Amazon.com is one of the most peculiar publicly traded companies in America. Despite the fact that it's more than two decades old, is the second largest retailer in the world's largest economy, and is the 25th largest company on the S&P 500 by market capitalization, it still doesn't earn a meaningful profit.
In its latest quarter, covering the three months ended Sept. 30, Amazon reported a net loss of $437 million. Meanwhile, its top-line revenue grew by an impressive 20%, to $20.58 billion, during the same period last year in which net sales were $17.09 billion.
But far from serving as evidence of Amazon's lack of profitability, these numbers reveal an important lesson about using the income statement to analyze a growing company that's focused on maximizing long-term shareholder value. Indeed, a peek at Amazon's statement of cash flows reveals that it's not only generating billions of dollars in excess funds from its operations, but that it's using that cash to expand on a number of important fronts.
The income statement's infirmities
While the income statement is probably the most commonly cited financial report -- in part because the price-to-earnings ratio is the best-known valuation metric for common stocks -- it's actually the one that tells us the least about a company's underlying operations. It purports to communicate how much a business earned during a given stretch of time; however, its true purpose is to reconcile the change in a company's balance sheet between two accounting periods.
This creates problems when it comes to assessing a company's ability to generate economic earnings. Among other things, it mandates that a company record non-cash charges for things like depreciation and stock-based employee compensation, even though neither of these are expenses in the traditional sense of the term. It also allows a company to record things as revenue and expenses in certain periods, even if they didn't actually receive or distribute any funds in those periods -- thus, the accounts payable and accounts receivable line items on the balance sheet.
It's for reasons like these that sophisticated investors prefer, instead, to use the statement of cash flows to measure a company's performance. As its title suggests, this report tracks the actual inflows and outflows of cash, and is thus less susceptible to manipulation and more indicative of a company's fiscal health. Additionally, by categorizing flows into three different activities -- operations, investing (including capital expenditures), and financing -- one can get a much better handle on expenditures that are associated with operating a business as opposed to growing one.
With this in mind, it's no coincidence that Amazon uses cash flow and not earnings to measure its own success. If you've ever read one of its quarterly earnings reports, then you know what I mean. Most companies start an earnings release by reporting revenue, net income, and earnings per share; here's the first substantive paragraph from Amazon's latest quarterly press release:
Operating cash flow increased 15% to $5.71 billion for the trailing twelve months, compared with $4.98 billion for the trailing twelve months ended September 30, 2013. Free cash flow increased to $1.08 billion for the trailing twelve months, compared with $388 million for the trailing twelve months ended September 30, 2013. Free cash flow for the trailing twelve months ended September 30, 2013 includes cash outflows for purchases of corporate office space and property in Seattle, Washington, of $1.4 billion.
This casts a different light on Amazon's performance during the three months ended Sept. 30 -- or, for that matter, during its entire existence as a publicly traded company. And it also helps explain why the market continues to have so much confidence in Amazon despite its anemic bottom line.
A deeper look at Amazon's cash flows
Digging a bit deeper, Amazon's statement of cash flows reveals that it generated $1.77 billion in cash flow from operations for the quarter. This is calculated by taking the e-commerce giant's $437 million accounting loss, and then backing out all of the non-cash debits and credits on its income statement. Not to belabor the point, but it's worth pausing here to appreciate just how large of a swing this is, as well as what this gap implies about the prudence of relying exclusively on the income statement to gauge value.
To get an even better feel for how different these two perspectives are, take a look at the chart below, which contrasts Amazon's cash flow from operations against its net income since 1997. While its earnings have essentially gone nowhere, the cash that it generates from operations has soared from $700,000 to more than $5.7 billion on a trailing 12-month basis -- and, mind you, this is despite the fact that Amazon continues to keep its prices, and thus margins, as low as possible.
Getting back to its most recent statement of cash flows, as we move down the report, we can see how Amazon spent the $1.77 billion in cash that its operations generated last quarter -- it's important to note here that it actually had $3.1 billion in positive cash flow when you factor in the $1.29 billion that it generated from the net sale of marketable securities. Of this total, it spent $1.4 billion on capital expenditures, $860 million on acquisitions, and a net $432 million on paying back long-term debt. Altogether, this yielded a $201 million increase in Amazon's end-of-period cash and cash equivalents.
What this confirms is that Amazon continues to recycle all of its cash back into growth. Its biggest investments lately are a bevy of new fulfillment centers and further expansion of its Amazon Web Services platform, which is largely responsible for the proliferation of desktop and mobile applications. Thus, to close the loop by cycling back to Amazon's income statement, it's these investments that are fueling the double-digit expansion of the company's top line.
The lesson for investors here is that the income statement can often paint a deceivingly inaccurate picture of a company's fundamental performance. After Amazon released its third-quarter earnings, for instance, it was widely assumed that its loss led to a steep drop in its stock price. If so, one would be excused for concluding that investors had their eyes on the wrong prize.
