Several external and internal forces have impacted Amazon’s (NASDAQ:AMZN) faith in recent years, sending shares on a seemingly never-ending roller coaster. As far as I can tell, analysts agree that margins will increase in the future quarters/years, which should help the share price rebound. I’ve done my fair share of research on this subject, and I agree with this premise. Large investing firms such as Goldman Sachs and Morgan Stanley all have Amazon stock on their Top Picks list.
Following bullish analyst comments, some purchasing power appeared to emerge this year in the $80-100 trading zone, which could be a strong sign of a probable recovery. However, I feel that Amazon became a show-me story following a string of uneven quarterly reports. Investors no longer accept promises; the corporation must deliver on multiple fronts.
First and foremost, the much-touted reversal in margins should be evident in Q1 profits. This, I feel, should be the primary catalyst. Based on my previous research on the company, I believe there is a good likelihood of this happening.
Second, management should affirm that the AWS growth deceleration is nearing its end after hitting mid-teens YoY growth in January. Based on encouraging management comments from SaaS businesses I used to cover on SA, I feel this is also a feasible possibility.
Other key drivers are the continuation of robust growth in advertising sales and how the general macroeconomic slowdown would affect the retail industry. All of these questions will be answered on the day of the highly anticipated earnings release, April 27th.
Personally, I believe that it is better from a risk/reward standpoint to buy the rumors, because, in the event of a probable “inflection” in earnings/margins, the value might quickly reset to a higher extent. Furthermore, I believe the downside risk at present valuation levels is relatively limited, and earnings estimates for Q1 are not that high.
I brought a unique issue to Readers till we are biting our nails waiting for Q1 earnings, which is stock-based compensation (SBC) within the company and how Amazon manages the consequent shareholder dilution. Recent rumors that the firm intends to expand cash perks at the expense of stock awards have rekindled interest in the subject, leaving key concerns unanswered. Following is a summary of how Amazon uses SBC as a compensation tool and how this affects investors and company fundamentals at the end.
My goal is to demonstrate that SBC is not used to such an extent at Amazon that it should discourage investors from purchasing the shares of an otherwise transformational firm trading at a reasonable valuation.
Amazon SBC in General
Amazon uses SBC by granting restricted stock units (RSUs) to its employees. One RSU typically symbolizes one share of the company, which will be “unlocked” by the recipient after working for the company for a predetermined period of time beginning on the award date. This is the so-called vesting term, which typically lasts four years (as in the case of Amazon) and is divided into smaller time spans.
RSUs provide a more consistent revenue stream than stock options because the employee receives the company’s shares regardless of the actual share price. Furthermore, RSUs do not require any cash investment. RSUs are more predictable not only for employees and the corporation but also for analysts. These were among the factors that made RSUs more popular among tech businesses in recent years, particularly after the Covid-induced stock market crisis, which terrified stock option holders to a large extent.
Amazon includes SBC expenses in its usual operating expenses. Although many technology businesses give non-GAAP earnings statistics that exclude SBC expenses, Amazon does not. As a result, when investors look at operating margins in earnings releases, they will see the impact of SBC expenses as well. The majority of SBC is tied to the AWS unit, as seen in the following breakdown:
Technology and content account for more than half of total SBC expenses, with AWS dominating the category.
Because SBC is not a cash item, its impact is reduced in the cash flow calculation, just as depreciation and amortization. As a result, the company’s cash flow margins do not include the effect of SBC. I feel that looking at FCF on a per-share basis is the greatest method to consider both a company’s cash generation potential and the dilution caused by SBC into a valuation framework.
Collecting all of the data linked to SBC is a difficult procedure for most smaller tech companies, but it is a much easier one for Amazon. The company publishes thorough data about SBC in its earnings release and earnings presentation, indicating that they are paying attention to this area.
Before getting into the specifics, I’d want to point out that Amazon’s financial records have been updated in retrospect to reflect the 20:1 stock split in March 2022. This allows pre- and post-stock split data to be compared.
SBC Will Rise Significantly in 2022
When it comes to quantifying SBC, there are a few points of reference that may be used. One common method employed by businesses is to calculate SBC expenses as a proportion of revenues. The fair value of an RSU-based stock award, like that of Amazon, is calculated by the number of shares issued and the company’s stock price on the day of the grant. SBC expense for the measurement period is calculated by multiplying these two for each stock award granted and totaling them. Employees who leave the company during this time have their RSUs forfeited, and the effect must be modified proportionately. Looking at Amazon SBC expenses as a percentage of revenues over the last five years, we see the following:
First, as a side note, it’s interesting looking at SBC expenses for complete fiscal years because they often reflect seasonality within the year. Amazon SBC expenses totaled 2.3-2.7% of total revenues from 2018 to 2021 but increased to 3.8% in 2022. The reasons for this increase are threefold, as seen in the chart below:
On the one hand, total revenues only increased by 9% year on year in 2022 (due to a global macroeconomic slowdown affecting retail and AWS operations), but SBC expenses increased by 54%, the greatest year-on-year increase in recent years. The latter could be due to continued recruiting and wage increases in the AWS sector, where SBC is more prevalent than in other sections of the business.
The net result has been a considerable increase in SBC expense as a percentage of revenues to 3.8% in 2022, up from 2.7% in 2021. Given that the operating margin in 2022 was 2.4%, this 3.8% is impressive.
However, what ultimately matters is the subsequent dilution of shareholders as a result of these stock awards, as this is the true price investors must pay. The 54% year-on-year increase in SBC expense, combined with a substantially lower average share price in 2022 compared to 2021, means that Amazon should have issued far more stock awards in 2022 than in 2021, resulting in increased future dilution for shareholders. We can see confirmation of this in the company’s most recent 10-K filing:
Amazon used stock awards as a method of employee remuneration for a significantly greater amount in 2022. In 2022, the corporation granted about 263 million RSUs to its employees, more than doubling the grants in 2021. Accounting for forfeitures and comparing this to the company’s average share count resulted in a 2.1% shareholder dilution. I believe that a 2% dilution in a year is not inconsequential, especially in the current climate where the company’s top-line growth has slowed significantly.
However, there is one thing a firm can do to offset the effect of SBC shareholder dilution: purchase back its own shares. Previously, Amazon avoided this action; nevertheless, in 2022, management decided to buy back 46.2 million shares worth $6 billion. This affects the 2022 dilution in the following ways:
Although 1.7% is still not insignificant, it is a positive sign, in my opinion, that management is concerned about dilution and is attempting to control it effectively. At the same time, it’s worth noting that Amazon only repurchased shares in the first and second quarters of 2022, while it didn’t repurchase any stock in the fourth quarter when shares were substantially lower. Other cash flow issues, I suppose, could have influenced this decision. It will be fascinating to see whether management decides to buy back shares again at $100 levels in the upcoming 10-Q filing.
Another metric for determining how efficiently a corporation manages shareholder dilution is the number of outstanding common shares and stock-based awards, which represents the company’s theoretical share count if every stock grant had been executed. Amazon periodically updates investors on this topic in their investor presentations.
Total diluted shares outstanding increased from 10.45 billion in Q4 2021 to 10.63 billion in Q4 2022, according to this chart. This equates to a 1.6% increase year on year, which is close to the 1.7% real dilution indicated above. These two do not have to go hand in hand in the short run because employee turnover or various vesting timelines can have a greater effect on diluted shares outstanding, but there should be a significant correlation in the long run.
Both data points suggest that shareholder dilution at Amazon was roughly 1.6-1.7% in 2022, a significant rise over previous years. At this point, the issue arises: Should investors be concerned?
At Current Levels, the Impact of Dilution Is Manageable
At first glance, the combination of declining fundamentals (9% yoy sales growth rate in 2022 and 1.8% operating margin in Q4 2022, both of which are many years’ lows) and considerably increasing shareholder dilution does not appear to be encouraging.
To demonstrate how 1.6-1.7% annual dilution could affect share valuation in the coming years, consider the following scenario: Assume Amazon achieves an operating margin of 10% in 2027, which, when combined with analysts’ current average revenue estimates, results in an operating income of $87.2 billion for that year. With a present enterprise value of $1.1 trillion, this translates to an EV/EBIT ratio of 12.6 and operating income in 2027. If we assume that dilution remains constant at 1.6-1.7% until 2027, we will have a cumulative dilution of 6.8% at the start of 2027. When this effect is factored into share valuation, the forward EV/EBIT ratio rises from 12.6 to 13.5. Although this rise is not insignificant, I feel it has little impact on whether an investor decides to acquire the shares or not. Based on this scenario, 1.6-1.7% annual dilution in the following years would not be disastrous.
The reason I did not anticipate further growth in dilution from present levels is that Amazon’s workforce expansion appeared to have slowed in 2022.
Based on previously announced layoffs, which also affect AWS employees, this trend is expected to continue beyond 2023. Because fewer employees mean fewer stock awards, there should be a natural deterrent to increased dilution.
Another intriguing part of the 2023 shareholder dilution will be whether Amazon tries to offset the effect by purchasing back shares as they did in H1 2022. This, I believe, will not occur until the corporation is able to rebuild its FCF-generating ability, which continued to weaken in 2022 following a bad 2021.
Even if Amazon has $54 billion in cash and cash equivalents on its balance sheet, spending billions on buybacks while burning cash would be unsustainable. To completely reduce the effect of possible shareholder dilution in 2023 (assuming 1.65% dilution), Amazon would have to buy back 169 million shares, which would cost $16.9 billion at a $100 share price. This demonstrates that Amazon currently has enough capital to offset shareholder dilution for three years, which is not much. This reinforces to me that unless the company’s cash-producing capability is restored, investors should not expect large buybacks. Based on my past research on the company, I believe there will be a significant change in this, maybe as early as 2023. If the company starts generating positive FCF again, I expect it will continue share buybacks to reduce dilution from present levels.
In addition, to share repurchases, it may be possible to reduce shareholder dilution by simply introducing a pay mix change for employees by decreasing stock awards and increasing cash compensation. Recent rumors indicate that Amazon is seriously considering this option, as the corporation acknowledged plans to reduce RSU grants slightly in 2025. Although this is only a minor initial step, if Amazon continues along this path, it might have a significant impact on the company’s fundamentals.
Because cash is the least risky sort of compensation, Amazon must provide less cash in total than the fair value of RSUs previously offered to compensate employees for reducing stock awards. I believe a 2:1 ratio is not far from reality, which means that for every $2 in RSUs lost, employees may receive $1 in cash. If Amazon decides to change its pay mix more dramatically, its total compensation expense will fall, boosting operating income and margins. FCF, on the other hand, would fall when the corporation transitioned from a non-cash compensation expense to a cash compensation expense. However, if this reduces the demand for stock buybacks, the effect may be minimized.
To summarize, there are some effective approaches to managing shareholder dilution, and Amazon is keeping a close watch on the subject based on recent experience. This, in and of itself, should be good news for investors, in my opinion.
During 2022, Amazon SBC expense growth and shareholder dilution increased considerably. However, I believe that the current level of yearly shareholder dilution of 1.6-1.7% is still appropriate. Slowing/reversing personnel growth, as well as a seemingly deliberate management approach to control dilution, lead me to believe that investors need not be concerned. I believe we are nearing the end of the dilution cycle, which should reverse as the company’s bottom line improves during the year.
At current levels, I believe Amazon stock offers an excellent long-term investment opportunity, and increased SBC expenditure and shareholder dilution in 2022 should not deter investors from investing in the company’s shares.
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