Friday, September 18, 2009

Free Cash Flow and Deflation

In writing about Free Cash Flow and deflation, I am not predicting the US is about to enter a severe deflationary period. I am only suggesting a full-blown encounter with deflation is possible and that because it is possible, and especially because we are not accustomed to investing in a deflationary period, it is worthwhile to consider how we might use Free Cash Flow and Investor Return in a long-term deflationary scenario.

1) Why bother with deflation at all? First, the strong rebound from the March lows indicate the equity markets have essentially recovered and, if there are any major worries on the horizon, inflation – not deflation – is at the top of the worry list. Second, should in fact we find ourselves in a deflationary economy, there will not be much point in investing in stocks as both earnings and multiples have historically contracted in deflationary periods.

In my view, the post-March equity rebound has been primarily driven by 1) recognition the financial markets are not going to explode; 2) wishful thinking about the shape and magnitude of the recovery in the basic economy; 3) fear on the part of professional investors who, having produced negative returns for their clients over the past year, know they will be quickly abandoned by their clients should they miss an equity rebound and therefore are fully invested in equities; and 4) speculative trading in financial stocks that has infected non-financial sectors. While there is some evidence the economy is on the mend, there is also evidence to the contrary. Interpretation of economic data in this environment is very risky – there appears to be a lot of statistical “dust” overhanging the raw data and this is likely to persist until the economy – the economy – not the financial markets – return to some state of normalcy.
To the second point, even if the economy as a whole enters a strong deflationary period, it does not mean all companies will be equally affected. The equity market as a whole will suffer multiple contraction but some stocks will still provide attractive returns. The trick is identifying those industries and companies that will prosper in spite of general economic conditions.

2) How will use of the Free Cash Flow Statement and the Free Cash Flow Worksheet differ under strong deflation conditions as compared to more normal conditions?

Let’s first go through the Free Cash Flow Statement.


As long as most public companies continue to report declining or flat Revenues we know we are entering or are in a deflationary period. Thus far many firms have been able to “improve” reported earnings as compared to recent guidance – not compared to previous guidance or to period over period. On the one hand, the equity market has applauded the earnings “improvement”, attributing it to brutal cost cutting. On the other hand, the equity market has expressed confidence that Revenue increases will follow in subsequent quarters. The equity market wants it both ways but cannot have it both ways - because one company’s successful cost reductions are the lost Revenues of its vendors. The cost cutting (and therefore the Revenue declines) will continue until business capacity is aligned with consumer, business and government demand. The government can only spend so much before the financial markets rein it in (as the bond market in 1980, by not buying US Treasuries, forced President Carter to slam on the credit brakes – a different economic scenario than today’s but the bottom line is:eventually markets rule over governments – even governments run by geniuses). The consumer is not returning to the “borrow and spend beyond your means” lifestyle that resulted in the capacity/hiring increases by business that characterized the last ten years. As business continues to cut costs by eliminating jobs and reducing purchases, consumers will continue to prepare for worse days ahead by increasing saving and living within their means. Only when we see continued increases in Revenues across a large portion of the economy can we be confident that deflation is no longer a major problem. Until that occurs, ignore the data dust and the equity market’s wishful thinking.

Operating Cash Flow Margin (OCFM)

Because the OCFM excludes Depreciation and other accounting estimates that smooth cash flows into averages and long term estimates, the OCFM is a more real-time portrait of a company’s cost margin than any margin based on GAAP numbers – as is or adjusted. In times like this, big changes are happening fast in how companies allocate cash so the more sensitive a ratio is the better. There is no overall cost margin as sensitive as the OCFM. If you find one, please advise and we will post it on the website.
When the economy is expanding and companies are enjoying increasing Revenues, identifying the low cost producer in an industry or niche is sometimes less important than finding the company about to significantly expand market share with new products or services. But in a deflationary environment, the low cost producers have the advantage because price gets a lot more relative attention from purchasing managers than it does in good times. The OCFM will help you identify the low cost producers. But make sure you are sufficiently conservative when projecting the OCFM. If Revenues are projected to decline and a company has already made substantial cost cuts, the OCFM is unlikely to increase or stabilize.

∆ Working Capital

Always a headache, in good times and bad, ∆ Working Capital is difficult to interpret and harder to project. A decline in Revenues may reduce Working Capital, thereby increasing estimated Free Cash Flow per share. But a decline in Working Capital is not a sustainable long term source of Free Cash Flow and investor return, so be careful. Many companies have reduced Working Capital in 2009 – but they cannot effect material reductions forever. Watch Days Receivable. Large increases may suggest ramping Revenues by extending terms and/or deteriorating financial condition of customers. The longer your time horizon, the more you may want to consider adjusting the ∆ Working Capital estimate to a smaller number.


Many companies have reduced Capex given lower Revenues and prevailing uncertainties. These Capex reductions are obvious in the Free Cash Flow Statement but will not be fully reflected in GAAP earnings because of depreciation. Again, the Free Cash Flow Statement provides a faster take on what is actually happening in a company (and in the economy). In a deflationary period some companies will shift to almost entirely maintenance Capex. When high cost producers cut maintenance Capex, start the timer.
Again, one company’s Capex reduction translates into many other companies’ lost Revenues and lower Free Cash Flows. Monitoring a list of a company’s largest customers is even more important in a deflationary scenario. If the major customers are experiencing declining Revenues, and if your company’s Revenues are the major customers’ Capex, then your company may have a problem.

Free Cash Flow

The Free Cash Flow Margin (FCFM) is especially important in deflation periods. The equity investor must be more attentive than usual to a company’s ability to generate sufficient cash flow to continue operations, service debt and pay dividends, if any. GAAP EPS is not only of no help on these points – it can provide misleading information.

Free Cash Flow Deployment

The equity investor must understand how much potential a company is likely to have to do acquisitions, buyback stock and reduce debt. Yes, there are far fewer companies engaged in these deployments than was the case only several years ago! But many companies continue to deploy cash in ways that increase investor return.
It does seem likely that if deflation takes hold, the relative sources of investor return will change. In the past, Revenue increases accounted for a large share of investor return. In a deflationary scenario, Revenue increases will take on proportionally less importance than in recent years. The OCFM will be somewhat more important as the low cost producers exploit their advantages and are rewarded more than has usually been the case. But costs can only be cut so far. How then, will companies differentiate themselves from their competitors – if not by higher Revenue increases and bigger cost reductions? There is only one area left for management to increase investor return (if they care to!): superior capital management. The Free Cash Flow Worksheet provides a picture of how management is allocating capital, both internally generated capital (Free Cash Flow) and externally obtained capital (debt and equity issues). Those management teams that can optimize capital generation and deployment for the benefit of shareholders will separate themselves from those managers entirely focused on revenues and costs. And once deflation ends and inflation begins, these capital-savvy CEO’s and CFO’s should be able to deliver very good returns to their investors.

Where should we look for companies that will do relatively well in a deflationary period?

1) Corporate America’s unused capacity (created by American consumers spending beyond their means with borrowed cash) must be realigned with the newly frugal American consumer. So any company that derives a large segment of its Revenues from capacity-increasing products/services should be avoided for now.

2) Companies that sell high-priced consumer goods/services should be avoided and companies that sell low-priced consumer goods/services should be considered.

3) US companies whose Revenues have a high percentage of foreign sales should be considered.

4) Companies that sell products/services that address their customers’ critical needs that must be satisfied even while customers’ Revenues and/or cash flows are declining. An example in both the corporate and consumer market could be Internet security products.

5) Go through the 100 Companies Worksheet. Thinking about the industry’s products/services and looking at the Free Cash Flow Worksheet, which industries are likely to be the best performers in an extended deflationary period? Which companies are likely to be the low cost producers? Which management teams are likely to do the best job of managing capital? Which companies are likely to be in the best position to exploit a recovery?

Tuesday, September 1, 2009

An Article In Seeking Alpha about My NYSSA Presentation

Here is the link to the article on the Seeking Alpha site: