NEW YORK (TheStreet) -- Amazon (AMZN) is known on Wall Street for its fairly opaque accounting practices and promises of profits later. Generally, this behavior has been rewarded, as Amazon's stock price has more than tripled over the past five years. In fact, recently, one analysis gives a price target of near $700 for the nearly profitless e-commerce firm (it's trading around $550 these days).
Unfortunately for the company's investors and its billionaire founder Jeff Bezos, Amazon's true price target should be closer to $400 for one very important, overlooked and misunderstood reason: Amazon's capital lease investments and how the way Amazon accounts for them inflates its free cash flow and return on invested capital far beyond what the company presents to investors. The way Amazon does it is legal but also misleading, especially for a company that's stock success has been based on slim or nonexistent profits. Let me explain.
A recent article in The Wall Street Journal argued that investors had rewarded Amazon when it started providing some needed transparency about the results in its Amazon Web Services unit, which provides cloud-computing services to businesses. But Amazon still hasn't provided enough transparency about AWS, and its continued use of creative accounting, which is 100% legitimate under generally accepted accounting principles, makes its financial performance appear better than it really is.
It all revolves around Amazon's use of capitalized leases. By using capitalized leases to account for its investments in servers and other equipment for its AWS business, Amazon is making two very important numbers that investors use to judge a company's performance -- free cash flow and return on invested capital -- look much better than they really are. Amazon public relations and investor relations were contacted to respond to this story but have not yet responded.
To understand all of this requires an exploration of some fairly complicated accounting. Let's get started.
Under GAAP, companies can categorize their leases in three ways: operating, capital and financing. Operating leases are accounted for as an expense, but capital and financing leases are booked, or "capitalized," onto the company's balance sheet to look like debt.
When leases are capitalized, analysts and investors don't see the financial impact of the leases on a common valuation metric: adjusted earnings before interest, taxes, depreciation and amortization, or adjusted EBITDA. (The "adjusted" means that noncash items are excluded.) In order for investors to calculate and understand this impact, Amazon should provide them with information allowing them to convert the capitalized leases back into cash rents, which would be the actual cash payments made on these assets.
Amazon indicates in its Securities and Exchange Commission filings and conference calls that it is using capital leases primarily for equipment investments in its Amazon Web Services business. These are investments for things like servers, data-storage equipment and other short-lived infrastructure assets.
Since the first quarter of 2013, Amazon's use of these leases has grown quickly at a 67% compound annual growth rate, and total investment for the trailing 12-month period ended on June 30 was $4.7 billion.
It's important to keep in mind that Amazon's capital lease investments are in addition to the cash-based property plant and equipment (PP&E) investments the company makes, which totaled an additional $4.6 billion for the same period.
Amazon's capital lease strategy means that on average Amazon is paying back these leases in about 30 months, which is a very rapid payback time and an intensive financing strategy. It raises an important question: What happens to the AWS equipment at the end of the lease terms? Clearly, servers and other computing equipment will need to be replaced, renewed or purchased so that AWS can continue to operate and grow.
Amazon needs to continue to borrow, and borrow a lot, and that's a tall feat for a profitless company (Amazon reported a net loss for all of 2014, and has reported net losses in three of the past five quarters.) What Amazon does is use accounting rules and unusual presentations to confuse investors and analysts, which is precisely what the company is doing with its reported numbers for free cash flow and return on invested capital. Let's start with free cash flow, an important measure for judging the financial health of a company.
Amazon likes to focus investors on its free cash flow. In its second-quarter earnings release, for example, it mentioned the increase in its free cash flow in the second paragraph, before it said anything about revenue or net profit/loss. But this item excludes the majority of cash flows from Amazon's capitalized leases.
Amazon's defines free cash flow as "Net cash provided by (used in) operating activities", which is found on Amazon's cash flow statement, less cash investments in property plant and investments. Amazon uses "Net cash provided by (used in) operating activities," because it begins with net income, then backs out noncash adjustments and adds in cash flows from operating assets and liabilities, but Amazon's free cash flow excludes both the investments the company is making in capitalized leases and also the vast majority of the repayments for these leases through cash rents. Amazon's free cash flow also includes cash flows from Amazon's working capital. Analysts and investors shouldn't be using working capital cash flows when they value Amazon, however, although unfortunately some seem to be doing this anyway. What all of this means is that Amazon is increasingly relying on its accounts payable to finance its activities.
Since the third quarter of 2011, Amazon has added $3.6 billion to its free cash flow metric as its negative working capital has grown. Although perhaps that's a good strategy for short-term financing, accounts payable are debt and should not be included when valuing Amazon's businesses, in the same way that debt proceeds are not used.
Lastly, Amazon hides its lease financing activity. To be fair, Amazon does provide a breakout and some information on cash interest expense for capital and financing leases when it reports annual results, but the company doesn't provide this information in the intervening quarterly reports.
If you review Amazon's financial statements for the first and second quarters of this year, you will not see anything for Amazon's capital and lease financing obligations. Amazon embeds these obligations within "Other long-term liabilities." The lease obligations are the largest component within "Other long-term liabilities," and they are material to AWS. Why doesn't Amazon break out this information?