Ultimately, the sole reason for making an investment is the belief that cash derived from the investment will exceed cash put into it. Cash production is what matters. Ben Graham opined on this subject when he said, "In the short run the market is a voting machine, but in the long run it is a weighing machine."
Stock market pricing may initially be a popularity contest. In the end, however, the key determinant is cash generation. Consequently, wise investors should seek reasonably priced businesses with "heavy" cash generating ability.
The Advisory Board Company (ABCO)
Business description, from the 2011 Annual Report: "We provide best practices research and analysis, business intelligence and software tools, and management and advisory services to the health care and education industries. Through 50 subscription based programs, we leverage our intellectual capital to drive performance improvement to our base of over 3,200 members by providing proven solutions to our members’ most important business problems."
Business Performance - The Balance Sheet
The balance sheet is in decent shape and is without any long-term indebtedness. The latest quarterly filing reports a $527M balance sheet with cash and marketable securities approximating $120M. One interesting aspect of the balance sheet that is subsequently discussed involves the Membership Fees Receivable.
The balance sheet is shown below:
Business Performance - The Income Statement
Revenues have increased from $81M in 2002 to $290.2 in 2011. Despite the nearly 3.6x increase in revenues, net income has only increased from $10M to $18.5M over the same period, a factor of 1.9x. However, net income did reach $32M in 2008.
The income statement is shown below:
Business Performance - The Cash Flow Statement
The cash flow statement is a critical component in understanding how The Advisory Board Company operates. A cursory scan of the cash flow statement shows what appears to be robust cash flows from operations. However, two CFO elements require further inspection.
- Deferred revenue is cash collected today for goods/services promised later (think of a 12-month magazine subscription paid-in-full in January). Deferred revenue is basically a loan granted to a business from a customer. The cost of the loan depends on how the product is priced, but it is often a wonderful source of supplemental business financing.
- Membership fees receivable is comparable to accounts receivable, and it contains three components that require further analysis: 1) Billed Fees 2) Unbilled Fees 3) Reserve for Uncollectible Revenue.
In addition to deferred revenue and membership fees receivable, we need to understand the true cash generating ability of the business. Each of these aspects are more completely discussed in a subsequent section.
The cash flow statement is shown below:
Discussion and Analysis
The Advisory Board Company is intriguing because its revenues continue to grow but its cash generation does not.
The figure below attempts to illustrate the true cash generating ability of the business by shifting cash flows to the periods where they are earned and by removing the effects from share purchases, stock options, etc.
As illustrated above, the core business generates very little cash when contrasted against nearly $300M in revenues. In fact, if The Advisory Board Company were a farm, then it would have increased its acreage by a factor of 3.6x without any meaningful increase in yield.
Graphically, operations look like this:
One reason for the differences between cash flow and net income stems from revenue recognition. As stated on page 51 of the 2011 Annual Report, "Billed fees receivable represent invoiced membership fees. Unbilled fees receivable represent fees due to be billed to members who have elected to pay on an installment basis and all of the unbilled fees recorded are expected to be billed in the next twelve months."
Translation: Fees expected to be billed in the next 12 months count as revenue. In effect, The Advisory Board Company is counting revenue from bills not yet even created. Perhaps not illegal, but certainly not conservative.
Graphically, here is how that policy is contributing to revenues. After reviewing this figure, it is clear why revenues are growing but not much cash is being generated.
The Advisory Board Company has succeeded admirably in growing revenues. Unfortunately, revenue growth without increased cash generating ability is largely wasted effort. If net income is taken at face value, then investors today are paying $62 per share for $1.07 of earnings. Paying 58x earnings generally leads to disappointing results. If cash generation is used instead of net income, then the business valuation is even lower.
Here is a table with other relevant valuation metrics using the trailing twelve months of data:
Aggressively, a 25x earnings multiple values The Advisory Board Company somewhere around $445M, or, $27 per share. More conservatively, a 15x earnings multiple values the business around $267M, or $16 per share. In either case, it is a far stretch from $62 per share and a $1B market capitalization.
Aggressive accounting, anemic cash flows, weakening margins, and a high stock price smells like trouble. It is not exactly clear what has been driving the stock price higher, but increasing revenues have probably helped. Another possibility is the expectation of a buyout/merger. Money is currently cheap, and history is rife with examples of value destroying mergers. Based on fundamentals, the cost of acquiring The Advisory Board Company is almost certainly prohibitive; however, bigger blunders have occurred (AOL-Time Warner). Additionally, insiders own only 6.9% of the company, and they have been actively selling.
Despite the stated risks, the risk/reward trade-off favors a short investment in The Advisory Board Company.