I’ll start this article with a confession; I’ve been wrong about Amazon (AMZN). Only so far, I hope, but I wrote several articles, including this one exactly 6 years ago, questioning the company’s sky-high valuation against meager earnings. So what has changed?
Well, not much besides a 679% return. For the full year of 2012, Amazon generated $2B in Free Cash Flow. Last year, it was $6B. Sure, a trebling of FCF sounds impressive, but not so much against a nearly 8-fold increase in the stock price. You could illustrate this in even starker contrast by saying AMZN has added $860B in market cap on a mere $4B increase in FCF.
This hardly sounds justified or sustainable, especially as FCF has gone negative over the first half of this year, when it was supposed to be supporting the valuation by now. Bulls explain this away by saying they are “investing” in things like infrastructure, both cloud and fulfillment, yet ignore that much of this is done with Capital Leases that are not always properly accounted for.
In Amazon’s financial statements, they lay out three separate definitions of Free Cash Flow. The headline number ignores these lease principal repayments, inflating it from $4.1 billion (a 24% decrease over the previous trailing twelve month period) to $10.4B (still only an 8% increase over the previous TTM).
Furthermore, the true FCF if these assets had been purchased with cash instead of leased looks even worse, as according to the latest quarterly report: “Free cash flow less finance lease principal repayments and assets acquired under capital leases decreased to $546 million for the trailing twelve months, compared with $1.4 billion for the trailing twelve months ended June 30, 2017.”
At the current valuation, investors could be paying as much as 1800x this measure of FCF, with the leading F actually standing for “Free”, not “Fake”, as I call the other misleading metrics.
So the vast majority of Amazon’s value lies in the (far) future, when they will have (presumably) increased their cash flow dramatically. Much of this is expected to come from Amazon Web Services (AWS), the cloud juggernaut that has (perhaps) justified a portion of this market cap increase.
AWS’ growth has indeed been impressive, racking (pun intended) up 50+% annual growth even as it has achieved massive scale. So admittedly I (and everybody else, including the rest of the industry) missed how truly important this would become to their business.
In fact, it is now so important that it constitutes 65% of their current operating income. This is not a typo, but rather due to the fact that it is covering vast (half a billion last quarter) losses in their international retail business.
However, even with all this growth and higher margins, at least relative to their other segments, AWS contributed “only” $1.6B in income last quarter. And mind you, this is Operating (not Net) Income, so it doesn’t account for all expenses, which obviously are sizeable when you have to replace servers every couple of years just to maintain the business, much less grow.
So using the “run rate” metric that cloud companies eagerly use to point out their no doubt endless growth, this is annualized “profit” of $6.5B. Never mind that this is more than all of Amazon has put up over the last year, but let’s say AWS constitutes half of AMZN’s current market cap value.
This would suggest that a stand alone AWS is trading at 75x earnings (again, Operating, not Net) and an eye-popping 20x sales. Maybe this is reasonable if it keeps growing at 50%, but this is unlikely from this now much larger base.
Especially as other deep pocketed competitors enter this area and likely drive down prices, as we’ve already seen from numerous price cuts. As I posted on another excellent article from one of my favorite authors, these are the net cash and free cash flow numbers from some of the other near trillion dollar companies looking to enter (or already in) this space:
Apple (AAPL): $147B
Google (GOOG): $110B
Microsoft (MSFT): $62B
Amazon (AMZN): -$10B
Even though I disagreed with him, I continue to respect him and it inspired me to write this article, so I thank him for the spirited discourse it spawned, which I hope will continue here.
Speaking of Apple, I will end with an illustration of how much growth and success is baked into Amazon’s current valuation. Apple has inarguably been the greatest large cap growth story in history, growing earnings at a 57% rate over a 5 year period from 2008-2013:
Source: Parsimony Investment Research
Amazon is projected to grow earnings at “only” a 46% rate over the next 5 years according to analysts, but let’s give them the benefit of the doubt and say they can repeat Apple’s record performance and grow earnings at 57% from last year’s $3B in net income.
So this would result in earnings of $29B, which at the current market cap would translate to a P/E ratio of 34. But remember, AAPL finished with a P/E that dipped under 10 in 2013 at the end of their epic earnings run.
Even assuming Amazon can repeat this and still be growing fast enough to deserve a multiple double this, this would only account for $580B in market cap value. Obviously AMZN already sports a valuation $400B greater than this, so it bears repeating: Amazon will have to exceed the greatest growth story in history and still generate another $400B in value somewhere.
They hit a home run with AWS, but they basically have to replicate this feat several more times just to justify the current valuation, much less put up the 20% annual gains investors seem to expect from the stock. At the end of 5 years, this would lead to a market cap of $2.4T; at the end of a decade: $6T.
This is starting to constitute a major portion of the entire US economy. Yes, you could argue they’re taking over the world, but given their ongoing losses overseas and spotty record at actually coming to dominate entire industries at decent margins, I would argue they’re already priced for it and more. If they fail to achieve this daunting task, the stock could fail to keep up.
It might not fall off a cliff anytime soon, barring a recession or bear market, but we could see similar performance to Microsoft at the beginning of the decade, where the business did quite well yet the stock went nowhere. Or we could see a repeat of Cisco from back then, which was similarly valued at over half a trillion dollars on a couple billion in earnings.
So history says to beware the narrative of a company that is assumed to be taking over the world. It is often more difficult to achieve in practice than assumed, even with a genius like Jeff Bezos at the helm, since he has had his share of misfires as well. Remember the Fire Phone? No, me neither…and if he’s so smart and infallible, why has he been selling so many shares lately?