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Free Cash Flow: Adjusting for Acquisitions, Capital Allocation and Corporate Character
Posted by: Geoff Gannon (IP Logged)
Date: February 13, 2012 02:14PM
Someone who reads my articles sent me this email:
…I would appreciate your thoughts on three questions of mine:
Great questions. I get similar questions a lot. Especially about how to treat cash flows used for acquisitions. Is it really free cash flow? Or is it basically just another form of capital expenditure?
And questions about management changing their stripes are very, very common. That’s a tough question. But since these two questions are connected, I’ll start with the acquisition issue first.
When calculating the free cash flow of serial acquirers, should the acquisition costs be factored in?
Yes. If the company really is a serial acquirer, acquisition costs should be considered equivalent to cap-ex. The issue of acquisitions is always one that can be considered part of cap-ex or not part of cap-ex. If spending on acquisitions is treated as if it is part of cap-ex, then your expectations for that company's growth would be higher (because they would be growing through acquisitions). If it is not counted as part of cap-ex, then your expectations for that company's growth should be lower (because you are not treating acquisition spending as a normal part of the company's year-to-year progress).
Sometimes it may be easier to estimate growth before acquisitions.
For example, a company involved in a mundane business like running hair salons – like Regis (RGS), dentist offices – like Birner Dental (BDMS), grocery stores – like Village Supermarket (VLGEA), or garbage dumps – like Waste Management (WM), may be easy to estimate as essentially a no-growth business.
Sotheby’s would be harder. Because there is not a steady, year-in-year-out kind of demand for their products. And a growth company like Facebook would also be impossibly hard to evaluate this way. There is no normal industry wide rate of growth at those kinds of businesses. You simply have to evaluate them on a company-specific basis. You have to dig into their growth stories the way someone like Phil Fisher would.
But what about companies in industries with very steady demand? Industries like hair salons, dentist offices, groceries and garbage.
You can think of such businesses in two ways. One way would be to assume roughly zero percent real growth (although the company's nominal revenues might grow in line with inflation) and then to treat acquisitions as one-time both in terms of costs and the growth they provide.
The other way would be to assume the company will spend a certain amount of its free cash flow on acquisitions each year. In that case, free cash flow might fall to nearly zero (because acquisition costs are so high). But then you would analyze the business as if it grows by 3%, 5%, 8%, 10%, or whatever the acquisition-fueled sales growth tends to be.
So there are two ways to analyze a business that grows by acquisition. It is up to you to either pick which way works best for your understanding of the business — or to use both approaches in parallel. What you must never do is assume acquisition growth is real but acquisition costs aren't. Or — more conservatively — that acquisition costs are real but the growth they provide is not. If acquisitions are a normal part of the business, so is the sales growth they provide. If acquisitions aren’t a normal part of the business, then neither is the sales growth they provide.
What are your thoughts on using pre-tax earnings, FCF, etc. yields to evaluate the attractiveness of securities? Intuitively, post-tax is all that matters, but pre-tax numbers allow for a more straightforward comparison between equities and fixed-income securities?
If you are analyzing the company as a potential control buyer — asking yourself what this company would be worth to private equity, a competitor, Berkshire Hathaway (BRK.A)(BRK.B), etc. — use pre-tax numbers. And use enterprise value instead of the stock price. Analyze the business like you are buying the whole thing — equity and debt — and you are getting all of their EBIT.
But if you are analyzing the company merely as a passive minority investor, use free cash flow or after-tax income. This second calculation is important in situations where you imagine being invested for a long time under the same management team or corporate culture. These are not situations where you imagine a change of control. They are not something you are looking to buy today and sell next year.
These are long-term holdings.
When you are looking at that kind of business — Berkshire Hathaway is certainly one, but CEC Entertainment (CEC), Birner Dental, Oracle (ORCL) etc. may also count — you are imagining yourself as a shareholder and silent partner in a business that will continue to be controlled by the current management team — or similar successors — and in which they will decide what your dividends are each year, they will decide how much stock is issued or bought back, etc.
Buy and hold investments should be analyzed on a free cash flow basis. Not an EV/EBIT basis. "Value" investments in the Ben Graham sense of the word — think cigar butts — should be analyzed on an enterprise value.
Simply put, make your Ben Graham investments on an EV/EBIT basis. And make your Warren Buffett investments on a price-to-free-cash-flow basis.
We can think of this as a public owner versus private owner choice. Are you buying the company because you think it is cheap relative to its intrinsic value and you expect to receive your investment gain in the forms of capital gains caused by a rising share price that will close the gap between price and value — some sort of merger, takeover, etc. — or do you imagine being invested in the company the way Warren Buffett is invested in Wells Fargo (WFC), Coca-Cola (KO), the Washington Post (WPO), etc.?
Enterprise value and operating income (“EBIT”) should be used when analyzing an investment as a private owner. This is how Joel Greenblatt seems to work. At least that is how he talks in "You Can Be a Stock Market Genius" and how he designed the magic formula (enterprise value and pre-tax earnings). If you are looking to buy a company on a public owner basis — like Berkshire Hathaway’s long-term investment mentioned above — then you need to look at the investment on an after-tax basis. Probably on a free cash flow basis. And you certainly need to make sure you are comfortable with current leverage, management and capital allocation policies. Because you are betting on those things continuing.
I know this sounds confusing. It sounds like I’m saying there are two different ways of analyzing a company. Do you really have to decide if you are buying a Ben Graham stock or a Warren Buffett stock? That just doesn’t sound right.
But think about the way Warren Buffett described the stocks Ben Graham bought in the 1950s and before. He called them used cigar butts. Stocks that were pretty much free. But that had only one puff left in them. The puff was all profit. But once you took that puff, you had to get out of the stock fast.
And Buffett has repeatedly said that he made a big mistake by buying control of Berkshire Hathaway. Everything he did after buying the dying textile mills was genius. Buying insurance companies, See’s Candies, etc. Brilliant. Buying Berkshire? Dumb.
How can that be?
It wasn’t because buying a net-net like Berkshire Hathaway was actually a mistake. It wasn’t. Buffett was right to buy Berkshire Hathaway stock at first. He was wrong to hang onto it. He was wrong to hold that kind of company — a bad one — year after year.
If you expect to buy a stock the way Ben Graham did — using a static intrinsic value estimate as your expected sell price — you can use enterprise value and EBIT as your valuation tools.
But if you start thinking about stocks the way Warren Buffett does today, you are moving into another area. Another way of thinking. This area of investment is not static. It’s not about getting one profitable puff and then selling out. It’s not about looking for a stock to rise 30% or 50% or 100% in one or two or three years. It’s about owning something for, well, forever.
That’s a different game entirely. It’s a different approach. It comes from Ben Graham’s principles. From his core beliefs. But it’s a different approach. It’s very close to Phil Fisher. And it’s an approach that depends more on management, capital allocation and the free cash flow they have to allocate rather than measures like enterprise value and EBIT.
Where capital allocation is important, you need to move beyond EV/EBIT. You need to start thinking dynamically. Start thinking about the future. The uses free cash flow will be put to. You need to start thinking about dividends and stock buybacks and acquisitions and all that.
Warren Buffett clearly does. If you listened to Buffett talk about why he bought IBM (IBM) — this was when he was talking to the folks over at CNBC — you could tell he was very excited about the idea that IBM had reduced its share count over time. He had no problem at all with modest sales growth if it was accompanied by constant share buybacks. That gives you a rising earnings per share number the same way much stronger sales growth — through acquisitions — would. Buybacks are just another form of capital allocation.
For stocks like IBM, don’t use enterprise value and EBIT. Use free cash flow. And really dig into the company’s history of capital allocation. Do you think they will have a higher or lower share count 10 years from now? Those are the questions that matter when analyzing something like IBM. Something where the uses free cash flow is put to are key.
Now for a more company-specific question. Sotheby's is inherently a very good business, but management owns only a small sliver of equity and in the past has failed to act prudently in the use of the balance sheet (impairment charges show up on cash flow statement following downturn in art market). The language in the SEC filings since that point is encouraging… which brings me to my question. How can an investor evaluate if management has learned from past missteps? Or it is so time consuming that a more efficient use of time would be to move on to other ideas?
My advice here is simple. Words don't matter. Behavior does. Character is behavior. And behavior is character. When looking to assess a person, look at their past record. The pattern that emerges is a portrait of that person. Don't listen so much to what others say about them, or even what they say about themselves.
Look at what they did.
Talking about buybacks tells you nothing. Actually doing 10 straight years of buybacks tells you something. There are companies like CEC Entertainment (CEC) and Sherwin Williams (SHW) that practice buybacks like that pretty consistently. Then there are Internet companies and tech giants that dilute their shareholders year after year. Finally, there are companies that raise their dividend every year.
Some companies overpay chasing instant growth through acquisitions. Companies will always tell you their latest purchase is a good idea, and then when they spin the unit off or sell it, they'll tell you they've learned focus matters. Five years later they'll be talking about diversification again. Today they may talk about unlocking shareholder value. But if the economy is really pumping and the stock market is really frothy in 5 or 10 years, you can bet they’ll be talking about the importance of growth again.
Focus on past behavior. Look at what people really did. Not just people. But institutions too. Understand the temptations all companies face. But don’t trust words. Trust deeds.
As far as I’m concerned, management's character is equivalent to their pattern of past behavior. Nothing more. Nothing less.
Talk to Geoff About Acquisitions, Capital Allocation, and Corporate Character firstname.lastname@example.org
Re Free Cash Flow Adjusting for Acquisitions Capital Allocation and Corporate Character
Posted by: Josh Zachariah (IP Logged)
Date: February 13, 2012 06:19PM
Great article as usual Geoff