At a golfing outing, Carl Icahn supposedly turned to famed value investor Marty Whitman and asked, "Hey, Marty, the airlines look pretty good, don't they?" To which, Whitman responded, "They look pretty good to people who don't distinguish between gross cash flow and net cash flow." This dialogue, famously recounted in King Icahn by Mark Stevens, should serve as an important caution to investors. Cash flow isn't everything.
To examine the case in greater detail, we can use four companies as a case study. The companies in order will be Delta Airlines (DAL), Southwest Airlines (LUV), Western Union (WU), and Google (GOOG). Shown below are the companies' prices relative to their gross and net cash flow in 2011. Figures are taken from Valueline, and net cash flow is defined as cash flow per share minus depreciation per share (focusing on depreciation rather than Capex should allow a more even comparison as Capex tends to vary a lot from year to year).
Price / CF
Price / Net CF
By any of these metrics, the airlines look like the cheapest purchases. Per dollar invested, the airlines generate the most cash in a given year. However, let's compare these rankings to actual five-year top line growth in revenue per share (which will ignore earnings fluctuations due to economic cycles, but which will capture increases due to share buy-backs). Additionally, let's take a look at how that revenue per share compares to net cash flow in 2011.
5-Year RPS Growth
Net CF / RPS
The winner of this comparison is Google, and with good cause. Although the company generates less cash flow relative to its price, the company generates substantial cash flow relative to its total sales. The airlines, on the other hand, require extraordinary amounts of capital in order to make a dollar of profit. As an investor in an airline today, you might be tempted by the large cash being thrown by these enterprises, but as an investor looking to profit in the long run, the capital intensity of the airline's business model prevents any substantial long-term appreciation of share price. Even Southwest's impressive run should be difficult for the airline to sustain.
Carl Icahn was a takeover artist, and he operated as many others like him did in the 80s, by using extraordinary amounts of debt to acquire companies on the open market. In order to finance this debt, Icahn needed a substantial amount of cash flow relative to the price he was paying. He jumped into TWA thinking he had found a cash cow, only to discover that the great cost of running the airline would weigh on his easy profit aspirations well into the late 80s.
To truly benefit from stock purchases and the power of compound interest, the value of a company in 10 years should outweigh its ability to generate cash today. The focus should be on how much the company can increase its cash generation, not on the absolute volume of cash generation.