Written by Summary
We hold a neutral view for Amazon due to the following mixed considerations.
Amazon is a stock that combines two rare traits – a dominating juggernaut yet still perfectly scalable.
Amazon’s accounting earnings underestimate its true earnings power, and its owners’ earnings are significantly higher.
Yet, AMZN stock’s valuation is still elevated line even when its profitability and true earning power are accounted for.
Amazon lease accounting brings further concern, and its free cash is heading in the wrong direction after adjusting for its financial leases.
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georgeclerk/iStock Unreleased via Getty Images Thesis
We hold a neutral view for Amazon (NASDAQ: AMZN ) due to the following mixed considerations: It is still at the stage that shows perfect scale and scalability at the same time. Both its ROCE (return on capital employed) and MROCE (marginal ROCE) have been on average 30% to 33% in recent years, demonstrating a scalable stage.
Its accounting earnings underestimate its true earnings power, and its owners’ earnings are significantly higher.
Yet, its valuation is still elevated even when its profitability and true earning power are accounted for. Its FW accounting PE is about 65+. And even after adjusting for its ROCE and owners’ earnings, its PE is still about 40+, not only expensive in absolute terms but also relative to other peers.
Its lease accounting brings further concern. Its FCF already turned negative without adjusting the financial leases in recent quarters (about negative $9B in Q4 2021). And it is a whopping negative $20B after adjusting for its leas accounting, sizable both in absolute terms and relative terms – if you consider its cash from operations is “only” $46B in 2021.
Chart 1 – Amazon – superb scale and scalability
For investors, a dream business to invest in would be a business that enjoys both scale and scalability. A business that earns a consistent and stable profit for every batch of resources invested no matter how large its scale becomes. However, such a business is really only a dream business. Diminishing returns act like gravity on all economic activities. At some point, gravity always catches up and the return begins to decline).
So for investors, the next best deal is to invest in a business that A) has high and stable profitability, and B) that is still in the scalable stage (the gravity of diminishing return has not caught up yet). And as shown in the next chart, AMZN seems to be such a business at such a stage.
This chart shows the ROCE (return of capital employed) and the MROCE (marginal ROCE) for AMZN over recent years. The ROCE calculation has been detailed in my earlier writings and won’t be repeated here. The MROCE data are estimated by the following steps. First, the capital employed was calculated for each year. Second, the earnings were calculated each year. Third, then the incremental of capital employed year over year was calculated. Similarly, the incremental earnings year over year were also calculated. And finally, the ratio between the incremental earnings and incremental capital employed was calculated to approximate the MROCE. During years when there were large fluctuations in either the incremental earnings or the capital employed, a multi-year running average was taken to smooth the fluctuations.
The results shown in the following chart show that at this stage, AMZN has been actually able to maintain an MROCE that is essentially the same as the average ROCE so far. As seen, the ROCE has been on average 33% in recent years, and the MROCE has been on average 30%. And the small difference is most likely due to inevitable uncertainties in the financial data and rounding off errors. So this result suggests that AMZN has not reached the stage of diminishing return yet – gravity has not caught up yet. And if the current MROCE continues, AMZN will continue its high and consistent ROCE. Author Chart 2 – true economic is higher than accounting earnings
AMZN’s accounting earnings do not reflect its true economic earning power. And the accounting earnings dramatically underestimate its true earning power (the so-called OE, owners’ earnings).
You can already appreciate the discrepancy by simply looking at the free cash flow (“FCF”) conversion ratio as shown in the following charts. You can see that FCF has been dramatically and consistently higher than EPS. The so-called FCF conversion ratio (FCF […]
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