West Coast Asset Management recently released their monthly newsletter. As always an interesting read that helps you focus on what is important.
Here it is:
When reviewing a potential investment, entrepreneurial investors conduct in-depth research on a wide range of quantitative and qualitative metrics, and pay special attention to cash flow. Cash flow is the lifeblood of nearly every business, and analyzing the in-flows and out-flows can tell us not only about the value of the business, but also provide great insight into a company’s financial health and the quality of its management.
While income statements often wear the finest adornments which can be crafted by their designer accountants, the cash flow statement stands more or less naked. It effectively reconciles cash between the income statement and balance sheet, adjusting for changes in working capital and non-cash items that often skew a company’s true profitability.
For instance, depreciation is a non-cash expense on income statements that can be misleading, especially for companies that have rapidly built new stores in the recent past and then slowed the pace of development as they approached market saturation. Depreciation would mask true profits in this scenario, because the income statement would reflect a high amount of depreciation associated with money that has already been spent on existing stores. Meanwhile, these existing stores only require a small amount of “maintenance” capital expenditures going forward.
An example of this is American Eagle Outfitters (AEO), which spent $244 million on capital expenditures during its 2009 fiscal year and only $84 million during its 2011 fiscal year, yet it still reported depreciation of $145 million during its 2011 fiscal year. For a company with a market capitalization of $2.5 billion, this is a very important distinction.
At the other end of the spectrum, derivative accounting can result in sizable non-cash gains that have little to do with the underlying fundamentals of a business. For example, if oil prices fall, an oil company may report a sizable increase in profits due to the “mark to market” value of its hedges that are locked in at higher prices. In this instance a non-cash “paper” gain is recorded on the income statement, but no cash is actually generated. As commodity prices often experience great fluctuation from quarter to quarter, a drop in oil prices shows up as a benefit on the income statement in this instance, while the negative implications of lower oil prices for the company’s remaining future production are not factored in. Thus, such an occurrence could appear as a windfall on the income statement, whereas the triggering event has actually lowered the value of the overall business.
Changes in working capital, such as inventory and receivables or payables, can also tell us a great deal about a business. Increased inventory may be a sign of stale product, such as outdated DVDs or books that are not selling and are not worth what they are valued on the balance sheet. Decreased receivables can be a sign of good cash management, while increased receivables can be a warning sign that a business is unable to collect from its customers or is not managing its cash flow prudently. In most cases, these changes are not a reason for concern, but it is better to have done the homework so that a warning signal can be spotted when it appears.
The cash flow statement can also reveal information about management’s capability and philosophy. For instance, it provides an accounting of capital allocation which consists of capital expenditures, acquisitions, dividends, share repurchases and debt repayments. This is important because it is not uncommon for management to have objectives and incentives that are not aimed at increasing per-share value for shareholders.
In the case of acquisitions and capital expenditures, investors can compare historical capital outlays to the associated value added (or destroyed) and determine whether and to what extent management has been creating value. If management has not been investing wisely, then shareholders rightly have good reason to pressure management to pay out excess profits in the form of increasing dividends and share repurchases.
Share repurchases can be a fantastic way to increase shareholder value if management is prudent with the price it pays. As an example, Gamestop Corporation (GME) repurchased 17.1 million shares during its fiscal year 2010 at an average price of $19.84 per share. Today its stock sells for $28 per share, a 40% gain and a pat on the back for management.
Evaluating a company’s past can often tell you a lot about its future. For instance, Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) philosophy for decades has been to deploy its excess profits in favor of business acquisitions and investments as opposed to share repurchases and dividends, and it has built an impressive empire in doing so. On the flip side, many consumer staple companies such as Coca-Cola (KO) have a long history of returning profits to shareholders through dividends and share repurchases.
At the core, examining a company’s cash flow is similar to a doctor’s examination of a patient. It focuses on how the past has led to the present, and it paints a picture of what the future is likely to bring. As entrepreneurial investors, we are most concerned about the future. Therefore, the cash flow statement is the most important tool at our disposal.
Link to the article:
http://wcam.com/wp-content/uploads/2011/06/wcam_excloutlk_nwsltr_June2011.pdf
Here it is:
When reviewing a potential investment, entrepreneurial investors conduct in-depth research on a wide range of quantitative and qualitative metrics, and pay special attention to cash flow. Cash flow is the lifeblood of nearly every business, and analyzing the in-flows and out-flows can tell us not only about the value of the business, but also provide great insight into a company’s financial health and the quality of its management.
While income statements often wear the finest adornments which can be crafted by their designer accountants, the cash flow statement stands more or less naked. It effectively reconciles cash between the income statement and balance sheet, adjusting for changes in working capital and non-cash items that often skew a company’s true profitability.
For instance, depreciation is a non-cash expense on income statements that can be misleading, especially for companies that have rapidly built new stores in the recent past and then slowed the pace of development as they approached market saturation. Depreciation would mask true profits in this scenario, because the income statement would reflect a high amount of depreciation associated with money that has already been spent on existing stores. Meanwhile, these existing stores only require a small amount of “maintenance” capital expenditures going forward.
An example of this is American Eagle Outfitters (AEO), which spent $244 million on capital expenditures during its 2009 fiscal year and only $84 million during its 2011 fiscal year, yet it still reported depreciation of $145 million during its 2011 fiscal year. For a company with a market capitalization of $2.5 billion, this is a very important distinction.
At the other end of the spectrum, derivative accounting can result in sizable non-cash gains that have little to do with the underlying fundamentals of a business. For example, if oil prices fall, an oil company may report a sizable increase in profits due to the “mark to market” value of its hedges that are locked in at higher prices. In this instance a non-cash “paper” gain is recorded on the income statement, but no cash is actually generated. As commodity prices often experience great fluctuation from quarter to quarter, a drop in oil prices shows up as a benefit on the income statement in this instance, while the negative implications of lower oil prices for the company’s remaining future production are not factored in. Thus, such an occurrence could appear as a windfall on the income statement, whereas the triggering event has actually lowered the value of the overall business.
Changes in working capital, such as inventory and receivables or payables, can also tell us a great deal about a business. Increased inventory may be a sign of stale product, such as outdated DVDs or books that are not selling and are not worth what they are valued on the balance sheet. Decreased receivables can be a sign of good cash management, while increased receivables can be a warning sign that a business is unable to collect from its customers or is not managing its cash flow prudently. In most cases, these changes are not a reason for concern, but it is better to have done the homework so that a warning signal can be spotted when it appears.
The cash flow statement can also reveal information about management’s capability and philosophy. For instance, it provides an accounting of capital allocation which consists of capital expenditures, acquisitions, dividends, share repurchases and debt repayments. This is important because it is not uncommon for management to have objectives and incentives that are not aimed at increasing per-share value for shareholders.
In the case of acquisitions and capital expenditures, investors can compare historical capital outlays to the associated value added (or destroyed) and determine whether and to what extent management has been creating value. If management has not been investing wisely, then shareholders rightly have good reason to pressure management to pay out excess profits in the form of increasing dividends and share repurchases.
Share repurchases can be a fantastic way to increase shareholder value if management is prudent with the price it pays. As an example, Gamestop Corporation (GME) repurchased 17.1 million shares during its fiscal year 2010 at an average price of $19.84 per share. Today its stock sells for $28 per share, a 40% gain and a pat on the back for management.
Evaluating a company’s past can often tell you a lot about its future. For instance, Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) philosophy for decades has been to deploy its excess profits in favor of business acquisitions and investments as opposed to share repurchases and dividends, and it has built an impressive empire in doing so. On the flip side, many consumer staple companies such as Coca-Cola (KO) have a long history of returning profits to shareholders through dividends and share repurchases.
At the core, examining a company’s cash flow is similar to a doctor’s examination of a patient. It focuses on how the past has led to the present, and it paints a picture of what the future is likely to bring. As entrepreneurial investors, we are most concerned about the future. Therefore, the cash flow statement is the most important tool at our disposal.
Link to the article:
http://wcam.com/wp-content/uploads/2011/06/wcam_excloutlk_nwsltr_June2011.pdf
