Jeff Bezos’ 2001 letter to shareholders dealt with two critical components in the culture of Amazon.com (AMZN, Financial). The first, as explored in a previous article, was customer service, and how it is intrinsically linked to the Amazon platform.
The second is Bezos’ insistence on the primacy of cash flow. While most of his peers concern themselves with the earnings and profitability of their companies, Bezos is much more interested in cash flows. In the letter, he said, “Why focus on cash flows? Because a share of stock is a share of a company’s future cash flows, and, as a result, cash flows more than any other single variable seem to do the best job of explaining a company’s stock price over the long term.”
John Rossman, a former Amazon executive and author of “The Amazon Way: 14 Leadership Principles Behind the World's Most Disruptive Company,” explains Bezos’ thinking this way: “He believes the Internet’s potential for growth is gargantuan and still fundamentally unexploited. To Jeff, the year is 1889, and the Oklahoma Land Rush is on— or, as he likes to put it, it’s still Day 1 of the Internet.”
Gargantuan growth is the prize, and Bezos aims to claim it by focusing on cash flow rather than earnings or net income. Looking back from 2018, it is clear Bezos was right about the growth opportunity. Today it is one of the largest, if not the largest, retailer on the face of the earth.
According to Rossman, the emphasis on cash flow and free cash flow began just a couple of years earlier, in 1999, when Warren Jenson became the company's chief financial officer. His arrival signalled a transition from a percentage-margin focus to a cash-margin focus. Cash margin accounts for capital expenditures with the cash flow context. As Investopedia notes, “If a company’s operating cash flow margin is increasing from year to year, it indicates its free cash flow is improving, as is its ability to expand its asset base and create long-term value for shareholders.”
Expanding the asset base is, of course, the road to gargantuan growth. Rossman said Bezos used to challenge skeptics with questions such as this one: “Do you want to be a $200 million company with a 20% margin or a $10 billion company with a 5% margin? I know which one I want to be!”
The concept “long term,” whether specific or implied, keeps arising. That’s certainly in line with the importance Bezos places on the long term. He is quoted as saying, “We believe that a fundamental measure of our success will be the shareholder value we create over the long term.” Apparently, as long as cash flow remains available, Bezos will keep enlarging Amazon’s already-giant Internet footprint.
A contrarian view of Bezos’ cash flow strategy comes from Timothy Green of The Motley Fool, in a CNN Money article. His arguments include:
- Amazon finances billions in capital spending using capital leases, which inflates its free cash flow. Green said the company took on $4.7 billion of capital leases in 2014, making its adjusted free cash flow negative.
- The aggressive depreciation of servers and computing equipment provides “vast increases” in Amazon’s operating cash flow.
- Amazon benefits from a negative cash conversion cycle; in other words, it collects payment from customers before paying suppliers. That increases cash flow, but as soon as the company stops growing, this contribution to cash flow will dry up.
Much of Green’s argument rested on the assumption that cash flow will sharply decrease when Amazon stops growing. However, as we’ve seen, Bezos' strategy is based on the belief that internet retailing continues to be in its early days, and there is still much claimed. The only way to capture that potential is to keep re-investing cash flow.
Bezos and Amazon are indeed doing that. The Telsey Advisory Group expects Amazon to capture 9.6% of total retail sales by 2020, mainly because of its incursions into the food category, through its acquisition of Whole Foods. The firm added, “The shift to online grocery is being driven by consumers' increasing comfort with buying almost anything online, along with greater product availability and improvement in the supply chain to offer faster delivery.”
Writing in the Harvard Business Review, Justin Fox referred to “Amazon’s Cash Machine,” saying, “Its earnings aren’t much to look at, but the company’s cash flows have been stupendous.” He followed up with a chart, which has been replicated and updated in GuruFocus. It shows operating cash flow in blue, free cash flow in red and net income in green:
The following GuruFocus chart shows free cash flow in blue and capital expenditures in green:
Note how the free cash flow diverged from operational cash, as shown in the first chart, when capital expenditures began to lessen in the late 2000s.
Summing up, Jeff Bezos has stayed true to his first principles, which include thinking long term and pursuing opportunities for gargantuan growth. In just two decades as a public company,Ă‚ Amazon has grown from an insignificant online bookstore to one of the biggest retail outlets on the planet.
That’s been possible because he’s taken a corporate road less traveled. Rather than focus on income and earnings metrics, he has focused on cash flow. Free cash flow provides funding for ongoing capital expenditures, and those expenditures made it possible to expand further and more quickly than most reasonable observers might expect.
Long-term investors will reap this sowing of cash flow into future revenue streams. Amazon does not yet focus on profitability, which means it will continue to grow and expand its market share in all directions. It’s unlikely that re-investment of cash flow will stop soon, considering the recent acquisition of Whole Foods.
Disclosure: I do not shares in any of the companies listed and do not expect to buy any in the next 72 hours.
