In light of the fierce debate over Amazon.com's (AMZN) valuation following its release of Q3 2013 earnings last Thursday, I decided to look into a fact often cited as a positive for the company: Amazon's ability to generate positive operating cash flows, and free cash flows, despite consistently negative GAAP income. My findings are not shocking nor will they resolve any debates about the stock price. But I found Amazon's ability to finance its meteoric expansion over the past decade with meager earnings and little external financing to be quite incredible. Further, understanding the financing sources behind Amazon's growth is vital to identifying potential sources of risk.
Amazon's Definition of Free Cash Flow
As a non-GAAP measure, there is not a single, definitive definition of free cash flow. Conceptually, FCF is the cash generated from business operations after accounting for investments necessary to maintain and/or grow the business (Capex) - the amount of cash which the company could afford to pay out to holders of capital. Most commonly, we look at unlevered free cash flow - cash flow which could be paid out to all holders of capital (debt, equity, preferred, etc), and hence meaning cash flow taking out after-tax interest payments.
Amazon calculates "Free Cash Flow" in its financial statements as Cash From Operations less Capital Expenditures, and hence is a bit different than the above definition [as it incorporates payments to debt holders]. But since Amazon has always held very minimal amounts of debt, I use Amazon's definition of FCF for consistency and do not make an adjustment for interest payments.
Amazon has had positive FCF in every year since 2002 and FCF peaked at $2.92 billion in 2009 - since then, FCF has steadily decreased to $395M in 2012 and $387M over the past twelve months:
Of course as you would expect, Amazon's ability to generate free cash flow has declined over the past few years as its profitability has declined. A dramatic expansion in revenues from $24.5 billion in 2009 to $70.1 billion over the past twelve months has required a large expansion in Capex and has not generated an increase in earnings (and hence operating cash flows) in the same proportion.
Where does Amazon's FCF Come From?
Over 2001-2012, Amazon has generated $12.3 billion of free cash flow [$20.4 billion in CFO less $8.1 billion in Capex]; over the same period, cumulative net income has been $4.2 billion. The fact that Amazon has sustained such a large discrepancy between cash flows and accrual-based earnings is remarkable. Where has this discrepancy been coming from?
The first factor is stock-based compensation. While Amazon's stock price suffered a significant decline in the early period of my analysis [Amazon reached a low around $6 per share in mid-2001] it has swiftly risen ever since [ignoring the 2008 financial crisis] and the rise since 2009 has been meteoric. Amazon's strong stock performance has increasingly allowed the company to pay its employees in non-cash stock compensation: stock based compensation has increased from $87M in 2005 to $341M in 2009 to $833M in 2012 and $1.044 billion over the past twelve months. As this compensation is non-cash, it is added back in calculating CFO - in total, SBC has contributed $3.02 billion to Amazon's CFO over 2001-2012.
Of course, while SBC is a non-cash expenditure, in the long run there is still a direct cost to shareholders in the form of dilution. Further, if Amazon's stock performance declines, employees may demand a greater share of compensation in cash.
The second, and arguably more interesting factor, is working liabilities - as Amazon's revenues have increased dramatically, so has the company's A/P account, which over the past four years has averaged 22.9% of revenues. As A/R has averaged only 4.9% over the past four years, the dramatic expansion in revenues has fueled a substantial increase in funding from working capital:
With A/P less A/R averaging 18% of revenues over the past four years, essentially a $10B increase in revenues has translated to a $1.8B increasing in net operating liabilities. Revenue growth in and of itself has thus been a source of internal financing for Amazon, providing cash the company can use to fund growth. Amazon has long sustained A/P well in excess of A/R, and over the 2001-2012 period, total increases in A/P less increases in A/R have been $10.2 billion.
In some sense, Amazon almost looks like an insurance business - the company's increase in operating liabilities have provided a source of financing for growth/investment similar to the float of an insurance operation. Of course, there is an issue with this analogy, that being that Amazon can only use operating liabilities as a funding source so long as revenues continue to increase at a large rate.
The increase in A/P of $10.2 billion over the past decade answers the question of how Amazon has financed growth internally. Amazon has found no need to tap the equity or debt markets over the past decade, aside from a roughly $3B debt issuance a year ago. Amazon also issued stock over the 2001-2006 period, but solely through the exercise of employee options. A substantial amount of stock was issued in 2009, but this did not affect cash as this stock was used to purchase Zappos.com. In summary, over the 2001-2012 period, the company has net share repurchases of $1.28B and net debt issuance of $623M, for net external financing of negative $658M:
Calculating Amazon's "Sustainable" Free Cash Flow
After considering the two most significant sources of Amazon's strong CFO over the past decade, I decided to look at what Amazon's free cash flow would look like without these factors. That is, assuming Amazon paid its employees entirely in cash and the A/P and A/R accounts stayed constant [a reasonable assumption when Amazon reaches a steady-state and revenues increase only slowly], what would its FCF be? I will call this Amazon's "sustainable" free cash flow.
We see that Amazon's free cash flow after removing these two effects has been trending downward since 2009 and has been negative from 2011-present. "Sustainable" FCF was negative $1.64 billion in 2012 and negative $1.71 billion in 2013.
What do these numbers show us? Quite simply, that removing the two factors discussed, both of which are not free/sustainable in the long run, Amazon would currently be in trouble and be forced to 1) seek external financing, or 2) focus on profitability and/or decrease investments.
In other words, in the long run there is no "free lunch": a normal business can't have negative earnings and positive free cash flows forever. Amazon has benefited from certain factors, largely the expansion of working capital and stock-based compensation, which have acted as sources of internal financing. But revenue growth will eventually slow, the business will mature, and these tailwinds will no longer be driving cash from operations.
The Takeaway for Amazon's Valuation
The two big takeaways in my opinion are 1) Amazon is currently at an inflection point, and 2) Amazon's internal financing is strongly tied to revenue growth and stock performance, which could expose the business to a high level of risk if economic conditions, growth, or investor sentiment deteriorate.
First, looking at free cash flow [simply as Amazon defines it, CFO - Capex], it has declined from $2.92B four years ago to just $387 million over the last twelve months. Cash and investments are currently only $7.7 billion, or 11% of LTM revenues, the lowest amount of cash & investments Amazon has had in relation to revenues over the 2001-2012 period [Cash & ST investments were 26% of revenues in 2009]. What this says is, as I mentioned above, Amazon has to either achieve profitability again, decrease investments tied to future growth, or raise funds by issuing debt or equity.
The second point is, there is a strong reflexive component in Amazon's success. First, with revenues: the consistent increases in revenues has led to increase in operating liabilities, which have been the primary funding source of investments, which have in turn led to future increases in revenue, and so on. There is nothing innately wrong with this - in fact, it's quite amazing how much Amazon has been able to invest without, on a net basis, raising a dime of additional capital and with minimal profitability. But a virtuous cycle such as this can easily reverse; if Amazon somehow failed to increase revenues next year [perhaps due to a need to focus on profitability, or an economic downturn, etc], it would have ~$1-2B less to invest in future growth.
Similarly with its stock price - Amazon is now effectively raising about $1B of cash per year through stock-based compensation. As long as the stock continues to increase in price, nobody will complain; but given an economic downturn or a large decline in investor sentiment, employees will likely demand more in cash compensation.
The result is that the "reflexivity" embedded in Amazon right now is great when stock prices are soaring and revenues are increasing by 20% per year, but these same forces could reverse if times get tough, leaving Amazon with the choice to either curtail its investment plans or issue debt or equity at precisely the wrong time.
I hold no stake in Amazon, and I would recommend the same position for all but the most risk-loving of investors. Amazon's long-run potential continues to be enormous, and I will not bet against a company with an expanding moat in a fast-growing business. But the potential for significant returns is still 5-10 years down the road at the earliest, and adjusting for time and risk, there just isn't a compelling argument to invest at the current price. Amazon's EV is currently $162 billion; as a simple exercise, given a 10% discount rate, Amazon will have to be worth $420B in ten years to justify the current valuation assuming the company does not pay dividends or repurchase shares in the meantime. If we're optimistic and assume a 4% FCF/EV yield (roughly Walmart's (WMT) currently FCF yield) then Amazon will have to generate $16.4B in free cash flow per year in a decade. As we noted earlier, Amazon's cumulative FCF from 2001-2012 was $12.2B, even with the two major tailwinds discussed in this article.