Amazon is trading at more than 200 times its earnings — here's why that's not as crazy as it sounds (AMZN)

Jeff Bezos

Ahead of Amazon's earnings report Thursday, the company is trading at a steep premium to its earnings.
Even with that premium, bulls have lots of reasons to like the company and its stock.
But there are some clouds overhanging the company, including criticism from President Trump and a swelling amount of debt and long-term obligations.

At more than 20 years old and with a valuation of more than $700 billion, Amazon's no startup. But if you're invested in the company, you're banking that it will continue to grow like one.

That bet has paid off quite handsomely of late. Amazon's shares have well more than doubled over the last two years and are up around 25% in the year to date.

But with the company's stock now trading at a precariously high rate of more than 200 times its earnings over the last year, the key question for investors is whether Amazon will be able to keep meeting their expectations.

For now, Wall Street thinks it can. When Amazon reports earnings on Thursday, analysts are expecting it will announce a 40% jump in sales — boosted in part by its Whole Foods acquisition — and are looking the company to forecast a similar increase for the second quarter.

Bulls have plenty they can point to support their optimism. Amazon dominates online commerce in the US and continues to grow its share of the market both here and abroad. Its purchase of Whole Foods last year gives it a new opportunity to grow its retail sales, luring Whole Foods customers to its web store and its online customers to the grocery chain.

Meanwhile, the company recently announced that it now has 100 million subscribers to its Prime service. Because Prime customers tend to spend more with the company than the average consumer, the ever growing number of them could lead to a boom in Amazon's retail sales.

Amazon's best bets may be outside traditional retail sales

But many analysts think that the company's best prospects are outside its traditional business of selling products directly to customers. There's a lot of optimism, for instance, about Amazon's prospects in a related area — selling and delivering goods for other merchants.

Over the last several years, Amazon has been building out its network of fulfillment centers around the world. Last year, it spent $10.1 billion — up from $6.7 billion the year before — in part to expand that network.

That outlay is starting to pay off. Last year, the company brought in $31.9 billion from commissions and shipping and delivery fees for sales by third-party vendors. That was up from around $23 billion in 2016.

Another area many analysts are hopeful about is advertising. As Amazon has become the first stop for folks shopping online, it's started to build up an advertising business, allowing companies to advertise their wares to its shoppers.

Many analysts have high hopes for that business, seeing it as a source of low-cost revenue growth, which could lead to substantial profits. It's already off to a strong start. Last year, the company brought in $4.7 billion in "other" revenue, which includes its advertising sales. That was up from about $3 billion the previous year.

AWS remains its crown jewel

But the biggest source of optimism for analysts and investors has generally been Amazon Web Services, the company's cloud-computing service. The company pioneered the market and now firmly leads it. With large and small businesses alike increasingly embracing the cloud and moving away from operating their own data centers, that's a good position to be in.

Amazon Web Services CEO Andy Jassy AWS has already been growing rapidly. Last year, the segment posted sales of $17.5 billion and reached an annualized run rate of $20 billion. That was up from $12.2 billion in sales in 2016.

Even though the cloud-computing effort still represents a small portion of Amazon's overall revenue, it already provides the lion's share of its profits. Last year, AWS brought in $4.3 billion in operating income, which more than made up for the $225 million operating loss posted by Amazon's combined North American and international retail operations.

Analysts are betting that AWS will continue to post such strong results.

But for any company trading at such a steep premium, falling even a little shy of analyst and investor expectations could be painful. And there are at least some reasons to be concerned about Amazon.

But Trump and debt may weigh on the company

Of late, the company and founder Jeff Bezos have found themselves in the sights of President Donald Trump, who has complained that Amazon unfairly competes with local retailers and pays less than it should to the US Postal Service for delivery costs. Those complaints could eventually weigh on Amazon's revenue and profits, particularly if they result in more uniform collection of online sales taxes — which could hit the company's third-party sellers — and higher postage rates.

Trump But there are other concerns beyond those coming from Trump. As the company has built out its fulfilment network and added new titles to its library of streaming videos available to its Prime members, its debt has started to swell and long-term obligations have started to swell. Last year, its long-term debt more than tripled to $24.7 billion, while its long-term obligations — which are largely comprised of lease agreements — jumped to $21 billion from $12.6 billion.

More broadly, Amazon has some $40 billion in bills coming due between now and the end of 2020 just from debt, leases, video content production agreements, and similar long-term commitments.

Much of the bull case around the company has been built around not its reported profits, which are traditional fairly modest, but around its ability to produce free cash flow, which is the difference between the money generated from its operations and its investments in property and equipment and other capital expenditures.

Last year, Amazon posted free cash flow of $8.4 billion. That was more than double its reported profit of $3 billion, but off from the $10.5 billion it posted the year before.

Free cash flow is supposed to be a way of getting at how much cash a company is really generating on an ongoing basis. But in Amazon's case, that may not be the case. If you start taking into account the money it's spending repaying its leasing costs, the company's cash flow starts to look a lot worse. By at least some measures, if you include such costs, Amazon actually saw a net outflow of cash last year, to the tune of $1.5 billion.

For now, though, Amazon's optimists are winning the day. As long as the company continue to post impressive growth, that likely won't change.

Join the conversation about this story »

NOW WATCH: These 3D printed homes can be constructed for $4,000 — and they might change the approach to underdeveloped housing