The common sense regarding Amazon.com (AMZN) is that while it might have a net earnings problem, it's still a free cash flow powerhouse. This common sense, supported by Amazon.com's published accounts, allows analysts to produce price targets justifying the present market price. They're even able do so using established fundamental approaches like DCF (Discounted Cash Flow) analysis, and not crazed-up statistics with eyeballs in them.
What I will show in this article is that Amazon.com presently isn't just challenged in producing net profits. It's also challenged in producing free cash flow. And I am not speaking about the recent drops in that published measure. What I am talking about, is the significant portion of capex that Amazon.com has driven off the balance sheet.
First, we need to understand how free cash flow is usually defined by Amazon.com and used by the analyst community. From Amazon.com's latest 10-Q, we have Amazon.com's definition for free cash flow:
Free cash flow, which we reconcile to "Net cash provided by (used in) operating activities," is cash flow from operations reduced by "Purchases of fixed assets, including internal-use software and website development." We use free cash flow, and ratios based on it, to conduct and evaluate our business because, although it is similar to cash flow from operations, we believe it typically will present a more conservative measure of cash flows since purchases of fixed assets are a necessary component of ongoing operations.
Thus in simpler terms, free cash flow is operating cash flow minus capex.
Now, we also have to introduce another concept. Operating leases, and how they are different from capital leases. As per Wikipedia:
An operating lease is a lease whose term is short compared to the useful life of the asset or piece of equipment (an airliner, a ship, etc.) being leased.
These are defined more precisely in FAS 13 (pdf). Basically operating leases are applied to situations where the payments by the lessee don't cover enough of the value of the assets being leased, meaning at some point either there's a lease extension or the lessee has to make further unscheduled payments to gain ownership of the asset. This also means that whatever value in minimum operating lease payments Amazon.com declares in its reports, this value necessarily underestimates the value of the assets being leased.
The major consequence from using operating leases instead of capital leases or outright purchases is that Amazon.com only recognizes the rents from the leases in its P&L, it doesn't recognize the assets and it doesn't recognize the concomitant liabilities. Also importantly, it doesn't recognize the cash outflow needed to buy these assets in the way it would have to, if it were making outright purchases.
So basically, Amazon.com is using external entities to handle a good portion of its capex, so that it doesn't have to recognize the cash outflows associated with that capex. And Amazon.com's capex is quite a good deal larger than the capex recognized on the cash flow statement!
How much larger? That's the next step. Below I provide a table summing up the disclosed operating leases over the last 4 years, plus the last quarter. I also show how much these operating leases increased from period to period. Unfortunately, Amazon.com's disclosures regarding these leases are very thin on the ground, so there's no way to know if the minimum rents disclosed in the 10-Qs and 10-Ks include a capital portion or whether they are interest-only.
This makes a big difference as the underlying hidden debt can be quite different depending on what these payments include. At the very least, the minimum rents would have to be less than 90% of the value of the underlying assets for these to classify as operating leases. But the rents can be a lot less if they are just covering an interest payment. For instance, using 5% as a discount rate on 2013 minimum rents ($476 million) in perpetuity, we would get a value as high as $9.52 billion, which would set a ceiling for our estimates of the underlying hidden debt. As a floor, we can use the total operating lease commitments divided by 0.9, which gives us $4.05 billion. (sources for all figures are AMZN's 10-Qs and 10-Ks for the respective periods)
As we can see from the table above, Amazon.com's real free cash flow, once we account for all the capex taking place off balance sheet, was dropping much faster than Amazon.com recognized during 2011. During 2012, it will certainly go negative. This also shows how DCFs not taking into account the off balance sheet capex are being distorted by Amazon.com's massive increased use of operating leases.
Summary of Impacts
So what are the impacts of this increased usage of operating leases by Amazon.com? There are several:
- On net earnings, the impact is minimal. The rents are more or less compensated by the absence of depreciation and financing costs;
- On operating earnings, the impact is visibly negative. This happens because the entire amount of rent is an operating expense, whereas if Amazon.com had bought the assets outright, only the depreciation cost would be at the operating level, with financing costs appearing below the operating line. This means that part of Amazon.com's operating earnings weakness can be attributed to this option (as much as $200-$300 million per year going forward would be my guess). However, as I said in the previous item, the impact on net earnings is minimal;
- On the balance sheet there is a significant impact. By using operating leases Amazon.com does not recognize the related assets. And it also doesn't recognize the related liabilities - that's why I talk about hidden debt. This is quantified in the previous section;
- Finally, perhaps the largest impact is on free cash flow. Here the impact is huge, as quantified in the previous section. The impact is huge because instead of recognizing the related capex used to buy or build the assets, Amazon.com only recognizes a tiny rent, which is but a fraction of the real cash outflow it would otherwise have to recognize.
Due to Amazon.com's massively increased usage of operating leases, we can safely say that Amazon.com is likely liable for a large off-balance sheet liability - the debt used to buy the assets it's now renting using those operating leases. Obviously to ascertain Amazon.com's liability one would need to look at the precise wording on the leases, but it's not likely that someone would invest large amounts of money in the specialized assets Amazon.com requires and not have a way of having Amazon.com be ultimately liable to pay for them. Even though we lack precise data on the nature of these leases, we can establish that the hidden debt should be within the range of $4.05 billion and $9.52 billion. In either case, it's a highly relevant number.
This also means that the performance of Amazon.com's free cash flow during the last few years has been a lot worse than the numbers put forward by Amazon.com and normally used by most analysts to project Amazon.com's value. This happens because the numbers Amazon.com uses do not take into account the capital expenditures being made to acquire the assets that are then rented by Amazon.com.
This also illustrates that Amazon.com's business has clearly diverged from the asset-light nature that it's generally believed to have. Amazon.com has to invest heavily in physical infrastructure and its business, and in light of that, doesn't throw off the cash that "dematerialized" internet companies can generate.
Disclosure: I am short AMZN.