More on Amazon's misleading free cash flow numbers and how this fudd all works (imho):
#reply-18608585
Quality of reported Free Cash Flow numbers is going to be next big battle in the ongoing charade of misleading accounting that CFOs literally hope that you will “buy in” to. Amazon wants you to look at Free Cash Flow, because even if earnings are fixed to properly reflect equity compensation expenses (restricted share grants), reported Free Cash Flow numbers will be no different for most companies whether they are expensing payments to employees with equity instruments or not. But there is a rub, imo, and that is that the Free Cash Flow numbers reported by companies who compensate employees with equity instruments, is inflated by a finance activity.
Here is how this latest financial charade works: In #reply-18516488, I gave my best efforts opinion regarding how issuing and expensing restricted shares impacts the accounting on the Income Statement, Cash Flow statement, Balance Sheet and Shareholders Equity statement, and so far, no one is stepping forward to refute my perception of accounting treatment for restricted share grants. For purposes of discussion, I further assumed that the full value of the stock was expensed all at once at date of grant rather than valued at date of grant, but then ratably expensed over the service period of the stock grant.
Now lets call this company that grants restricted shares “Amazon A”. The accounting conclusion for Amazon A with regard to granting restricted stock was that both Net Income and Retained Earnings are reduced by the (value of the restricted grant less the tax savings), that Cash Flow from Operations, Free Cash Flow, Net increase in Cash and Cash Equivalents and Shareholders Equity are increased by the amount of the tax savings, and that Paid in Capital is increased by the value of the stock grant. Although Paid in Capital increases, this increase in value is not posted in the finance section of the Cash Flow Statement for Amazon A.
Now lets take the exact same company, but call it Amazon B, and have Amazon B first sell these same shares to the public, and then pay the employees with the cash proceeds from the sale of the shares rather than directly granting the shares to the employees. This is an exact equivalent economic activity as to what Amazon A did, except for the nuance of Amazon A expensing the restricted shares over the life of the service period versus Amazon B expensing the entire amount of cash payment to employees at one moment in time. (And again, we are ignoring this amortization of expense difference between Amazon A and Amazon B for purposes of this debate, because this difference in the expensing period is immaterial to the conclusion of this piece.)
Now, let's see what happens to the financial statements for Amazon B, who sells the shares first and then uses the proceeds to pay the employees rather than directly granting the shares to the employees. Please note that for Amazon B, the expression "Value of the Shares" can be used interchangeably with "Cash Compensation to Employees". They are both the exact same number. Here we go: Net Income and Retained Earnings are reduced by the exact same value as in the example for Amazon A above---(value of the shares less the tax savings). The Net increase in Cash and Cash Equivalents at the bottom of the Cash Flow Statement is exactly the same as Amazon A---increased by the amount of the tax savings. Shareholders Equity is also increased by the amount of the tax savings. And Paid in Capital is increased by the amount of the value the shares were sold for, the same value as in Amazon A.
Everything is right on track to be exactly the same for Amazon A and Amazon B, and most importantly, the impact on the Shareholders Equity statement is exactly the same----Retained Earnings are reduced by the (value of the shares less the tax savings) and Paid in Capital is increased by the value of the shares. But whoa, not so fast, a funny thing happened to Cash Flow from Operations and Free Cash Flow on the way to the bottom line of the Cash Flow statement and the Shareholders Equity statement. In Amazon B, cash flow from operations is reduced by the (value of the stock less the tax savings); and in Amazon B, Free Cash Flow is reduced by the (value of the stock less the tax savings). But Amazon B recognizes the finance activity related to selling shares, so Cash Flow from Financing Activities on the Cash Flow statement is increased by the value of the stock that was sold. Hence, the bottom line of the Cash Flow statement for both Amazon A and Amazon B is exactly the same, but Amazon A is able to brag about much more impressive Cash Flow from Operations and Free Cash Flow than Amazon B, while Amazon B reports less Cash Flow from Operations, less Free Cash Flow, but greater Cash Flow from Financing Activities on the Cash Flow statement than does Amazon A.
So therein lies the rub. There is absolutely no way in hell that anyone can argue that Amazon A is performing any better or worse than Amazon B, and there is no way in hell that anyone can argue that Amazon A and Amazon B are not exact economic equivalents, but Amazon A’s CFO wants you to focus on the reported Free Cash Flow numbers for Amazon A, which are better than Amazon B's reported FCF numbers. Never mind that the impact from these equivalent equity related transactions is exactly the same on reported earnings for both companies; never mind that the final impact on the bottom line for Net Income, the Cash Flow statement, Balance Sheet, Retained Earnings, Paid in Capital and Shareholders Equity is exactly the same for both companies. The Amazon A CFO simply doesn’t want you to realize this. He wants you to think that his company, Amazon A, with the higher reported Free Cash Flow number is doing better than Amazon B, who is paying employees with cash proceeds from the sale of stock. But Amazon A’s performance is no better than Amazon B's, and Amazon A’s reported Cash Flow from Operations and Free Cash Flow numbers are arguably inflated by a finance activity. Otherwise, how the heck did Amazon A end up with an increase in Paid in Capital, the same increase in Paid in Capital as did Amazon B, whom no one denies is engaged in finance activities, and why is the makeup of Amazon A’s Shareholder Equity section precisely the same as the makeup of Amazon B’s Shareholder Equity section?
If you are seriously interested in evaluating the performance of Amazon A, you will take in to account how the finance related activity, granting of shares to employees, is inflating reported Cash Flow from Operations numbers and reported Free Cash Flow numbers, and you will not be conned in to valuing the Amazon “As” of the world more highly than the Amazon “Bs” of the world---companies that pay their employees in cash. Quality of reported Free Cash Flow numbers matter. Blindly accepting reported Free Cash Flow numbers without understanding what goes in to them may get you somewhere in the short run, but if you are interested in evaluating the core, internal performance of the company, you better understand what is and isn’t included in that Free Cash Flow number.
JMO and contrasting opinions are encouraged and welcome.
Regards, Huey |
