The Private Market Value Strategy: Part 2 - Cheap Cash Flow

by: Philip Mause

In Part 1 of this series, I discussed situations in which an investor could calculate the fair value of the assets held by a corporation and determine that the stock was priced so as to produce a substantial discount to asset value. This part will deal with the more complex situation that arises when the assets are very hard to evaluate and enterprise must be valued based on its ability to produce cash flow.

Enterprise Price - Once again, we will focus on the price an investor pays for the enterprise rather than on the market cap. I am using the phrase "enterprise price" because the more generally accepted phrase - "enterprise value" - can create confusion. What we are talking about here is the market cap (the stock price times the number of fully diluted shares) plus net debt (total debt minus balance sheet cash) or minus net cash (balance sheet cash minus total debt). This number is better described as a "price" than a "value" because the vagaries of the market may create a number that really bears little relationship to the underlying value of the company. Thus, Enterprise Price (the same as the widely used Enterprise Value) is our key metric - in our formulations, it will be represented by the symbol "EP".

Net Cash or Net Debt - Calculating net cash or net debt for an operating company raises a number of issues. As was pointed out in Part 1, it is sometimes appropriate to include a portion of accounts receivable in net cash. Another issue is "customer deposits." Customers who make deposits (on orders of equipment or as damage deposits on leases) increase the company's "cash" but - in a very real sense - the customers still have an interest in that cash. For this reason, I generally subtract customer deposits from net cash. A more complicated issue is raised by "deferred revenue." Deferred revenue is created when a company collects cash but does not book the entire amount as income because the payment is, in part, for goods or services outside the reporting period. For example, when a magazine company sells a five year subscription and gets paid in cash, only some of that cash is correctly reportable as income in the year it is received, the rest is deferred revenue to be reported as income in the years in which the service paid for is delivered. I have not developed an entirely satisfactory way to deal with this problem and, at this point, do not subtract deferred revenue from net cash because it is not at all clear that the cost of generating the income in future years bears any relationship to the amount of revenue that has been deferred. I am aware that this may result in an overstatement of net cash and it is one of many, many reasons that I seek to have a comfortable margin of error in applying this metric. Of course, there are other liabilities which, depending upon the circumstances, should be deducted from net cash. These include pension liabilities and tax liability. If these are significant and reasonably ascertainable, further deductions from net cash should be considered.

Owner Cash Flow - I use the concept "owner cash flow" to represent the funds available, after expenses and taxes, to pay for dividends and share repurchases. I sometimes like to think of a situation in which an individual bought the entire company and then received a distribution every year. It is not the same as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Owner Cash Flow (OCF) starts with net after tax income, adds depreciation and amortization, adds net interest payments, subtracts net interest income and then subtracts capital expenditures (MUTF:CAPEX). It, thus, differs from EBITDA in that: 1. tax expenditures are included, 2. interest income is deducted, and 3. CAPEX is deducted. It will virtually inevitably be a lower number than EBITDA. I believe that OCF is a more realistic representation of funds available to owners because, in order to stay in business, companies must pay their taxes and must invest a certain amount in their businesses. EBITDA is more useful in identifying funds available to service debt in the context of a leveraged buyout. Interest income and interest expense are backed out because we are using EP and trying to isolate the performance of the business itself independent of its debt or balance sheet cash.

OCF Issues - The biggest issue I have had in terms of estimating OCF is the impact of acquisitions. In any given year, large companies frequently make acquisitions of smaller companies. In some cases, the acquisition is an extraordinary event that increases the size of the business or adds a completely new line of business expanding operations significantly. In other cases, companies have a practice of making multiple "tack on" business acquisitions each year in their "space" as part of their overall business strategy. If the way a company continues to generate owner cash flow is by making acquisitions each year, then a strong argument could be made that the expense of such acquisition should really be treated the same as CAPEX. It is another issue I make note of in determining how to apply this metric. There is, unfortunately no easy answer on this one. I should note that I do not back out "share based compensation" even though this is a non-cash expense. If you back out share based compensation in calculated owner cash flow, then - in order to keep share count constant - you have to allocate funds to repurchase enough shares to offset stock option grants.

Recent Analysis - I have employed this methodology or variations of it in a number of recent articles. Initially, I just backed out interest payments or interest income to get Enterprise Earnings and compared Enterprise Price to Enterprise Earnings (EP/EE). I generally looked for a ratio below 10 and got very enthusiastic if the ratio was less than 8. I found some extremely low ratios and many of them turned out very well. I have since decided to refine things a bit and try to get a handle on cash flow. On June 20, 2012, I recommended Brocade Communications (NASDAQ:BRCD) in an article while it was trading at $4.69. On December 17, 2012, I recommended Western Digital (NYSE:WDC) then trading at $37.78 and Seagate (NASDAQ:STX) then trading at $27.68 in this article. I wrote a piece examining Xerox (NYSE:XRX) then trading at $6.69, Hewlett Packard (NYSE:HPQ) then trading at $13.68, and Dell Computer (DELL) then trading at $9.97 on January 1, 2013. An article on February 25, 2013, examined Microsoft (NASDAQ:MSFT) then trading at $27.76 and Apple (NASDAQ:AAPL) then trading at $450.81. And, finally, an article on April 25, 2013, recommended Cisco (NASDAQ:CSCO) at $20.39.

The table below compares the stock prices when I wrote the articles to the stock prices at Friday's close.

Stock and Date Price at time of article Price now
DELL (1/1/13) $9.97 Takeover
XRX(1/1/13) $6.69 $10.72
HPQ(1/1/13) $13.68 $30.02
CSCO(4/25/13) $20.39 $22.56
AAPL(2/25/13) $450.81 $543.99
MSFT(2/25/13) $27.76 $37.64
WDC(12/17/12) $37.78 $86.71
STX(12/17/12) $27.68 $50.14
BRCD(6/20/12) $4.69 $9.62

The strategy has worked out pretty well but, admittedly, it was during a period of time in which a dartboard strategy would have worked out reasonably well. A few interesting reflections. I initially was much more enthusiastic about STX than about WDC, but the metric described about favored WDC because of its stronger balance sheet. Additionally, WDC seems to have shot up quite a bit more on a percentage basis. DELL materialized almost immediately as a big winner due to the takeover with the price going up into the $13 range. I have always suspected that the key players were aware of the latent value in the financing receivables. Because of the way these stocks (and others) have appreciated, it is getting harder and harder to find stocks with either an EP/EE or an EP/OCF below 10. I will discuss where we go from here in an upcoming part to this series. CSCO seems to jump off the page as a laggard in comparison with the others. This suggests two possibilities - 1. CSCO is simply a stock that will not vindicate this strategy, or 2. CSCO may be due for a pop. I will deal with this issue in a future part to this series.

There is no finality in this business. I am always looking for ways to sharpen the saw and develop better tools. I am very concerned that this approach involves rear window analysis and really tells us little or nothing about the future. It has to be tempered with an understanding of the business a company is involved in and its general direction. There are clearly enormous judgment calls involved in estimating balance sheet cash, balance sheet debt and owner cash flow. However, I think that an effort to replicate private market value helps identify undervalued companies and companies ripe for a takeover, a share repurchase strategy or action by activist investors.

Disclosure: I am long WDC, STX, AAPL, MSFT, BRCD, XRX, HPQ, CSCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.