Friday, July 20, 2012

Negative Working-Capital Cycle

The excerpt below is from an interview in Barron's with Paul Isaac.

In the interview, Isaac says he wouldn't buy Amazon (AMZN) at even $ 100 per share. He also says the company's free cash flow is not well understood.

Some of his thoughts on Amazon from the interview:

Amazon generates a lot of cash from its negative working-capital cycle, which funds the build-out of physical facilities to support logistics and fulfillment. In a sense, it borrows short from customers and uses that money to fund long-lived capital assets.

Rapid sales growth masks this process. Broad-based stock-option compensation requires an appreciating stock...It dismounts from that treadmill at great risk to its model.

The stock currently sells at $ 226/share. Many fans of Amazon's business emphasize free cash flow over its relatively weak earnings. A focus on free cash flow usually makes sense if there's a large non-cash charge flowing through the income statement. Unfortunately, in this case, the main driver is their negative working-capital cycle.*

These are very useful sources of cheap funding (actually, zero cost funding if sufficient growth is sustained) but should not be viewed as higher quality operating free cash flow.

Check out the whole interview. In it, Isaac also explains why he likes Devon Energy (DVN)) and Greif Brothers (GEF.B) among others. I have no opinion on either stock.

As far as Amazon goes, my main problem has always been stock valuation and the amount of share dilution that has occurred over the years, not the potential long-term prospects of the business itself. To me, figuring out whether the company's per-share intrinsic value will increase over time in a way that -- relative to the current market price -- the investor will be compensated well is the tough part when it comes to Amazon.

Unlike many other businesses, estimating Amazon's current per-share value and, within a narrow enough range, how much that value is likely to increase over time is just a very difficult thing to do. The company will probably turn out to be worth quite a lot, but the range of valuations is too wide to figure out what price today represents an acceptable margin of safety. Well, at least I can't figure this out. 

I'm just more comfortable with a business that has good long-term prospects and already makes a lot of money now; more comfortable with one that sells at a sensible multiple of what it has already plainly demonstrated it can earn. There are plenty that fit that description and quite a few of them have been available at more than reasonable valuations in recent years.

I have much respect for the way CEO Jeff Bezos seems to always be building Amazon's business with an eye toward the longer term.

I'm just not convinced that translates into great risk-adjusted returns.

With that said, I do pay attention to Amazon for at least the following reason:

They're one of a handful of companies with the potential to disrupt other good businesses if they decide to do so.

As an investor, you have to keep an eye on the company as one that can potentially damage or maybe even destroy the economic moat of another business.

Adam

No position in Amazon, Devon, or Greif Brothers

Related posts:
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks

* Amazon gets a nice boost of cheap funding each year from unearned revenue, accounts payable that's in excess of account receivable, etc. 

Also, like many tech stocks, it's worth noting that adding back stock-based compensation (as is done in the Operating Activities section of the cash flow statement) boosts free cash flow but is potentially a material source of future dilution (much as it has been in the past) and likely quite expensive for continuing shareholders over the long haul. Yes, it's a non-cash expense but, unlike some other non-cash expenses, it shouldn't be ignored. One way to think of this is to calculate how much net cash would be needed to keep share count stable over time. Well, that incremental cash expended is a very real cost to shareholders and should be subtracted from free cash flow for a better understanding of the business economics. It's, at the very least, a rather big stretch to consider economically meaningful any free cash flow calculation that doesn't attempt to account for the cost of stock-based compensation. For certain companies -- those that make heavy use of stock for compensation -- the cost is very real even if difficult to estimate. The reality is that these potentially material costs are generally rather difficult to pin down with any precision. Unfortunately, with stock-based compensation, the best case that can usually be expected is an estimated range of costs (the economic costs...not the accounting costs). A bit messy? No doubt, but that messiness doesn't mean the costs can be ignored to make it seem more neat than it is. Not everything that matters economically can be precisely quantified. In fact, some of the most important things can't be quantified at all.
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