At Amazon, It’s All About Cash Flow
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.
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. … 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.”
Part A: Company Financing (20 marks)
1. According to Source 2 how did Amazon’s Cash Conversion Cycle in 2014 compare to other retailers in that year? What does it say about Amazon’s working capital management? (2 marks)
2. According to Source 2 why is having a negative Cash Conversion Cycle important for a company wanting to experiment with investing in new products that could fail or succeed? (2 marks)
3. If Amazon couldn’t use cash to fund its new projects, what two financing options would they have available to them (see Source 2)? Discuss what advantages and disadvantages these financing options would have for Amazon. (3 marks)
4. Based on Source 1 (Annual Report) what is Amazon’s Cash Conversion Cycle in 2018? How does this compare with the Cash Conversion Cycle in 2014 (Source 2) and what does it say about Amazon’s supplier relationships? (5 marks)
5. Based on Pages 6-14 of Amazon’s Annual Report (Source 1) what do you believe are the three most significant risks facing Amazon in 2018? Are these risks systematic or unsystematic? Why? (3 marks)
6. Imagine that in 2007 you purchased an Amazon $1000 face value bond with a fixed annual coupon rate of 4.5% which matures at the end of 2020. Currently it is the end of 2019 and the bond has a yield to maturity of 5%. What would be the price of the bond today in 2019? (3 marks)
7. Consider Source 3. If you bought Amazon shares at the beginning of June 2014 and sold them at the beginning of June 2019, what would be your approximate holding period return? (Assume no dividends.) What does this suggest about the investments that Amazon made from 2014 to 2019? (2 marks)
Part B: Capital Budgeting (20 marks)
Read the article below and answer the following questions:
Source 4: Amazon Go
Amazon’s cashierless Go stores could be a $4 billion business by 2021, new research suggests
The futuristic shops bring in more revenue than regular convenience stores. Rani MollaJan 4, 2019, 10:33am EST
Jason Del Rey / Recode
Amazon Go is not only trying to out-convenience convenience stores, it could out-earn them, too. And that could mean a new, giant multi-billion dollar business for Amazon within just a few years.
Amazon’s new cashless, cashierless stores — which allow customers to just grab items off shelves and automatically get charged upon exiting, thanks to a bevy of sensors and cameras — bring in about 50 percent more revenue on average than typical convenience stores, according to new estimates from RBC Capital Markets analysts.
Using their own purchases at Go stores as data points, RBC analysts estimated that the typical order size at the new futuristic shops is around $10. The analysts also counted the number of visitors to an Amazon Go — an average of 550 a day — which would mean the average Go store generates an estimated $1.5 million in revenue a year excluding days when current Amazon Go stores are closed.
Amazon has considered a plan to open as many as 3,000 Amazon Go stores by 2021, according to a Bloomberg report, meaning the futuristic shops could generate in the ballpark of $4.5 billion in sales a year if the company follows that aggressive store rollout plan and if new-store sales are similar to current RBC estimates.
While Amazon Go has the potential to become a multi-billion-dollar business, it will be expensive to get there. Amazon Go stores need more initial investment than normal convenience stores, with the first Go location requiring more than $1 million in hardware alone. Amazon would need to spend as much as $3 billion to roll out 3,000 stores, Morgan Stanley has estimated.
Answer the following questions with the aid of excel spreadsheets. **You also need to answer the below questions in your word file and refer to your excel spreadsheets as supporting documents. Upload your ONE excel spreadsheet separately under “Excel File for Report”. Consider Sources 1-4 above. (All figures are in USD).
Imagine based on the above article Amazon decides to open 3000 US stores (today) in 2019. Assume the spending to roll out the 3000 stores (from the article) would be incurred today. Assume the sales per year (for the 3000 stores) mentioned in the article would occur at the end of each year for 10 years. Due to the absence of cashiers and other staff annual variable costs would only be 10% of revenues in the first five years, and 5% of revenues in the final 5 years of the project as efficiencies increase. Annual fixed costs will be $1.5 billion per year for 10 years. In addition to the initial investment mentioned in the article, Amazon will need to secure the hardware and software capital to run the stores, which will cost an additional $7 billion today. All capital invested in the stores will be depreciated on a straight-line basis over 10 years to 0 and can be sold at the end of year 10 for $1 billion. Due to Amazon’s cash management policies, they want to recover their initial investment within 2 years. Assume all cash flows occur at the end of the year and all values are in USD. Assume the tax rate is 30% over the 10 years.
1. Based on the above information and sources what are the free cash flows generated by Amazon’s 3000 new stores over the 10 year period (refer to your excel spreadsheet)? (8 marks)
2. Calculate the NPV for the new AmazonGo Stores assuming the cost of capital is 12% and 5%. Which discount rate should Amazon use given that this is a speculative venture? (3 marks)
3. What is the discounted payback period for the project and how does it compare to what the company is hoping for? Do you believe their target is realistic? (3 marks)
4. What are the weaknesses about how cash flows are estimated in the article? Can we rely on them in our analysis? (3 marks)
5. Based on your analysis in parts 1-4 would you recommend Amazon undertake the project? Why or why not? (3 marks)
Part C: Personal Reflection (8 marks)
Write a brief 200 to 300-word reflection on:
a) How Class Case Study 1 in Week 6 influenced your answers in Part A of this assignment.
b) The process you went through to complete Part B of this assignment.
c) What you will do differently when preparing for Case Study 2 in Week 12 to get the best mark possible (as compared to your preparation in Case Study 1).