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At Amazon, It’s All About Cash

by Justin Fox
OCTOBER 20, 2014

In a few days, Amazon will report its quarterly earnings. If recent quarters are any indication,
there will be a lot of worried talk before and after the announcement about the company’s
minuscule or perhaps even negative profits. If its stock price continues to slide downward, the
story will probably be that investors are losing patience with Amazon’s persistently low profit

Maybe that’s true. Why stock prices do what they do over the short term is an enduring mystery,
and I’m not going to claim to solve it here. But given that the company’s profit margins have
never been much to look at, it’s a little hard to understand why that would suddenly be a big deal

The far more interesting things in Amazon’s earnings releases, it turns out, can be found on the
cash flow statement. Here, for example, are the company’s net income and cash flow over the
past decade:
The difference between the top and bottom lines here is mostly about investments in buildings,
machines, and other things, which are written down over time in the income statement but
ignored in calculating operating cash flow. That operating cash flow is much higher than net
income at a company that has been investing huge amounts of money as it strives for global retail
domination isn’t a big surprise, although the sheer size of the difference, and the sharp upward
trajectory of the cash flow line, is still staggering.

Free cash flow does count all of Amazon’s investments — although it counts them when the
money is spent instead of depreciating and amortizing them over subsequent years. That it has
remained consistently higher (usually more than $1 billion higher) than net income is a
remarkable and very important thing. And the difference between free cash flow and net income
is all about timing.

Net income is a noble if flawed attempt to match expenses and revenue in time. For example, if
you sell a service that you’ll be delivering for the next twelve months, the costs and revenues are
supposed to be parceled out over those twelve months, regardless of when the cash changes
hands. Or if you sell a book, the money received from the buyer and the money paid out to the
publisher are recorded in the same quarter, even if the payments don’t happen in the same

With free cash flow, on the other hand, what counts is when the money actually changes hands.
So if you have a business where your customers pay you quickly, you manage your inventory
well, and you’re able to take your time in paying your suppliers, your free cash flow can be
consistently positive even when your net income is not. Which is exactly the kind of business
that Jeff Bezos and his colleagues have constructed at Amazon over the past decade.

According to my instructor in such matters, Harvard Business School finance professor Mihir
Desai, the key metric of a company’s cash-generating prowess is the cash conversion cycle, which
is days of inventory plus days sales outstanding (how long it takes your customers to pay you,
basically), minus how many days it takes you to pay your suppliers. Super-efficient retailers such
as Walmart and Costco have been able to bring their CCC down to the single digits. That’s
impressive. But at Amazon last year, the CCC was negative 30.6 days.

The only remotely comparable company with a CCC in Amazon’s range is Apple, where last year’s
cycle was an even longer -44.5 days. This is in itself an interesting phenomenon. In the past,
Desai says, the companies that threw off huge amounts of cash were generally in low-tech
industries with addicted or at least very faithful customers — tobacco, gaming, groceries. Now
here are two cutting-edge companies operating in often-fickle markets, and they’re cash

In Amazon’s case, all this cash is being used to finance the company’s continued explosive
growth. The company doesn’t need to borrow, it doesn’t need to issue stock. It can just keep
spending its own cash to attack new sectors and upgrade its offerings. “The typical view on Bezos
is that he’s so dedicated to the customer and he’s showing that shareholders don’t matter,” says
Desai. “And the truth is, no, he has an economically fine-tuned engine that serves his goals in a
really interesting and thoughtful way.”
This is one of the reasons why Bezos just landed atop HBR’s list of the best-performing CEOs on
the planet. That is of course no guarantee that he will stay there — if the huge investments Bezos
is making don’t pan out, Amazon will be in trouble. But all that cash flowing in and sticking
around a while before it has to go back out again makes it possible for the company to undertake
experiments, learn from mistakes, and keep plowing ahead regardless of what those on the
outside (such as shareholders) think. So an apparent failure like the Amazon Fire phone can be
treated as a learning experience rather than a crisis.

Still, it’s crucial to this approach that Amazon’s fine-tuned cash machine keeps humming. In its
10Qs, Amazon invariably attributes its “cash-generating operating cycle” to good inventory
management: “On average, our high inventory velocity means we generally collect from
consumers before our payments to suppliers come due,” is the boilerplate explanation.

Actually, though, it isn’t inventory management that distinguishes Amazon from Walmart and
Costco. Walmart has an “inventory velocity” similar to Amazon’s while Costco, with its limited
selection, turns its inventory substantially faster. Walmart and Costco also both get paid by
customers more quickly than Amazon does. Where Amazon stands out is how excruciatingly long
it takes it to pay its suppliers — 95.8 days on average last year, according to Morningstar,
compared with 30.1 for Costco and 38.5 for Walmart.

Skeptics have argued in the past that suppliers may not be willing to put up with that forever.
And in fact, recent quarterly reports seem to show the payables period shrinking and Amazon’s
cash conversion advantage narrowing (the company’s business is extremely seasonal, so
quarterly numbers are pretty noisy). It’s too early to tell whether this is the new normal, but it is
an entirely reasonable thing for investors to worry about. Which is probably a much better
explanation for why Amazon’s stock price has been sputtering this year than the story that
shareholders are “losing patience.”

Justin Fox, a former editorial director of Harvard Business Review, is a columnist for
Bloomberg View. He is the author of The Myth of the Rational Market. Follow him on Twitter
This article is about FINANCE & ACCOUNTING


Leave a Comment



Brian 3 years ago

Knowledge@Wharton just published something on this topic. http://knowledge.wharton.upenn...

Pay specic attention to this portion:

"Amazon’s much-touted “free cash ow” numbers are also suspect,

according to Raff. “Some of the statistics [Amazon quotes] are
calculated in somewhat puzzling ways,” he said. Amazon has said that its
free cash ow has grown in the 12 months preceding September 2014,
from $388 million to $1.1 billion. However, that included big chunks of
depreciation and stock-based compensation, according to a report by
Akshay Kaul in Seeking Alpha.com.
“Neither of these t very comfortably within a denition of free cash
ow — certainly, neither is available for distribution to
shareholders, as they are both intrinsic costs of carrying on the
business, and do not represent distributable cash,” Kaul wrote."

REPLY 00


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