Amazon’s AI Spending is Pressuring Free Cash Flow. Is the Stock Still a Buy?

Amazon (NASDAQ:AMZN), as owner of Amazon Web Services (AWS), has become one of the principal players in the AI story. AWS is the world's No. 1 cloud service provider, offering customers a wide range of AI products and services, from chips to large language models. And the non-AI portfolio is also going strong, meaning both the core and AI businesses are pushing revenue to record levels.

In the third quarter, AWS' annual revenue run rate reached $184 billion. This is as its quarterly revenue soared 39% to $46 billion, for the highest growth in almost five years. Amazon as a whole benefited, with total revenue and operating income climbing.

But one dark cloud is perturbing the blue skies. And that's the idea of spending. In order to address today's demand and prepare for future demand, Amazon must make significant investments. It's been doing this, to the tune of $220 billion in capital spending that's forecast for the full year. This has put pressure on free cash flow, and the tech giant says this headwind will continue until it is able to monetize new data centers.

Considering all of this, is Amazon stock still a buy? Let's find out.

Image source: Getty Images.

Amazon's solid moat

First, let's take a look at Amazon's path so far. E-commerce was the company's first business, and it continues to be the major revenue driver. Amazon has a fantastic moat, or competitive advantage, here, having built out a vast fulfillment network worldwide. And its low prices and Prime subscription service, which offers speedy delivery and other benefits, keep customers loyal. All of this has helped revenue grow over time.

In the early 2000s, Amazon launched AWS, and this business offered the company another significant revenue stream. In fact, in recent years, it's become the company's profit driver. Today it makes up more than 60% of the company's total operating income.

Revenue from AWS' core services has marched higher over time, and over the past couple of years, AI products and services have truly supercharged growth. Customers that already came to AWS for their non-AI needs easily turned to this player for their AI needs as well.

All of this meant that Amazon had to invest in new data centers and equipment, something that it's been doing in recent times. As a result, capex has been climbing. Though the company kept its capex forecast for the year unchanged in the third quarter, it lifted the forecast by $20 billion in the second quarter.

Purchases of property and equipment drove negative free cash flow

This has put pressure on free cash flow, and in the third quarter, the company reported negative free cash flow of more than $42 billion for the trailing 12 months. The purchases of property and equipment drove this outflow. Amazon chief executive officer Andy Jassy said during the second-quarter earnings call that the free cash flow headwinds would continue until Amazon's new data centers were up and running. He also noted that data center spending happens two years before the monetization happens -- but the good news is as soon as servers are plugged in, the monetization immediately starts.

Still, this suggests that Amazon may experience free cash flow pressure for quite some time. With this in mind, is Amazon stock still a buy?

If Amazon aims to continue its leadership in AI, it must participate in this infrastructure build-out. So this moment of spending is necessary. At the same time, Amazon continues to deliver revenue growth from its e-commerce business, and AWS' growth shows us that the investment in AI has been worthwhile. And we're in the early stages of the AI story, suggesting significant growth ahead. Amazon Bedrock, the company's inference service, has become its fastest-growing multi-billion-dollar service.

Meanwhile, Amazon stock trades at 23x forward earnings estimates, which looks dirt cheap considering the tech giant’s solid financial picture, strengths in e-commerce and cloud, and long-term AI prospects. And that makes Amazon a stock to buy and hold for the long haul.

Adria Cimino has positions in Amazon. The Motley Fool has positions in and recommends Amazon. The Motley Fool has a disclosure policy.