by Dave Kranzler of Investment Research Dynamics
On January 31st, Amazon reported an expected “beat” for Q4 revenue and net income. After the headline report hit the tape, the stock soared $59 to $1777 from the closing price ($1718) minutes earlier. But then the stock began plunging. It closed the after-hours session at $1635, down $142 from the earnings headline spike and down $83 from the NYSE close. The Company guided Q1 revenues down below the consensus estimate. Amazon’s Q4 numbers also reflected a slow-down in revenue growth.
I predicted Q4 would show slowing growth based on the fact that AMZN enjoyed four quarters of year-over-year comparisons which included Whole Foods numbers for Q4 2017 to Q3 2018 vs comparable year-earlier quarters which did not include Whole Foods numbers (A GAAP rule-change allows companies to avoid restating historical numbers after a big acquisition – this enabled AMZN to report 3 quarters in 2018 with WF numbers but leave WF numbers out of historical financials). Q4 2018 is the first year-over-year quarterly comparison which was an “apples to apples” comparison of the numbers. And AMZN did not disappoint me by disappointing.
If the AMZN Einsteins on Wall Street are aware of the Whole Foods accounting gimmick, they certainly never mentioned it in their analysis, which probably explains why AMZN’s stock is down 6.4% since reporting Q4 while the SPX is up 2.6% in the same time period.
AMZN’s year-over-year revenue growth rate for Q4 came in at 19.7%, the slowest growth rate since Q1 2015. If AMZN revenue comes in at the mid-point of Q1 2019 guidance ($58 billion), it would represent a year-over-year growth of rate of 13.6% – the slowest revenue growth rate since 2001.
I noticed an interesting development in AMZN’s numbers which the analyst community will no doubt overlook or fail to see. AMZN’s gross margin jumped from 37.1% in 2017 to 40.3% in 2018. This made no sense given that Whole Foods’ gross margin was running about the same as AMZN’s prior to the merger. The obvious place to look for gross margin accounting manipulation (understating cost of goods sold) is the balance sheet. Property, plant and equipment jumped 27% from 2017 year-end, or $13 billion. This increase is not attributable to the WF acquisition because the 2017 year-end balance sheet would reflect the WF acquisition. I also noticed a 27% jump in “other assets.” Other assets contains the “intangible” value of video content acquired.
While I can’t prove this without seeing the inside books, I would suggest that the likely explanation is that AMZN is capitalizing costs that should be expensed in the year the costs are incurred. I would also bet that AMZN has slowed down the rate at which it depreciates its media content. This is the primary source of accounting manipulation utilized by Netflix. Capitalizing expenses and slowing down the rate of depreciation has the effect of reducing cost of goods sold and increasing gross profit, thereby increasing the gross margin.
A counter-argument would be that AWS continues to grow at 40% and is a high margin business. However, AWS revenues have been running about 10% of AMZN’s revenue base for quite some time. Thus, while AWS’ business might contribute to a small improvement in AMZN’s gross margin, a 300 basis point jump in one year is too good to be true.
I would suggest that AMZN altered its cost recognition accounting in order to offset slowing revenue growth with a higher reported gross income, which translates into higher operating and net profits. This enables AMZN to “beat” earnings estimates – at least in the short run.
As I’ve detailed in the past and in the Amazon dot Con report (available to Short Seller’s Journal subscribers), AMZN presents its “free cash flow” in a non-GAAP format in order to make it look like the business model generates a lot of free cash flow. As AMZN discloses in a footnote buried in the 10Q/K, its presentation for free cash flow is non-GAAP. At the bottom of its statement of cash flows from operations is a section titled, “supplemental cash flow information.” This section includes “property and equipment acquired under capital leases” of $10.6 billion and “property and equipment under build-to-suit leases” of $3.6 billion. Together, this is cash spent during 2018 of $14.2 billion.
These expenditures have been growing annually for many years and should be netted out from AMZN’s “investing activities” section in the statement of cash flows. Subtracting the $14.2 billion from the cash used or provided by operations, investing and financing yields negative $3.4 billion. This is the actual “free cash flow” generated by AMZN’s operations in 2018 vs. the positive $11.6 billion “free cash flow” number shown on page 1 of AMZN’s Q4 earnings presentation.
One last point. My biggest contention is that AMZN’s revenues are driven primarily by the attraction of 2-day free delivery for Prime members. Stripping away AWS from AMZN’s revenues and operating income gives AMZN a 2.5% operating margin. This is about half of the operating margin generated by AMZN’s comparable competitors like Walmart, Target and Best Buy. Most of that 2.5% operating margin is attributable to Whole Foods. AMZN’s cost of fulfillment (the cost of getting a product from the “shelf” and delivered to the buyer), surged to 25.6% of revenues from 22.8% in 2017. In 2010, before Prime really began to take off, AMZN’s cost of fulfillment was 13% of revenues.
AMZN’s e-commerce business barely generates an operating profit (international e-commerce generated a $2.1 billion operating loss in 2018). If we could calculate a net income for just e-commerce, it’s likely that AMZN would show a net loss. As the rate of AMZN’s revenue growth slows, the cost of fulfillment is going to consume AMZN’s operating margin.
My point is that AMZN stimulates e-commerce sales with the allure of free 2-day shipping. AMZN’s stock price keys off revenue growth. Unless AMZN can keep revenue growing at historical rates, the stock price is going to reprice down to a multiple based on a hybrid cloud computing services and retail business. The growth rate in Prime subscriptions has been the “holy grail” of AMZN’s revenue growth rate. But the growth rate in Prime memberships plummeted to 26% year-over-year in Q4, down from 50%+ growth rates historically.
AMZN’s stock trades at an eye-watering 65x operating income. It trades at 76x trailing EPS. Keep in mind that there’s a good argument to be made that AMZN stretched its GAAP income measurements with accounting games that reduced cost of goods sold and increased operating/net income. The jump in gross margin is a one-time event and likely not sustainable. Perhaps Bezos will plan another big acquisition in order to keep kicking the accounting indiscretions down the proverbial road.
Regardless, the stock remains insanely overvalued. As a comparison, Walmart trades at 2x operating income and a P/E of 18. Target trades at 9x operating income and a P/E of 11. AMZN’s stock price could get cut in half and it would still be overvalued relative to retailer comps. That said, AMZN’s stock price will likely trade directionally with the stock market, although it will outperform to the downside when the bear market resumes.
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