Amazon: Airing Out The Financial Laundry

Summary:

• Amazon.com, Inc. had a disappointing, but not surprising, Q4.
• The company continues to spend on AWS, which we think is unnecessary given the current macro environment.
• After digging around under the financial hood, we believe that Amazon’s management used Q4 as an opportunity to clean the financial house.

Head In The Cloud

In a long-ago time, things were just right for Amazon.com, Inc. (NASDAQ:AMZN). Interest rates were low, consumer sentiment was strong, and the skies were cloud-free. The company was seemingly unstoppable as it expanded beyond its online store and into cloud-based computing with Amazon Web Services (AWS), the grocery business with its acquisition of Whole Foods, and myriad other services such as Prime Video and Music.

How things have changed.

In addition to troubling reports that the FTC may be preparing an antitrust case against the company, growth seems to be slowing at The Everything Store.

If Amazon’s Q4 report was disappointing, at least we can say it wasn’t a surprise. We previously wrote about our concern that AWS growth was slowing (read that article here) and that this would pull down the company’s overall earnings. We can now say that our thesis was correct – AWS growth did slow, and the cloud services customer base that skews toward the smaller end is still sensitive to price. We expect this softness will continue for much of the year.

Investors reacted negatively to the earnings report, with the stock dropping more than 8% after the announcement. Commentary was quick to follow, with pronouncements such as Amazon “Is No Longer A Growth Stock.”

But is that the case? We want to dive in here and see what road we see the company taking in the near future.

Spending Like It’s 1999

In its heyday, Amazon was a prime example of a company that leveraged rock-bottom interest rates to fund its growth. Today, the company generates enough cash that it no longer needs to tap credit markets, but expansion remains top of mind.

In the Q3 call, management made it clear that investing in AWS infrastructure was a top priority, despite increasing price sensitivity among customers. In Q4, the story was largely the same.

To wit, in 2022 the company spent $58 billion on capital expenditures (vs $55 billion in 2021). In its 10K filing, the company notes that this amount “primarily reflect[s] investments in technology infrastructure (the majority of which is to support AWS business growth) and in additional capacity to support our fulfillment network. We expect to continue these investments over time, with increased spending on technology infrastructure.”

The heavy focus on AWS shows up in the company’s spending. In its Operating Expenses breakdown, Amazon categorizes its AWS spending as largely contained within the Technology and Content line item. While expenses at Amazon grew across the board in the fourth quarter, this particular line item took the largest leap of all, from representing 11.9% of net sales in 2021 to 14.2% in 2022.

The next question to ask, of course, is whether or not this spending is warranted.

The answer, like so many other things, is dependent on your perspective. If you believe that – despite the current slowdown – that demand for cloud computing services will ramp dramatically over the next few years, then the answer is probably yes. If you think that Amazon should build when the demand materializes, then the answer is no.

Our opinion is that the answer lies somewhere in the middle. We would prefer that the company slow its CAPEX expenditures on data centers until demand is more present. After all, incremental needs in capacity can quickly be brought online with a hyperscale location with a data center company if excess is needed. But that, at the end of the day, is just our opinion. Each investor must answer the question for itself.

Write It Down

From going through the fourth quarter SEC filings, we almost get the sense that Amazon, knowing it would be a weak quarter, decided to pile on (just our opinion, of course). Getting bad news out of the way and cleaning house, after all, can usher in better times.

To that end, Amazon placed a slew of one-time charges and write-offs into the notes of its 10-K. These non-recurring charges often jolt investors who don’t take the time to read through the details of the reports and can often create a short period of panic-selling. These one-time charges and write-downs, then, are important for investors to note as the compression they placed on operating margin is not likely to occur again.

In Q4, Amazon took a $1.1 billion impairment charge against physical locations ($720 million of which was recorded in Q4, meaning the remainder should reflect in Q1), a $480 million one-time charge for terminating leases before commencement of fulfillment operations, and a $720 million charge for severance-related costs ($640 million of which were recorded in Q4). This adds up to a $1.84 billion headwind against operating margin.

In a company the size of Amazon, a $1.84 billion headwind may seem small, but it’s a sign to us that management is taking the opportunity to present all the bad news at once and set the stage for a rebound. Consider that these decisions were made in the same quarter that the company experienced a $15 billion loss due to foreign exchange rates and a $12.7 billion loss on Amazon’s equity stake in Rivian Automotive, Inc. (RIVN).

Let It All Out

This take-out-the-trash approach to financial reporting in the quarter is further evidenced by the fact that management didn’t resort to accounting chicanery in an attempt to make the numbers appear more beneficial.

In tough times, management teams with subpar scruples will sometimes find reasons to reduce or deplete held reserves. Releasing expense reserves has a positive effect on the balance sheet and income statement, and in the quarter-to-quarter game of Wall Street expectations, sometimes these tactics can push a company over the finish line. For example, say a company holds back 2% of sales each quarter to create a reserve to cover bad debts in their accounts receivable. That 2% reserve constitutes an expense against revenue. In a quarter where the numbers are going to expectations, management may be tempted to empty out that reserve, declaring that they are not expecting any bad debts for that quarter, and voila, the numbers have been met.

Amazon’s management, however, seemed intent on airing out the dirty laundry in Q4, and on doing it with integrity. To this end, the company’s reserve held for returns didn’t shrink or stay level – it grew in 2022 to $1.3 billion from $1 billion.

For us, these small things build confidence in a company’s management team. When investors know that the small things will be done correctly, they can feel more assured that management is competent and will act with integrity.

The Bottom Line

Amazon’s Q4 earnings were disappointing, but not surprising. We were also pleased to see that after digging around under the hood, we found no evidence of accounting trickery or attempts to present the numbers for anything other than what they represented, which fortifies our confidence in management.

Going forward, we expect the outlook for Amazon to improve, though it may take 2-3 quarters to really turn around. As the company course-corrects through a likely recession, it is likely to launch several new products that we believe will continue to position it as a global leader in the e-commerce marketplace. One surprise for us was that RxPass (see our article here), was brought up only twice on the earnings call – and not in prepared remarks but by CEO Andy Jassy in answers to analyst questions. Indeed, not one analyst asked about this product, which we think will be Amazon’s first successful foothold into the healthcare industry.

Despite this quarter and the prospect of a difficult first half of 2023, we are overall bullish on Amazon’s long-term prospects. We do believe there will come a day when the company will have to abandon its grow-all-the-time-at-all-costs mindset and embrace a more steady-state reality (perhaps one in which it pays a dividend), but for now, that day is many years away. We also believe that the weakness in AWS will recover in the long term.

Indeed, we would consider Amazon.com, Inc. stock a buy if it were not for the specter of antitrust action on the horizon. If that threat does materialize, we will be interested to know its nature and scope. We will be keeping a close eye on the company for now and maintain our hold opinion.

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Disclosure: I/we have a beneficial long position in the shares of AMZN either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock, you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.

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