Amazon: Earnings Analysis

Amazon and Microsoft both spent aggressively on AI.

Both beat earnings and rallied.

But,

I don’t think they rallied for the same reason.

There is a major difference between the two, a difference that lies in the center of what markets are choosing to bid and sell right now.

A tug-of-war between quality balance sheets and growth at whatever cost is dividing how these companies trade.

Microsoft rallied on Wednesday night because the growth trade sold off that day, and markets chose to bid quality balance sheets and cash flow.

Amazon rallied yesterday, when the market chose to bid growth at whatever cost (backed by the Citadel bailout money.)

We have to ask whether Amazon rallied by its own merit, or whether the price action was a result of what the market preferred on that day.

Here’s the good news:

That’s everything that was good about Amazon.

We need to talk about the risks to future earnings now…

One accounting decision changed the way I looked at the quarter, a decision that has created every downward adjustment in the history of finance.

For one,

On the other side of the equation comes a ridiculous 242% jump in EPS, which in reality was much lower on a cash basis.

This is Amazon we’re talking about (a bullet proof balance sheet), but that doesn’t mean they are immune to risks.

Risks the bond market is already beginning to pay insurance for through credit default swaps.

If Amazon earnings were so strong, why does the market think they will default on the latest debt wave?

Much like Microsoft and Google,

Most of the growth this quarter came from cloud computing for commercial use.

AWS is killing it, joining the double-digit rise in compute demand across corporates and other medium-sized businesses across the economy.

Advertising is also doing great, as Prime video and third-party services continue to expand.

Overall,

This is the conclusion that comes from a well-diversified business that keeps expanding through any business cycle.

Not only is revenue expanding for cloud.

Margins have jumped significantly from 32.9% to 39.4% in a single year.

Demonstrating that, despite rising investment costs on the required infrastructure, the rising computing market costs and demand across new AI releases for most businesses (chat bots, connecting Claude and ChatGPT to everyday usage) are able to maintain benefits above the cost of expansion.

I would like to make one distinction here in how the AI race is developing.

Companies who are already embedded in the AI ecosystem are winning, while those who are starting to build their ecosystem from scratch are having a much harder time doing so.

It’s why Google, Microsoft, and now Amazon continue to see their cloud revenue and margins expand with such ease.

The second aspect comes from HOW these companies are approaching the expansion itself.

Amazon has gone down the Google and Meta route.

Because its peers are investing heavily into cloud compute capacity, so must Amazon in order to maintain its market positioning.

One outage, one slowdown in services, could significantly alter how the current AWS path looks like in the future.

But,

Capex has now surpassed all of Amazon’s free cash flow for the quarter, a pace that could end up drawing the trailing twelve months (TTM) trajectory into a net outflow.

In fact, Amazon saw a net outflow of $7.6 billion this quarter.

As I explained with Google…

This will have a major impact on future shareholder returns, as buyback programs need to be halted, and future M&A opportunities are lost as well.

At the end of the day,

Investors kept these companies at the top of their holdings because of their ability to generate (and compound) free cash flow.

This is the single most important financial metric behind a stock’s volatility and risks.

Companies with less free cash flow (or lack thereof) tend to be more volatile regardless of their size.

The reason is that free cash flow allows for better financial flexibility, reaction to competition, and adaptation to changing markets.

If the economics behind cloud or AI were to deviate from future projections…

Amazon - and others with net outflows - will have a harder time adjusting.

And believe me,

All of the bonanza in cloud computing is drawing major competition out of China and other peers within the United States.

Bond yields are high and rising.

Which affects Amazon as they decided to balloon their debt load from $66 billion last year to $129 billion this quarter.

A debt load that now carries a much higher interest expense.

With no free cash flow left to absorb these rising debt costs, Amazon may take a page out of Google’s playbook and:

At which point a race to the bottom dynamic begins.

This fact has a direct negative effect on Amazon’s earnings and balance sheet quality, which is why the stock had gone down on days when quality and value factors outperformed the market.

Again, yesterday was led by “growth at any cost” so the fact that the debt and free cash flow deterioration were there did not matter.

Google sold off on similar dynamics, because on that day markets cared about quality and value instead.

On the “Other income” aspect of earnings.

Amazon reported a $53.4 billion unrealized equity gain as cash income.

This is wrong in many ways, as it deceives investors from the reality of the core business.

In fact,

Taking out this item on a per share basis has a negative $3.80 impact, revealing Amazon only generated $1.95 in EPS compared to the $5.75 reported.

Still,

This figure beat analyst expectations for $1.82 in EPS, unlike Google (who missed expectations after adjustments were made.)

Why does this matter?

Not only does that significantly boost Amazon’s P/E multiple, but it also creates a major tail-risk down the line.

Say that Anthropic’s valuation changes in light of new information, like:

Then what happens to Amazon’s earnings as they have to re-rate their equity P/L?

A cash $1.95 figure in EPS could quickly be reported at $0.30 or so adjusting for a small decline on that stake.

That accounting choice could work both ways, and even drive Amazon into a ($3.00) loss per share.

If you’re an Amazon bull, you have every right to be excited by the earnings results.

But,

I wouldn’t be of any use to you if I didn’t flag these tail risks around the company (and the stock.)

So my advice is that you plan your position sizing, stop losses, or hedging instruments accordingly.

This week’s selloff was a small example of what could happen should these factors affect valuation opinions.

Are you willing to take that risk?

That’s all for today folks.

I will see you on our Sunday weekly plan email, and cover a few important topics on Monday as I continue my due diligence on my next mid-cap compounder.

Until next time,

OFFSIDE RESEARCH

Against the Tape, Ahead of the Curve.