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Amazon.com: Free Cash Flow Is Not What The Bulls Purport It To Be.

|Includes: Amazon.com, Inc. (AMZN)

Amazon.com

Free Cash Flow Not What Company nor Consensus Analysis Purports

Significant Implications for Discounted Cash Flow Based Valuations

Introduction:

We have long taken issue with consensus analysis of Amazon.com's (NASDAQ:AMZN) financial statements and consequent discounted cash flow (NYSE:DCF) based valuations. Largely due to management's ability to successfully skew the discussion of free cash flow (NYSE:FCF) toward its preferred presentation, the street's DCF models have ignored material economic costs from the company's stock-based compensation (SBC) program and/or overstated the economic benefit accruing to AMZN's shareholders from the company's negative working capital cycle. So while we have long been both satisfied customers and believers in AMZN's ability to gain long-term market share, except for rare occasions, we have concluded that market levels for the shares over-valued the company's future earnings and FCF directly accruing to the benefit of its shareholders.

During the past seven quarters, an additional factor has quickly emerged that further questions consensus equity valuation: Capital intensity has risen materially into increasingly short-lived assets as the company pursues its various growth initiatives. Critically, management has chosen to finance much of this equipment through capitalized lease commitments. Therefore, although combined purchased and leased capital equipment totaled $9.7 billion during the most recent LTM period, less than half this amount was reflected in the DCF models that we have reviewed.

As long as AMZN's operating performance remained in line with consensus expectations, our insights into the company's valuation presented no actionable trading ideas. However, given the company's disappointing third quarter earnings report we have been surprised that our concerns have not found a wider voice. Rather, after the company's third quarter report, two prominent analysts quickly published aggressive purchase recommendations, with target prices forty percent above the late October market price. With the shares now trading above their pre-earnings price, we believe our analysis presents a timely, alternative perspective.

We have had an opportunity to review the published reports from the two analysts referenced above. In each case, their target prices require what appear to us to be heroic assumptions on long-term revenue growth and margin expansion, while simultaneously misrepresenting the company's existing cash flow production and capital spending levels.

As a rejoinder to these reports, we here bye embark on two exercises. First, is to reset the bar, as it were, by properly reflecting the company's existing cash flow dynamics and economic costs. Subsequently, we plan to weigh the rapidly evolving competitive set in both its core retail franchise and emerging Amazon Web Services (AWS) business against the company's recent operating performance and the lofty projections underlying these two DCF based valuation models.

The remainder of this report will address with the first of these exercises through an analysis of three factors; (1) The actual economic cost of the company's SBC plan, (2) a reasoned rejection of the proposition that negative working capital cycles generate a permanent source of cash available to shareholders and, lastly, (3) correcting the exclusion of capitalized lease costs from the company's capital expenditures.

Amazon's Stock Based Compensation Plan Has A Material, Demonstrated Cost

We appreciate that this is an old debate. But, particularly in positive stock price scenarios, SBC has a real cost to shareholders. Amazon, like most technology companies is typically evaluated on its Non-GAAP earnings, excluding SBC expense and non-cash acquisition related charges. For AMZN, however, there is an important twist compared to most of its technology peers: AMZN's SBC is entirely composed of restricted stock awards, so that unlike option-based plans, AMZN's stock need not appreciated post grant date for the grantee to realize value. More simply, absent forfeiture or bankruptcy, restricted stock grants dilute existing holders. Table one, shown below, demonstrates the historical cost of the company's SBC plans. Since year-end 2007, cumulative SBC expenses are $4.7 billion and outstanding shares have increased by 47 million. Adjusted for the tax benefits the company has received periodically and the cash expended to repurchase shares, the current market value of the additional shares is $15.9 billion; The economic cost to shareholders has been 3.4 times greater than the recognized GAAP expense. We acknowledge that the higher cost reflects the increase in the AMZN's share price during this period. However, the point is that DCF models that exclude any attempt to quantify this cost are simply failing to account for what is, in effect, deferred compensation that merely creates temporary cash inflows to the firm but, also, imparts real costs to shareholders. For analysts to consider measures of cash flow prior to SBC expenses, while simultaneously failing to gross up outstanding share counts to reflect restricted stock grants effectively creates an economic scenario where SBC has zero cost to existing shareholders. This is a patently false premise.

             

Nine Months

 

Year Ended

Ended

TABLE ONE

2008

2009

2010

2011

2012

2013

Sep-14

Stock Based Compensation Expense ($MM)

$275

$341

$424

$557

$833

$1,134

$1,089

Cumulative Stock Based Compensation

           

4,653

Basic Shares Outstanding (NYSE:MM)

428

444

451

455

454

459

463

Change in Basic Shares 1

12

16

7

4

-1

5

4

Cumulative Change in Basic Shares

           

47

MV of Incremental Shares ($MM)

           

$15,792

Excess Tax Benefits

(159)

(105)

(259)

(62)

(429)

(78)

(121)

Repurchases of Common Stock

100

   

277

960

   

Cumulative Share Repurchases and Tax Benefits

         

124

Total Cost of Incremental Shares ($MM)

           

$15,916

1) Year end 2007 Share Count of 416mm

             

Negative Working Capital Cycles Create Temporary Cash To The Firm, Not FCF to Its Shareholders

AMZN's management repetitively states that its financial focus is on long-term, sustainable growth in FCF. We're good with that. Yet, for such a sophisticated management group, its preferred presentation of FCF is calculated in a simplistic manner with significant, self-admitted, limitations.[1] With respect to its working capital accounts, basic financial accounting identifies changes in working capital as timing differences between receipt of revenue and payment to vendors. Admittedly, all things equal, business models with negative working capital cycles are preferable to those that require sizable investments in inventory. But, their relative value, particularly in the low interest rate environment extant, is minimal. Rather than being directly accretive to FCF, their value to shareholders is reflected in interest income earned on the created float. To consider net growth in these accounts FCF confuses cash inflows to the firm that should be discounted from FCF accruing to shareholders that can be capitalized. In AMZN's case, given the rapid growth in its core retail business, (CFFO) has been disproportionately affected by its negative working cycle.

Table Two below illustrates that, on average, from 2008-2012 these timing differences represented 42% of AMZN's CFFO. More recently, as the company's retail revenue growth has slowed toward 20%, growth in its negative working capital balances has also slowed to year-over-year growth rates of 14%. We conclude this section with the following thoughts. Historically, AMZN's working capital cycle has represented an outsized proportion of management's chosen calculation of FCF. More importantly, the sell-side DCF models that we have reviewed, by accepting management's definition and capitalizing this temporary source of cash in their models have significantly overvalued AMZN's equity.

             

LTM

 

Year Ended

Ended

TABLE TWO ($MM)

2008

2009

2010

2011

2012

2013

Sep-14

Change in Working Capital Accounts ($MM)

$714

$1,612

$1,581

$1,464

$1,523

$767

$824

Cash From Operations

1,697

3,293

3,495

3,903

4,180

5,475

5,705

Change in WC/Cash from Operations

42.1%

49.0%

45.2%

37.5%

36.4%

14.0%

14.4%

The Combined Influence of SBC and Negative Working Capital Has Been Staggering!

Table Three summarizes the combined impact of SBC and the company's working capital cycle on its CFFO. We do not contest that these two factors positively impact short-term cash flows into the firm. What we have attempted to highlight is that they are disproportionately large in AMZN's case and, more importantly, that capitalizing them distorts the financial analysis of AMZN's equity value.

             

LTM

             
 

Year Ended

Ended

             

TABLE THREE ($MM)

2008

2009

2010

2011

2012

2013

Sep-14

             

Change in WC plus SBC/Cash from Operations

58.3%

59.3%

57.4%

51.8%

56.4%

34.7%

33.5%

             

Leased Based Capital Spending Is Not Accounted For Under Management's FCF Definition

Table four presents AMZN's capital spending history, with 2012's total adjusted down to reflect its $1.4 billion real-estate purchase in downtown Seattle. During the past seven quarters, acquisitions of capital assets have tripled, rising from $3.2 billion to $9.7 billion. As a percentage of LTM sales, this represents an increase from 5.3% to 11.3%. Coincident with this aggressive increase in investment, AMZN's management has chosen to rely increasingly on leasing transactions, with the ratio of leased-to-purchased capital assets rising from 35% during 2012 to 109% during the most recent LTM period.

             

LTM

 

Year Ended

Ended

TABLE FOUR ($MM)

2008

2009

2010

2011

2012

2013

Sep-14

Purchased Capital Expenditures

$333

$373

$979

$1,811

$2,385

$3,444

$4,627

Capitalized Lease Commitments

148

147

405

753

802

1,867

3,901

Financing Lease Commitments

72

188

172

259

29

877

1,134

Total Cash and Leased Capital Expenditures

$553

$708

$1,556

$2,823

$3,216

$6,188

$9,662

Yr/Yr Change in Total

76.7%

28.0%

119.8%

81.4%

13.9%

92.4%

42.3%

Leased/Purchased Capital Spending

66.1%

89.8%

58.9%

55.9%

34.8%

79.7%

108.8%

Apart from the increased risk that flows from higher investment spending, why does this matter? To answer this question, we need to return to the company's preferred presentation of FCF and examine basic accounting for capitalized leases. To restate, AMZN's management defines FCF as CFFO less capital spending. However, under GAAP the investment section of the company's cash flow statement, rightly, does not reflect any cash outflow upon the acquisition of leased assets. So where do the costs of these leases appear? Amazingly, in both the company's preferred presentation and the two sell-side DCF models that we have reviewed, absent the implied interest component, they don't. That's right, $5 billion of acquired assets during the most recent LTM period that apparently impose no cost to AMZN!

To clarify this fallacy, lets review the GAAP treatment of capitalized leases. Upon the original commitment, no cash exchange occurs between AMZN and its respective vendors, so the company's cash flow statement does not reflect the value of the acquired assets as capital spending. On the balance sheet, the property, plant and equipment (PPE) account is debited for the value of the leased assets and long-term liabilities are credited for a like amount. During subsequent periods as scheduled lease payments are made, the income statement reflects a non-cash expense allocated to depreciation and cash interest expense. Importantly, as it relates to AMZN, the cash portion of the lease payment allocated to depreciation on the income statement flows through the financing section of the cash flow statement. The interplay between GAAP treatment and AMZN's preferred presentation of FCF essentially creates a free lunch for the company and its street advocates: AMZN's purported cash generation reflects fully the economic benefit of these assets, yet their cash costs are essentially ignored by both management's and the street's respective presentations

Table Five presents future payment obligations from existing leases. These amounts are sourced from disclosure contained in the company's recent 10-Q. During the next 27 months, $4 billion of contractual cash outflows exist based on the lease agreements in place.

 

Quarter

           
 

Ending

Year Ending

   

Table SIX ($MM)

14-Dec

2015

2016

2017

2018

Beyond

Total

Capital Leases, Including Interest

$820

$2,006

$958

$327

$135

$141

$4,387

Financing Leases, Including Interest

27

95

96

98

99

943

1,358

Total Lease Commitments

$847

$2,101

$1,054

$425

$234

$1,084

$5,745

We have now called to question both the company and street's simplified presentations of AMZN's FCF. Table Five presents two separate analyses. The first adjusts management's calculation of FCF by assuming that leased assets were, instead, purchased. This simple adjustment reveals that in stark contrast to its direct technology and retail competitors that AMZN has become a significant consumer of capital. This comparison deteriorates further, as additional adjustments are made to CFFO to reflect SBC and working capital accounts. As shown at the bottom of Table Five, what adjusted FCF accruing to AMZN's equity holders has been negative since 2011. The company's business opportunity may warrant this level of spending, but as analysts and investors our first responsibility is to accurately assess the current financial position before we attempt to model the future, and our analysis reaches starkly different starting point than consensus.

So, while we acknowledge that this analysis makes no attempt to discern maintenance from growth capital, nor have we yet attempted to model potential returns on growth capital, our goal to this point is simply to highlight shortcomings in the company's preferred presentation of its FCF and to caution potential investors to take a critical look at the line-item components of the street's DCF models. For, from our analysis, AMZN has become a massive consumer of capital as it pursues its growth initiatives. Consequently, its risk profile is much higher than assumed by its sell-side advocates.

             

LTM

 

Year Ended

Ended

Table FIVE ($MM)

2008

2009

2010

2011

2012

2013

Sep-14

Cash from Operations

$1,697

$3,293

$3,495

$3,903

$4,180

$5,475

$5,705

Less Capital Spending

333

373

979

1,811

2,385

3,444

4,627

FCF as per Company Presentation

$1,364

$2,920

$2,516

$2,092

$1,795

$2,031

$1,078

Assume Leased Assets were Purchased

220

335

577

1,012

831

2,744

5,035

Adjusted FCF as per Company Definition

$1,144

$2,585

$1,939

$1,080

$964

$(713)

$(3,957)

FCF adjusted for SBC, Working Capital and Capitalized Leases

         

Cash from Operations

$1,697

$3,293

$3,495

$3,903

$4,180

$5,475

$5,705

Less Net SBC Impacts

116

236

165

495

404

1,056

968

Less Changes in Working Capital

714

1,612

1,581

1,464

1,523

767

824

Adjusted Cash from Operations

$867

$1,445

$1,749

$1,944

$2,253

$3,652

$3,913

Less Capital Spending

333

373

979

1,811

2,385

3,444

4,627

Less Leased Capital Assets

220

335

577

1,012

831

2,744

5,035

Adjusted FCF Accruing to Equity

$314

$737

$193

$(879)

$(963)

$(2,536)

$(5,749)

Summary

In this report, we have recast AMZN's historical financial results in a manner that provides improved insight into the FCF accruing to its equity holders, as well as management's expanding risk appetite. To provide context for these adjustments, Table Six includes a representative excerpt from a recently published sell-side FCF model. Earlier we referenced the heroic assumptions embedded in consensus thought. As an example, this model projects adjusted EBITDA will more than triple over the next four years. As for the methodology employed to calculate FCF to value the equity, to the author's credit, SBC expenses are deducted. However, our two other concerns, adding the growth in negative working capital balances directly into FCF and ignoring the cost of capital leases both remain, there bye materially overestimating projected FCF used to value the equity.

We have adjusted their calculation to reflect both changes in working capital accounts and capitalized leases. With respect to leases, rather than estimating new lease commitments executed in the forward years, we have chosen only to subtract the future lease payments due on AMZN's existing lease contracts. By doing so, we implicitly accept consensus assumptions that the company's recent increases in capital spending will quickly moderate, despite management's direct caution against doing so.[2].

Lastly, the author presents FCF yields based on AMZN's stock price at the report's print date. Interestingly, for this calculation they chose to add-back SBC to conform specifically to management's prescribe methodology. We have updated their projections for the subsequent increase in the stock's price and present a comparison of these results with our calculations as the last two line items in Table Six. We believe this comparison best supports our submission that management's preferred, simplified description of FCF, coupled with the sell-side's acquiescence to its validity have lead to market prices unsupported by the known facts. The rewards may come, but their potential realization entails accepting significantly higher levels of risk and a longer dated pay-off than currently acknowledged by the stock's proponents.

   

Year Ended

TABLE SIX ($MM)

 

2014

2015

2016

2017

2018

Adjusted EBITDA

 

$6,275

$8,494

$11,681

$15,577

$20,723

Less Cash Taxes

 

(2)

(197)

(611)

(1,422)

(2,522)

Less SBC

 

(1,526)

(2,006)

(2,515)

(3,057)

(3,840)

Less Capital Spending

 

(4,905)

(6,337)

(7,419)

(8,648)

(9,950)

Plus Changes in Working Capital

 

1,533

1,979

1,904

2,377

2,925

FCF Used to Value Equity

 

$1,375

$1,933

$3,040

$4,827

$7,336

Adjusted for

           

Working Capital

 

$(1,533)

$(1,979)

$(1,904)

$(2,377)

$(2,925)

Lease Payments1

 

(1,300)

(2,101)

(1,054)

(425)

(234)

FCF to Value Equity as Herein Defined

 

$(1,458)

$(2,147)

$82

$2,025

$4,177

FCF Yield as per Sell-Side Report

 

1.3%

2.5%

3.6%

5.1%

7.3%

FCF Yield as Herein Defined

 

NM

NM

0.1%

1.3%

2.7%

1 2014 lease payments are an estimated.

           

Tom Doyle

hhkadvisors@gmail.com

201.819.8022


[1] Free cash flow, which we reconcile to "Net cash provided by (used in) operating activities," is cash flow from operations reduced by "Purchases of property and equipment, including internal-use software and website development," which are included in cash flow from investing activities. Free cash flow has limitations due to the fact that it does not represent the residual cash flow available for discretionary expenditures. (Amazon.com 8-K dated October 23, 2014)

[2] Capital expenditures were $1.4 billion and $1.0 billion during Q3 2014 and Q3 2013, and $3.7 billion and $2.6 billion for the nine months ended September 30, 2014 and 2013, with the increase primarily reflecting additional investments in support of continued business growth due to investments in technology infrastructure, including AWS, and additional capacity to support our fulfillment operations. We expect this trend to continue over time. (Amazon 10-Q dated October 24, 2014)

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.