Amazon.com (Is it the only company left that actually has dot com in its official name? There used a bunch of them.) is updated and rated Sell at $1,196.
I can’t deny that my rating performance on this stock has been very poor. I first added it to the site on July 4, 2015 rated Sell at $438. Prior to today, my last update was Sell at $1004 on June 24 this year. In fairness, the reports I post consist of a lot more than the final rating and in that June 24 report there was certainly a lot of information and the concluding sentence in the rating cell was “Nevertheless, the shares could certainly continue to rise and some may wish to hold it but should be aware that its earnings need to grow massively to justify the stock price.”
I continue to look at Amazon to try to understand what I am missing. The stock is currently trading at 305 times trailing year GAAP earnings. That presents something of a mystery.
Several possibilities come to mind as follows:
- The stock is way over-valued, or
- GAAP earnings are going to increase at huge rates like 50 or 100% for quite a few years, or
- GAAP earnings vastly understate the “true” economic earnings of the company at this time, or
- Some combination of the above.
Looking at its income statement, I think a good case can be made that GAAP earnings are way understating the “true” earnings due to excessively conservative accounting (which most likely is required by accounting regulations). There is a large expense for “Technology and content”. The company explains that “Technology costs consist principally of research and development activities…” Research and development will probably benefit many future years and is therefore in substance creating an asset. To the extent that some of this large technology and content expense is actually going to benefit future years, current earnings are under-stated. Similarly Amazon spends a lot of money on Marketing and some of that will surely benefit future years. The difficulty is that I have no way to guess how much of this expense should perhaps be added back to calculate an adjusted earnings.
Amazon itself likes to focus on various measures of free cash flow. Amazon is unusual in that it collects payment from customers before it has to pay its supplies. It also collects PRIME and Amazon Web Services revenue upfront. Most companies must invest in working capital as sales grow. Amazon instead finds that its cash balances grow with increasing sales even if the sales are done at break even. This creates a sort of “float” similar in some ways to Berkshire Hathaway’s float and to deferred income taxes. It’s a liability but it keeps growing over time. The question arises as to whether at least some of this component of operating cash flow is akin to earnings and should be added back in calculating an adjusted earnings.
In any case Amazon is trading at 73 times free cash flow so even if that were considered earnings the stock would be expensive.
One of the mysteries of Amazon is how does it finance its huge balance sheet growth?
Assets have grown by $51 billion from $64 billion at thne end of 2015 to $115 billion at Q3 2017. That required $51 billion of additional liabilities or equity. Only $4.2 billion came from added retained earnings. $6.8 billion came from issuing shares in “the issuance of employee benefit plan stock” (Which was not for cash but which allows for an expense to be paid without cash) and through the exercise of stock options and to a small extent by paying for some acquisitions with shares. I don’t think there has been any public offering of the shares in at least ten years. So, Amazon has not been issuing shares to the public but stock issued to the employee benefit plan exercises and or acquisitions paid in shares did finance a material portion of the growth. Debt is up by $16 billion and all of that increase came in 2017 with the Whole Foods acquisition. So, with the exception of the whole foods acquisition Amazon has not recently been financing growth by issuing debt. Accounts Payables are up by $5.7 billion and that financed most but not all of the growth in receivables and inventory. Accrued expenses are up by $5.5 billion. Unearned revenue is up by 2.0 billion (PRIME and Amazon Web Services upfront payments from customers). Other long-term liabilities, which consist mostly of lease obligations are up $9.6 billion. I am not sure if I have solved the mystery here but Amazon is growing its sales faster than its assets and, despite relatively low GAAP profits, it has been able to finance the asset growth through operating liabilities and by issuing shares for a material component of compensation and without adding to debt (until the acquisition of Whole Foods).
The bottom line is that Amazon does look over-valued in relation to earnings and I don’t think any view of adjusted earnings that I could come up with would change that.
However a strategy of refusing to buy the shares on that basis has resulted in a missed opportunity here. A simply strategy of buying Amazon based on sales growth and share price momentum has done very well. The fact is that a value-oriented investing strategy will always tend to “miss” many stocks. But a value-oriented strategy may still still be superior in the long term. At some point, fear will return to the markets and a stock like Amazon could be vulnerable. Time will tell.