Analysis of Bezos' Fcf Pronouncements

ANALYSIS OF BEZOS' FCF pronouncements

A critical concern with Bezos' pronouncement (calling free cash flow (FCF)/share the "ultimate financial measure") is that FCF/share does not fully and accurately measure Amazon.com's financial performance in a medium to long term context. As with any online retailer, Amazon's most objective analysis should involve an earnings or net income parameter. Certain management dissatisfied with the level of their reported net income wrongly assert that cash flow is a more valid performance measure than is net income. That assertion assumes that depreciation and other non-cash costs are not valid expenses. However, history of the retail industry sector suggests that only net income is properly regarded as a measure of performance that can be directly related to the equity investment as indicative of operating performance. If we add back depreciation to net income and determine a resulting return on investment (ROI), we are confusing ROI with some aspect of ROI for fixed assets.

Next, we must further analyze Bezos' viewpoint while understanding that no other statement measures profitability as well as the income statement. Admittedly, income statements do NOT usually reflect timing of cash flows and direct effects of operations on liquidity and solvency. Several of those effects are reported on the statement of cash flows (SCF).

Next, note that analysis of cash from operations (CFO) reflects a broader concept of operations than net income. These cash flows encompass all earnings-related activities of the enterprise. In a broad sense, CFO measures not only expenses and revenues but also cash demands of their broader activities, such as investments in inventories and receivables. As such, CFO more closely reflects the liquidity aspect of an enterprise but is NOT always a clear measure of profitability since it may not include a) material revenues such as equity in the earnings of certain subsidiaries, or b) major costs involving use of long-lived property, plant or equipment.

Next, as regards Amazon specifically, the measure of FCF is a mathematical derivative from the SCF. With this FCF measure, critical focus must be paid to selected details within its computation. As is the case of any cash flow measure, management's hidden motives regarding FCF measures can dramatically affect its validity.

A positive FCF suggests a discretionary amount available for primary operations after deductions for mandatory financing commitments and outlays to maintain productive operations at existing levels. Obviously, sustaining both organic growth and high levels of ongoing financial strength require a major contribution of FCF. Regarding Amazon however, the specific amount of capital expenditure (cap ex) needed to maintain productive capacity.has NOT been clearly disclosed by Bezos or Amazon. Clearly, that specific amount is fully included (and effectively hidden) in Amazon's total capital expenditures, which must ALSO INCLUDE planned expenditures for expansions of operations . Nowhere in Bezos' pronouncements do we see his inclusion of these types of meaningful cap ex analyses along with his rationale for relating those analyses to his bold FCF/share pronouncements. Consequently, a neutral industry analyst has no means to break down capital expenditures between these two categories and FASB has unfortunately declined to require discrete classification of expansion costs versus costs of maintaining existing capacities.

Based on the above discussion, the underpinnings of Bezos' bold FCF/share pronouncements cannot be supported. Also, the above discussion applies equally to analysis of either FCF or FCF/share since FCF is the numerator for both measurements.

Since Amazon's quarterly earnings announcement on 10/25/2005, Wall Street analysts have a heightened concern with Amazon's lessening operating margins (operating income/sales). As discussed above, Bezos' pronouncement is only valid if FCF/share is considered in combination with a net income type valuation. A net income parameter obviously speaks more closely to profitability measurements, which is a more objective measure to synthesize earnings activity. These issues are quickly becoming more critical as Amazon's share of their retail industry market space gradually diminishes, as we were dramatically and quickly reminded after 10/25/2005, as mentioned above. Specifically, the Amazon business model is, to a great degree, at risk due to global competition and other economic factors beyond its control within the US. Admittedly however, this market reality does not always fully explain Amazon's somewhat unpredictable equity market performance since 1995.

Also, Bezos' viewpoint (per his pronouncement above) clearly reflects that of a company insider with a material motivation (and highly vested financial interests) to keep Amazon's stock price as inflated as possible. However, the vast majority of end users of Amazon's financial statements are highly concerned with some measure of profitability, especially given that Amazon is now a mature public company whose one-time startup costs (from 1995 forward) were booked and absorbed years ago. In my analysis herein, I have not intentionally downplayed value of ratio analysis and more erudite technical/ financial analysis. However, an ideal approach to a current Amazon analysis primarily involves a street-smart approach (a 'Jim Kramer' type of street-smarts, for lack of other analogy) that looks beyond Bezos' biased pronouncements. Bezos' bias is further illustrated in his April, 2005 letter to shareholders when he discusses parameters involving working capital, capital expenditures, future share dilution, present value of future earnings, future cash flows, income statement measurements, and EBITDA measurements. Specifically, he fails to objectively reflect their importance in terms of measuring profitability and "sustainable" growth. Also, Bezos' overly simplistic and unrepresentative analysis of the '$160 million dollar transport machine' example is not fully relevant to discussion herein since Amazon's current growth does not require disproportionately large capital expenditures as with that transport enterprise.

In other words, to focus exclusively on Bezos' FCF/share parameter(s) will fail to reflect Amazon's medium and long-term financial health and market performance. Furthermore, events of 10/25/2005 discussed above serve as a reality check that Wall Street analysts will maintain an unwavering