Amazon’s $17 Billion Cash Flow Boost

And why they’ll pay for it later…

In my articles on financial statements, I try to explain the philosophy and research approach I deploy when looking at a company, especially one in a new or unfamiliar industry. I have picked Amazon for this two part article on the Cash Flow Statement because Jeff Bezos places a clear emphasis on long term free cash flow generation and Amazon therefore is more helpful in its presentation than many other companies.

Some shareholders and investors may feel that Amazon is over enthusiastic, as it provides no less than 3 different definitions of free cash flow. I know I may confuse matters further by adopting a fourth, but hopefully these two articles will explain my logic.

For those interested in this topic and who want to improve their skills, don’t miss the invite to pre-register for the first cohort of my Forensic Analysis course at the end of this article.

I have used Amazon’s latest reported data, Q3, 2022, and have taken the trailing 12 months data, as a single quarter’s cash flow is often distorted by movements in working capital etc. The table shows the Cash Flow Statement for the period, using Sentieo data.

Amazon Q3 2022 Cash Flow

Source: Behind the Balance Sheet from Sentieo data

The table clearly shows that Amazon had very little change in cash in the period and generated just $5bn, but the refinancing of debt obscures the underlying change and I shall return to the subject of free cash flow generated next week. Let’s start here by looking at the Operating Cash Flow section of the statement which is the key section I focus on, to determine the ongoing cash generation capacity of the business.

Amazon Q3 2022 Operating Cash Flow

Source: Behind the Balance Sheet from Sentieo data

At first glance, nothing remarkable has happened here – a $15bn drop in net income has translated into a $15bn drop in operating cash flow. In both periods, cash from operations exceeds net income by c.$28bn. In the last twelve months, Amazon looks more cash generative, given the lower earnings

But for those familiar with Amazon, and its negative working capital profile, this would be rather surprising. In contrast to many companies, Amazon has traditionally released cash as it grew, because it has negative working capital – on average, customers pay Amazon before the company pays its suppliers. Hence, unlike most companies, it does not need cash to finance higher receivables and inventory as revenues grow.

Investors would therefore likely have expected the gap between cash from operations and net income – a relationship viewed by many as an indicator of earnings quality – to grow. This is because the company had higher revenues and in spite of the lower earnings (net income) number.

Amazon’s favourable working capital position is likely achieved by a combination of

• Highly efficient inventory holdings

• Customers paying in advance of receipt of the goods

• A high element of subscription income from Amazon Prime and AWS

• Long payable days (10 year average before this year of 68 days sales, obviously longer on a COGS basis)

Amazon Working Capital

Source: Behind the Balance Sheet from Sentieo data

It’s interesting that the cash conversion is not panning out quite as might have been expected and that the working capital position appears to be weakening somewhat – here is the more recent quarterly cash conversion cycle from Sentieo’s calculations:

Amazon Recent Quarterly Collection Cycle

Source: Behind the Balance Sheet from Sentieo data

The chart below offers a longer zoom out on the quarterly collection cycle than the chart above and additionally shows the individual components. A similar trend is visible, and it appears that Amazon saw a big increase in payables in the pandemic and this has now reversed and overshot a little as of the third quarter.

Amazon Longer Term Quarterly Collection Cycle

Source: Behind the Balance Sheet from Sentieo data

I don’t know enough about Amazon to judge if this is a temporary phenomenon and the conversion cycle will return to previous more normal ranges or whether it could be a longer lasting trend. Paying customers can read a separate article explaining why I think this could be a potential concern.

The principal driver of this deterioration in the working capital position in Q3, 2022 has been a much slower increase in accounts payable with a consequent reduction in the payable days. This could well be reversed - Amazon could just take longer to pay its bills. But this is not the only issue to take away from the operating cash flow breakdown. I have summarised the table below to make the analysis simpler and clearer, and to show the stock based compensation separately:

Summary Cash from Operations

Source: Behind the Balance Sheet from Sentieo data

Taking out stock based comp, that $15bn drop in net income has translated into a $21bn drop in the cash from operations which has fallen from $43bn to $22bn. And this is the way we ought to think about the cash generation because stock based compensation should really be considered a method of financing, as I explained in several articles I have written in the past on stock based comp, here, here and here.

The better way of treating stock based comp is to imagine that the employees had received these payments not in the form of stock options or restricted stock units (RSUs), but as if the company had instead given them cash, which it had raised in an equity issue – the economics are identical but the characteristics of the cash flow statement are significantly different:

• Cash from operations is reduced, in this case by $17.7bn

• Cash from financing is correspondingly increased by the notional issue of $17.7bn of stock

• Free cash flow is reduced by $17.7bn (I shall illustrate this in the next instalment)

This is a much better treatment and is one I advise my institutional clients to implement in their cash flow analysis. It’s easy to do and it gives a better representation of the underlying economics which should be the true purpose of the accounting standards.

Here is Amazon’s 2022 Q3 TTM cash flow statement before and after this change:

Adjusting for SBC as Cash

Source: Behind the Balance Sheet from Sentieo data

The right hand column, which implements this simple change to treat SBC as if it were cash, is a much better representation of the underlying economics of the business. Next week, I shall continue the analysis, going down the Cash Flow Statement and with a focus on Free Cash Flow. It will be a little longer so I may split it in to two parts.

Paying subscribers can usually read on for additional, exclusive material. I would like these educational articles to receive as wide an airing as possible. My former method of publishing the extra content at the end is not conducive to effective SEO within Substack; hence paying subscribers will receive a separate email highlighting another important issue relating to Amazon’s free cash flow generation.

It’s my intention this year to give more to paying subscribers and less to free subscribers. Please don’t worry, I enjoy writing and sharing my knowledge with both groups but I feel a responsibility to deliver value for money. In particular, if you are a professional investor and you are not already a paying subscriber, please expense it and enable me to devote more of my time to research and writing these articles. Thanks.

If you want to improve your analytical skills and be able to analyse financial statements like a professional, I am launching the first cohort of my Forensic Analysis course in February. You can pre-register here for early notification. If you have already emailed me, you are already on the list.

There are limited spaces and I am offering this first cohort a reduced rate so I would encourage those interested to sign up now. The course is based on my Forensic Accounting Course which has had 450+ students from some of the largest and most successful funds in the world - names like Schroders, Wellington, Baillie Gifford and many more.