Amazon (AMZN -0.36%) has given investors plenty to worry about lately. Its shares have plunged more than 40% year to date. The company's fourth-quarter guidance was much weaker than anticipated. Its e-commerce and cloud hosting customers are tightening their purse strings.
But those aren't really the biggest issues. Here's the single most concerning trend for Amazon.
The most important metric
What's the most important financial metric for a business? Some might say earnings. Others might think it's revenue. I'd argue, though, that the best answer is free cash flow.
A company can be losing money hand over fist even though its revenue is rising. Businesses can get creative with their accounting practices to make earnings look good. But it's harder to manipulate free cash flow, especially over time.
Free cash flow is calculated by subtracting capital expenditures from net cash generated by operating activities. It provides one of the best ways to evaluate a company's financial health.
The concerning news for Amazon is that its free cash flow has fallen dramatically. Even with a relatively small improvement in the third quarter, the company still generated negative free cash flow. The trend certainly doesn't look encouraging.
Amazon's underlying problems
Why is one of the biggest companies in the world experiencing such a sharp decline in free cash flow? There are several reasons.
First, Amazon's earnings have fallen significantly. This is due to the company's operating expenses increasing across the board. In particular, Amazon's cost of sales has risen markedly, in part as a result of investment in its fulfillment network and higher shipping and labor costs.
Second, the company's cash from operating activities has also decreased, primarily due to two factors. Depreciation and amortization expenses have risen. So has stock-based compensation.
Third, Amazon's capital investments have grown in some areas. In the first nine months of this year, the company spent $4.9 billion more on purchases of property and equipment than it did during the same period in 2021.
Turning things around
Now for some good news for Amazon shareholders. The company appears to be poised to turn things around. Investors can realistically expect Amazon's free cash flow to increase going forward.
For one thing, Amazon is committed to reducing its spending. The company announced recently that it's laying off 10,000 employees. This move should reduce costs by at least $1 billion and comes on the heels of a hiring pause in some of Amazon's businesses.
Amazon is also shutting down some units. Amazon Care will cease operations by the end of this year. The company is closing online fabric retailer Fabric.com. It's mothballing the Amazon Explore virtual tour feature.
Overall, capital investments in 2022 are projected to be around the same level as they were in 2021. But Amazon is now focusing more on expanding its Amazon Web Services infrastructure. That makes sense considering that the cloud hosting business is an important growth driver for the company.
There's also a possibility that Amazon could benefit from macroeconomic improvement. A couple of recent indicators hint that inflation could be coming down, albeit modestly. The Federal Reserve's interest rate hikes could lead to further inflation moderation.
Down but not out
Because of its various problems, Amazon stock has plunged below its previous high, the most since the Great Recession. However, the headwinds should only be temporary. The company is also taking the right steps in the meantime. Amazon is down, but it's definitely not out. Investors who buy and hold the stock will almost certainly be glad they did.