Amazon set for lowest growth in 20 years
Head of Equity Strategy
Summary: While most companies get punished for guiding lower revenue than estimates, Amazon shares somehow felt the love from investors in what we believe is a misguided interpretation of the Q4 earnings. The market is often right, but in this case we believe the market is overestimating growth and underestimating the risks to its operations from higher wage and logistics costs on top of an overhang from massive investments during the pandemic. Amazon is set for its lowest growth in 20 years which could suddenly put downward pressure on its equity valuation which is still at a steep premium to the US technology sector.
Overnight Amazon spike set to fade as growth is overestimated
Following yesterday’s carnage in Meta shares, Amazon turned sentiment with its Q4 earnings release with its shares up 11% in pre-market trading. While the price action is positive the underlying dynamics are not being appreciated in our view. The market is a big voting machine and mostly right, but we believe the market is potentially getting Amazon wrong.
First the figures. Amazon delivered Q4 EPS of $27.75 vs est. $3.77 which was mainly driven by recognizing $11.8 in non-operating income with the majority coming from gains on its Rivian ownership. With Rivian down 42% this non-operating asset is already worth a lot less and with recent comments from the Mercedes-Benz CEO that growth of electric vehicles will be increasingly constrained by lack of ressources, we believe Rivian will disappoint against expectations in the coming years. Amazon’s operating income fell to $3.5bn in Q4, which higher than the $2.4bn expected, but the lowest figure since Q3 2019 and its worst Q4 result since Q4 2017, as accelerating costs and investments are impacting profitability.
Amazon delivered Q4 revenue of $137.4bn vs est. $137.8bn, and AWS revenue was in line with estimates, but more importantly the Q1 revenue guidance was $112-117bn vs est. $120.5 telling yet again the story that analysts are too optimistic on the pandemic winners which are facing tough headwinds. The Q1 operating income guidance is $3-6bn vs est. $6.1bn which suggests lower profitability trajectory than expected but the wide range shows that Amazon has little visibility on its costs and revenue. What makes the price action weird at Amazon is that most companies get punished for guidance revenue lower than estimates. If Amazon hits the mid-point of its Q1 revenue guidance it will translate into 5.5% revenue growth (a long way from 16% y/y expected for all of 2022) which will be the lowest growth rate since Q3 2001; even the Q4 revenue growth rate at 9.4% y/y is one of the lowest growth rates in the company’s history, and still investors are rewarding Amazon. Why?
There are several potential explanations. One is the cloud business AWS which is still a market leader and growing fast. This business it the main driver of the equity value, but with antitrust regulation changing and with the focus on Amazon, the company might be forced to separate the two businesses. This could be forced on the notion of the precautionary principle of prohibiting Amazon from cross-subsidizing its retail business with cash flows from the cloud business.
The second potential explanation for the market’s enthusiasm is the capital expenditures which sits 96% (the difference between the two lines in the chart below converted back from logarithmic values) above the level if Amazon had following its trend growth in investments from before the pandemic. Given Amazon’s previous success and ability to generate high return on capital, some investors might think that these investments will lead to massive future growth. But the pandemic has been unusual and the bottlenecks in logistics could have forced Amazon to insource more of its operations which means that a larger part of capital expenditures are just maintenance investments swapping from third parties to its own balance sheet, and thus the actual amount available for real future growth is lower than perceived. In any case, the 262% increase in capital expenditures during the pandemic will begin to weigh on operating income through depreciation and given Amazon’s size it is questionable whether it can get the same ROIC out of those investments as before.
Finally, Amazon’s business model has never been stress-tested during high inflation and fast changing supply chains, and bottlenecks in global logistics. These forces on top of tightening financial conditions increases the downside risks on Amazon’s operations.
The market is still paying around 27 times 12-month trailing EBITDA which more than double the MSCI World Index and 34% premium to Nasdaq 100 companies. Alone the sheer size of Amazon means that the mean reversion effects on growth are intensifying and we believe the valuation metrics will continue to come down and act as headwinds for investors. While we are in favour of the wisdom of the crowd, we believe the price reaction to Amazon’s earnings is potentially wrong and investors are overestimating growth.
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