'Show Me The Kwan, Jerry!' Cash Is King

Includes: ETP, MO, PM
by: Michael Connellan

The most important single number in a company's financial statements is...Cash Flow from Operations! Because if a company isn't producing cash from its ongoing business, then all the rest is smoke and mirrors. As someone who's been a senior executive in a NYSE company, an investment banker, and CEO of two successful private PE-backed companies, I've seen it from all sides, and at the end of the day it's all about the cash. As Rod Tidwell said in the movie Jerry Maguire, "Show me the Kwan!"

Companies have three basic financial statements: Balance Sheet, Statement of Income, and Statement of Cash Flows. The Statement of Cash Flows itself has four fundamental elements: Cash Flow from Operations, Cash Flow from Investing, Cash Flow from Financing, and finally the Change in Cash and Cash Equivalents. Let's look at one of my favorite companies to see how this works in practice.

Philip Morris International (NYSE:PM) was spun off from its parent Altria (NYSE:MO) in 2008 in order to separate the international tobacco business from the domestic. Since that time PM has been using its cash flow to steadily increase the dividend, and buy back its own shares. The dividend has gone from $1.00 in 2008, to $2.56 in 2011. During that same time the company has re-purchased 253 million shares. So where did all that cash come from?

The Dec 31, 2010, audited financials show PM produced $9.437 billion in cash from operations. Note that PM reported only $7.259 billion in Net Income for that year, illustrating one reason why you have to look at the Statement of Cash Flows. In 2010, PM needed to spend only $713 million on capital expenditures to maintain its business, leaving it with $8.724 billion in 'free' cash flow. Whatever one thinks of the tobacco business, PM clearly is a cash generating machine. Of that amount PM's Board decided to pay out $4.423 billion to shareholders in dividends, leaving it with $4.301 billion. PM next used that much and more - $4.801 billion - to repurchase its own stock. To fund that repurchase and take advantage of attractive interest rates, the company then borrowed a net $938 million. The net amount, coupled with other lesser adjustments, resulted in PM ending the year with $163 million more cash on hand than it started with in 2010, even after a large dividend increase and repurchasing shares. To summarize the key figures:

Cash flow from operations $9.437 billion
- Cash flow from investing [cap ex] - $0.713 billion
- Dividends paid - $4.423 billion
Remaining cash flow = $4.301 billion
+ Additional borrowing + $0.938 billion
- Stock repurchase - $4.801 billion
- Other adjustments - $0.275 billion
= Change in cash during year = $0.163 billion

Non-cash charges such as depreciation and amortization, as well as other GAAP-mandated adjustments, result in Net Income being a less true indicator of financial health than cash flow. Many analysts, for instance, measure the dividend as a percent of EPS, but EPS is based on Net Income so with many companies the result can be a percent, which appears 'too high' yet is easily sustainable based on the company's cash flow. Payroll, vendors, lenders and dividend recipients can only be paid in cash, not 'Net Income.' Look at the dividend relative to cash flow, not Net Income.

What if the company doesn't have adequate cash flow, or like REITs and Business Development Companies, which have to pay out 90% of Net Income, can't retain much of its cash flow? The answer is that these companies are frankly dependent upon the external capital markets for their success and survival. Let's look at one example. Energy Transfer Partners LP (NYSE:ETP) is a major natural gas pipeline and propane distribution company. It's rated "4 Stars" [Buy] by S&P, and has a BBB- credit rating. ETP pays an 8.04% dividend.

Unlike PM, ETP is in a very capital intensive business due largely to its 17,500 miles of pipeline and associated storage capacity. At the same time, as a pipeline MLP its unitholders expect attractive dividends. ETP's Statement of Cash Flows for 2010, summarized, looks like this:

Cash flow from operations $1.202 billion
- Cash flow from investing [cap ex] - $1.350 billion
= Free cash flow - $0.148 billion
- Dividends paid - $1.066 billion
= Remaining cash flow - $1.214 billion

We can see from these numbers that ETP in 2010 didn't even generate enough cash from operations to cover its capital expenditure budget, much less its dividend payments. So where did the money come from? Looking deeper into the third major part of the Statement of Cash Flows we see that ETP funded its cash needs by selling $1.137 billion more of stock, and by borrowing $0.192 billion more. By using this money as well as a small amount of cash on hand from 2009, ETP was able to pay its dividend. However, it clearly demonstrates our point: ETP in 2010 was dependent upon the external capital markets. Had it not been able to sell stock, or borrow money, the company could not have met its obligations.

In closing, the Statement of Cash Flows is a critically important part of the financial statements, and before investing thousands of dollars investors should absolutely study it. Within the Statement of Cash Flows, the key number is Cash Flow from Operations, and especially how it compares with capital expenditures. Is there then enough cash left to pay the dividend? If not, it may still be a good investment but an investor needs to realize the company doesn't necessarily control its own destiny - the global capital markets do.

Disclosure: I am long PM, ETP.