Free Cash Flow Isn't Always so Free

by: Alan Brochstein, CFA

Yesterday was the 4th of July, which ranks right up there with Thanksgiving at the top of my list of favorite holidays. This is a day where we celebrate the freedom in our country that we still enjoy after declaring our independence 233 years ago. Political freedom is a value that we typically associate with countries in which the entrepreneurial spirit thrives and the economy grows. We shouldn't take our freedom for granted, as most people on our planet still don't enjoy the opportunities that we do.

It is exciting, however, to see individual rights improving for many in lesser developed countries, as we can expect these new-found freedoms to help them improve their standards of living in coming decades. So, to all my fellow Americans, I wish you a Happy 4th, and to those who don't yet enjoy political and economic freedom, I offer my wishes for improvement in those areas.

Just as individuals who are free are more able to realize their potential, companies too flourish when they aren't so encumbered. The world has changed greatly over the past year, and I continue to be extremely cautious regarding companies that are encumbered with too much debt and other liabilities. Yes, a very strange segue and not exactly analogous, but stay with me! We have moved to a world of deleveraging, where only the fittest will survive. I have been harping on this subject as my number one theme for 2009 since late last year, though I have stayed off the soapbox for the past few months. How soon investors forget, it seems, as many of the most unfit companies as measured by their earnings power and balance sheet strength relative to their debt burdens have been among the best performers.

Today, I want to discuss the notion of free cash flow (FCF). There are a couple of ways to define it, which can lead to vastly different results. A very popular method is to take the working capital changes that contribute to Cash From Operations (change in AR, change in Inventories, etc) and subtract Capital Expenditures. In recessionary times, this method can mislead as AR and Inventory decline creating cash and CapEx gets cut to the bone as companies look to save cash. It leads to a very positive view of a negative situation. Another method is to take Net Income, add back depreciation (a non-cash expense) and then subtract CapEx. In a receding economy like ours, often the depreciation gets slashed due to the write-off of Goodwill, creating a very negative change in the future FCF compared to the past FCF (income is falling and now depreciation gets cut).

Investors tend to value companies with "high" generation of FCF relative to the market cap. If FCF is "real", it is a measure of what is truly available to equity holders for potential dividends. There are many ways in which FCF isn't real - too many for me to discuss here and probably lots that go well beyond my accounting knowledge. I already mentioned how declining companies generate increases in cashflow generation that are not sustainable unless the company totally shrinks away (which isn't usually a good thing!). Another factor that can diminish the value of the calculation is when the company is a serial acquirer. If the business model depends upon more and more acquisitions (using that "free" cash), what happens when the music stops (as it is in this environment)? Similarly, often an investment in the business isn't classified as "Capital Equipment", but it is a necessary investment. An example of this is the rental-car industry. Finally, is FCF "real" when the company is spending all of it and then some on share repurchases?

When it's all said and done, I think that there are a lot of "fake" FCF stories out there. These tend to be companies that see their debt go up year after year despite all this "free" cash flow. In this environment, where it is increasingly difficult and more expensive to borrow, paying down debt has become the highest priority for most of these companies. For the next few years, many companies will have to cut dividends despite generating all this "free" cash flow. I decided to run a screen of some companies with very high historical FCF generation relative to their current market caps but that are encumbered with debt and other liabilities. In this environment, future FCF isn't likely to be as high as historical FCF, so anyone blindly buying these "high" yielding stocks (FCF/Market Cap) is potentially assuming solvency risk without adequate compensation.

In my screen, I took the S&P 500 and kept all companies trading at less than 12.5X P/FCF (i.e. an 8% or higher FCF yield). Note that we are skipping some real potential pigs by omitting companies that don't even generate FCF. Next, I constrained net debt to capital (total debt less cash) to 35%, which is slightly higher than the median of all companies in the index. The next parameter is that I wanted to make sure that the Total Liabilities were at least 5X the trailing FCF, so I constrained FCF/TL to a maximum of 20%. In order to strip out any companies that are growing so fast that they aren't likely to face potential liquidity or solvency issues, I constrained maximum EPS growth of 0% this year and 25% next year (though I am probably omitting some companies that still deserve to be on the list because they won't actually achieve the expected growth). Finally, I limited my analysis to the Energy, Materials, Industrials, Consumer Discretionary and Consumer Staples sectors.

FCF but Too Much Debt SP5

These companies (click on chart to enlarge) are down a bit more than the market year-to-date after being down as a group slighlty more than the market in 2008. I also included a column that highlights the Total Liabilities relative to the Current Assets (the higher, the worse). These stocks have a median forward PE of just 11, which perhaps looks good to naive investors that don't look past that single metric. As a group, these companies have debt and other liabilities in excess of 10X historical FCF. Most of these companies have very little or perhaps negative tangible equity. Many of these companies may seem beaten up enough, but who knows. Gannett (NYSE:GCI), for instance, trades at just 2.5X expected earnings, but they have immense burdens and an imploding business. In general, I don't expect good things for most of these companies. I have written specifically about General Electric (NYSE:GE) in the past and am very negative on that name again after calling off the dogs in March (see the comments from that article). I called GE a "value" pit in that article, and I think that the description applies to most of these companies as well.

I decided to forge ahead and apply the same parameters to the S&P 400 Mid-Cap members. For those unaware, this index is up sharply year-to-date. The results from the screen kicked out several names with similar characteristics (not surprisingly). The shocker was that this group is up a median of 17% after declining a bit more than the large-cap group in 2008. So, some of this year's performance may be making up for last year's action. In some ways, the big companies have bigger problems in absolute dollars, but some of the names on this list are likely to encounter unfriendly financiers as well.

FCF but Too Much Debt MID-CAP

I know that Oshkosh (NYSE:OSK) just won a big contract, but is it enough to overcome their horrible balance sheet? United Rentals (NYSE:URI), a failed LBO, is a great example of fake free cashflow. We found that out when they wiped out a lot of the Goodwill late in 2008. This is a company that had $726mm in equity at the end of 1998 and $2.04 billion at the end of Q3-2008 only to end up with -$29mm at the end of 2008. In a decade, it paid no dividends and saw its equity wiped out. Its total debt grew by over $1.7 billion during that decade. Ironically, its share count went up but came back right to where it started after they repurchased a bunch in 2008. That was a brilliant move - 31% of the company at 22, spending $600mm. Oh, over that decade they produced FCF of $5.5 billion. Go figure. The answer is that the calculation of FCF is flawed - the company has minimal "capital equipment expenditures" but massive investment in its rentable inventory (not called inventory though, as that is stuff for sale). So, they spend big bucks every year on something that's not inventory and not capital equipment but used as the core of their business. There are lots of companies out there like this (as an aside, this is my issue with Aaron's Rentals (NYSE:AAN) about which I wrote recently).

Let's conclude with a quick look at Regis (NYSE:RGS), which is a serial acquirer in a very slow-growth industry (hair salons) that is actually more economically sensitive than many recognize. They last did an acquisition in early 2008, and their sales growth, which was steady for so many years, declined sharply (down 14% in Q4 and 11% in Q1) after the following annual growth rates:

  • 6/2008: 4% (store closings)
  • 6/2007: 8%
  • 6/2006: 11%
  • 6/2005: 14%
  • 6/2004: 14%
  • 6/2003: 16%
  • 6/2002: 11%
  • 6/2001: 15%

Organic growth slipped from 4% to 3% to 2% over the past few fiscal years before falling to -1.4% in the first three quarters of FY09. The company generated FCF of $538mm over the past 5 years ending in June 2008. It paid dividends to shareholders of about $36mm. The company repurchased stock in 2008 and 2007, spending a total of $135mm to repurchase about 4mm shares at about $34 per share. The rest of the FCF went to pay for acquisitions. Going forward, it's a slow-growth industry, these guys have a ton of debt and the game is over (acquisitions). I wish them luck!

Tying it altogether, more than ever (after this big rally that has lifted some of these overleveraged companies) investors need to be very cautious about investing in any company. The economy isn't likely to grow significantly until the next Presidential election in my opinion, and it could contract again. Companies are slashing expenses and investments today to survive until tomorrow. In that environment, overall sales are not likely to rebound. If one feels compelled to invest in any stocks (rather than corporate bonds, which offer better downside protection by far), they ought to be investing in debt-free companies that aren't likely to endure losses. The exercise I have shared today helps to avoid high FCF-yielding companies whose shareholders aren't likely to ever get their hands on that "free" cash flow. I would turn the whole thing around and look at companies with no net debt, with FCF no less than 50% of total liabilities and FCF yields in excess of 4%. There are 33 in the S&P 500 Large-Cap(in all 10 sectors, not just the ones in the screens above), 31 in the S&P 400 Mid-Cap and 69 in the S&P 600 Small-Cap (yes, I still prefer smaller vs. larger companies).

Disclosure: No position in any of the stocks included in the discussion or the tables