Opening my mailbox today I was surprised to find the 2016 Amazon Annual Report that I requested not even 24 hours ago the same feeling that many customers of Amazon feel everyday. I figured now might be a good time to finally talk about Amazon in length considering their second quarter was released yesterday. I assume my opinion of Wall Streets and Main Streets favorite stock might differ just a little bit.
To start the consensus I hear whenever the name Amazon gets brought up is that it is expensive but either (1) You don’t want to miss the next move higher. (if it walks, talks and acts like a bubb… nevermind) (2) Jeff Bezos can do no wrong. (3) I love the company. Not one time have I heard someone justify a purchase of Amazon stock by considering their fundamentals.
Amazon has done a great job at diverting eyes from their GAAP numbers, you would be hard pressed not to find a CEO who wishes they were in the same position as Jeff Bezos in terms of reporting numbers. Somehow shareholders have been convinced that GAAP profits do not matter, soak that in for a second. Since when did GAAP metrics in terms of profits not matter, and if we don’t look at Amazon based on GAAP earnings why do we even look at the GAAP earnings of any other company.
There are several companies that have tried and failed at trying to point investors to metrics other than GAAP metrics in terms of earnings. Valeant is one of them and I hate to make that comparison in light of the revenue fraud that they committed. Get rid of all the baggage of fraud that is attached to Valeant, and I know its not a great comparison since Amazon actually has a real business but play along if you will. Valeant reports non-GAAP earnings that excludes one time charges associated with acquisitions they partake in, the problem is that they get their growth from these acquisitions so it is a real expense of the business. Some companies like to try and force EBITDA down their investors throats, a rather ridiculous calculation. WorldCom loved this non-GAAP financial metric and understated about $3.8 billion. In what world are taxes and deprecation not a real expense. Furthermore interest is a very real expense, if a company needs to lever up just to achieve those earnings then without the debt they wouldn’t achieve those earnings. I don’t trust companies whose go to metric of choice was a formula created by investment bankers so they could charge more fees in the 1980s from LBO’s such as EBIT or EBITDA. This is why when you add up all the GAAP earnings that Valeant has achieved commutative over the last 10 years you arrive at -2.3 billion dollars.
I use these two examples not to try and say Amazon is a fraudulent company because it is not, but how come it takes for something to go wrong with a company to shun non-GAAP reporting, after WorldCom investors were skeptical of those types of financial reporting. But even with Valeant, investors seem to be taking a blind eye and still have no problem with their non-GAAP reporting even with all the scandal.
So what is Amazons non-GAAP metric of choice? Free Cash Flow, as defined by taking cash provided by Operating Activities and subtracting Capital Expenditures and Acquisitions net of cash. Now these numbers would look great but they exclude a very key part of Amazon’s growth. Currently Amazon uses Capital Leases to acquire warehouses in some cases, but for the most part they use them to grow AWS, and acquire servers. The problem is that the principle payments of these Capital Leases are charged to the Financing Activities of the Cash Flow Statement and would not show up under a Free Cash Flow Calculation. So what would those Free Cash Flow numbers look like when you subtract the Capital Leases principle payments.
Another issue I have with these numbers is the Cash from Operating Activities, investors shouldn’t take this number at face value, but should dig in and see how Amazon achieved $16.4 billion in Operating Cash Flow. $3.9 billion comes from changes in working capital, half of the working capital changes comes from an increase in Accounts Payable and the other half comes from an increase in Unearned Revenue. $11 billion in comes from Depreciation and Amortization as well as Stock Based Compensation, broken up $8.1 billion from D & A, $2.9 billion from Stock Based Compensation. As an investor one should ask why Amazon has such as high Depreciation with $29 billion of Property and Equipment on their balance sheet. Since we know that Amazon has two primary businesses, retail and AWS then most of those P&E assets should be warehouses which would have a deprecation life of 25-40 years.
Here is an interesting statistic to chew on for Amazon investors from the 2010 annual report Amazon reported $568 million in deprecation, in their latest 2016 annual report that number has grown to $8.116 billion, or a 1,328% increase in 6 years. As a percentage of Cash from Operating Activities Deprecation has increased from 16% in 2010 to 49% in 2016.
These data centers that Amazon is building up is a rather capital intensive business, just look at Google’s Capital Expenditures. The difference between Google and AWS is that Google doesn’t have to lower prices 52 times in a year. So essentially Amazons two main businesses can be broken down as Retail: Low margin Fixed Cost Business. AWS: High Margin Capital Intensive Business. Deprecation and Amortization is a real expense for Amazon because of the Capital Leases that they have for AWS.
Amazon is a fantastic company for customers there is no disputing that, but that doesn’t mean it translate to being a fantastic company for shareholders, current investors or potential investors have to ask themselves a very serious question. Is Amazon really worth $500 billion today? If you were to have the chance to buy Amazon whole how long do you think it would take to get the $500 billion back and if you know when then is it at a reasonable rate of return. Let’s take a look at the last two quarters Free Cash Flow reported in 2017 to get a better view of the current state of Amazon.
And now with Capital Leases.
Currently, at least for me anyway, Amazon is no where close to a price where you would achieve a reasonable rate of return, but that doesn’t matter to current or potential investors as of right now. Rather investors are hoping to buy the stock now in hopes that it will just keep going higher, you hear this over and over, Amazon will be the first to one trillion in market cap, or Apple, Facebook, or Google. Not one mention on whether or not the underlying business is anywhere close to being worth that dollar value.
I like GAAP numbers, maybe call me naive but I believe there is a reason why they are the numbers that regulators want investors to see and the fact of the matter is that Amazon is is trading at 258 times GAAP earnings. Think about your favorite company right now, if they were trading at the same multiples as Amazon how would you feel, would you think that its cheap, fairly priced, expensive? What makes Amazons earnings different from other companies? Because Amazon says it doesn’t matter? If Amazons GAAP earnings didn’t look like this and instead looked like Walmarts earnings for example when they were achieving this type of revenue do you think they would try so hard for the analyst to not think to hard about them. Or maybe its a coincidence they put their cash flow statement as the first financial statement in every 10K or 10Q.
As an owner of Amazon over the last decade on a GAAP basis you earned $6.957 billion dollars, 34% of which was made within the last year.
I have struggled with Amazon for quite a while, I understand the business, I understand the value that it provides to customers but I simply cannot justify the price. Its almost like seeing a nice reliable 2017 Honda Odyssey priced at $200,000, you know that its a good car but know that you shouldn’t be paying that much for it. Frustratingly enough I understand the growth of Amazon and what it will look like in the next decade, currently $64 billion of Amazons revenue comes from general merchandise sold in the United States, compared to Walmart where $307 billion of sales came from the United States. While the runway for Amazon is large the market has largely priced in a decade of runway already.
Some may be saying that if I believe Amazon is this overvalued than I should be short the stock. Unfortunately I don’t think its safe for me to try and stop a moving train with my bare hands regardless if I think that train is heading in the wrong direction, if the passengers want to go along for the ride regardless of the consequences then more power to them. In fact I hope I am wrong and that Amazons underlying business catches up to its valuation because of sheer amount of DIY investors that listen to financial talking heads that I think are pilling into the stock as of late. If the market ever prices Amazon as it would any other company these people would be in big trouble.
For added fun here is some euphoric comments about Amazon from Seeking Alpha:
I’d love to hear any opinions, I have no problem with my analysis being questioned or proven wrong. I have no long or short position in AMZN
As a footnote of sorts, I have recently ordered the annual reports of all the Dow Jones 30 because I can no longer stand reading annual reports on a computer screen. Also I have the Dow Transports coming as well, if you ever want a prelude to how well the economy is doing staying up to date on the Dow Transports might be better than any economic indicator. Enjoy Q2 2017 earnings season.
Disclosure: As always do your own research on everything that I provided as this is not a recommendation and I am not a registered investment adviser nor am I an investment professional .