What Is Amazon's True Free Cash Flow?

Oct.22.10 | About: Amazon.com, Inc. (AMZN)

Click to enlargeAmazon (NASDAQ:AMZN) spends a lot of money on capital leases for new fulfillment center builds, which under a quirk of GAAP do not show up as capital expenditures in the cash flow statement, but directly add to fixed assets on the balance sheet. Amazon does provide this information under their cash flow statement, but conveniently leaves it out when calculating free cash flow, and every analyst does the same, vastly overstating the company's free cash flow.

For instance, in the twelve months ending Sept 2010, the company calculated its free cash flow as $1,829 million (cash flow from operations of $2,617 million less $788 million for purchase of fixed assets). However, the company also spent $333 million on acquiring fixed assets under capital leases and a further $214 million for what it calls "fixed assets acquired under build-to-suit leases."

Their 10-Q reveals that the latter item is a capital lease for an expansion to their headquarters. Taking into account these two items, free cash flow would be $1,282 million or $2.81 per share compared to their calculated figure of $4.01 per share.

Lastly, the company also has a huge amount of stock compensation which is added back in operating cash flow. This increases the share count, and the company would have to spend this much money buying back shares to maintain a steady share count.

Therefore, one should deduct this from the free cash flow to get an accurate figure that cannot be gamed. (Otherwise, a company can boost free cash flow by switching to paying its employees in stock from cash.) Deducting $404 million of stock compensation gets you to a FCF figure of $878 million or $1.92 per share, less than half of Amazon's calculated number.

Amazon has a great working capital model where the company takes longer to pay its suppliers than the time it takes to sell merchandise. (In the most recent quarter, payables was at 56 days, while inventory was at 30 days.) Thus, working capital is a source of cash and the company likes to tout its superior cash flow in relation to its net income.

It is the only company I've seen that puts its cash flow statement ahead of its income statement in its quarterly earnings release. It also provides a convenient trailing twelve months tally. However, its calculation of free cash flow is erroneous, misleading and disingenuous.

As a check, look at Amazon's balance sheet. Over the last 12 months, fixed assets have gone from $1,086 million to $2,099 million, a 93% increase, far outpacing the recent 45% sales growth. From the cash flow statement, capital expenditure of $788 million exceeded depreciation of $510 million by only $278 million, which is not enough to explain the $1,013 million increase in fixed assets. Add back the $333 million and $214 million in capital leases, and you should get a $825 million increase in fixed assets, which is somewhat less than the actual increase, which was probably got a bit of a boost from acquisitions of other companies like Zappos.

This look at Amazon's free cash flow has wide implications for its valuation. A lot of analysts and investors like to value Amazon on a free cash multiple. However, it turns out that Amazon's actual free cash flow is less than half of its self-calculated figure, and it is trading at 80x trailing FCF, not 40x. Also, many analysts expect that the recent drop in Amazon's operating margin due to higher operating expenses will be temporary.

This analysis shows that as the huge recent capital expenditures enter the income statement as depreciation, the margin is unlikely to recover any time soon. Including capital leases, the company spent $1,335 million on capital expenditures in the last twelve months, compared to $510 million of depreciation. Depreciation is sure to increase rapidly even as by the company's own statements, capital expenditure will remain at this elevated level.

Disclosure: Author short AMZN