Amazon (AMZN) stock fell more than 8% in the week following Donald Trump’s win, shedding roughly $35 billion in market capitalization.
The Trump victory has placed Amazon’s role in Washington in focus. The company spent $9.07 million in lobbying efforts in 2015, making it the fourth-largest tech industry spender inside the Beltway. Trump, however, has criticized the company over tax and antitrust issues in the past. This raises concerns that a Trump IRS or Department of Justice may push antitrust or tax audits on Amazon.
But while the markets are focused here, is there something else investors should really be worried about these days? In the weeks preceding the 2016 election, it appeared that Wall Street analysts were falling all over each other to offer a more bullish outlook on Amazon.com stock. After the stock hit a new all-time high of $847.21 in early October, analyst price targets rose to $1,000 per share and higher.
Shyam Patil at Susquehanna saw how high his bank could shoot an arrow and said $1,250 per share. Why not? The company is opening 18 new fulfillment centers this fall. Revenues continue to surge. And Jeff Bezos’ strategy to build market share — and annihilate competition — reads like it’s ripped from the pages of a John D. Rockefeller biography. Everyone seems to agree on the same thing: Amazon stock is headed higher.
But in this line of work, danger lurks as consensus grows more absolute; just look at the election polls and last year’s forecasts for Valeant Pharmaceuticals (VRX).
According to TipRanks, 31 of 33 analysts now have a Buy rating on AMZN with a consensus price target of $948.58. That represents potential upside of 28.36% from the closing price on Nov. 11. This consensus begs two questions given the hype: First, who are the analysts not issuing a Buy rating? And second, for what reason should someone not buy into the exuberance that propelled AMZN stock up more than 122% over the last two years?
According to TipRanks, Needham & Company’s Kerry Rice reiterated a Hold rating in late October due to concerns about margin pressure as Amazon boosts investment in new business lines. The second Hold reiteration comes from SunTrust’s Robert Peck, whose analysis over the last two years offers an interesting look into the financing and accounting strategy of Amazon. A dive into SunTrust’s 2015 analyst report offers a glimpse into an Amazon cash flow issue that — while totally legal and in line with generally accepted accounting principles (GAAP) standards – should at least draw the interest of professional traders and shareholders.
That issue is the company’s use of capital leases in its Web Services Division.
Amazon’s capital lease gambit
In March 2015, SunTrust wrote that Amazon stock was trading at 70 times “its forward Adjusted Free Cash Flow, when adjusting for capital leases versus 40% growth.” Peck’s team argued then that the stock’s upside had been captured.
The key term in that sentence is “capital leases,” which the firm doesn’t show in its cash flow. Later in the report, SunTrust explains that “capital leases are important to consider in measuring true cash outflows, because the traditional simple free cash flow definition misses the Principal Repayment, which can be material to real cash flow.”
The firm uses capitalized leases as an accounting tool for its investments in Amazon Web Services Division on hardware like servers and equipment. This enables the company to bolster its free cash flow and separate it from reality.
Accounting isn’t a particularly exciting topic. But GAAP standards aren’t meant to be. The rules call for all companies to structure their leases in three ways: Capital, financing or operating. When the company issues an operating lease, it counts on the books as an expense. The other two options are placed on the firm’s balance sheet – or “capitalized” – to appear as debt.
John Spaid, EVP Finance at National Health Investors Inc., argues that many analysts and investors don’t see the financial impact of capitalized leases on EBITDA. Spaid began writing on the topic in 2014 in The Street, arguing that the manipulation of cash flow makes it possible to miss and thus leads to a higher valuation of the stock.
“The primary thing that is different about Amazon is that they are using capital leases for very short-lived assets – two to three years. Everything going into AWS cloud facilities. They make massive investments, [paid] for partially out of cash and partially out of capitalized investments,” Spaid said, arguing that it is a “very rapid payback time and an intensive financing strategy.”
As SunTrust pointed out in their 2015 report, capital leases are really a “cash outflow for the company and totaled $1.4 billion in 2014, up from $780 million in 2013 and $506 million in 2012.” In its 2015 annual report, Amazon listed total long-term capital lease obligations of $4.212 billion. That money has to be repaid, and quickly.
That’s where Spaid begins to ask other questions about the company’s cash flow. “After two to three years, what happens to these assets? Does Amazon own the asset? Probably not. Could they buy it cheap? Maybe. Is it now obsolete? Who knows,” asks Spaid.
The next set of questions involves what happens when the company needs to upgrade its hardware and expand? Naturally, it will need to borrow more money, likely use more leases, and purchase and replace more equipment to keep its AWS division growing. Amazon has dramatically increased its use of capitalized leases over the last four years.
Spaid originally questioned this issue back in 2014 in the pages of The Street. Today, he still seems dissatisfied with analysts’ willingness to address the accounting issue. To gain a better understanding of Amazon’s real value, Spaid urges analysts and investors to “convert its capital leases back to operating (cash/rent/expense) leases, exclude cash flows from working capital, and subtract net leased assets from invested capital.” This would provide a better understanding of the firm’s return on invested capital and its real cash flows.