I recently had a discussion with a financial advisor/investor about using cash flow to value a company. He brought up as an example Abbott Labs (NYSE:ABT), saying he was investing based upon a perceived high free cash flow yield; greater than 10%, which was estimated from a computer scan. The discussion led me to more closely look at the reported annual cash flow from 2000-2010.
The way that one prepares the statement of cash flows using the indirect method is that any increase in a non-cash asset on the balance sheet is a subtraction to cash flows. A reduction in a non-cash asset on the balance sheet is an addition to cash flows. As an example, if accounts receivable (AR) increased from 100 to 150, over the course of a year, then -50 would be recorded under the line item AR on the statement of cash flows. If AR decreased from 100 to 50 then +50 would be recorded. If one still does not understand this process, I would hope this link would help or you can google "indirect method statement of cash flows".
Let's look at trade receivables as reported by the change in cash flows verses changes on the balance sheet ( all data in thousands). Click to enlarge:
The change using the figure derived from the balance sheet would be reported as -642,093 for 2010. I did not make this figure negative on the spreadsheet since the absolute difference of 642,093 + (-394,665) is the same as -642,093 - (-394,665).
Under the line item Trade Receivable, ABT showed an outflow of $3.46 Billion over 10 years on its cash flow statement vs. $5 Billion as shown on the balance sheet. The difference between the two was over $1.5 Billion dollars.
Next, look at inventories. Click to enlarge:
One can see again that the difference over 10 years adds up to over $1.1Billion
One sees similar patterns when looking at prepaid expenses. I tried to match up as closely as possible the line items from the balance sheet and statement of cash flows, any difference of title is found in the original filing. Click to enlarge:
The difference over 10 years is over $1.7 Billion. But most of this outflow happened in early in the 10 year period. From 2007-2010 the Cash Flow Statement showed a cash contribution of +$184 million, while the Balance Sheet increased $390 million, which would be a cash outflow of -$390 million. This creates a difference of $574 million, with cash flowing away from the company instead of towards it from 2007-2010.
Where did positive cash contributions come from? It appears from increases in liabilities. Look at the line item "Trade accounts payable and other liabilities". An increase in this line item is a straightforward increase in cash and vice versa.
It is hard to know for sure what is in the "other liabilities". So I included both 'Salaries' and the line item 'Other Assets' in the analysis. Click to enlarge:
We can see that ABT has increased its Liabilities by $3.5 Billion more than was reported on the cash flow statement. This is a cash inflow to the company and increases the financial leverage of ABT.
One might object that the fluctuations in the Balance Sheet are a result of foreign operations that ABT has. However, I do not find this argument very convincing since the net effect of foreign currency adjustments on the statement of cash flows from 2001-2010 is only -$178 Million. Foreign operations do impact the Balance Sheet but can they account for billions in differences over 10 years? I do not believe so. If anyone wants to do all the foreign currency translations for 10 years, and prove the above analysis materially wrong, please provide an article and a link to it in the comments below. Click to enlarge:
Why is ABT allowed to have its cash flow from operations not match changes in the Balance Sheet? The answer: ABT has been on an acquisition binge over the last 10 years, spending over $31 Billion dollars to acquire other companies. Click to enlarge:
We still see large differences in the data in 2008 and 2009, when there were no acquisitions made in 2007 and "only" $250 Million in 2008. Below is the best description I found for what happens to the cash flow statement when a purchase of another company is made :
...although current assets and liabilities have increased, the change is not reflected in cash from operations (CFO). The cash flow change in operating accounts does not equal the actual change on the balance sheet. Because the additional inventories and receivables are acquired as part of an acquisition, the cash paid for their acquisition is treated as cash for investment.
However, reported cash from operations in the year of the acquisition(and in subsequent years) may still be distorted. The degree of distortion depends on whether the level of working capital immediately after the acquisition is maintained over time.
The potential distortion can be illustrated by considering the inventory acquired. Although the cash paid for the acquisition of the inventory does not flow through cash from operations, the cash received when the inventory is sold does. Thus, CFO is inflated as the proceeds of sale are included while the cost of acquiring the inventory is not. [Bold not in original]
This distortion will be somewhat mitigated if inventory is continually replaced, as the cash outflows for new inventory will offset cash inflows from sales. However if there is a reduction in the acquired firm's working capital, CFO may be distorted, and careful analysis is required to understand the impact.
From: The Analysis and Use of Financial Statements by White, Sondhi, & Fried (1994 Edition) pages 859-861
Knowing that CFO may be inflated by business acquisitions, let's examine the working captial of ABT since 2000 to get an idea if the distortion would be mitigated. Click to enlarge:
We can see that the working capital of ABT has not been stable at all over this whole period. It has varied immensely--nominally, as a percentage of sales, and percentage of total assets in the capital structure of the company.
Now, we'll look at the performance of ABT, by breaking down its Return on Equity (ROE) using DuPont analysis, over its decade-long buying binge. I will use the basic version:
- ROE = Net Profit Margin x Asset Turnover x Financial Leverage
- ROE = (Net Profit / Sales) x (Sales / Assets) x (Assets / Equity)
click to enlarge
ABT has increased its financial leverage in order to keep its ROE higher than it would have been with constant leverage. If ABT had the same leverage in 2010 that it had in 2000, then its 2010 ROE would have been 14.7% verses 22%. One can see the steady decline in asset use efficiency, as shown by ABT's Asset Turnover (Sales/Assets) ratio dropping over time. Products which ABT has developed or acquired, have not produced the same or greater amount of sales compared to the capital spent to develop/acquire said products.
ABT's SG&A expense as a percentage of sales went from 21.1% in 2000 up to 29.5% in 2010 (not shown in graph). The net profit margin has been down to flat. Hence, mathematically, the only way to keep stable or increase ROE is to increase ABT's leverage.
Now, after a decade of combining companies, ABT announced that it will split into two different companies. It seems management has decided to try something different after a decade of a lethargic stock price. Click to enlarge:
One can look at various other articles on Seeking Alpha about the pros and cons of this decision. I have not done any research into ABT's product pipeline, patent expirations, potential competitors, and regulatory environment. All very important items when valuing a pharmaceutical and medical devices company.
The above analysis shows the pitfalls of using cash flow metrics to value a company which has continual acquisitions. I would imagine that the operating cash flows will become even more opaque for the entities proceeding from the split. You can learn more about how to analyze and adjust the balance sheet and cash flows from acquisitions in the book referenced in the quotation above.
One needs to do more research than just filtering the highest "Free Cash Flow" yields off of a computer screen; it is a start but not an end for the investment decision making process. I passed on the opportunity to invest in ABT. An investor should look for companies with better reconciled Cash Flow & Balance Sheet statements, stable to increasing Asset Turnover and Net Profit Margins with a high ROE -- that does not require increased leverage.
Maybe ABT will develop the next "wonder" drug or medical device and I will miss out, but over the last decade Abbott Labs has not delivered.