Dear Mr. Gannon,
…In your calculation of free cash flow you mention investors should subtract increased investments in working capital, as these represent unaccounted uses of cash for the business. I was wondering what happens if this investment is negative? Do we add this onto our FCF calculation, since mathematically two negatives make a positive? Has the company really gained any cash? Moreover, what does a negative investment in working capital imply? (One of the companies I’m analysing in Australia has been showing negative changes in working capital for the last few years: after it began divesting from unprofitable operations, improving margins and boosting return on equity. If I count the cash I know it’s a good thing since FCF has improved. However, their working capital investment which is negative has me slightly worried as I don’t know whether that’s a good or a bad thing, or even if it will be recurring).
You seem to understand this issue well. The important thing is looking at how the cash flow is being generated. It depends on the situation. There is no one rule to fit all companies. I could take you through some specific company examples. But I don't want to waste your time right now. If you have time – here are some companies you could look at for examples of companies where constantly increasing working capital (in the very long run) has been a drag on the business:
· Lakeland Industries (NASDAQ:LAKE)
· ADDvantage Technologies (NASDAQ:AEY)
Both companies tend to reinvest profits into additional inventory. This means that as long as they are growing they can't afford to pay out any cash. Earnings must be retained. The upside is you got growth for many years. The downside is they had little or no ability to buy back stock, pay dividends, etc. Now for the other side – look at Taitron Components (NASDAQ:TAIT). Here we see free cash flow being generated by a slow motion liquidation. Current assets like inventory have been falling over time. This has provided much of the cash.
Should you count this? Should you ignore the cash flow Taitron has generated over the last decade or so because it is from reductions to working capital? And should you treat Lakeland and ADDvantage as if they actually have little or no earnings simply because they have reinvested these earnings in working capital growth instead of buying back stock, paying a dividend, etc.?
Neither extreme is right.
Teledyne had a policy of crediting its subsidiaries with the average of that unit's free cash flow (as in cash actually returned to shareholders) and its reported profits. If it reported profits of $10 million but kept all of its cash (adding to inventory, receivables, etc.) then Teledyne would say that unit's earnings were $5 million (because $5 million is the average of $10 million in reported profits and $0 in cash paid out).
A company's goal is to generate the most cash profits. But reduced investment in plant, inventory, etc. could reduce cash profits in future periods. So could low spending on research, advertising, etc. but these are expensed on the income statement in a more obvious way. Capital spending and working capital growth are trickier. The answer is that neither measure is perfect. I always look at both operating profit and free cash flow. And I look at operating profit and free cash flow – both – relative to sales and invested tangible assets over at least a 10 year period. This gives me some idea of the earning power of the business.
It is better to be roughly right than exactly wrong. Don't be foolish. If it is obvious a company is reinvesting all of its cash flow into additional inventory to support growth – for instance sales and inventory are both rising at 10% a year over each of the last 10 years – then clearly the company is not producing cash now because it is instead growing the business. Likewise, if a company is generating free cash flow merely through liquidation of inventory and receivables running off – understand that for what it is. That kind of free cash flow is not sustainable.
These issues are common among net-nets. There is another issue relating to free cash flow. It has to do with the business itself. Do the businesses in this industry tend to constantly produce more free cash flow than expected relative to operating income or less?
For example, in the U.S. you would expect operating income times 0.65 to be roughly the amount of "normal" free cash flow (after-tax) a company should generate in the long run. In reality, inflation would normally cause this number to be lower than I just said even if cash receipts were timed to match reported income. But it's not an issue we need to worry about in a modest or reasonable inflation environment. Even at 4% inflation, it should be hardly noticeable at most companies.
Now, the other big issue here is how cash is received in the business. And how it is used. This is my advertising agency vs. railroad example. A railroad will tend to have free cash flow that is low relative to reported operating earnings. An advertising agency will tend to have free cash flow that is high relative to reported operating earnings. This is a different issue entirely. One is an asset light business (the ad agency) that could – theoretically – pay out earnings in cash almost from the first year it is open if it neither grows nor shrinks. The railroad is different. A railroad will tend to need to always pay more in cash in the future to replace assets than it is depreciating them at. With long-lived assets the difference can become substantial. This is even more noticeable in a growth phase. There is a huge difference between a growing railroad and a growing ad agency. The ad agency will produce cash with a higher present value because it will arrive sooner than the railroad. Today, this is much less noticeable because growth in actual physical assets is subdued at railroads in the U.S. Check out cruise lines for an example of a fast growing asset heavy business. American railroads once looked like that – long, long ago.
Anyway, here's my answer to question #1. Use common sense. Don't ignore your intuition. Use your entire understanding of the business and its uses of cash over the last decade. Understand if it is growing, decaying, etc.
Separate businesses that are experiencing huge changes in working capital – like AEY vs. TAIT – from companies that will continue to convert earnings into immediate cash at different rates like Omnicom (NYSE:OMC) vs. Carnival (NYSE:CCL).
These are two different issues.
Also, keep in mind that the best business is one that receives cash early on relative to when it records sales and needs little or no additional capital (plant, inventory, receivables, etc.) to grow the business. The less cash investment needed and the quicker the cash return on additional investment hits the coffers – the better the business is. If you are looking for long-term investments, focus on cash flow mechanics that will be permanent. And never give full credit to the cash flow reported by a company like TAIT. That kind of free cash flow is not sustainable.
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