At Amazon, It’s All About Cash Flow
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 margins.
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 now.
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 quarter.
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 machines.
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.”
At Amazon, It’s All About Cash Flow
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