Negative Free Cash Flow Companies - Bargains Or Toxic Investments?

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Includes: HD, NFLX, RBCN
by: Seattle Contributor

Summary

Some of the greatest market performers are Negative Free Cash Flow.

Others are investment traps waiting to suck your money.

It is best to decide on a case by case scenario.

When evaluating various methods of investing research there is a plethora of options one can consider:

  • historical earnings
  • revenue growth
  • gross and or net margins
  • return on equity
  • market share
  • cash flow
  • technical analysis
  • insider ownership stakes
  • the list is almost endless

So what does one do to ultimately pick the best investment strategy? The answer depends on several factors. Personal risk tolerance, time frame for return on your investment and overall objectives are the most common factors that determine the ultimate avenue that is best suited for the investor.

In recent years I have noticed that for me, technical analysis and cash flow trends work best; but the cash flow I use is often tied to finding companies with "negative" cash flow.

First, let's explain what Negative free cash flow is. A good explanation of free cash flow can be found on Investopedia's website but the simplified quick explanation from them is "Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base". In other words, capital expenditures would be a good reason for negative free cash flow (herein abbreviated as NFCF). Another possible reason for NFCF would be seasonality of a business such as construction. Also of interest is the need to evaluate the industry the company operates in. Retail stocks and other companies with high margins can afford to operate with negative free cash flow. Conversely, mining stocks, semiconductor stocks and oil & gas companies) all with relatively low operating margins) are ill equipped to continue as ongoing entities if negative free cash flows become a way of life.

So with that being said, let's look at a few stocks operating with NFCF. Specifically, I am going to mention the success of Home Depot (NYSE:HD) and Netflix (NASDAQ:NFLX) and the problems faced by Rubicon Technologies (NASDAQ:RBCN).

Over the past 20 years, Home Depot had a string in which 15 of 16 years were NFCF from 1985 to 2001. The NFCF resulted in major capital expenditures to expand via rapid store openings, add distribution centers, and invest in cutting edge inventory technology. Taking into consideration dividends and on a split adjusted basis HD was $0.17 a share in August 1985. During that period the stock rallied and was as high as $51.03 in December 1999.

NFLX is another stock that has a similar performance. Despite all the constant chatter on the street suggesting that NFLX cannot sustain the current lofty price per share of over $100 because of their NFCF, they too have rewarded investors handsomely. A direct to retail business model has allowed funds to be reinvested on a continual basis to accelerate an almost parabolic growth in their subscriber base. On October 2002 shares of NFLX were trading at a split adjusted basis of $0.35 and currently sell for $114.56 despite the huge market sell off this week.

Conversely, Rubicon Technologies has been unable to generate any profits while being NFCF. Stiff pricing competition within their industry for their primary products and a product that has not been increasing the revenue stream are the culprits here. As a result, secondary stock offerings have been used to secure the balance sheet; yet that has not proven to be enough. A once high flyer, shares of RBCN used to trade at over $30 a share and are now changing hand for just $1.14 share.

Negative Free Cash Flow does not always mean a company's past financial performance is indicative of troubles ahead, nor does it imply that there will be a net loss per share. Evaluating the industry, reasons for the current NFCF and future expectations can all be aids to make a final determination of whether there is indeed value to be extracted from a company with NFCF. Failed acquisitions, discontinuing money losing businesses and subsidiaries however can be red flags.

If one is to invest in companies with NFCF there is one key element that cannot be overlooked: the quality and/or reputation of the desired companies management. Companies with management that divvies up excuses for earnings and cash flow misses tend to repeat these excuses in the future. All companies are entitle to an occasional miss, but how management communicates what happened is often as important as the actual results.

Conclusion

Just like in the overall market, diversification is key when examining Negative Free Cash Flow investments. While there can always be room in ones portfolio for all types of investments, diversity is key. And please, perform proper due diligence and only invest if your risk tolerance allows you to justify your actions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.