Amazon's Life Blood: Trickling Free Cash Flow

It's difficult to determine why Amazon.com (AMZN) is being granted the premium valuation that it has, especially given that operating income and structural free cash flow are down over the last year, and true free cash flow was up a scant 8%. Plus, does the non-growing online retailer with slim margins deserve a big premium compared to the still-growing online auctioneer, eBay (EBAY)? The market has been suggesting it does for nearly a year now, even though eBay has the superior business model and financials.

Investors gain insight and confidence on their investments by applying metrics and analysis that not everyone has ready access to. The investing media may be focused on the often misleading earnings per share and P/E ratio, but free cash flow is the lifeblood of any company, and is the only true way to measure a firm's cash-generating health. At Complete Growth Investor, we calculate various measures of free cash flow on all of our stocks, from true free cash flow [TFCF], to structural free cash flow [SFCF] to -- where appropriate -- maintenance structural free cash flow [MSFCF].

Today, we take a closer look at some numbers under the surface at Amazon.

[True free cash flow is cash from operations minus capital expenditures minus tax benefits from stock options. Structural free cash flow (what Warren Buffett calls "owner's earnings") is net income from operations plus depreciation and amortization minus capital expenditures. These are two key ways to measure the health and growth -- or lack of it -- at a business. Both can show realities that mere earnings per share often miss.]

For the full twelve months of 2006, Amazon's true free cash flow grew 8% year-over-year, but this was due mainly to lesser tax benefits from stock options that we deduct from results. Indeed, operating cash flow was actually down for the year, to $702 million from $733 million, even though sales increased 26% to $10.7 billion. This clearly tells us that Amazon has yet to reach a point of operating leverage: in fact, right now, new sales are coming only with higher costs. This is revealed more clearly when we run structural free cash flow numbers.

The firm's SFCF declined 35% in 2006, to just $179 million. This is because net income for the year took a 47% dive (partly due to tax rates), to $190 million from $359 million. Even adding back in much higher depreciation and amortization charges this year, SFCF declined 35%. Capital expenditures, meanwhile, were flat at $216 million compared to $204 million a year ago. Tax rates aside, SFCF is more indicative of what's going on at Amazon because it relies on net income -- what gets to the bottom line -- while TFCF is looking more at the cash flowing through the business, but not necessarily landing on the income statement.

Everyone knows by now that Amazon has a strong, negative cash conversion cycle, whereby it brings in cash from customers long before it needs to pay it back out, basically providing itself a cash "cushion" on which to survive all but indefinitely. Hey, maybe this is why the firm trades at a very rich 91x SFCF and fairly expensive 34x TFCF, when competitor eBay is only trading at multiples in the 20s to both measures.

But then again, no, that can't be the reason. Because both eBay and Google (GOOG) have cash conversion cycles that are even more attractive than Amazon's: these firms collect cash without even having to deliver a product, just a platform. The bills that eBay and Google pay are largely "voluntary": they're choosing to pay to grow the business, but they're not beholden to paying product suppliers the way that Amazon is. So, although everyone likes to talk about it, arguing that Amazon's negative cash conversion cycle is special and deserves a higher price doesn't ring true in today's world of "virtual" businesses.

Taking a quick look at P/E, why is Amazon trading at a 92 P/E and 45 forward P/E, when eBay has a 42 P/E and forward P/E of just 22, and Google a 47 P/E and 25 forward P/E? Are Amazon's earnings, which are up and down the last few years, worth nearly twice as much to investors as earnings at quickly-growing Google and admirably-growing eBay? Really, there isn't a good explanation.

Especially when you look at Amazon's guidance: the firm expects sales to increase 21% to 28% in 2007, with operating income in a range of down 9% year-over-year, to +30%: a giant range suggesting that management doesn't know which way things may shake out this year: they're waiting for leverage to hit, too, but if it hasn't yet, why would it now? Shipping costs are not going any lower; they in fact have become a more significant cost in relation to sales.

Plus, this wide-ranging guidance, it should be noted, includes an estimated $165 million in stock-based compensation benefits this year: a significant amount when your net income was only $190 million last year. In other words, almost no matter what, even though sales will increase again (naturally), true net income (or TFCF) may not budge much at all, especially when you take out such gains.

So, why the premium price on the shares?

I admire Amazon's shopping experience, and although I don't use the site nearly as much as I have in years past (and even less now that I use Apple's (AAPL) iTunes), I still see the value offered by its clear format and strong customer service. But more than 10 years into this now, I don't agree with the premium price that Wall Street is affording the business. Margins aren't improving, net income isn't growing in any step-ladder approach the way they are at eBay and Google (and nothing like the growth espoused by Hewitt Heiserman at EarningsPower.com), and the competitive landscape is only getting more crowded.

When a company continues to grow sales but doesn't grow FCF and earnings in-kind, you give it time to mature, but for how long do you wait and hope for traction to take hold? Not years and years when you see no sign of expenses slowing with each additional sale.

Amazon may continue to have favorable cash flow dynamics, but at this valuation it's hard to see the long-term reward as being very favorable in relation to the risk.

Disclosure: Author is short AMZN.

Comments

[Linda Nelson:]

You should try Unbox. Lot's more video content than iTunes. Unbox is the beginning of the VOD revolution in the way that people will get their movies. This service is so easy to use. I just plug my ZEN (a wonderful little handheld video device made by Creative) into my PC, click on Unbox icon, pick a movie and with one click and a little time (less than forty minutes for a feature), I have the movie I want to watch. This device acts like a DVR (TiVo is a DVR), but it's tiny enough for me to take with me anywhere. I can watch content on the go and one of the great features is that when I am at home, I can plug it into my TV and watch in DVD quality on the "big screen". I can't be the only person catching on to this. I have a particular interest in being ahead of the curve, because I am a film producer and want to see my independent films find new audiences. This type of delivery system could well replace DVDs, going to the video store (which by the way, only needs to be a few burning kiosks) and rent-by-mail services like Netflix. Unbox, combined with ZEN or any other compatible handheld that works like it, is the first service that truly lets you watch what you want, where you want. I'm really excited about it and I'm sure others will be.

2007 Mar 10 11:13 AM