Is Amazon's Free Cash Flow Overstated? 20 comments
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Questions:
- Do analysts understand the definition and meaning of free cash flow [FCF]?
- Do they understand the quality of Amazon’s (AMZN) FCF?
- What is the most meaningful method to compute it?
- Should an increase in Current Liabilities be included in FCF, as is being done by most analysts?
Companies, analysts and investors understand the importance of FCF, but there is no real consensus on the definition FCF and of how to compute it. This allows for different results in the determination of FCF, as it varies depending on the definition used, and these variations will give different conclusions as to the performance of the company. In certain cases, adjustments should be made to the FCF figures so that a quality determination can be made .
Amazon is a company with substantial growth in sales, cash flow and liabilities. The following cash flow and free cash flow figures were published by Money Central on January 30, 2008 and are similar to the determination made by various analysts.
...Operating cash flow was $1.41 billion in 2007, compared with $0.70 billion in 2006. Free cash flow increased 143% to $1.18 billion in 2007, compared with $0.49 billion in 2006...
The FCF number of $1.18bn. is a great number, but does it accurately reflect the true picture of Amazon’s FCF? Does it consider the quality of what they are calling FCF and how much of the increase of what they are calling “FCF” is due to the increase in Current Liabilities? To answer these questions, you must understand what FCF is.
Definitions of Free Cash Flow
- "FCF is what a company has left over at the end of the year - or quarter - after paying for all the salaries, bills, interest on debt, and taxes and after making capital expenditures to expand the business.”
- “Free Cash Flow, strictly speaking, is the amount of money left over from the operations of a company that is available for distribution to owners (stockholders) of the capital employed in the company.” For a fundamental investor, this is a very important number because, if you owned this company outright, FCF is the money that you would get to withdraw for yourself.
- "IT IS DEFINED AS CASH WITHOUT ANY RESTRICTIONS ON IT USE. It is available for any purpose at any time."
Free cash flow in one year or period is almost meaningless without examining the QUALITY of the cash flow.
The quality of what many are adding to FCF should be questioned, as they are using funds left over from operations on a short term basis, BUT NOT AVAILABLE FOR DISTRIBUTIONS TO THE OWNERS in their computations of FCF. This cash is not FCF as it will be used to pay liabilities due shortly after December 31. This can be shown by reviewing Amazon’s Statement of Cash Flow for the March 31, 2008 quarter; it shows Cash From Operating Activities as a negative $645 million: this is because the December 31 liabilities were paid in that quarter.
It is true that Amazon had a substantial increase in Cash From Operations [CFO] for the December quarter; a portion of that is due to them getting paid for products by customers before they have to pay suppliers for the goods sold. This $100s of millions of cash is temporarily held and invested, and gives Amazon a substantial amount of investment income, but this cash should not be considered FCF.
In comparing Amazon’s December 2006 and 2007 balance sheets, total Current Liabilities increased from $2.5 billion in 2006, to $3.7 billion in 2007 an increase of $1.2 bn. or 46.7% which is much greater than the Sales increase of 38.5% for the year. In regards to the Statement of Cash Flow, as accounts payables and Current Liabilities increase, Cash Flow from Operations [CFO] increases. If a company can stretch out the time it takes to pay its bills at year end, this will increase the Cash From Operations figure and depending on the formula used to compute FCF, that figure also. This short-term "increase" in cash is simply a result of not paying out the cash that is owed by the company. In other words, the effect is temporary and can overstate the cash that the company appeared to receive from operations during the year. In the long run, the changes will vanish (as can be seen in the March 31, 2008 CF Statement). That is why adjustments should be made to both the CF and the FCF figures.
The following is a partial list of the definitions of FCF currently in use, as listed in an article in the NY CPA Journal; similar definitions can be found on Investopedia and Wikipedia.
- Cash provided by operations less capital expenditures
- Cash provided by operations less capital expenditures and dividends paid
- Net income plus depreciation less capital expenditures
- EBITDA less capital expenditures
The following, from above, are two examples of basic formulas, to compute FCF for the 12 months ended 12/31/07:
(This is a formula commonly used by many analysts and the method Money Central published that I listed above. This method ignores the quality of the FCF and includes the increase of liabilities in the FCF total. The Statements of Cash Flow can be found on Yahoo Finance.)
Cash Flow From Operations.......$1.405 bn.
- Less Capital Expenditure............224
- Free Cash Flow................................$1.181bn
Net Income.....................................$476ml
- Plus Depreciation.........................246
- Less Capital Expenditures..........-224
- Free Cash Flow.................................$496 ml
As can be seen from the above two computation, there is a substantial difference in determining FCF. Since there is no real consensus on the definition FCF or CF adjustments are usually made to the figures depending on what the purpose of the analysis is and the formula used. If you were buying a business, you would want to know what the FCF is to aid in determining a purchase price.
Free Cash Flow, strictly speaking, is the amount of money left over from the operations of a company that is available for distribution to owners (stockholders) of the capital employed in the company.
A buyer of a business would not consider a temporary increase of cash held to pay Current Liabilities FCF. It is a source of investment income, but it is not available for distribution to the owners and is not FCF.
Disclosure: Author has a short position in AMZN
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This article has 20 comments:
GOLDMAN SACHS, October 9, 2001 -
Recommended List Large-Cap Growth
Price:US$33.45 Target price: US$48 S&P 500: 1051
United States Enron Corp. (ENE)
Gas & Power Convergence
Still the best of the best. With perceptions far below reality, we see major catalysts in third-quarter results and increased
disclosure in coming months. We strongly reiterate our Recommended List rating and our conviction in high and sustained growth prospects, even though we have cut 2002 EPS to $2.15 and our price target to $48. We expect Enron shares to recover dramatically in the coming months. We view the current period as an extremely rare opportunity to purchase the shares of a company that remains extremely well positioned to grow at a substantial rate and earn strong returns in the still-very-young and evolving energy convergence space.
We strongly reiterate our Recommended List rating on Enron stock. We spoke recently with top management including the CEO, CFO, chief accounting officer, and the head of wholesale services.
We challenged top management on the wide range of investor concerns that have weighed heavily on the shares and believe that the majority of market speculation is groundless, and that which has some truth to it, to be exaggerated.
Misconceptions abound and perceptions are far below reality, in our view We believe that investors have virtually given up on Enron (down 60% year to date) and its prospects based on the long list of extremely negative stories about the company and its financial condition.
The company's limited transparency on its sources of earnings, its cash flow, and financials in general has hurt investor perceptions as management has declined to be more specific in refuting outrageous claims that have assumed a life of their own.
We believe Enron's fundamentals are still strong despite the weak economy. We view Enron as one of the best companies in the economy, let alone among the companies in our energy convergence space. We are confident in the company's ability to grow earnings more than 20% annually for the next five years, despite its already large base.
www.actwin.com/kalostr...
however, i doubt that staunch amzn-stock-lovers will really pay attention. for me, it is an important fresh input that fits very well into a picture that shows amzn being excessively overvalued
blogs.moneycentral.msn...
Trying to argue that "Net income plus depreciation less capital expenditures" is a better or even useful definition of free cash flow is downright stupid.
Using that definition, increasing amounts of cash tied up in inventory would be counted as free cash flow.
It would also count increases in account receivables where the companies hasn't yet received payments for the revenue and income it has reported as free cash flow.
In other words, using the definition championed by the author, free cash flow would not track cash at all.
Think about this, for Amazon’s December Quarter- if AMZN received longer payment term on say $300ml of Accounts Payables, of which they paid in December and instead paid this $300ml in January 2008, this would have increased cash at Dec 31, 2007 by $300ml, and also Total Cash Flow From Operating Activities. Using your definition, FCF would have also increase by $300ml- (Net Income would remain the same).
It is correct that CFFOA would be increased by $300ml, but $300ml should not be considered as a part of FCF, it will be used to pay bills so how can it be considered FCF? Including this $300ml in FCF is wrong, it is not FCF. It is true that Amazon earns interest income from the float, but this $300ml is not FCF.
finance.yahoo.com/q/cf...
To consider FCF in valuing a business, you should use the FCF definition that Warren Buffett uses, he would laugh at the one the company and many analysts use.
“Structural free cash flow [SFCF] -- what Warren Buffett calls "owner's earnings" -- is net income from operations plus depreciation and amortization minus capital expenditures.”
You are confusing Cash Flow with Free Cash Flow
You can argue whether earnings is a better measure than free cash flow, but you can't define free cash flow to be earnings.
Free cash flow has to be a measure of cash. If you change it to measure earnings, then it would serve no purpose.
Arguing that free cash flow could be manipulated by pushing out payable is no different than arguing that earnings could be manipulated by making accounting entry adjustments.
But free cash flow is far more difficult to manipulate since it tracks real cash. You could delay paying your mortgage for a few days to push it into the next month, but then you'd have 2 payments to make in the following month. The "extra" FCF would quickly be reversed by negative FCF in the following month.
The correct definition of free cash flow is operating cash flow minus capital expenditures because it measures the amount of real cash that became available and also when the cash became available.
It then allows valuing a company based on discount cash flow which takes the amount of free cash flow a company generates and discounts them based on when the cash became available.
The reason earnings can't be used in place of free cash flow is because earnings makes no distinction as to when the cash from the earnings is received or becomes available. You can report earnings today and not have any cash associated with the earnings for 10 years or 20 years or forever in some cases.
Defining free cash flow as earnings is nothing short of idiotic and would make discount cash flow calculation impossible.
Point is- if you were evaluating a business to buy, how would you consider the Cash in Bank at Dec 31, that would be paid out during the next quarter? Would you pay multiples for it? Or would you be more interested in Net Income? (Which in Amazon's has very little of.
Is that so difficult to understand? check out the statement of Cash Flow and see how that large cash balance decreased over $1billion.
finance.yahoo.com/q/cf...
THE CPA JOURNAL
The Cash Flow Statement:
Problems with the Current Rules
By Neil S. Weiss and James G.S. Yang
...Concerning the concept of free cash flows, two points should be emphasized: First, increasing reliance is being placed on free cash flow numbers by a variety of users, including investor analysts, credit analysts, and finance and economics theoreticians. Second, as a result of the many users of free cash flow, a variety of definitions have been introduced for the determination of free cash flow....
The weaknesses with the cash flow statement can be divided into five sections:----
1) differences between commercial and industrial companies versus financial institutions; 2) problems with operating activities; 3) problems with investing activities; 4) problems with financing activities; and 5) the role of free cash flow. The authors offer potential solutions to these problems that could improve the cash flow statement.
The Role of Free Cash Flow-
... The concept of free cash flow was born for this reason. IT IS DEFINED AS CASH WITHOUT ANY RESTRICTIONS ON IT USE. It is available for any purpose at any time. It is similar to the concept of unappropriated retained earnings. Free cash flow has become increasingly important in financial statement analysis, yet the accounting profession has ignored it. ONE CURRENT PROBLEM WITH FREE CASH FLOW IS THAT IT HAS A NUMBER OF DEFINITIONS. As a result, different users may be using different definitions and drawing DIFFERENT CONCLUSIONS ABOUT A COMPANY’S PERFORMANCE....
* Cash provided by operations less capital expenditures
* Cash provided by operations less capital expenditures and dividends paid
* Net income plus depreciation less capital expenditures
* EBITDA less captial expenditures
* Earnings before interest and taxes (EBIT) multiplied by 1 minus the tax rate, plus depreciation and amortization less changes in operating working capital and less capital spending.....
The differences in definitions are based on key issues concerning what should be considered in determining free cash flow:------
.....Should it be before or after the adjustments for changes in operating assets and liabilities? Using a free cash flow figure based on funds-flow before adjustments for changes in operating assets and liabilities takes a long-run view. In the long run, the changes will vanish. Furthermore, these funds-flow numbers are not DISPORTED BY COMPANY PRACTICES SUCH AS DELAYING PAYMENT OF TRADE CREDITORS TO INFLATE CASH PROVIDED BY OPERATIONS....
www.nysscpa.org/printv...
Sorry, you can tilt at this windmill all you want. But no one in their right mind would equate earnings with free cash flow - certainly not Warren Buffet no matter how hard you try to attribute that equation of owner's earnings with free cash flow to him.
As for Amazon's build up of accounts payables in Q4 followed by the pay down in Q1, Amazon has always reported free cash flow as a trailing 12-month figure simply because of the seasonal effects on Amazon's free cash flow. By using a trailing 12-month figure, Amazon's free cash flow always includes a large negative FCF in Q1 to go along with a large positive FCF in Q4.
Also, if Amazon simply changed their fiscal year to end on Jan 31 instead of Dec 31, their seasonal fluctuation in quarterly FCF would be eliminated. But their total FCF would still be the same. So there's nothing wrong with the current FCF definition used by Amazon and every other company out there.
Anyway, I think I've explained this pretty clearly. I'll leave it to the readers to decide what they think is right.
Compare 2 businesses that sell the same amount of goods at the same prices and produce the same income. Everything is the same except for the amount of inventory each company needs to operate.
Company A needs 30 days of inventory to operate.
Company B needs 120 days of inventory to operate.
Both companies have the same payment terms with their vendors - 60 days.
Let's say 60 days of AP is equal to $100m.
Company A needs 30 days of inventory, so its inventory is $50m.
Company B needs 120 days of inventory, so its inventory is $200m.
Now both companies double sales and everything else doubles as well.
For both companies, AP increases from $100m to $200m.
Company A inventory increases from $50m to $100m.
Company B inventory increases from $200m to $400m.
For company A, vendors provided an additional $100m of goods, but since its inventory only grew by $50m, the remaining $50m is available as cash.
For company B, vendors also provided an addition $100m of goods, but since it's inventory grew by $200m, it had to use $100m of its own cash to fund the growth of inventory.
This continues as they grow. Company A keeps having more cash available. Company B keeps having to put more cash into inventory.
So even though they sell the same amount of stuff and make the same income, company A has a lot more free cash than company B.
And it's not because company A is not paying it's vendors. Company A has the same AP and paying it's vendors the same as Company B.
The difference is simply that company A converted inventory into cash much faster than company B.
The free cash flow difference came from the difference in inventory.
So even though their earnings are the same, these 2 companies have very different free cash flows and very different valuations.
But the author of the article above wants you to believe that these companies have the same free cash flow and therefore the same value. He's nuts.
1. "FCF is what a company has left over at the end of the year - or quarter - after paying for all the salaries, bills, interest on debt, and taxes and after making capital expenditures to expand the business.”
2. “Free Cash Flow, strictly speaking, is the amount of money left over from the operations of a company that is available for distribution to owners (stockholders) of the capital employed in the company.” For a fundamental investor, this is a very important number because, if you owned this company outright, FCF is the money that you would get to withdraw for yourself.
3. "IT IS DEFINED AS CASH WITHOUT ANY RESTRICTIONS ON IT USE. It is available for any purpose at any time."
This is an example, using Amazon’s, of why you should look at other definition in computing FCF, as it can be manipulated and misinterpreted, 2 scenarios-
(A) Using their reported December 31, 2007 year end figures and
(B) In which they worked out longer credit, delaying payments on $500ml of AP to January 2008. This had no effect on profit only the Cash In Bank and A/P increased by $500ml.
This stretching out of the payment of A/P increased Cash in Bank and by using your definition also increased FCF by $500ml, an amount that would vanish in the next quarter. Again read the actual definition of FCF above.
.........................
Earning..................
Cash in Bk.................3.1 bn..........3.6bn
A/P......................
$ Flow from Oper’n.....1.405bn.......
- Cap Expenditures.......-.2...
“Free Cash Flow”.........$1.18bn....
The $500ml increase is meaningless and not FCF. This is why many people use the definition of FCF that starts with Net Income, including Warren Buffett, when valuing a business, etc.
free cash flow
1. Definition
Operating cash flows (net income plus amortization and depreciation) minus capital expenditures and dividends. Free cash flow is the amount of cash that a company has left over after it has paid all of its expenses, including investments.
www.investorwords.com/...
What is Free Cash Flow?
Free cash flow is simply a measure of the ability of a company to generate internal growth. This is sometimes referred to as organic growth.
How is Free Cash Flow Calculated?
Free cash flow is calculated by adding net income with depreciation and deferred taxes and then subtracting dividends paid and capital expenditures.
Net Income + Depreciation + Deferred Taxes - Dividends Paid- Capital Expenditures = Free Cash Flow
dividendmoney.com/free.../
Free Cash Flow
Similar to earnings, but omitting purely "paper only" expenses, and accounting for capital spending when it actually occurs rather than depreciating it over many years.
The real difference between earnings and free cash flow is that depreciation accounts for sunk costs of the past; free cash flow is meant to capture all real cash outlays of the present.
www.moneychimp.com/glo...
...This is an example, using Amazon’s, of why you should look at other definition in computing FCF. 2 scenarios-
(A) Using their reported December 31, 2007 year end figures and
(B) In which they worked out longer credit, delaying payments on $500ml of AP to January 2008. This had no effect on profit only the Cash In Bank and A/P increased by $500ml.
This stretching out of the payment of A/P increased Cash in Bank and by using your definition also increased FCF by $500ml, an amount that would vanish in the next quarter. Again read the actual definition of FCF above.
.........................
Earnings.................
Cash in Bk.................3.1 bn..........3.6bn
A/P......................
$ Flow from Oper’n.....1.405bn.......
- Cap Expenditures.......-.2...
“Free Cash Flow”.........$1.18bn....
The $500ml increase is meaningless and not FCF. This is why many people use the definition of FCF that starts with Net Income, including Warren Buffett, when valuing a business, etc....
Another thing with respect to AMZN is to watch out for Citi's analyst Mark Mahaney... his research and calls on AMZN are a bit off the wall.