Spilling The Ink On Amazon

May 13, 2022 8:43 AM ETAmazon.com, Inc. (AMZN)128 Comments38 Likes
Ray Merola profile picture
Ray Merola
13.32K Followers

Summary

  • I believe the investment decision whether to buy, hold or sell Amazon stock is straightforward.
  • Do you believe management has the competency to navigate the company through current headwinds?
  • On the 1Q 2022 earnings conference call, management spelled out these headwinds and what they intend to do about them.
  • If you trust management, the stock appears undervalued.  If not, it may be time to head for the exits.
  • In this article, we will review the situation and follow up with three data sets offering additional perspectives.

Amazon fulfilment centre

georgeclerk/iStock Unreleased via Getty Images

I hesitated to write this article about Amazon Inc (NASDAQ:AMZN): there's been so many written about this ticker already. However, I ended up electing to add one more log on the fire because amidst the hand-wringing and horrendous share price decline, I believe investors have a relatively straightforward choice about whether to buy, hold, or exit the stock.

This article won't rehash the 1Q 2022 earnings report. That data is readily available and has been sliced and diced ad infinitum.

Instead, let's step back from the reported numbers and think more about the retail business model, management's willingness to identify problems, and their subsequent ability to solve these problems.

Management Explained What's Dogging the Company

One thing I respect about Amazon's management is they can boil things down. During the 1Q 2022 earnings conference call, CFO Brian Olsavsky articulated what's causing business headaches:

...we continue to face a variety of cost pressures in our consumer business.

We'll break these into two buckets, externally driven costs, primarily inflation; and internally controllable costs, primarily productivity and fixed cost deleverage.

Mr. Olsavsky goes on to offer details. Here's three bullet points summing up management's observations as to the current slate of retail problems:

  • Inflationary costs

  • Labor and productivity problems

  • FBA (Fulfillment by Amazon) overcapacity

Inflationary Costs

Expounding upon his earlier comments, Mr. Olsavsky explained:

The externally driven costs are a result of intensifying inflationary pressures throughout Q1. Line haul air and ocean shipping rates continue to be at or above the rates in the second half of last year, which were already much higher than pre-COVID levels.

Inflation was called out. No surprise here. Specifically, fuel and shipping costs were cited; examples were given. This bucket increased year-over-year expenses by $2 billion. Furthermore, management pointed out these costs are driven externally and are expected to be around for some time.

Labor And Productivity

The conference call continued:

... in the second half of 2021, we were operating in a labor-constrained environment. With the emergence of the Omicron variant in late 2021, we saw a substantial increase in fulfillment network employees that on leave, and we continue to hire new employees to cover these absences. As the variant subsided in the second half of the quarter and employees returned from leave, we quickly transitioned from being understaffed to being overstaffed, resulting in lower productivity. This lower productivity added approximately $2 billion in costs compared to last year.

During the pandemic, management responded by hiring staff. Amazon retail business was booming, and higher sales coupled with pandemic-related employee absenteeism resulted in the company adding too much staff.

After paying up in a labor-constrained market, Amazon was indeed staffed for a post-pandemic sales spike. Then matters were compounded by having to double down to cover high COVID-related absenteeism. Having finally getting their arms around an understaffed situation, the rug got pulled out. Sales normalized, thereby transforming the business to an overstaffed position.

Another $2 billion down the drain.

Do I blame management for taking these actions? No. The salient question is, "What are they going to do about it?" Read on.

FBA Overcapacity

In turn, CFO Olsavsky addressed Fulfillment by Amazon:

Despite still seeing strong customer demand and expansion of our FBA business, we currently have excess capacity in our fulfillment and transportation network. Capacity decisions are made years in advance, and we made conscious decisions in 2020 and early 2021 to not let space be a constraint on our business.

During the pandemic, we were facing not only unprecedented demand, but also extended lead times on new capacity. And we built towards the high end of a very volatile demand outlook.

Fulfillment by Amazon had been and remains a core focus area. Management elected to pour both capital and expense money into FBA. They overshot. As sales normalized, it became clear system capacity became greater than the volume to fill it.

Resultant FBA overcapacity and inefficiency cost the company yet another year-over-year $2 billion.

The aforementioned three identified items cost Amazon ~$6 billion in the first quarter of 2022.

Investors Are Challenged to Make a Straightforward Choice

Here's the question:

Do you believe Amazon management has the ability to fix the identified problems?

And the associated question:

Are the identified problems permanent conditions or transitory?

As an investor, I believe in a few immutable truths: one of these is, "management makes a difference."

Inflation

Indeed, management cannot "fix" inflation, but they can take actions to mitigate it. For one, Amazon has a particularly strong franchise. A strong franchise permits some level of pricing power. Management had already announced a February 1, 2022, increase in Prime Membership fees from $119 a year to $139 a year. As pointed out in my first article about Amazon, the move was likely to add $4 billion per year to the bottom line. I suggested there were no obvious reasons to believe the increase would cause members to walk away or discourage new members from joining. Management confirmed this view on the conference call:

Throughout the past two years, we've seen stronger usage of Prime benefits by Prime members and a greater reliance on Amazon for their shopping and entertainment. In the first quarter, we made encouraging progress on key customer metrics.

In addition, on April 28 management instituted a 5% fuel surcharge to Amazon sellers. The company is laying off some inflationary costs to their sellers and permitting them to pass the cost along to Amazon customers; in full, in part, or not at all.

Remember, inflation was the identified item management stated it had the least influence to control.

Labor and Productivity

Conversely, management has a great deal of ability to manage labor. Overstaffing can be handled via attrition and / or layoffs. Automation accelerates the demand for less staff.

Management remarked they will be driving appropriate changes immediately and expects to reduce these headwinds in 2Q 2022.

I expect staff re-sizing may be largely complete by year-end 2022. Management has a significant control over this item.

FBA Overcapacity

Management summed up FBA overcapacity with the following remarks:

Now that demand patterns have stabilized, we see an opportunity to better match our capacity to demand. We have lowered our operations, capital expenditures for 2022 and are evaluating other ways to increase our fixed cost leverage.

Key takeaways: demand patterns stabilized, and costs will be lowered to match capacity and volume. Comparable to labor costs, management has significant control here.

More Color

On the call, management added they expect the total $6 billion excess 1Q 2022 costs to be pared down to $4 billion in the second quarter. That expectation was baked into the 2Q guidance.

Asking The Question Again...

As a current or prospective Amazon investor, " Do you believe Amazon management has the ability to fix the identified problems?" Specifically, these include inflationary costs, excess staffing, and FBA overcapacity.

If you can answer, "yes," then you are on your way to determining Amazon is a good investment. If you believe the answer is, "no," then walk away.

If you are in the "affirmative" camp, then it stands to reason you do believe these three headwinds are transient. These are not permanent impairments to the Amazon retail business model.

Additional Context on The State of Affairs

Now we will turn to some supplemental data sets. As an investor, I try to read beyond the headlines and look behind the numbers.

Let's walk through three data sets. Using this data, let's see where it leads us.

Net Sales Growth Rates

The Street expressed anxiety about Amazon's year-over-year sales growth rate. Here's some perspective.

  • 1Q22 net sales increased 7 percent quarter-over-quarter

  • Net first quarter trailing-twelve-month sales increased 14 percent

Amazon 1Q TTM sales growth

Amazon 1Q22 earnings presentation

On its face, even a 14% increase is a deceleration from the long-term growth rate. However, perspective adds context: the 2021 post-pandemic sales spike skewed the numbers.

Here's a FAST Graph illustrating Amazon annual net sales for the period 2015 through 2021. Note the x-axis on the chart highlights the annual revenue growth rate.

Amazon 2015-21 net sales growth rate

FAST Graphs

We find between 2015 and 2019 (pre-pandemic), the average annual revenue growth rate was under 26 percent. In 2020, the sales growth shot up to 36 percent. In 2021, revenue grew about 20 percent; that was off an unusually high base.

If we attempt to smooth the curve by applying a 25 percent growth rate to the 2019 baseline ($280.5 billion), sales shake out to $351 billion and $438 billion in 2020 and 2021, respectively.

The actual reported sales were $386 billion and $470 billion in 2020 and 2021; materially higher. That's because 2020 was an unusual year.

Now then, looking ahead to 2022 and maintaining a 25 percent annual growth rate, this years' sales would need to come in at $548 billion.

Current Street estimates forecast Amazon 2022 sales to be $527 billion. The $21 billion gap versus the 25 percent average eight-year bogey means the 2022 net sales growth rate would be "only" 20 percent.

But that's about the same net sales growth rate experienced in 2015, 2019, and 2021.

Is a 20 percent growth rate after several years averaging 25 percent growth a reason for investors to cut the share price by a third?

What If the Current Headwinds Vanished?

What would have the Amazon 1Q 2022 results have looked like if the $6 billion headwinds didn't exist? That's not hard to model.

Here's some quick data points.

Select Year-over-Year 1Q 22 Results Actual versus X Headwinds

Actual 1Q 2022

Actual 1Q 2021

1Q22 X Headwinds

Operating Income $B

3.7

8.9

9.7

Operating Margin %

3.2

8.2

8.3

Amazon management identified the $6 billion year-over-year headwinds. If these expenses didn't exist, operating income would have increased by 9 percent, and operating margins could have expanded by 10 bps.

The point here isn't just to conduct a theoretical exercise. The actuals didn't work out that way. The actual results are what matter.

However, the point is looking at these figures in context of the earlier question begging an answer: are you confident management mitigate and fix these identified headwinds?

Because if one believes they can, it indicates these headwinds are transient and not permanent conditions. If so, why wouldn't Amazon return to operating income growth and solid margins?

Furthermore, should AMZN stock priced at $3500 just months ago be valued at $2100 today?

Sifting The Cash Flow Statement

In my previous article (mentioned earlier), I highlighted "sifting the cash flow statement." I offered a view of GAAP full-year 2021 operating cash flow versus "levered free cash flow."

Levered free cash flow (LFCF) is the amount of money a company has left remaining after excluding working capital movements, including capital expenditures, and identifying net borrowing / repayments.

LFCF can provide insight as to a businesses' ability to generate cash after considering multiple sources and application of funds.

Here's Amazon's year-over-year 1Q 2022 LFCF:

Amazon - 1Q 2022 v 1Q 2021 Levered Free Cash Flow ($B)

1Q 2022

1Q 2021

Operating Cash Flow

-2.8

4.2

X Working Capital Movement

+13.5

+10.8

Less Capital Expenditures

-15.0

-12.1

Net Financing / Payments*

+4.7

-3.4

LFCF

+0.4

-0.5

*Includes lease liabilities

Year-over-year LFCF doesn't look much different. What stands out are large movements in working capital and capital expenditures.

These working capital movements are unlikely to continue to swing so heavily. Over the past year or so, it's been consuming an enormous amount of cash flow. In 2021, working capital movement took up over $24 billion in cash flow. Another $13.5 billion was consumed in just the first quarter of 2022.

Working capital movements reduced levered free cash flow in 2019 and 2020.

Similarly, capex has run from under $17 billion in 2019 to $61 billion in 2021. Currently, Amazon is on a similar 2021 pace in 2022. However, management already called this out; they explained opex and capex were going to be reduced this year.

Do you believe working capital movement and capex are chronic, long-term headwinds or represent a business transition / pivot point with a finite end?

I contend the latter.

Actionable Conclusions

If you've read this far, you've likely come to the conclusion that Amazon management isn't foundering. They know what's wrong and they believe they know how to fix it. The business is suffering from headwinds and growing pains instigated by a confluence of the pandemic, inflation, and the ongoing implementation of long-term business strategies.

Next, we've looked at three data sets in order to obtain some longer-term context.

Net sales are not in the tank. A 2020 pandemic-related stay-at-home sales spike skewed historical growth rates. Smoothing out the spike and accounting for a modest growth cooldown (reducing revenue growth for a mega-billion company to "only" 20 percent) does not spell doom. For perspective, Amazon net sales rose 20 percent in 2015, 2019, and 2021.

Transient headwinds do not automatically mean permanent conditions. Reinforcing the "management can fix this" thesis, if the 1Q 2022 $6 billion headwinds were removed, operating income and operating margins would be acceptable. That continues to beg the investment question, "are these headwinds permanent or transitory?" I believe these are the latter.

The apparently dismal cash flow figures are less alarming when examined through the LFCF window. What immediately jumps out are enormous movements in working capital and historically unprecedented amounts of capital expenditures. Are these "forever" occurrences? No, I believe management has the ability and moxie to adjust and adapt the business.

Therefore, I am constructive on the business; and with shares trading at a 40 percent haircut to those just several months ago, I am likewise constructive on the stock. It would appear prudent to initiate a position or accumulate shares on this weakness.

A Word on Valuation

Determining a Fair Value Estimate for AMZN is tricky. Frankly, certain valuation metrics like PE just don't work. They've never worked for this stock.

For Amazon, I prefer to value the company using Price-to-Sales and Price-to-Cash Flow.

Here is a FAST Graph for AMZN stock illustrating the P/S relationship.

Amazon P/S historical valuation

FAST Graphs

I believe applying a 2.6x multiple is now appropriate (the pink line). This is lower than the six-year, 3.4x historical average multiple and a re-rate of my earlier 3.5x FVE multiple. I suggest the lower P/S multiple is warranted given uncertainties while management works their way through various headwinds.

Using a 2.6x P/S multiple on 2023 projected sales, AMZN shares may be valued at $3150 each (pre-split).

Turning to P / OCF, I have been unable to model or uncover Street 2022 or 2023 operating cash flow forecasts with enough confidence to utilize the metric. Nonetheless, I believe reasonably accurate forecasts and modeling data will become available after the 2Q earnings report. An 18x P/OCF ratio now seems reasonable. In the meantime, I will standby and wait for defensible figures.

In any event, AMZN shares at $2100 appear to offer significant and asymmetric value.

Please do your own careful due diligence before making any investment decision. This article is not a recommendation to buy or sell any stock. Good luck with all your 2022 investments.

This article was written by

Ray Merola profile picture
13.32K Followers
Individual investor focused upon a limited number of diversified stocks. Seeks stocks selling below fair value estimates; favors dividend growth and/or income. Advocates fundamental investment analysis, supplemented by the technical charts. Options strategies primarily employed to generate additional income or hedge risk. If interested, you may find out more about my investment philosophy in the I.S.S. (Investment Strategy Statement) found in my listing of published articles.
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Disclosure: I/we have a beneficial long position in the shares of AMZN either through stock ownership, options, or other derivatives. 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.

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