The following analysis and commentary is from the most recent Short Seller’s Journal. In the context of the stock market going “full idiot” right now, AMZN’s share price has levitated to an absurd valuation. You can learn more about this newsletter here: Short Seller’s Journal Information.
Amazon (AMZN) reported its Q2 numbers on Thursday after the close and smashed the consensus estimates across the board. The operating profit margin was 5.7%, up from 2.7% YoY and 3.7% in Q1 2023. The stock jumped $11 on Friday, closing at $139.57 although it traded as high as $143.63. The source of the jubilation was an unexpectedly large increase in product sales (e-commerce, Whole Foods, etc) and a $3.2 billion operating profit generated by the products division. Interestingly, the Street and media ignored the glaring slowdown in AWS’ sales growth as well as the 6% YoY decline in operating profits for the cloud services business. Here’s what that slowdown in revenue growth looks like graphically (chart source: Bill Maurer, Seeking Alpha):
Another source of glee from the Street was a decline in the percentage cost of fulfillment for the products division. Analysts measure this as a percentage of total revenues. However, the Company discloses that the cost of AWS fulfillment is lumped into technology and content costs. Fulfillment, technology and content costs combined represented 32.2% of total revenues in Q2 vs 31.6% in Q2 2023. The cost of technology services “fulfillment” rose. In reading through the accounting treatment for products fulfillment, I believe it’s also possible that AMZN was able to shift the timing of recognizing some fulfillment costs to Q3. Finally, note that the average cost of fuel declined during Q2. Fuel costs likely will increase in Q3. These are variables that affect fulfillment cost accounting that Wall Street either neglects to recognize or fails to disclose.
Consolidated operating income more than doubled YoY from $3.3 billion to $7.6 billion, though the international products segment is still generating an operating loss. From a net income standpoint, AMZN generated $6.75 billion in net income vs a $2 billion net loss in Q2 2022. The Company likes to highlight free cash flow as the barometer of its operational performance. On a trailing twelve month basis the company swung from negative FCF to FCF of $7.8 billion.
However, for “show and tell” purposes AMZN uses its own version of FCF, defined as cash flow from operations less capex. This is non-GAAP and quite useless, particularly in AMZN’s case. Including the cost of principal payments on finance leases and financing obligations, AMZN’s GAAP FCF was $1.9 billion. Finance leases and financing obligations are a recurring and integral part of AMZN’s operations and thus true FCF is the $1.9 billion number.
While AMZN’s e-commerce business seemed to be hitting on all cylinders in Q2 and the Company guided revenues higher for Q3, for me the glaring red flag is valuation. First, up until this latest quarter, AMZN’s high valuation (market cap/operating income and P/E ratio) was rationalized by the bulls based on high growth/high margin AWS segment. That seems to be no longer. AWS is getting hammered by competition from the MSFT and GOOG cloud services businesses. It’s losing market share and the price competition is quickly eroding margins. In Q2 AWS’ operating margin was 24.2% vs 29% in Q2 2022. At one point in time historically, AWS’ operating margin hit the 30’s%.
AMZN’s price/sales ratio is 2.52. This is nose-bleed territory for a retailer. The average P/S for WMT, TGT and BBY combined is roughly 0.5. For the first half of 2023, AMZN generated $12.4 billion in operating income. I’ll give it the benefit of doubt and assume it manages to grow that by 10% in the 2H of 2023 to arrive at my estimated full-year operating income of $26 billion. The forward price/operating income ratio on this basis is 50.7. Keep in mind that’s the operating income multiple – 50.7 is more than double the price/earnings ratio of the S&P 500.
AMZN’s stock jumped because, based on just one quarterly observation, the market believes AMZN has turned around its e-commerce/products business and that it will sustain the cost improvements and sales growth. I disagree. AMZN likely will run out of room to cut operational costs and will likely face higher fuel costs for the rest of the year. Gasoline futures are 15.3% higher than at the end of June while oil futures (Brent) are up 19.4% from the end of June. The Company also will face strong headwinds from a rapidly slowing global economy and increasing financial stress of the average U.S. consumer. Also, the high-growth and profitability narrative for AWS is no longer. Furthermore, as the economy slides further into recession, companies will be cutting back on cloud services capex.
I am highly confident that AMZN will have a difficult time going forward to generate the operational and financial performance presented in Q2. Of course, the performance of the stock depends on the degree to which the stock market continues to view companies like AMZN with rose-colored glasses. As long as the bubbleheads continue to chase rainbows, AMZN’s stock will stay aloft. That said, I think longer-dated OTM puts are attractive, particularly if the stock market cracks this fall, which I believe will happen.