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Mark R. Hake, CFA

Amazon Stock Soars as It Returns to Positive Free Cash Flow, But It's Still Cheap

Amazon (AMZN) stock is soaring today up about 11% to $143.16 in mid-day trading on Aug. 4. The company's Q2 results, released after hours on Aug. 3, showed positive free cash flow (i.e., inflows of cash to the company after all cash expenses and payments). 

That means it is no longer burning through its cash balance after capex spending and changes in working capital. This is giving options traders a field day.

Free Cash Flow Drivers

For example, Amazon reported that its free cash flow (FCF) returned to an inflow of $7.9 billion over the last 12 months. This compares to an outflow (i.e., cash-burning) last quarter of $3.3 billion, and a horrific FCF outflow in Q4 of $11.6 billion.

The fundamental reason is that Q2 sales were up 11% year-over-year. This included terrific growth in four major areas: advertising, AWS, prime and third-party selling.

This can be seen on the Supplemental Financial Page of the earnings release at the end.

Amazon Sales Growth Breakdown YoY - Q2 2023

This page shows, for example, that Advertising was up 22% YoY and Prime (subscription services) was up 14%. But the two largest contributors were AWS, up 12%, and 3rd-party services, up 18%.

That augurs well for the company's progress going forward. Granted, the company spent $3.686 billion less in capex during Q2 over the last 12 months compared to Q1. But that still only accounts for one-third of the $11.18 billion swing in FCF between Q1 and Q2. 

For example, adding the Q1 $3.3 billion FCF outflow to the Q2 $7.878 billion FCF inflow equals $11.18 billion. So the $3.686 billion lower capex savings is just one-third of that swing. This promises that if the company's fundamental revenue growth stays strong, its FCF will likely keep soaring.

Moreover, Amazon's FCF margin (i.e., FCF / Revenue) hit 1.46%, and this is likely to rise to 3.0% going forward. $This means that the AMZN stock could be considered cheap. Here's why.

AMZN Stock Still Cheap

Analysts now project that sales next year will top $630 billion, up from $567 billion this year. Moreover, over the next few months, I suspect those projections could rise to $640 billion or so. 

So, if we apply the 3.0% FCF margin that Amazon is likely to achieve over the next 12 months, FCF will hit $19 billion (i.e., 3.0% x $640 billion). This is not unprecedented as Amazon generated a positive FCF of $20.4 billion in Q4 2020. 

In fact, given that it made a 5.26% FCF margin in Q4 2020, I suspect that Amazon could potentially make 5% on $640 billion in sales next year. That puts its FCF at $32 billion.

This is important, since if we use a 2% FCF yield and apply it to $32 billion in FCF forecasts for 2024, that means the market cap could potentially hit $1.6 trillion (i.e., $32b/0.02 = $1,600 billion).

This is 21% over today's market cap of $1.32 trillion. In other words, AMZN stock could rise 21% from today's price of $143.16 to $173.00 per share. 

That means that options players today can have a field day both buying long calls over the near term, as well as selling out-of-the-money (OTM) put options for income.

Using Options to Play AMZN Stock

For example, the $155 strike price calls expiring on Oct. 20 are selling for just $3.78 per call option. That means that AMZN stock would have to rise by about 11% to $158.78 per share from today's price for this trade to go over breakeven.

But given our forecast of a target price of $173 per share, that may be achievable.

Moreover, traders could short near-term OTM puts in order to help pay for this call option purchase. For example, the Sept. 1 expiration put option chain shows that the $137.00 strike price puts trade for $2.07 per put.

AMZN Puts - Expiring Sept. 1 - Barchart - As of Aug. 4, 2023

That would cover much of the cost of the $3.78 long call purchase, although not all of it. Moreover, the $137 strike price is about 4% below today's price with just 28 days until expiration.

That means that the investor could potentially repeat the trade sometime in the next month. This second short sale would likely more than cover the cost of the long-call purchase. So, in this case, traders can more or less fund a free upside call option in AMZN stock with relatively little risk.

That shows that investors have ways to play this good news from Amazon relating to their free cash flow.

More Stock Market News from Barchart

On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
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