Amazon (NASDAQ:AMZN) stock will benefit from the company’s huge expected gain in free cash flow (FCF) in the fourth quarter of 2019. This is important, because some might assume that the “lower” guidance that Amazon provided in Q3 leads to lower or negative FCF. This is not the case.
I will show you in this article how you can estimate the FCF gain for Amazon, based on their guidance. This will allow you to estimate the value of Amazon stock going forward.
Amazon’s Q4 Guidance
Here is what Amazon actually said in its Q3 statement: Sales growth of between 11% and 20% in Q4. In addition, Operating income will be between $1.2 billion and $2.9 billion.
Last year, Q4 sales growth was 19.7% YoY. So Q4 2019 sales growth of 11% to 20% will be slightly lower.
But the operating income last year was $3.786 billion. And this was at a lower sales level.
So the expected range of $1.2 and $2.9 billion is lower on an absolute and margin basis than last year.
But what does this really mean? We can estimate the FCF number based on this guidance.
Estimating Sales and Operating Income Using the Guidance
I estimate that sales for Q4 2019 will likely be about $84.475 billion. This represents about a 17.3% increase over last year. I reached that number two ways.
First, I took the midpoint of the range that Amazon provided. That is $83.25 billion (i.e., ($86.5 billion + $80 billion)/2). Next, I look at what other retailers are saying about their sales growth in Q4.
So I decided to take the midpoint between the midpoint number $83.25 billion, and the upper end of the range, $86 billion. That results in an estimate of $84.475.
A third reason I did this was that analysts on CNBC said that Amazon is typically very conservative in its estimates.
We can now estimate the Q4 operating income number. Using the same methodology as above for sales, I estimate that operating income will be $2.475 billion. Again, we took the midpoint of the midpoint and the top end of the range provided.
This results in an operating margin of 2.9% (i.e., $2.475 billion divided by $84.475 billion). This is lower than last year’s operating margin which was 5.2% but only slightly lower than Q4 2017, at 3.5%.
Estimating FCF Using Amazon’s Guidance
One way to estimate FCF is to use the “conversion” methodology. Conversion is an analyst tool that estimates FCF based on how much of operating income in the past was converted into FCF.
For example, look at the table below. You can see by looking at the last column that in Q4 2018 Amazon was able to convert operating income into over three times that number in FCF. For example, operating income of $3.8 billion turned into $12.7 billion in Q4 FCF.
The same happened in Q4 2017. The conversion rate was 411%. For example, $2.1 billion in operating income converted into $8.7 billion in FCF. The average of the two year’s conversion rate is 373.7%.
So using that number, I estimate that FCF will be 3.74 times the operating income estimate for Q4. You can see in the table this results in a huge number for Q4 FCF: $9.25 billion.
Note also that even though $9.25 billion a large number, the FCF margin of 10.5% is actually lower than Q4 2018 (17.6%) and Q4 2017 (14.5%).
What the FCF Estimate Means for Amazon Stock
The first thing this means is that the $9.25 billion FCF for Q4 2019 will raise Amazon’s cash balance. I estimate it will grow to $30.1 billion. That means cash is now 3% of Amazon stock’s $906 billion enterprise value.
The second thing it means is Amazon will have accumulated $16.6 billion in FCF over the last 12 months. That gives Amazon a 1.9% FCF yield (i.e., $16.6 billion divided by its market value of $890 billion.
This is important compared to the past four quarters. AMZN stock’s FCF yield of 1.9% is at a high point. You can see this in the table at right.
It shows that Amazon stock’s FCF yield is lower than in the past four quarters. This means the market values its FCF fairly richly.
What This Means for Amazon Stock Investors
We were able to estimate the likely free cash flow number for Amazon’s fourth quarter. This led to an estimate that the stock today has an FCF yield that is more expensive in the past.
Investors might want to hold off on taking any new positions in Amazon stock for this reason. I suspect that once Amazon provides an estimate for its Q4 sales later next month, things could change. The market seems to be anticipating that those estimates will be at the higher end of Amazon’s guidance.
If that is true, then the AMZN FCF yield probably signals that Amazon stock is fairly valued right now.
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.