Amazon's Q2 Earnings Show Why Stock Remains A Long-Term Buy

Free cash flow certainly doesn’t do it. Over the past four quarters, Amazon’s free cash flow has, in fact, been negative. Net profit at least is positive, but at $1.13 per share, implying a price-to-earnings multiple well past 100x.

Furthermore, mark-to-market accounting related to the company’s investment in electric truck manufacturer Rivian Automotive (NASDAQ:RIVN) has affected Amazon’s results over the past three quarters. Still, the total net effect has been essentially zero.

Even revenue doesn’t look that spectacular. A 2.5x price-to-revenue multiple is not terribly attractive, given the bulk of revenue comes from low-margin product sales. Meanwhile, the company’s top-line growth has slowed dramatically: revenue increased just 7% year-over-year in both the first and second quarters.

At the least, from a high level, AMZN looks like an avoid. From the right angle, particularly after a double-digit rally following last week’s earnings report, the stock seems like an easy short.

But this is a case where broad fundamental metrics don’t tell the whole story—or enough of the story. It takes a closer look to understand the real value here and why AMZN stock might well be undervalued rather than overvalued.

Again, the headline numbers don’t look great. But three more specific figures highlight the value here.

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First, Amazon Web Services (AWS), the company’s cloud business, has generated a stunning $22.4 billion operating income over the past four quarters. (It’s worth noting that the figure includes the unit’s share of corporate costs, which isn’t the case for many companies that report a segment-level profit.)

Apply a 21% tax rate to that figure, and AWS would generate a net income of about $17.7 billion. That’s with profit growing at a 28% rate year-over-year in Q2, with that growth decelerating from previous quarters.

There is debate about what a standalone AWS would be worth. Whatever the exact figure, it’s not difficult to argue that AWS supports at least half the valuation here; a 40x price-to-earnings multiple for 28% growth is not unreasonable, even in a market less aggressive than it was six months ago.

At the very least, AWS is one of the best businesses in the world, full stop. Bear in mind that the business retains a dominant market share while competing against Alphabet (NASDAQ:GOOGL) and Microsoft (NASDAQ:MSFT), two of the best operators out there.

The second metric concerns Amazon’s advertising business: in the second quarter, Amazon generated $8.7 billion in advertising revenue. Over the past 12 months, ad sales have totaled $34 billion. To put that into context, that figure is almost triple the total revenue at Twitter (NYSE:TWTR), Snap (NYSE:SNAP), and Pinterest (NYSE:PINS) combined.

Amazon is an advertising behemoth. And while online ad sales seem to be stagnating, Amazon’s revenue stream rose a healthy 18% year-over-year in Q2.

Finally, there’s the subscription revenue stream. That revenue—mostly from Prime subscriptions—has totaled $33 billion over the past four quarters.

There are three massive businesses here—and we haven’t even discussed the actual e-commerce business yet.

Those three metrics have led some investors to argue, notably after AMZN sold off this spring, that the retail business is available “for free.” A 50x earnings multiple on AWS and 10x revenue multiples on advertising and Prime gets the equity value here to about $1.5 trillion,

That case may be a bit too simplistic, to be honest. Both Prime and advertising revenues are included in Amazon’s North American and International segments. Even with those revenues, neither segment has been profitable over the past four quarters. Competition in the cloud infrastructure business raises the risk of lower profit margins and a lower valuation for AWS.

Still, the broad outline makes some sense. The individual parts of Amazon’s businesses quite obviously have real value. What obscures that value on a consolidated basis is that the company continues to invest heavily in the business. Whether content for Prime Video, the move to one-day shipping, or the massive (and expensive) buildout of a world-class fulfillment business, Amazon is not earning the profits it could.

And that’s a good thing. AMZN stock has been one of the market’s great success stories because it has successfully re-invested its profits into the business. That, in turn, has led to AWS and more than 200 million Prime subscribers—and, by the way, an obviously valuable e-commerce business.

Amazon’s e-commerce revenue growth has indeed slowed. But difficult comparisons are a big factor. And it’s worth noting that every retail business is seeing massive deceleration. In fact, two of the best ‘omnichannel’ retailers in the U.S., Walmart (NYSE:WMT) and Target (NYSE:TGT) just posted disastrous quarters.

From the outside, it’s impossible to precisely define how much Amazon is investing and how much profit the company could earn if it focused solely on driving near-term profit. But we have a good amount of data to suggest that the figure would be big. This is the best cloud business, one of the best subscription businesses, and, if Q2 results are any indication, perhaps the best e-commerce business.

That’s what investors are paying for. That’s why Amazon is valued at $1.4 trillion. Equity investors aren’t just buying fundamentals. They’re buying a business. Amazon remains one of the best in the world.

Disclosure: As of this writing, Vince Martin has no positions in any securities mentioned.

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