Amazon continues to disrupt the traditional retail landscape and its cloud-based services are gaining momentum, but shares look to be running ahead of its fundamental trajectory. Let’s take a look at its most recent quarter.
By Kris Rosemann
Shares of Amazon (AMZN) are trading at more than 40 times 2016 free cash flow, a tremendous level, even for a company whose top-line is growing as quickly as Amazon’s. High levels of uncertainty regarding its long-term operating margin increases the challenges in deriving the company’s “true” intrinsic value, and while we’re fans of the e-commerce giant’s increasing free cash flow generation, we’re not comfortable anointing Amazon Web Services (AWS), the true driver of its profitability and free cash flow improvements, as a long-term winner in the rapidly evolving cloud-based services space. Though far from its roots during the dot-com bubble, Amazon is still a speculative idea, in our view, and simply put, the current price tag is too high for us to consider.
That said, the momentum Amazon is seeing in its free cash flow generation of late is encouraging as it reported February 2 that operating cash flow in 2016 jumped 38% from the year-ago period, to $16.4 billion, and free cash flow leapt to $9.7 billion in the year from $7.3 in 2015. The company’s top line continues to expand, net sales in the fourth quarter advanced 22% on a year-over-year basis, which outpaced operating income growth in the quarter due to more aggressive spending in areas such as fulfillment facility development, Amazon Prime, and video content.
Management is anticipating the increased spending to continue into 2017, and has issued guidance for operating income to fall in the first quarter of the year, even as it continues to expect solid double-digit growth on its top line. Revenue growth is projected to be in a range of 14%-23%, a rather wide range and one that came in below consensus estimates for the quarter. Shares were punished for the lower-than-anticipated top-line guidance, but the bigger issue remains margin uncertainty, from our point of view.
At this point in time, we agree that it is rational to expect strong revenue growth for the foreseeable future for Amazon, but a reasonable picture of the long-term margin profile of the company continues to be obscure. For example, in the first quarter of 2017, a quarter that was more than a month underway when guidance was issued, management is guiding operating margin to be in a range of 0.7%-2.7%. Not only are these margins razor thin, but even the high end of the guidance is roughly a one percentage point contraction from the first quarter of 2016. To justify Amazon’s current price tag, normalized operating margins in the mid-single-digit range are absolutely necessary.
Amazon’s long-term goal to optimize free cash flow will benefit from growth in the higher margin Amazon Web Services business, which is now at a $14 billion revenue annual run rate, but it may not be large enough to buoy near-term bottom-line performance as the company continues to invest in its lower-margin consumer facing business. Maintaining momentum in AWS won’t be easy, but we think management has a solid handle on how the business is shaping up. It announced multiple price cuts to its AWS products in the fourth quarter of 2016, something that is becoming commonplace as new and improved functionalities are developed and operating efficiencies are extracted. Competition will remain intense, potentially further pressuring pricing, and other industry heavyweights, such as Microsoft’s (MSFT) Azure platform, are seeing similar momentum.
All in, we’re anticipating Amazon continuing to drive significant top-line growth, and investors are likely to continue bidding shares higher in this forthy market. However, we don’t make many trades in the newsletter portfolios that offer little fundamental support should investor sentiment, often a fickle beast, surrounding the stock change unexpectedly. We’re not doubting the staying power of Amazon, in either its eCommerce or AWS operations, but the future landscape of cloud-based services is one characterized by massive amounts of uncertainty and outside of AWS we’re not sure the firm has an long-term answer to its past profitability woes. Amazon’s building momentum in free cash flow generation is a welcome sight, and its balance sheet health is worth noting–its net cash balance was ~$18.3 billion at the end of 2016–but with shares at more than 40 times 2016 free cash flow, we’re simply not interested.