Tuesday, August 25, 2009

Latest Amazon.com Reader Review

2.0 out of 5 stars Oversimplification creates problems, August 21, 2009
By R. Reece (Orinda, CA United States) - See all my reviews
The author's definition of operating cash flow (from which he derives a profit margin that is important in his selection process) has a major flaw. In excluding all working capital changes from operating cash flow, his model misevaluates companies that are forced to make large accruals for deferred revenue. Any company that recognizes revenue ratably (over the term of a contract) falls in this category. Changes in deferred revenue accruals flow back into cash flow in the working capital line. This is one of the most important adjustments one must make to understand the earnings of companies with ratable revenue recognition.

The simplistic analysis of capital expenditures also causes many problems that lead one to cast out too many good stocks. Take for example WMS, a maker of slot machines. By the author's method, free cash flow is down 24% year over year. Why is the stock up about 40% over that span? A large chunk of WMS's capex is the cost of machines that are leased by casinos rather than purchased. WMS gets more than $60 a day in revenue from each machine, on average.

How does one evaluate the ROI? A machine might cost WMS $5,000-$8,000 to make. A casino needs to keep the machine on its floor little more than three months for WMS to get paid back for its investment. And when the casino returns the game to WMS, the company can refurbish it cheaply and re-lease it, or sell it outright.

WMS has grown gross cash flow (the author's version of operating cash flow) for four straight years, 26% CAGR, 250% increase. Over that span the stock little more than doubled. Perhaps it's still inexpensive now, or maybe it was overvalued four years ago.

WMS will never be inexpensive on free cash flow until the company ceases growing leased machine placements, which of course would be a bad thing. In such a case the author's method works in reverse, missing the growth story and finding a high ROI company only when its best days are behind it.