Bezos’s 2004 Shareholder Letter: Free Cash Flow per Share and the Teleportation Counterexample

#BezosShareholderLetter2004 #FocusOnFreeCashFlow This letter explains free cash flow in financial investment relatively clearly. Robin thinks Bezos wants to emphasize Amazon's strong ability to generate cash. Fixed-asset capital expenditure accounts for 4% of revenue, yet Amazon collects payment quickly after selling products. Accounts-receivable days are low, inventory turns extremely fast, and suppliers are paid later. It is therefore a good business in which growing sales generate more cash flow. ----- To our shareholders: Our ultimate measure of financial performance, and the measure we use to drive long-term growth, is free cash flow per share. Why not focus first on earnings, as many other companies do? Our simple answer is that earnings do not translate directly into cash flow. A stock's value reflects the discounted value of future cash flows, rather than future earnings. Future earnings are an important component of future cash flow, but not its only component. Working capital, capital expenditures, and future dilution are also important measures. Counterintuitive as it sounds, a company's earnings can sometimes hurt shareholders. This happens when the investment required for growth exceeds the present value of the cash flows it generates. (This happens when the capital investments required for growth exceed the present value of the cash flow derived from those investments.) (Zhang Xiaoyu gives a clearer explanation in “Amazon | The Essence of Company Value—Free Cash Flow,” part of his Classic Business Case Course. Please refer to that lesson.) Imagine, for example, that someone invents a teleportation machine. It costs US$160 million, can transport 100,000 passengers a year, and has a useful life of four years. Each trip costs the passenger 1,000, with 450 in materials and energy costs and 50 in labor and other costs. Imagine business is strong in the first year: the machine completes 100,000 trips and earns 10 million after all expenses and depreciation, a 10% net margin. Because earnings are the company's primary goal, the entrepreneur buys one more machine in Year 2, two in Year 3, and four in Year 4. Impressive, isn't it? Earnings double annually and total 150 million. An investor considering earnings alone should be very pleased. But cash flow tells a different story. Over four years, the teleportation business accumulates negative cash flow of 530 million. In many other situations, earnings closely approximate cash flow. But the teleportation example shows that we cannot judge whether shareholder value is being created or destroyed merely by looking at earnings. Focusing only on EBITDA (Earnings Before Interest, Taxes, Depreciation and Aamortization) would likewise produce a mistaken assessment of the business's health. Annual EBITDA is 50 million, 100 million, 200 million, and 400 million, doubling each year. But without considering the 1.28 billion in capital expenditure needed to generate this “cash flow,” we miss the full picture: EBITDA is not cash flow. What if we changed the growth rate and adjusted machine purchases accordingly? Would cash flow improve or worsen? Paradoxically, slower growth produces better cash flow. Once the first machine has been purchased, the ideal earnings-growth trajectory is to reach 100% capacity quickly and then remain there each year. Yet even with only one machine, cumulative gross cash flow has not exceeded the initial investment by the fourth year, when the machine is retired. That means the present value of the cash flows remains negative. Unfortunately, the teleportation business is fundamentally flawed. The calculations give us no reason to buy this machine and operate the business; it produces no substantive growth. Our example is extreme and simple: a quick calculation tells investors that the business makes no sense. Reality is more complicated, but this tension between earnings and cash flow appears everywhere. Cash flow often receives less attention than it deserves. Insightful investors do not stop at a company's revenue. /Our most important financial measure: free cash flow per share/ Amazon.com's financial objective is long-term growth in free cash flow per share. Amazon.com's free cash flow is driven primarily by operating profit, alongside sound management of working capital and capital expenditure. We increase operating profit by improving every aspect of the customer experience to grow sales while controlling our cost structure. We have a “cash generative operating cycle”: inventory turns so quickly that we receive payment from buyers before paying for the purchase of housing [wording in the collected Chinese text]. Fast turnover also means less investment in inventory: last year's business of 7 billion required only 480 million in inventory. (The operating cycle is number of days of sales in inventory plus number of days of sales in accounts receivable minus accounts payable days. This is a form of negative operating-cash-flow requirement: the larger the business, the greater the operating cash inflow.) Our capital efficiency is reflected in very low fixed-capital investment: just 4% of 2004 sales, or 246 million. In 2004, our free cash flow grew from 131 million to 477 million, an increase of 38%. We are confident that continued improvements in customer experience and further price reductions will strengthen both our value proposition and our cash flow. As for dilution, total shares outstanding plus stock-based awards were unchanged from 2003 and down 1% from three years earlier. We also converted 6 million potentially dilutive shares into 600 million in convertible debt maturing in 2009 and 2010. Efficiently managing share issuance means more cash flow per share and more substantial long-term value. Our focus on cash flow is not new. We set it out in our 1997 shareholder letter. I have attached that letter and hope current and prospective shareholders will read it. As always, on behalf of Amazon.com, I thank customers for their trust in me, employees for their hard work, and shareholders for their support and encouragement. Jeffrey P. Bezos (Chinese translation by Vinchent)