In my last article on Amazon (NASDAQ:AMZN) I argued that it was undervalued by the market. This was based on a simplified sum-of-the-parts analysis. Since then, the company has reported its Q3 earnings and given its outlook for the year. I still believe Amazon stock is very cheap, despite the lower than expected earnings.
According to Amazon’s Q3 financials, sales increased sequentially from Q2 2019 and also on a year-over-year basis. But analysts were not happy that its net income fell 26% from $2.89 billion in the prior quarter (Q2) to just $2.13 billion. Net income also fell 20% from the year-ago quarter level of $2.88 billion.
Even more distressing to analysts was the drop in free cash flow from Q2 2019. Even though FCF was up significantly Y0Y, FCF fell 6% sequentially from Q2.
For example, trailing 12-month FCF was $25 billion in Q2 2019, and in Q3 2019 it fell $1.5 billion to $23.5 billion.
This is important because Amazon puts a lot of emphasis on its free cash flow as a measure of the health of its businesses.
Moreover, Amazon gave a lower forecast on sales and operating earnings for Q4. It said operating earnings would be between $1.8 billion and $2.8 billion, compared to $3.8 billion in Q4 2018.
Amazon Stock Still Looks Undervalued
In the sum-of-the-parts analysis used in last month’s article, AMZN was seen as worth $1.21 trillion, or $2,444 per share. This is 37.5% higher than today’s price of $1,777 per share for AMZN stock.
The analysis was based on a value of $550 billion for Amazon Web Services (AWS) and $660 billion for the non-AWS businesses.
Adjusting for the expected downturn in Q3 and the upcoming Q4 2019 sales drop, the value for Amazon is still attractive. For example, most of the downturn comes from the non-AWS cloud businesses (North America, International, and physical stores). AWS is still picking up market share.
As I mentioned, FCF fell 6% this quarter. Therefore applying a 6% discount to the non-AWS portion of the sum-of-the-parts gives it a value of $620 billion. Adding in the same AWS value of $550 billion brings the total value for Amazon stock to $1,170 billion.
Since there are now 495 million shares outstanding, the total value for Amazon is $2,363 per share. That is still 33% above today’s price.
Even assuming a 20% cut to the non-AWS portion of the sum-of-the-parts gives AMZN stock a value of $1,078 billion, or $2,178 per share. That still represents a 22.5% upside for the Amazon stock price.
What Should Investors Do?
Some analysts believe that the market has over-reacted to the softening guidance for Q4 revenue and operating earnings. One analyst believes that India, Brazil, and Mexico (“IBM”), as well as opportunities in advertising, media, fin-tech and drone delivery all, are long-term positives for Amazon.
That analyst puts a $2,000 price target on Amazon. His analysis uses a sophisticated Discount Cash Flow (DCF) analysis to derive the value for AMZN stock. That target price represents an upside of 12.5% from today’s price.
So using both a sum-of-the-parts analysis and a DCF analysis yield higher price targets for Amazon. Investors in the stock will likely take comfort in these target prices.
In addition, given the recent downturn in Amazon stock, new investors might find this an opportune time to dive in.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake writes the Total Yield Value Guide which analyzes stocks that are significantly undervalued. Subscribers receive a 2-week free trial period. Subscribe here.
