[BizHankook] Amazon’s operating profit for the second quarter increased by 43% compared to the previous year. Net income rose by 245% over the same period. This was largely driven by the rising value of Anthropic, an AI company in which Amazon has invested. In other words, profit earned from selling goods and services to customers was bolstered by gains from the appreciation of its equity holdings.
It is worth paying attention to this distinction in the earnings reports for Microsoft and Amazon being released this week. Microsoft will disclose its earnings after the U.S. market closes on the 28th (local time), and Amazon will hold its earnings conference call on the 29th. Beyond whether revenue and net income exceeded expectations, it is crucial to see how much of the money poured into AI is being recouped.
Amazon’s second-quarter net income included $53.4 billion in non-operating pre-tax income, primarily from its investment in Anthropic. While an increase in the value of investment assets is good for shareholders, it does not mean that the company actually received that much cash. If net income shows a significant increase again, one must examine the source of that profit—whether it stems from the rising value of invested companies or from increased profits in the online shopping and cloud businesses.
When a company buys a server, the cash flows out upon payment, but the equipment cost is reflected as an expense over the duration of its usage. For instance, if a 10 billion won piece of equipment is amortized equally over five years, the annual cost is 2 billion won. Since cash is spent upfront while profits are recognized incrementally, the company’s available cash can shrink even as profit rises. To see this, one must check free cash flow. This figure is calculated by taking operating cash flow—the money actually earned and spent during business operations—and subtracting the cash spent on buildings and equipment. It allows one to see if the company is funding its investments internally while expanding its data centers.
Amazon’s operating cash flow for the year ending in late June increased by 33% compared to the previous year. However, its free cash flow, which accounts for capital expenditures, was a deficit of $7.6 billion. The company explained that the increase in facility spending was mainly due to AI investments. While they earned more cash from operations, they poured even more into facilities. While net income jumped due to the rising value of their AI investments, cash continues to be poured into building AI infrastructure.
The situation is similar for Microsoft. Operating cash flow from April to June rose 30% year-on-year. However, after spending $35.8 billion on equipment, its remaining free cash flow fell to $19.6 billion, a decrease of about 23%. Capital expenditures grew faster than incoming cash. Such changes affect how we judge whether a stock is cheap. If net income rises, the price-to-earnings ratio (PER) drops. The stock might look cheap even if the price remains the same. However, if that profit includes significant valuation gains from investment assets that cannot be immediately converted to cash, it is hard to argue that the stock has become cheaper. If growing the business now requires far more equipment than in the past, one must first question whether the same historical PER should be applied.
Of course, a company should not be avoided simply because its investment costs are high. Revenue from Amazon’s cloud business, AWS, grew 37% year-on-year in the second quarter. If the number of customers is increasing and servers are in short supply, investments are necessary to fulfill orders. Even if cash is tight now, if there is a basis to believe that revenue and profit will grow from new facilities, there is a reason to invest. Conversely, if customers do not increase as expected or if significant price discounts are required even after expanding facilities, it will take much longer to recoup the investment costs.
In this round of announcements, one must compare the results against the promises made by the companies previously. Microsoft projected that its Azure revenue for July–September would grow by about 45% year-on-year (excluding currency effects) and that capital expenditures would exceed $50 billion. Growth rates must be compared using the same currency standards. If they are spending more on investments while lowering growth projections, they need to explain when they expect to start making money from the expanded facilities.
One should not be immediately reassured if capital expenditure figures decrease. Due to a change in accounting methods, Microsoft will no longer include some data center lease agreements in its capital expenditure figures. However, the lease payments must still be made. The company’s forecast of over $50 billion already reflects this change. Therefore, a simple comparison with the previous quarter's capital expenditures might lead to a misjudgment of the actual investment burden.
Amazon projected its third-quarter operating profit to be between $22.5 billion and $26.5 billion. It is necessary to see where the actual operating profit lands within this range and whether the free cash flow deficit for the one-year period ending in September has grown larger than $7.6 billion. Even if the deficit has narrowed, one must examine whether it is due to earning more cash from operations or because the timing of equipment payments has shifted.
One cannot expect stock prices to rise just because the company beat expectations; the market may have already anticipated higher results. If revenue guidance is lowered and the investment burden grows, but net income alone surges, the urgency to buy more stock decreases. Examining cloud revenue and capital expenditures alongside net income growth rates will help determine if the company is growing enough to cover its increased investment costs.