Shares of Amazon.com (NASDAQ:AMZN) soared over 14% last Friday following the release of its first quarter earnings report. While revenue came in slightly ahead of expectations, the primary source of excitement was new information about the growth and profitability of the Amazon Web Services cloud computing business.
Indeed, AWS revenue grew 49% year-over-year to $1.57 billion. This puts it on pace for annual revenue of more than $6 billion.
However, Amazon investors and analysts may be getting a little carried away about the profitability of AWS. Its apparently strong profit margin is being bolstered by a 1990s-era accounting trick that should have been laid to rest long ago.
The stock options expensing controversy
For decades, U.S. tech companies have used stock awards -- primarily in the form of stock options -- as a major part of their employee compensation. And for decades, they fought against including those stock awards as an expense in their official earnings statements.
Silicon Valley companies argued that since stock was not cash, it did not qualify as an expense. Economists almost universally derided this rationalization. Tech companies also claimed that it was difficult to value stock options. Economists retorted that models for valuing options have become quite sophisticated.
In 2004, the Financial Accounting Standards Board -- which sets U.S. accounting and reporting standards -- finally updated its generally accepted accounting principles to require the expensing of stock options. Thus, tech comapnies are now required to report GAAP earnings, including the cost of stock awards. But they have reacted by promoting the use of non-GAAP financial metrics that once again remove the cost of stock-based compensation.
Stock awards at Amazon
Amazon is one such tech company making heavy use of stock-based compensation. For the most part, it rewards employees with restricted share units -- essentially stock with some restrictions on selling -- rather than options. Valuing these RSUs is much more straightforward than valuing employee stock options, removing one major argument against expensing them.
Yet Amazon still puts non-GAAP financial measures -- segment operating income and consolidated segment operating income (or CSOI) -- front and center in its earnings releases. Conveniently, both metrics ignore stock compensation.
This has an enormous impact on reported profitability. In 2014, Amazon CSOI totaled $1.8 billion. But after deducting $1.5 billion in stock that it handed out to employees, as well as some other expenses it excludes from CSOI, the company actually lost money.
How this applies to AWS
Amazon broke out results for its Amazon Web Services segment for the first time in the recent earnings report. Investors were pleased to see that AWS operating income totaled $265 million on revenue of $1.57 billion, for a relatively robust 16.9% segment operating margin.
But segment operating income is not a very good measure of profitability, because this metric excludes stock-based compensation. For the full company, stock-based compensation reached $407 million last quarter. As a result, CSOI of $706 million was nearly three times its GAAP operating income of $255 million.
Since stock-based compensation is most prevalent in the tech industry, and AWS is the high-tech portion of Amazon, it seems reasonable to attribute a significant chunk of stock compensation expense to AWS.
As a rough estimate, suppose Amazon were to allocate its stock compensation expense according to each business segment's proportion of CSOI. AWS segment operating income of $265 million represented 37.5% of first quarter CSOI. Allocating to AWS a proportionate chunk of the $407 million in stock-based compensation would have reduced its segment operating income to just $112 million, for a much more modest 7.2% segment margin.
Stock compensation is a real cost
By excluding stock-based compensation from its segment results, Amazon encourages investors to ignore a significant category of expenses, just as most 1990s-era tech titans did. But while stock-based compensation is a non-cash cost, it leads to shareholder dilution over time.
If Amazon eventually tries to offset that dilution through share buybacks, then it will become a very real cash cost. The number of common shares and underlying shares for stock awards has increased by 36 million in the past six years. At the current stock price, it would need to spend more than $15 billion on share buybacks to offset all of that dilution.
After adding back the cost of stock-based compensation, Amazon looks a whole lot less profitable. There may not be a single "best way" to allocate that cost across the different operating segments. But however it is divided up, profitability at AWS -- and the company as a whole -- looks much less impressive once stock compensation is accounted for.
Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.