Not Even Jeff Bezos Would Buy Amazon's Cash Flow

Look at the chart below and ask yourself if this looks like that of a retailer that's healthy or one on the brink of becoming the next retail disaster?

AMZN Net Income TTM Chart

AMZN Net Income TTM data by YCharts.

To me, this looks like a failure waiting to happen. I understand the great story behind Amazon.com (NASDAQ: AMZN  ) , I'm a Prime user and I get great value from the service. But when you look at Amazon from a purely fundamental level, the company looks like it's in ruins. Net income has vanished, inventory turnover has been declining for a decade, and the CEO now says that he doesn't care about margins.

As a short-seller of Amazon I constantly need to keep an eye on the company to see if my investment thesis is wrong, especially since the stock is going up. But my latest dive into the financials only bolstered my opinion about the stock.

The case of low-quality cash flow
Earlier this week, Jeff Bezos said that cash flow per share was the most important thing for Amazon, not profit margins, and I couldn't disagree at first. As investors, we're looking for cash out of investments, eventually in the form of dividends or share buybacks. Free cash flow is what pays for these two things, so cash is what we should worry about.

But how does a company have shrinking margins and no net income but still generate a ton of cash like Amazon has? The answer struck me like a ton of bricks: You play games with the balance sheet.

Early in my days at 3M, I learned from new CEO James McNerney one of the ways a so-called "great" business manager makes money. You squeeze your suppliers by setting your own terms and extending payment terms as far as you can (at 3M that was 90 days) and you squeeze your customers by demanding shorter payment terms of 30 days or cash at sale. If your former terms were 30 days for both payables and receivables, you get a net 60-day cash flow straight to your bank while barely lifting a finger. If you're growing quickly and turning over inventory quickly, you don't even have to change the terms to get an infusion of cash, just watch it roll in.

So, how did Amazon generate $3.37 billion from operations over the last 12 months and $943 million in the third quarter despite reporting a net loss? The answer is that Amazon has longer payable terms with suppliers than it has with customers, so when it increases sales it actually generates cash even though it may not be making any money on the sale. The other big cash "generator" is depreciation, which is a very real cost because it's money already spent.

AMZN Cash from Operations TTM Chart

AMZN Cash from Operations TTM data by YCharts.

You can see above that operating cash flow is less than the change in payables and the change in depreciation over the past year. Even if we subtract the negative cash flow from the change in receivables, Amazon still isn't making a decent return for investors.

More questions for Amazon
If Bezos wants to be judged by cash flow, then we have to take a very close look at the cash flow statement. Some items on the income statement don't necessarily look negative on a cash flow statement even though they are very real costs. For example, depreciation is a very real cost but it doesn't require cash flow, so it is added back in the operating cash flow section.

A few items caught my eye as questionable sources of cash flow. Over the past year Amazon has made a net $334 million from unearned revenue, $703 million from accrued expenses and "other," and saved a net $565 million in cash from stock-based compensation on the cash flow statement. Compare that to total operating cash flow of $3.37 billion and these low-quality cash flow items take a big chunk out of cash flow, especially when added to the payable/receivable combination I pointed out above.

I could point out all of these things or just point to the decline in generic free cash flow as a red flag for investors. After all, this is what Jeff Bezos wants to be judged by.

AMZN Free Cash Flow TTM Chart

AMZN Free Cash Flow TTM data by YCharts.

Better than the competition?
My biggest problem with investing in Amazon is that it takes a huge leap of faith to assume that cash flow will grow even though profit margins are stuck at zero. All we know is that the company knows how to grow, not that it knows how to make money.

The table below has some fundamental data from Amazon and some of its competitors. Apple (NASDAQ: AAPL  ) and Microsoft (NASDAQ: MSFT  ) are competing in the tablet and cloud spaces and both have better ratios for investors, except for Microsoft's growth. Apple trumps Amazon across the board. Target (NYSE: TGT  ) turns far more revenue into profit, and with a new price-match guarantee, we know the company won't be undersold. eBay (NASDAQ: EBAY  ) is often a forgotten competitor of Amazon, but the company has managed to grow profitably and trades at much more attractive ratios than Amazon.

Company 

Profit Margin

Price/Book

Return on Assets

Q/Q Revenue Growth

P/E Ratio

Amazon

0.07%

15.97

1.58%

26.9%

3,163

Apple

26.67%

4.11

23.61%

27.2%

11.8

Microsoft

21.71%

3.27

14.21%

(7.9%)

14.3

Target

4.2%

2.41

6.69%

3.2%

13.4

eBay

28.52%

3.43

6.05%

14.8%

16.0

Source: Yahoo! Finance.

Amazon can grow; that isn't in question. What I do have questions about is whether Amazon can grow profitably and generate quality long-term free cash flow. I think the four companies above do a better job of that than Amazon, and we don't have to take the same leap of faith that they'll eventually turn a real profit.

Foolish bottom line
I'm going to stay short shares of Amazon because even Jeff Bezos' preferred method of evaluating the company doesn't look good to me. But you should do more digging whether you agree with me or not.

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