longtermvalue

Yes, Financial Companies Can Be Analyzed

Thanks Charlie - that process laid out there was how I thought it worked. I have stuff at work that I'll look at tomorrow that may be able to shed more light.

Yes, Financial Companies Can Be Analyzed

Charlie - that is what I am getting at. You indicated that "the process is highly subjective with little overall guidelines," which I know to be true for most unregulated companies estimating their general liabilities. Do you KNOW that to be true for banks in estimating their reserves, or is that a best guess kinda thing?

Mr Brown wrote: "I’ll spare you the details of the minutiae of reserve accounting. Suffice it to say, though, that managements have very little discretion... Auditors do not permit (and investors would not want) managements to have broad discretion over the size of reserves."

That makes me think there is an aspect of banking regulations that more or less ties the hands of management teams in establishing reserves. That would be news to me, it would be highly relevant to this debate, and I would like Mr Brown to address this further (if he has made it through the endless comments of drivel).

Yes, Financial Companies Can Be Analyzed

Charlie - I know what reserves are, but my question is what are the guidelines for establishing them? Mr Brown indicated that bank mgmt teams have little lattitude, so I would like to flesh this point out.

Yes, Financial Companies Can Be Analyzed

Because I am a glutton for punishment, I actually am interested in learning more about the minutiae of reserve accounting. Any advice here.

Good column, and there is a good chance you are right - I am still building my circle of competence in this area before I dive in.

Amazon: Is 'Free Cash Flow' More Important Than Net Income?

Good points. The reason I brought this whole thing up was to engage in this type of discussion. While I have never seriously considered AMZN as an investment for several reasons, there are several companies that appear interesting on a FCF basis that have the same negative CCC characteristic - most subscription businesses, for example.

Out of curiousity, I downloaded from bloomberg the cash conversion cycles for all the S&P 500 companies. Of the 500, only 69% had data (not sure why so many were missing, but whatever). Of the companies with data, 13% had negative CCC. While a distinct minority, that's still 1/8 of the investment universe (assuming it's representative) for which, at a minimum, there seems to be a lack of clarity on the best way to treat this wrinkle.

At any rate, good luck with your fund.

Amazon: Is 'Free Cash Flow' More Important Than Net Income?

Thank you for the thoughtful response.

You are correct that I was overly aggressive in writing "Cash is cash is cash" – I was trying to get across that cash flow is a lot closer to economic reality than GAAP, and that one cannot fault cash flow for not being the same as GAAP profits (they are inherently two different things). Cash flow figures can indeed be manipulated, but I still maintain that this is more difficult than manipulating GAAP earnings.

I agree that the benefit of negative CCC will only happen as long as they have revenue growth. But one does not need the negative days to EXPAND in order to generate FCF from WC as long as the business is growing. It appears your argument mirrors Mulford’s (I own a copy of this book) on page 137 regarding HD. Incremental improvements from the current level probably should not be counted on without strong justification. But I would also point you to page 250, where he goes through the different layers of CFFO adjustments for WC. Most of the arguments presented in the original post and responses seemed to designate AMZN’s WC changes as “layer 1,” or CFFO that warrants reversal since it is clearly non-recurring. I tend to think that given AMZN’s long history of negative CCC, it is not clear that such an adjustment is required, and if it is, it may be more appropriately classified as layer 2 or 3, which require greater care and judgment in their application.

I agree that it can be dangerous to extrapolate this out too far, but is that any more true for WC changes than revenue, COGS, or any other financial metric? There seems to be an almost visceral reaction to negative CCC such that people think it is unsustainable, and that the natural state of the world should be for it to be positive. I just don’t think the case for that point of view has been made.

Additionally, if we were to take the alternative route, how would one go about valuing the float as a financial asset?

Amazon: Is 'Free Cash Flow' More Important Than Net Income?

As opposed to simply making assertions, please present an argument as to why FCF from WC is of poor quality, and why it should not be viewed as CFFO.

Amazon: Is 'Free Cash Flow' More Important Than Net Income?

ok - I thought your beef was whether or not it was really cash flow. Because as I think any CPA would know, you can run out of money if you have extended payment terms with customers, let inventory collect dust on shelves and pay your suppliers as fast as possible, even as FCF as you define it would indicate the company is swimming in cash. Why? Because there are sources and uses of cash that don't touch the income statement that we need to take into consideration.

But as I reread this, I think your concern is that while an increase in A/P is in fact cash flow coming in the door, it is not FREE.

I think I see your point better. The intuition for increases in A/R and Inventory as uses of cash make sense (the owner does not have access to that cash because you have to invest in inventory and extend credit), but the intuition might be less clear with increases in A/P as a source of FREE, extractable cash to the owner.

More on that in a second, but first the topic of timing. I don't think you can just isolate on Q1 '08 as a reversal of Q4, because it cherry picks the only quarter that WC results in an outflow of cash. From a valuation perspective, I do think you need to look at it over time (i.e., it will be a big source of cash in Q2, Q3, and Q4 and negative again in Q1 '09, and for the next 4 quarters, still a big source of cash). As long as the firm continues to grow (and consensus seems to be that AMZN has a lot of runway for growth), this reduction in A/P is offset even more by increases in A/P from new business. So the "float" continually grows itself. When does it stop? When AMZN's business stops growing.

Another way to help the intuition on this: it seems like a negative CCC is akin to every day going and taking out a line of credit. But you keep paying it off all the time by taking out ever bigger lines of credit. From time to time, you can't get the bigger line, so you have to dip into your own pocketbook, but the long-run pattern is that you pay off older credit lines with newer, bigger credit lines. So on a NET basis (until growth stops), more money is coming in than going out. The excess is extractable - free, real, greenback, take-your-wife-on-a-se... cash.

I am not going to get into your point by point on how much AMZN is worth, because as I am now saying for the third time, it is just not my cup of tea and you're cherry-picking Q1 data. I'm talking about the process.

Amazon: Is 'Free Cash Flow' More Important Than Net Income?

sorry the table didn't work - let me know if you couldn't track which numbers were which. In each row, the first number is AverageCo, the second is RichCo, and the third is RichCo with the $5mm addback to the change in WC.

Is Amazon's Free Cash Flow Overstated?

I'm with you, netmargin - this topic just popped up again under another AMZN thread by the same author. You are 100% right on the money. Cash is cash is cash.

Amazon: Is 'Free Cash Flow' More Important Than Net Income?

1) “Company makes very little profit, a total of $1.5bn in the past 6 years P/E 67- very high Market Valuation $33bn “
I have already described why I believed GAAP earnings to be relatively unimportant. Besides, I already conceded that it’s a bit pricey for my blood. My point in writing was to delve into this issue of why FCF would not be better than earnings.

2) “Their Total Debt has been increasing every year”
Debt load appears to be very manageable at more than 10X covered.

3) “FCF seems to be a way to pump up or support the stock price”
I think it is much harder to manipulate FCF than it is to manipulate earnings. Furthermore, price manipulations can work in the short-run, but in the long-run, the economics always win. Bezos, as owner ¼ of the equity, would appear to be in it for the long haul.

4) “You said Berkshire recognized the valued that float, he used a more meaningful definition to measure it, as was mentioned in the article.”
I think the definition you offered is sufficient in most circumstances of low/steady growth companies where you don’t have a negative CCC. In those cases, it just doesn’t move the needle much. I don’t know of Buffett offering the precise definition you cite (I don’t doubt it either), but I do know the ironclad one he has discussed is the present value of the cash that the owner can extract over the life of the business. From there, I use my judgment as to what can be extracted. A structural negative CCC represents extractable cash, and I have seen no argument why it isn't.

5) “The way some analysts, Amazon, FCF it can be easily manupulated. For example in the December quarter, if they obtained better terms on $100ml of A/Ps and delayed payment until January their "FCF" (their definition) would have been $100ml higher, $1.281bn rather than $1.181bn. Would that add'l $100ml be meaningful? (except for some investment income)?”
This is why I previously indicated that it must be structural issue and not just shifting between time periods. If it is a one-off thing where they were able to push out payables a bit longer this once and we don’t expect that to happen again, then that $100mm is not meaningful from a valuation standpoint. If, however, the business model is such that they are able to consistently generate cash from working capital, then an appropriate valuation should reflect that. When you talk about manipulation, I would also just say that getting better terms from suppliers seems more like a sound business practice that adds value than manipulation. And contrary to your claim, it is not easily done – by extending terms (i.e., Amazon wants 60 days to pay, rather than 30, or whatever the numbers are), Amazon would be extracting cash from its suppliers, who probably wouldn’t like it and would push back as much as possible.

Consider two fictional companies – AverageCo and RichCo:
AverageCo RichCo RichCo*
NI $100 $100 $100
D&A $40 $40 $40
Change in WC ($20) $20 $15*
CFFO $120 $160 $155
CFFI (incl Capex) ($40) ($40) ($40)
FCF $80 $120 $115
Value of firm at 10X $800 $1,200 $1,150
* Adjusted for $5mm of unsustainably extended terms

NI, D&A, CFFI are identical. The only point of difference is that AverageCo (like most companies) has a positive CCC (and WC is therefore a use of $20mm cash), while RichCo has a negative CCC (and WC is therefore a source of $20mm cash). The situation you present, a presumably unsustainable extension of terms with suppliers, would make RichCo’s change in WC of $20mm unsustainably high. So maybe it’s only a $15mm source of cash – that doesn’t make the $15mm irrelevant. I just slapped a simple multiple on it to make things easy, but if you DCF it, you get to the same place. If you accept the premise that FCF is a superior measure of value than GAAP profits (for reasons I discussed in my previous post), the valuation difference between AverageCo and RichCo is substantial (50% greater). Adjusting for the unsustainably extended terms decreases the valuation from $1,200 to $1,150, but it does not make them $800 (AverageCo's value) or $1,000 (10X the $100 accounting profit).

Amazon: Is 'Free Cash Flow' More Important Than Net Income?

I am neither long nor short AMZN. (too pricey for a boring value guy like me, but too good a company to short, which I don’t do much of anyway.)

As an aside, I would indicate that much of the success of Berkshire was due to the fact that Buffett recognized the value of that float and increased it over time via investing. That is where most of Berkshire’s wealth comes from, but that is Buffett and this is a totally different animal…

Anyway, moving on – It looks like there are two levels of disagreement here. First, should we value based on earnings or on some measure of free cash flow? Second, if it is free cash, how should we define it?

On the first question, I don’t know that there is an objective answer and we could descend into some no-win argument. For whatever it's worth, I tend to think that free cash is the best way to look at it, since earnings are an opinion (determined by industry convention, management estimates or fictions, and FASB), but cash is a fact (or at least much closer to it). You can’t take your earnings and buy a warehouse, expand your factories, pay a dividend or buy back shares. You need cash to do that – and earnings are just a shorthand way of approximating free cash (not the other way around). If you disagree and are set on earnings as the real driver, at this point, we must part ways.

On the second question, it looks like you don’t accept the argument that working capital changes should be accounted for in the definition of free cash flow. Most of the time, companies need to invest in inventories, etc… and only get paid later (they have a positive cash conversion cycle, which results in a negative value as you go down the statement of cash flows (i.e., it is a use of cash). But a negative cash conversion cycle (provided it is structural and not anomalous) is valuable – not kinda, sorta, maybe, but real, cash in the bank valuable. Overall, a negative cash conversion cycle means you get paid before you have to pay everybody else. A private buyer would get his hands on that cash, and relatively active markets for corporate control keep public companies in some reasonable approximation of that private market value.

So, is AMZN’s negative CCC consistent (indicating something structural rather than fleeting)? Every year since 1995, AMZN’s working capital has been a source of cash – less to borrow from the bank or raise in a secondary, more to expand or buy back stock, etc… It is always good to have a negative CCC (not just sometimes) – that is the reason they don’t have a lot of debt and have been able to buy back their stock (not the inverse, as you seem to indicate, that it is not valuable because they have tons of cash).

Another way to look at it – Buffett says (and I agree, just to give it some extra credibility) that the value of a business over time is how much cash you can take out of it. To me, that seems clear as day, it’s just CFFO – CFFI. You can set up a simple DCF and you will see that a swing from a positive CCC to a negative one can have massive implications on the value of the stock. The caveat is that the company has to be growing at some level (at 0% growth, there will be no change in WC balances and no source/use of cash).

Finally, on the quarterly issue, this is due to the nature of their business – in Q4 they sell books and gifts for the holidays (lots of cash in) and in the new year, they pay the publishers. Every Q1, CFFO falls dramatically for that reason. It’s just seasonality – nothing more.