AMZN is undervalued; strong AWS growth and backlog outweigh short-term negative FCF risks.

Amazon's revenue growth accelerated to 20%, its operating income increased by 43%, and its backlog of AI business is $500 billion .

However, the company is also expected to generate negative free cash flow of $40 billion over the next two years. So, do the advantages outweigh the disadvantages? Is the risk worth the reward?

Does Amazon stock represent an excellent buying opportunity now in October?

The main driver of Amazon's revenue growth acceleration has been the AWS sector, which is great news for investors because this sector is more profitable and viable than the e-commerce sector.

In the last quarter, revenue growth accelerated to 36.7% in this profitable segment, marking five consecutive quarters of accelerated growth and the fastest growth for this segment at Amazon in 18 quarters.

In fact, the backlog of business in this sector has reached $500 billion, specifically $496 billion, with triple-digit year-on-year growth . What you see here in orange is Amazon's total assets, that is, all assets currently recorded in the company's books.

In purple , I have placed the return on invested capital for Amazon. That is, the amount of money that Amazon generates from the capital invested in the company. I think it's interesting to see these two lines together, as I note that Amazon's total assets have increased from about $100 billion in 2017 to more than $1 trillion in the last quarter.

The majority of those assets went to the AWS sector, data centers and their components. This is where the bulk of these new assets were invested.

The return on invested capital actually increases as total assets increase. It is at record levels. Therefore, both total assets and return on invested capital are increasing, both are at record levels and continue to rise. This is impressive to me.

It is difficult to achieve , and even more difficult to achieve when your business scope reaches this level.

This doesn't happen on Amazon. In fact, as their assets increased, they became better at generating returns on those assets. They are becoming smarter in operation...well, I shouldn't say...yes, they are becoming smarter. This...this is a big part of it too.

But, I think the biggest part is that they have found a new category in artificial intelligence, a new opportunity in artificial intelligence that generates a more profitable return.

It's the AWS sector, as we saw in the introduction, and revenue growth in that sector is accelerating.

The operating profit margin in that sector is close to 40%, while operating margins in their e-commerce business are less than 10%.

So, as they build more assets that serve those AI needs for clients like OpenAI and Anthropic, they are achieving better returns on invested capital.

The good news for investors is that Amazon has nearly $500 billion in backorders for these assets. So, they are building these data centers , and they already have customer orders ready.

Once these data centers are operational, the customer purchases that product. It is not a situation that boils down to "Let's build it and hope we find a customer." It is a situation where the customer has already signed the intent to purchase, has already signed the contract , and you just have to build the thing to serve that customer.

You mentioned that Amazon is building these data centers and the components inside them, and that represents the largest part of their investment. Therefore, since this is a significant cost for them, they have also greatly increased investment in their own segments.

They have the Graviton and Trainium chips, the central processing unit (CPU) and the graphics processing unit (GPU), which are already growing significantly.

Annual revenue is $25 billion, representing triple-digit growth compared to the same quarter last year . Their AI revenue has also increased significantly quarter after quarter, and is also above 25 billion and growing at a triple-digit rate year-on-year.

So, this is the category in which Amazon spends a lot of capital, and the biggest risk that Amazon investors notice and point to is that the company will generate negative cash flow this year and possibly even next year.

And I agree with them; they will generate negative cash flow this year and next year. If you look at my assessment of Amazon’s discounted cash flows , I estimate the company will have a negative free cash flow of $34 billion this year.

I estimate that it will generate a negative cash flow of $5.6 billion in the following year.

Therefore, I expect two consecutive years of negative free cash flow for Amazon, and then 2028 will be a relatively slow year in terms of free cash flow at $41 billion for Amazon.

However, starting in 2029, I believe that investments in artificial intelligence and data centers will stabilize or begin to decline. Therefore, I believe 2028 will be the last year for Amazon to increase spending on data centers .

Despite those negative years in Amazon's free cash flow, I estimate that the business will grow significantly in free cash flow from that point onward, and the fair value of the company that I calculated is $296 compared to the current market price of $253.

It appears to be undervalued using my discounted cash flow model. Then , if you look at it based on a forward price-to-earnings ratio of only 24, I think it's also very attractive.

Remember, revenue just increased by 20%, and operating income increased by 43%. They have a backlog of orders worth $500 billion.

Their chip business is growing at triple-digit rates, and we have yet to see Amazon's big language model. They are working on one, according to what I heard management discussing.

Therefore, this could be another catalyst driving growth for Amazon.