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The Capital Memo
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Stock-based compensation. Under GAAP, when a company pays employees in stock, the expense reduces net income on the income statement, and then GAAP adds it back to operating cash flow because no cash actually moved. The accounting is internally consistent, since cash genuinely didn't change hands, but the activity is sitting in the wrong category. Stock-based compensation is a financing decision. The company is using equity, which is a financing instrument, to pay employees instead of using cash. Mauboussin moves it out of operating activities and into financing activities, where it sits next to share repurchases and dividends. For Amazon in 2020, stock-based compensation was $9.2 billion. Reclassify it, and reported operating cash flow falls by the same amount.
Leases. A company that needs a building can buy it or lease it. The economic substance of the two choices is similar, even though the cash flow statement treats them as different activities. A purchased building goes into investing activities. A leased building, depending on classification under Topic 842, splits between operating and financing. Mauboussin's fix is to move every lease into investing, on the view that an asset acquired through a lease is still an investment in productive capacity. For Amazon, the 2020 filings show roughly $5.8 billion of property and equipment acquired under finance leases and build-to-suit arrangements. That is currently scattered across operating and financing rather than landing in investing alongside what a comparable purchase would have looked like.
Intangibles. Most R&D, software development, advertising, and brand spending hits the income statement as expense in the year it is incurred. That treatment was reasonable in 1965, when the typical corporate investment was a factory or a fleet of trucks. It is less natural for a business like Amazon, where the largest investments are software, AWS infrastructure code, and machine learning systems that produce returns over many years. Amazon's 2020 technology and content line was $42.7 billion, and a meaningful portion of that figure represents long-lived investment that should arguably be capitalized and amortized rather than expensed in the year of spending. Mauboussin proposes doing exactly that, the same way GAAP would treat a factory.
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Amazon 2020 · The Reclassifications
$9.2B / $5.8B / $42.7B
Stock-based comp moves into financing. Lease additions move into investing. A portion of tech and content investment, capitalized. The total cash through the business, unchanged.
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Mauboussin is careful to point out that none of these adjustments change Amazon's actual free cash flow. The total cash going in and out of the business in a year is unchanged. What shifts is the composition: the category each dollar of cash gets assigned to on the statement.
Composition is where most valuation work happens. P/E ratios, operating cash flow multiples, return on invested capital, free cash flow yield: each of these depends on which bucket the underlying cash sits in. The standard GAAP presentation makes the buckets non-comparable across companies, and the non-comparability is widening every year as the economy tilts further into intangibles and equity-based compensation.
Two analysts working from the same Amazon 10-K, both competent, can reach materially different valuation conclusions. The thing that separates them is whether either one bothered to recategorize the buckets before plugging the numbers into a model.
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The institutional friction.
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It is fair to ask why, if these adjustments are useful, they aren't standard practice. Most of the answer is about who has the incentive to do the work. Sell-side analysts produce models on tight earnings-season deadlines, where the marginal benefit of a more accurate ROIC denominator does not pay for itself by 7 a.m. The headline cash flow figure a company reports in its earnings release is going to be the largest one GAAP allows, because that is what investor relations teams are paid to produce. Audit firms apply the standards as written, and the standards do not currently allow Mauboussin's presentation. Adoption requires individual investors to do the recategorization themselves, on a portfolio of companies, by hand.
The investors who do this work tend to be long-only managers running concentrated portfolios, where holding periods are long enough for accounting comparability to actually pay. Counterpoint Global is one. A handful of family offices and PE shops I have come across run versions of it. Their conclusion, in broad terms, is that the adjusted numbers are simply more useful in day-to-day work, both for comparing companies in the same sector and for tracking a single company's economic returns over time. The data is already in the filings; the work is mostly transcription.
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The cash flow statement was designed for an industrial economy. Stock-based compensation, leases, and intangible investment were small line items at the time the standards were written, and treating them as edge cases in the operating section made sense for that economy. None of those three are small anymore. At most large U.S. tech companies they are central to how the business produces returns. Mauboussin's reclassifications are an attempt to make the existing 10-K disclosures legible for the kind of business reading them today.
Have a good Monday.
— Marques
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About the author
Marques Blank writes The Capital Memo. CMA, MBA, Series 65.
Source
Mauboussin, M. & Callahan, D. (2021). Categorizing for Clarity: Cash Flow Statement Adjustments to Improve Insight. Consilient Observer, Counterpoint Global Insights, Morgan Stanley Investment Management, October 6. · Amazon.com Inc. Form 10-K for fiscal year 2020.
For informational purposes only. Not investment advice. Specific securities mentioned are case studies, not recommendations. Dollar figures sourced from Amazon's 2020 Form 10-K. Past performance does not predict future results.
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