Warren Buffett (Trades, Portfolio)’s famous advice to “be fearful when others are greedy, and be greedy when others are fearful” is a very interesting approach to buying good companies at good prices. Finding a good company that has a good price and is going through a good time with clear prospects is often quite difficult, but for long-term investors who have the stomach for the good old buy and hold, buying good companies at good prices but that are going through a delicate time or with slightly cloudy prospects is often enough.
In my opinion, Amazon.com Inc. (NASDAQ:AMZN) fits the bill. After posting mixed second-quarter earnings, which disappointed the market with a miss in revenue and worse-than-expected guidance for the next quarter, the shares retreated sharply before recovering.
This, together with the tech sell-off and fears of a recession, means Amazon is at one of the best valuation levels in recent years, even though it is worth around $1.86 trillion.
Looking at the multiples, Amazon is cheaper than it was years ago, even though it has improved substantially in terms of revenue, market share, options and cash generation. After the dip, the forward price-earnings ratio reached its historic low of 36, while the price-to-operating cash flow ratio reached 16.50, close to the levels seen in the 2008 recession and other more troubled periods, which means this multiple is also close to its low of 13.30 and far from its mean of 27.50 over the last 20 years. Note these multiples are reaching their lowest level even though free cash flow over the last 12 months has reached its highest level.
Source: GuruFocus
For the stock to be trading so far from its averages and for a bargain of 16 times its operating cash flow, you might think the prospects have changed, but no. In fact, according to the estimates, expectations for Amazon remain excellent. Over the next three years, the revenue growth rate is estimated at 10.80%, earnings per share at 35.20% and operating cash flow per share at 30%.
It may seem disproportionately cheap for a stock that is expected to grow its cash from operations by 30% and is still trading at only 16 times, but there are some reasons that inflate this indicator and should be clarified. One of the reasons is capital expenditures, though cash generated by operating activities was $108 billion over the last 12 months, the capital expenditure was almost $60 billion, putting pressure on the generation of shareholder value in the short term. As I highlighted previously, in the short term this capex is likely to remain high to support the growth of Amazon Web Services, automation and other initiatives. In the words of management, the second half of 2024 is set to be higher to “support the growing need for AWS infrastructure.” At some point, as these initiatives mature, this capex should decline and, consequently, free cash flow will expand.
Another reason for operating cash flow being higher than net income is stock-based compensation, which is a non-cash expense that dilutes the shareholder over time and depending on the volume can be detrimental in the long term. Cash generation for the shareholder is expected to increase much faster than the amount by which the shareholder is diluted by the stock-based compensation, to the extent that value generation for the shareholder is greater and compensates for this negative factor. Not only that, but at some point in the next few years when operating cash flow increases and capex decreases, the buyback and other forms of shareholder remuneration may increase and surpass the stock-based compensation. But even with this positive outlook, there is no guarantee this will happen, so it may continue to be a relevant pressure for value generation in the medium term and benefit these price-to-cash flow indicators and should be monitored.
Something interesting to note is the longer history is not so positive, with stock-based compensation increasing significantly along with operating cash flow. However, in the most recent period, there has been a certain stability in this type of compensation, while cash flow continues to grow substantially.
Source: GuruFocus
All this implies that Amazon shares are trading at an attractive level compared to their own history and considering future prospects. It is hard to say that a stock trading at more than 35 times earnings is a bargain, but we must balance this by considering not only the size of its moats, but also the amount the company can generate and the pace at which it will be able to increase this cash flow. Amazon, therefore, has a fair valuation and is not an expensive company for what it offers.
It is not possible to justify this discount on stocks with second-quarter earnings, since although they were not entirely positive, they were not that bad either. Revenue was $147.98 billion, while estimates were for $148.78 billion, but the consensus on AWS revenue was surprising.
On the other hand, earnings per share came in at $1.26 while Wall Street was expecting something close to $1.02.
For the next quarter, Amazon expects revenue between $154 billion and $158.50 billion and operating income in the range of $11.50 billion and $15 billion, disappointing the market which expected higher volumes. Amazon Chief Financial Officer Brian Olsavsky justified these assumptions with some factors, such as pressure on margins in the third quarter due to Prime Day deals and marketing spend on account of the event and consumer attention on other events around the world.
On the positive side, the operating margin reached 10%, up 4 percentage points year over year, driven mainly by better margins at AWS and International, which were up 11 percentage pointes and 4 points respectively. Despite the cloudy expectations for AWS’s margins in the medium term, it is interesting to note the company’s initiatives to reduce cost-to-serve, improve inventory and other profitability initiatives are maturing and are already showing results, especially for the International segment, which until recently was unprofitable and now, with the start of operating leverage and these strategies, already has a margin of 0.90%.
Another factor driving the brief decline in Amazon’s stock was the fear of a recession, brought on by triggers such as weaker employment data and an interest rate increase in Japan.
At first glance, a recession is bad for Amazon’s operations and should have some impact on its fundamentals. In recessions, it is common for there to be lower consumer spending, which directly affects sales growth, as well as possible margin pressures due to price, lower cost dilution and other potential challenges.
This is obvious since a large part of Amazon’s operations come from retail, which is a segment that is very affected by the economic environment, with a lot of competition. With worse data on inflation, unemployment, citizens’ disposable income and more, expectations for people buying from Amazon or even being willing to sign up for subscriptions or spend on ads are reduced, especially for non-essential products. If there is this macroeconomic pressure on the consumer, not only will they think twice before buying products such as household and kitchen appliances, but if that product is cheaper at a competitor, the customer will possibly give up the quality of the service in favor of a cheaper price, which can lead to a price war and a reduction in margins.
But in second-level thinking, a recession could benefit Amazon in the medium term. The e-commerce giant is known not only for its very good service, with its fast delivery and ease of shopping, but also for its very competitive prices. This is made possible by its incredible gains in scale due to its colossal size. If there is one player in the retail sector that is able to survive the recession, it is Amazon, which means that, in this scenario, there is less competition as smaller companies become less competitive and this ends up translating into a gain in market share for the large, established players. Further, although some non-essentials are affected in this environment, some of Amazon’s products can be considered essential, showing little fluctuation even in more complex scenarios.
And that’s if a challenging macroeconomic environment that lasts does materialize since as the American economy is quite resilient, there is a possibility that the signals in parts are just noise or other positive factors compensate.
In any case, I believe the best stance to adopt is something balanced, buying a good company at good prices is good, so adding exposure to Amazon after it dips seems interesting to me since it still has its moat and great growth prospects.
At the same time, it is not plausible to get rid of all your cash or allocate a large sum just because of a short-term dip. The current share price can serve as an opportunity, but it’s not a huge dip.
In short, Amazon is not exactly recession-proof, but it has enough of a moat and financial strength to survive bad times and eventually return to growth. The company has a financial strength score of 8 out of 10, with more than $70 billion of cash on hand (although a significant amount of long-term debt) and consistent and growing operating cash generation.
Source: GuruFocus
The long term is still bright
The most recent quarter came with some positive news, such as improved margins and a continuation of growth, but it also brought some uncertainty for the next quarter, with a more cautious outlook on growth and some margin hurdles. This was further catalyzed by fears of recession and a sell-off in big tech.
Even so, if we consider a longer investment horizon, Amazon is likely to remain a solid company that can increase shareholder value generation. Its capex of $50 billion reinforces that the company still has a lot to capture in terms of revenue growth and efficiency improvements.
The company’s internal strategies, coupled with its leadership in the cloud, retail, logistics and other sectors, make it a resilient company even in the most challenging scenarios. Perhaps at first Amazon will be affected by a more complex landscape, but again, for investors who have the cash to take advantage of the dips and a long investment horizon, it should benefit and be able to capture this generation of value.
All in all, at current prices Amazon can be considered a company that offers a good risk-return ratio and encompasses both a reasonable valuation and excellent prospects.
This article first appeared on GuruFocus.
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