Amazon (AMZN) - Get Report stock soared Friday after the company reported better-than-expected quarterly results. Amid the hoopla, however, investors shouldn't forget one important thing: Amazon still isn't providing sufficient clarity in its accounting for investors to accurately assess how well the company is using its capital.
The key issue here is Amazon's reliance upon capitalized leases for the technology equipment the company uses in its Amazon Web Services cloud-computing business. This topic is examined in much more detail in this article, but essentially the company is accounting for the leases on this equipment in a way that makes them look like debt. (An alternative would be accounting for the leases as operating expenses.)
You might ask why this complicated-sounding accounting makes a difference if the company's results are beating estimates and the stock is near its all-time highs.
Well, it's important, because the use of capitalized leases has helped Amazon in the past make two key gauges of a company's performance -- free cash flow and return on invested capital, or ROIC -- look better than they really were, and that is explained in greater detail in the same article referenced earlier.
OK, we will give Amazon some credit for the way it reported its third-quarter results Thursday. The company did add two new slides to the visual presentation it released to accompany its earnings conference call. Those slides are on pages 4 and 5 of the link above. One shows free cash flow minus lease principal repayments, and the other shows free cash flow minus "finance lease principal repayments and capital acquired under capital leases."
These slides support the point in the earlier article that the capitalized leases have a significant negative impact on the company's cash flow. After all, the unadjusted free cash flow figure (on page 3 of the presentation) for the latest quarter is $5.499 billion. But when you exclude lease principal payments (page 4), free cash flow drops to $3.092 billion. Exclude finance lease principal repayments and capital acquired under capital leases (page 5) and voila, free cash flow falls to $637 million in the latest quarter. This number is important, because it's what Amazon's free cash flow would look like if the leased AWS equipment were acquired like cash property, plant and equipment. What's more, that page shows that this adjusted free cash flow was negative in the four previous quarters.
Amazon did not respond to email requests to discuss the changes it made to its third-quarter conference call slides.
Despite those two new slides, Amazon needs to provide even more information going forward. The company did not break out its capital lease obligations on its balance sheet. (Right now, they're included under "Other long-term liabilities.") It also hasn't provided information that can help investors calculate the cash rents the company is paying.
Cash rents on capital leases are principal payments on capital and financing lease obligations plus the interest expense Amazon imputed on the lease transaction less occasional other noncash adjustments. In other words, it's the cash payments on the leases.
What's more, the company still doesn't provide any forward guidance on its investments whether they be made in cash or using capitalized leases. These investments now total $9 billion for the 12 months ended on Sept. 30, 2015.
Curiously, Amazon did not include a slide in that presentation that it had included in past quarterly reports -- the one on its ROIC.
The reason ROIC is an important metric is that if you take this number and compare it to a company's weighted average cost of capital, or WACC, you can get a good sense of whether the company is using its capital effectively. If ROIC is less than WACC, the company is essentially destroying value.
So, even though Amazon omitted that ROIC slide from the third-quarter results, we calculated our own ROIC. It excludes cash flows from working capital and treats leases and their respective rents as though they were not capitalized. The result was 10%. Let's give credit where credit is due: That's a significant improvement from the 5% adjusted number we calculated for the company's second quarter in the earlier article. It's also up from the -6% result for the third quarter of 2014.
So how does that improved number compare to the company's WACC? Well, Amazon's WACC is generally believed to be about 10%. That means that Amazon is beginning to cover its WACC. If it can continue to improve its ROIC, it will display that it is using its capital effectively. (Our earlier article posited that Amazon was destroying value, because the second-quarter ROIC of 5% was less than the WACC of 10%.) Here are two graphics that shows how Amazon calculates various metrics, and how we came up with our adjusted ones.
In sum, Amazon appears to be making progress; its ROIC is now equal to its WACC. But Amazon's ROIC must continue to improve substantially and provide a return on market capitalization, which at about $280 billion is currently 14 times larger than book invested capital.
The company still isn't providing enough information to allow investors to fully understand the company's capitalized lease financing strategy.
So here's what Amazon needs to do. First, with every quarterly financial release, Amazon should break out its lease obligations on its balance sheet. Second, Amazon should provide a calculation of cash rents. This would allow investors to easily figure out another valuable measure of a company's performance: earnings before interest, taxes, depreciation and amortization adjusted for cash rents. Lastly, Amazon should begin providing forecasts of future investments in PP&E, segmented according to recurring investments and new EBITDA-enhancing ones. These disclosures are common among other publicly traded companies.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.