Amazon (AMZN 0.54%) is one of the more complicated and hotly debated stocks even among the most seasoned investors. The company has revolutionized the way we shop and built a $134 billion market cap that makes it among the most valuable in the world.
But on the way, Amazon has run a virtually break even business and still reveals very little about how new products and investments like AWS, Kindle, Amazon Prime, and Amazon Fresh are paying off financially.
Image source: Amazon.
Recently, fellow Fools Andrew Tonner and John Maxfield gave the basic facts surrounding the Amazon bull story, which focuses not on mounting GAAP losses but the company's impressive operating cash flow numbers. Operating cash flow has been an incredible $5.7 billion in the last twelve months compared to a $216 million loss on the income statement.
But before you start thinking Amazon is magically swimming in cash while reporting losses, you need to know where this cash flow is coming from and why there's such a discrepancy between net income and cash flow.
The income statement's flaws
One of the flaws in an income statement that is often pointed out by analysts is that "its true purpose is to reconcile the change in a company's balance sheet between two accounting periods." There are lots of non-cash charges, like depreciation, and the income statement does little to show where cash came from or where it is going in any given period.
That's why the statement of cash flows is also reported along with the income statement and balance sheet by companies each quarter. The point of this statement is to show where cash came from and where it was spent in the quarter.
But it's also true that you can't take a statement of cash flows at face value because there are equally misleading components in that financial statement as well. Below I'll cover the three I think investors should keep in mind when looking at Amazon's cash flows.
Creating cash out of thin air
One of the great advantages of Amazon's growth is that it has what's called a negative cash conversion cycle. When you buy something from Amazon you pay for it immediately, but Amazon will pay its suppliers 30, 60, or maybe even 90 days after it sells the item, so as long as Amazon is growing it'll be generating cash from its sales whether it's making money on each sale or not.
On the cash flow statement this can be seen in changes in accounts payable (what it owes suppliers) and accounts receivable (what customers owe Amazon). In the last twelve months, Amazon has generated $1.83 billion in cash by growing accounts payable while spending a net $1.17 billion in cash by growing receivables owed from customers. On a net basis, Amazon generated $661 million in operating cash flow from this negative cash conversion cycle.
Operating a business with a negative cash conversion cycle can make cash flow a desirable reporting metric as opposed to net income, which shows a better value of the profit made from each transaction. In that respect, this component of the cash flow statement can show deceptive value.
Cash today, cost tomorrow
Another big line item that pops out on Amazon's statement of cash flows is "Additions to unearned revenue." These are primarily prepayments for Amazon Prime and its AWS service. For example, when you pay for Prime you pay upfront for the year's services so on the income statement Amazon spreads out the payment (or amortizes it) as revenue it earns over the entire year. A similar dynamic plays out with AWS.
What's key about this line item is that like the negative cash conversion cycle discussed above it can make near term cash flow look stronger than it is. In the last year, Amazon has recorded $3.87 billion in unearned revenue and amortized (or recognized) previously unearned revenue to the tune of $3.18 billion. That means that Amazon recorded a net cash gain of $699 million from services -- or costs -- it hasn't yet performed for customers.
Like the negative cash conversion cycle, the income statement does a better job than the cash flow statement showing services that have been paid for and the costs associated with performing those services. The costs associated with shipping your packages 2-day or buying content for streaming services are written off as they occur and a little slice of revenue is associated with some of those costs. But if you're losing money year after year you're probably not charging customers enough to cover the costs associated with Prime and AWS even if the operating cash flow from both are positive short-term.
Investing in the future ... forever
The biggest argument that Amazon bulls make and the largest items on the cash flow statement are invested capital and depreciation. Depreciation is the way that the income statement accounts for the cost associated with buying a long-term asset that should generate value for many years. A building, for example, is typically depreciated over 30 years because it's expected to add value for at least that long. A server, on the other hand, may be depreciated over 5 or 7 years because its useful life is much shorter.
In Amazon's case, a $300 million fulfillment center will have just $10 million per year associated to cost of goods sold on the income statement for 30 years. On the cash flow statement, this would be shown as a $300 million cash outflow under "Investing Activities" the year the fulfillment center is built and then for 30 years the $10 million in depreciation on the income statement would actually be added back to the operating cash flow figure because it wasn't a cash outlay during the year.
Below I've built a very simple example of what this would look like on financial statements. In this example I say that in Year 0 the only thing the company does is buy a piece of equipment for $100. This piece of equipment has an estimated useful life of 5 years so it'll be depreciated for five years and it generates product that's sold for $20.
To make this example simple I've assumed that the company has no operating, financing, or tax costs and there are no cost of goods from the piece of equipment besides depreciation. Therefore the revenue the company generates is also the same as its cash flow.
|
Revenue |
Net Income |
Cash Flow | |
|---|---|---|---|
|
Year 0 |
$0 |
$0 |
-$100 |
|
Year 1 |
$20 |
$0 |
$20 |
|
Year 2 |
$20 |
$0 |
$20 |
|
Year 3 |
$20 |
$0 |
$20 |
|
Year 4 |
$20 |
$0 |
$20 |
|
Year 5 |
$20 |
$0 |
$20 |
|
Year 6 |
$20 |
$20 |
$20 |
Note: Author's own calculations.
You can see that in Years 1-5 there's positive cash flow but zero net income because of the depreciation of the equipment. But also notice that the total cash flow from Year 0-5 is $0.
You can also see that both net income and cash flow are $20 in Year 6, which is when the equipment is fully depreciated.
Now imagine this investment in equipment happening over and over, year after year, and you get an idea what's on Amazon's income and cash flow statements. The equipment purchased will cause cash outflows in early years as money is spent on equipment and net income will be low despite the fact that operating cash flow may rise.
But notice that there's only a positive return on investments in capital investment if the equipment, software, or building outperforms its estimated useful life or if it generates higher returns than its depreciation cost. That's when net income is produced.
We can look at the $181 million in net losses Amazon has had since the start of 2013 as evidence that there's not a positive return on the investment made over a decade or more.
Another way to measure this is by looking at retained earnings, which is the sum of all profits the company has had in its history minus dividends paid ($0 in Amazon's case), compared to the capital that's been invested. By this measure, Amazon has invested $19.9 billion since 1999 on long-term investments and acquisitions and has retained earnings of just $1.74 billion in its entire history.
We would also expect that as growth of the business slows the cash spent on capital expenditures will come closer to depreciation recognized each year, at which point net income should begin showing the returns on that long-term investment. In Amazon's case, spending is slowing but we have yet to see the uptick in net income.
Amazon's slowing investment in growth
What most people say about Amazon is that it's investing money in fulfillment centers and equipment that will drive future growth and profits. But the truth is that today it's barely investing enough to replace old equipment and has yet to record the net income we should now be seeing from more than a decade of heavy investment.
In the past twelve months, Amazon has invested $4.63 billion in property, equipment, and software while recognizing $4.33 billion in depreciation on investments in those items in previous years. Depreciated equipment gets old and needs to be replaced so, it's really just investing to maintain its business, not grow it.
Once a business reaches the point where it's depreciating as much in assets as it's investing in new assets it's hard to argue that the cash flow statement shows value better than the income statement.
Net income vs. cash flow long-term
Over a long enough period of time, net income and cash flow from operations and investing should be fairly similar. In many ways, I think the income statement actually shows the value Amazon is generating better than the cash flow statement, especially now that depreciation and investment in capital equipment is nearly equal.
But at the very least investors need to understand what's included in Amazon's $5.7 billion operating cash flow figure when someone starts throwing that figure around. It includes $661 million in cash from a negative cash conversion cycle, $699 million in prepaid revenue for things like Amazon Prime, and $4.33 billion in depreciation that's been added back from the income statement.
Those three items alone eat up nearly all of the operating cash Amazon generated in the past 12 months. That's important context to understand when looking at Amazon, whether you're a bull or a bear on the stock long-term.
