Rule Breaker - Companies
Notes on Amazon's Quarter

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By TMFTardior
May 4, 2001

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Hey Lydia (and Howie, this may help you too),

Sorry it took so long to get back to you. Went to Omaha for the pilgrimage this weekend, and I'm just catching up now.

Jeff said: (BTW, if you don't understand working capital issues and negative cash conversion cycles, and you want to own Amazon or do, you should read up on the topics.)

Working capital is the money that a company is using now on short-term things, like credit receipts and inventory on the current assets side, payrolls and payments to suppliers on the current liabilities side. As the Foolish Flow Ratio implies, current assets are a drag, because they represent money owed to the company but not yet collected, and current liabilities are good, since they represent money the company owes but has not yet paid out. That's counter-intuitive, but it's better for cash flow to have current liabilities rather than assets (except cash, of course).

The cash conversion cycle is a marvelous tool that puts numbers on the accounts receivable and inventory (on the asset side) and accounts payable (on the liabilities side). Phil Weiss wrote a great article explaining it.

A negative cash conversion cycle is when payables -- the good ones -- exceed receivables and inventory. This is the state that Amazon is normally in. It collects money from its customers very quickly, but pays it out to its suppliers much later. It also keeps less inventory than most companies, so it doesn't have too much tied up there.

Example: I run a lemonade stand. (I know, it's trite, but bear with me.) I buy lemonade from a guy who lets me pay at the end of the month. You buy my lemonade and I get the money now, but I don't have to pay dude for a few weeks. In the meantime, I'll make more money with which to pay him, so I can spend the money you gave me now. My cash flow is great, since I get money long before I have to pay it out.

If that didn't help, former Fool Randy Befumo wrote a great article about Amazon's cash conversion cycle for

Jeff also said: Amazon is an attempt to build a great volume business with relatively low invested capital. If you don't understand this concept, and own or want to own Amazon, you should learn about it. Then you'll probably learn not to be so concerned with Amazon's eventual low net profit margin (although surely analysts will harp on it all the time).

This is a similar concept. If you allow that Amazon has negative cash conversion cycle, then it doesn't need money to supply its store or to pay employees. Once I have my first lemonade, I never have to pay for it again, since I always get paid well in advance of having to pay my suppliers and workers. Essentially, my suppliers are funding my operation.

So what other investments in the business do I have to make? Just buy the store and rent the property. Amazon has a great advantage here, too, since it can have a high-volume business without paying for more and more stores. Contrast Starbucks, for whom 5/7ths of its 35% growth comes from expansion, for which it has to pay capital expenditures.

Amazon can grow essentially without capital expenditures. It can build nothing this year, yet grow 20-30%. That's a heck of a thing. It means that its return on the capital that it has invested in the site and warehouses can produce a high return, so long as it actually does grow.

For that reason, since it takes little by way of invested capital to run Amazon, the money it makes is worth more than if I'd spent a lot to earn the same return. If you spend $10 on your lemonade stand and earn $100 profit, you've done much better than I, who spent $70 to earn $100. Your return on invested capital is better. It doesn't much matter if your margins are lower than mine, you still are more profitable. That's why ROIC is much more important than margins alone.

For more on this, you can try Dale Wettlaufer's Return on Invested Capital, but I'll warn you that it takes a few reads over a period of a few years to understand it. :) Better to read Andrew Chan's first.

There's lots of stuff to learn about here, but it's all pretty essential stuff. I think it's worth the time.

Hope this helps. Fool on!