Verizon, Boeing, et al.
Management has made it clear that they are committed to supporting the growing needs of AWS. For example, AWS also has completed the launch of its first 16 Local Zones in the U.S. And AMZN has announced plans for new Local Zones in 32 metropolitan areas in 26 countries around the world. All told, for full-year 2022, the infrastructure spending is expected to grow year-over-year in large part to support AWS. And infrastructure expenditures are expected to represent about half of the total capital investments in 2022.
Valuation And Projected Returns
Moving on to valuation and projected returns. Since the FCF adjusted for lease obligations is in the negatives, the usual valuation metrics are no longer applicable here, if you apply the typical price to FCF ratio. However, a near-zero or negative FCF may not necessarily be a negative indicator regarding Amazon as an investment.
My approach in such cases is to consider a hypothetical scenario. I would imagine if AMZN stops such heavy reinvesting and only reinvests 10% of its earnings like the other mature companies (such as AAPL and GOOG, et al) and see what its growth (the organic and sustainable growth) would be. The details of such analyses are in my earlier article on Amazon’s owners’ earnings. And the end results are summarized in the following chart. In this hypothetical scenario, the total return will be about 6.2% per year, consisting of about 4.2% of organic growth rate and about 2% of owners earning yield.
Summary And Other Risks
AZMN was caught in a perfect storm last Friday after its 2022 Q1 earnings report. Its shares fell 14% due to a mix of intrinsic and extrinsic factors. This article addressed the intrinsic factors only. Its operating cash flow suffered a whopping 30% drop to $46.3B TTM. Combined with its active capital investments, its FFC after adjusting for its lease obligations dropped to a negative $22.3B in Q1 2022. On the positive side, it certainly shows Amazon still finds many growth areas to invest heavily, especially AWS. However, a net cash outflow of more than $20B per quarter is sizable even for a juggernaut like AMZN. And its AWS growth requires continued heavy infrastructure investments going forward.
Before, concluding, a few words about some of the key external risks AMZN is facing now.
- Cost and wage control. AMZN is facing pressure from rising costs and wages due to the surging inflation. Its Q2 guidance expects a step-up in stock-based compensation expense. It expects to see a stock-based compensation expense of approximately $6 billion this year, almost double the $3.3 billion in Q1, largely reflecting wage inflation.
- Global supply change interruptions. It also faces risks imposed by the global supply chain interruptions and the ripple effects such as inventory management, variability in demand, and fulfillment throughput and productivity. The COVID-19 pandemic and geopolitical conflicts can cause issues (such as the lockdown in Shanghai and the Russian-Ukraine war) to amplify many of these risks.
- Finally, its outlook also depends on a healthy U.S. and global economy. However, a recession could be possible in the U.S. or even globally. The U.S. Bureau of Economic Analysis just reported that GDP unexpectedly falls in Q1 2022 as inflation continues to rise. A recession is defined as a GDP contraction in two consecutive quarters.
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This article was written by
Envision Research, aka Lucas Ma, has over 15+ years of investment experience and holds a Masters with in Quantitative Investment and a PhD in Mechanical Engineering with a focus on renewable energy, both from Stanford University. He also has 30+ years of hands-on experience in high-tech R&D and consulting, housing sector, credit sector, and actual portfolio management.
He leads the investing group Envision Early Retirement along with Sensor Unlimited where they offer proven solutions to generate both high income and high growth with isolated risks through dynamic asset allocation. Features include: two model portfolios - one for short-term survival/withdrawal and one for aggressive long-term growth, direct access via chat to discuss ideas, monthly updates on all holdings, tax discussions, and ticker critiques by request.
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