Review in the Toronto Globe and Mail

The following appeared in the Toronto Globe and Mail, Canada's second largest newspaper:

July 11, 2012

Free cash flow: It's better than profit

By ROBERT McWHIRTER

Why free cash flow is so important in determining a company's true value

What are we looking for?
Rising free cash flow, low enterprise value to free cash flow and good incremental operating cash flow for each dollar of increased sales.
Free cash flow (or FCF) is cash available for investors after the company has funded its cash costs, its receivables and inventory and its capital expenditures. In his book, Free Cash Flow: Seeing Through the Accounting Fog Machine, author George C. Christy, CFA, makes a compelling case for the importance and impact of free cash flow on a company's true value.
Mr. Christy quotes Alex Pollock of the American Enterprise Institute (AEI): "Every calculation of net profit reflects choices from among competing theories of accounting. ... They are matters of opinion ... not matters of fact. ... Profit is an opinion, cash is a fact." In addition to his work at AEI, Mr. Pollock is a seasoned banker with more than over 35 years in the industry, and is the a former president and CEO of the Federal Home Loan Bank of Chicago.
Growth investors should pay attention as Mr. Christy notes that: "All too often companies produce terrific revenue and EPS growth rates while sacrificing margins and/or using excessive amounts of capital." He adds: "A company that chronically provides revenue increases and negative cash flow does not include investor return among its priorities."
More about today's screen
In creating today's offering, I filtered the Morningstar CPMS database of Canadian companies for large firms using Mr. Christy's criteria.
In addition to companies with strong free cash flow growth and good incremental operating cash flow for each dollar of increased sales, I looked for firms with:
A market cap greater than $295-million;
No negative earnings surprises and positive estimate revisions.
This screen follows Mr. Christy's insight. "Some of the best return candidates can be found in the bottom of free cash flow yields ... companies that may have recently transitioned from negative to positive FCF and may have good prospects for continued growth."
What did we find?
Back testing – based on up to 25 stocks from September, 2004 to June, 2012, using the Morningstar CPMS database, showed Mr. Christy's criteria significantly outperformed the S&P/TSX composite index (14.1 per cent for the portfolio versus 7.5 per cent for the S&P/TSX). The median trailing P/E and EV/FCF for the portfolio is similar to the typical Canadian stock.
The median increase in year-over-year free cash flow is 90 per cent versus negative 4 per cent for the S&P/TSX. The median trailing free cash flow yield is 5 per cent versus negative 2 per cent.
The median year-over-year sales growth of 17 per cent versus 6 per cent is almost three times greater than the S&P/TSX. The median increase in incremental cash flow for each dollar of additional sales is also three times greater. This combination appears to be a significant contributor to the outperformance of the portfolio.
Robert McWhirter is president of Selective Asset Management Inc. [http://www.selectiveasset.com/default.asp]

Letter to the Editor in Barron's

Following is my (extensively edited!) letter in the 9/20/10 Barron's:

The Sept. 6 Follow-Up article on the French drug company Sanofi's proposal to buy Genzyme ("How Not to Spend $18.5 Billion") quoted Sanofi CEO Chris Viehbacher as saying, "I personally don't believe that buybacks add any shareholder value." Apparently, Viehbacher has looked at the stock prices of Sanofi and other drug companies after buybacks and has decided that repurchases "don't work" because the stocks didn't climb afterward. But this ignores other factors that also affect share value and investor return, including anticipated changes in free cash flow, total debt, dividends and acquisitions. The net change in all of these factors–not just buybacks–will eventually be reflected in the stock price.

Found: McDonald's $700 Million in Buybacks

A reader emailed me in August about the "missing" $700 million in buybacks in McDonald's 2006 GAAP Cash Flow statement that I referenced on page 130 of my book. I have just found the $700 million. It is on page 35 of the 2006 annual report on the McDonald's website in the Cash Flow section. A footnote explains the $3.7 billion in buybacks referenced in the CEO's letter to shareholders includes $743.6 million for 18.6 million shares acquired in the 2006 Chipotle exchange.
The $743.6 million number is not in the $2959.4 million buyback number in the GAAP Cash Flow on page 42.
Why not?
I don't know.
The difference between the $2959.4 million number and the $3.7
billion number (sorry about the million/billions) is $759.6 million - "only"
$16.5 million off the $743.6 million.
Where is the $16.5 million?
I don't know.
If you know, please send me an email and I will post it here.
Thank you.

Typos etc.

There is a "Corrections" post in May, 2009 that provides corrections to typos etc.
Look in the far right column of this page and click on May 2009.

In April 2009 you will find corrected instructions for adding additional historical periods to the FCF Worksheet.

Please take a quick look at all of the posting topics as there may be something that interests you.

If you find other typos, errors, etc., please email me.

Thank you.

Barron's 3/22/10

Bill Priest, CEO of Epoch Investment Partners, was good enough to praise the book in an interview with Barron's Neil Martin. See "Watch What They Do With Their Cash" on
page 36.

Latest Amazon.com Reader Review

4.0 out of 5 stars Cash is king, September 20, 2009
By graham - See all my reviews

Bruce Berkowitz sums it up best on the cover, follow the cash and you can value the business. I found the book excellent in leading you through the balance and income statements and most importantly deciphering just how much cash is being generated. The free cash flow talked about in the book seems to approximate Buffet's "owners earning" but it helps in dealing with the tricky aspect of adjusting those earnings to deal with the full business cycle. The book references excel sample sheets throughout and details the methodology behind them in a clear and concise manner, this is not to say it is easy, sometimes you really have to think, but the answers are there. Thoroughly enjoyed the book and have made several very successful investments using it as part of my toolset to value a business. Highly recommended

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.



Revenues

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.

Capex

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?