Margins vs Free Cash Flow
Don't Confuse Trees for a Forest
Every once in awhile there’s a great tweet or article that reminds me that Margins do not equal Free Cash Flow. In some ways, this is a continuation of my post last week about The Fallacy of Benchmarking, an undue focus on margins can obscure great moves that influence eventual free cash flow.
Ben Shaechter, had a great tweet the other day that he found from reading a Pinterest quarterly filing. In it, Pinterest states that they entered into a contract with AWS to purchase at least $3.25B of cloud services from AWS over 9 years. That’s $360M a year which seems like a mind-boggling number on the surface.
Then from Amazon’s most recent quarterly earnings, they mentioned seeing “pricing pressure”. This spooked many investors. However, the follow-on to the pricing pressure comment shows that it is as a result of longer-term contracts being signed as more companies are realizing the long term needs they have for digital transformation. The snippets from both AWS and Azure related to this are shown below.
So the question is who’s getting the better deal here and is this bearish for AWS?
First off, if you ever are at an Indian wedding ceremony, make sure to bring crossword puzzles or download mobile games in advance :) The celebrations before and after the ceremony are awesome, during the ceremony…not so much.
But back to the issue at hand
What we sometimes forget is that margins are in fact a shorthand for free cash flow. When margins go up, we assume that there will be more free cash flow in the future, when margins go down we naturally assume the opposite.
However, as we know shortcuts have plenty of pitfalls. They usually don’t do well with nuances. I.e. if you’re driving from NYC to NJ the “shortcut” would be to just drive straight from Battery Park to Jersey City. The nuance is that there just happens to be a ton of water so driving there would cause your car to sink into the ocean. You actually have to take the Holland Tunnel to get across.
So relying on shortcuts is not something we should do without thinking through the nuances.
In this case, I would argue that both Pinterest and AWS are getting a great deal. Pinterest is most definitely locking in a discounted rate for the cloud services they expect to consume in the long term. If they continue to grow at the rate they are, then that $360M/year will actually be quite cheap in a few years. And vice versa, AWS knows how much Pinterest is paying them contractually so they can allocate the cash flow from that deal with more certainty to invest in other parts of the business.
This allows them to hire more readily, build more services with strong certainty, and also provides for a customer over the next 9 years vs having to deal with annual renewals and potential churn. So even if the margin % is lower, the absolute free cash flow dollars are likely higher as the LTV/CAC ratio just went super high for AWS in this deal. Minimal CAC (customer acquisition costs) to keep Pinterest and an assured LTV (lifetime value) of 9 years. That means a lot of free cash flow regardless of the margin % hit.
Furthermore, Pinterest is also learning all about the AWS services, how they integrate, how the sh*tty AWS UIs work, etc. Which makes them even more likely to stick with AWS as the contract ends in Apr 2029 leading to guess what…..more free cash flow and higher LTVs!
So please share this with a friend, colleague, your grandparents, whomever the next time someone mentions margin % decreasing as a negative without examining the details behind it.
Shortcuts are great as long we understand the nuance.
Great stuff, very true. People often don't take the time to understand the underlying economics.