Why Free Cashflow is King

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Why free cashflow is King? Invast.com.au explains the importance of cashflow in this 'Insights' report. It is a common question when buying a company. Many analysts, when talking about stocks, often quote price to earnings ratio's or analysis of revenue and investment returns. We explained why we liked this method so much.

Transcript of Why Free Cashflow is King

  • Invast Insights Week Commencing November 18, 2013
  • www.invast.com.au | 1800 468 278 This week we look at the following topics: 1.0 Why Free Cashflow is king 2.0 Oil price revisited where to from here 3.0 Is the carry-trade alive and kicking? 4.0 Is Keep an eye on this small cap stock 5.0 Recap of our 2013 covered topics 6.0 Weekly economic calendar
  • www.invast.com.au | 1800 468 278
  • www.invast.com.au | 1800 468 278 1.0 Why Free Cashflow is king What is it worth? This is the most common question when buying a company. The question can also be applied to any other asset, like asking what a certain property, currency income annuity or commodity is worth. If you dont trade stocks this section might not seem important to you, but its worth noting that companies are the basis for all index and stock market measurements. Companies often dictate where central banks pitch their monetary policy, in return driving currencies. For this reason, we hope this analysis is of use to you regardless of what asset class you trade. When chatting about stocks, many analysts often quote the price to earnings ratio or go into detailed analysis on revenue, margins and investment returns. In most circumstances most of these numbers are useless and over the years we have grown to prefer one specific measure above all the rest Free Cashflow per share. We explain why we like this method so much below. But firstly, we need to put this discussion into context. The process of valuation is at best, a guess.There are no perfect methods or magic measurements.
  • www.invast.com.au | 1800 468 278
  • www.invast.com.au | 1800 468 278 When we launched this weekly publication back in late August, we explained that the process of valuation is guesswork right from the beginning. We made clear that our role here is to help improve your investment and trading returns. At times we get some of our thoughts right and we also get some wrong. But we dont take our estimates and numbers too emotionally, they are just a guide to help build our thoughts and ideas. Many other analysts fall into the habit of using a particular method as it becomes common practice. They get hooked, obsessed and talk about margins, ratios, earnings drivers and so on without really thinking about what the importance of cash in a business. We decided to write this section after reading a newspaper headline, explaining Australian electronics retailer Dick Smiths plans to list on the Australian stock market. We were surprised at the range of numbers being mentioned. The newspaper said Dick Smith was valued by a certain investment bank at between 11.5 to 14.5 times its earnings. This measure is called a price to earnings ratio. The actual numbers mentioned arent the problem but the valuation method is. We dont think it is appropriate for a business like Dick Smith.
  • www.invast.com.au | 1800 468 278 Dick Smith is an Australian electronics retailer, previously under the ownership of Woolworths. After many years of stress with Dick Smith, Woolworths recently made the decision to sell and move on. Woolworths by the way is the largest retailer in Australia. You would have probably realised that by now. If the largest retailer in Australia cannot make money from a concept, we think others will also struggle. Retailing is very difficult but there can be opportunities to turnaround interesting businesses. We dont doubt this, but we just dont have confidence in Dick Smith as a concept. We think a price to earnings ratio as inappropriate since earnings as a measurement are not the best indicator of what Dick Smith owners will make. Measuring earnings alone is too simple. For example, costs could fall and revenue rise in a certain period of time, which will lift earnings. This was the same case with Myer prior to its sale in a few years ago at $4.10, before it fell below $2 two years later. Retailers like Dick Smith and Myer require ongoing spending in their stores to make sure customers keep coming back. If you survive without spending money, competitors will eventually copy and take away your profits. Barriers
  • www.invast.com.au | 1800 468 278 to entry are low. To maintain power and discourage competition, retailers need to keep spending money. As a measurement, earnings do not always capture this investment requirement. The more stores you open, the largest the annual commitment becomes to refurbish and maintain your stores. Myers previous owners spent around half a billion dollars getting the business back to a respectable competitive level before selling shares to the market. The investment cycle for retailers is at most ten years. The best retailers like Woolworths pour billions of dollars each year to improve products and expand their stores, ensuring they dont lose the fight with arch rivals. Retailers can do well at certain points, mainly due to external factors. In a particular period of time, earnings might be growing because new stores and improved consumer sentiment is driving sales but that means nothing if in a few years time, stores need to be completely refurbished and new money spent on products, layout etc. when customers tune out. Myer is starting to realise this. Using a price to earnings ratio on a good earnings base is very misleading and the smart money doesnt buy the rational. It is a measure
  • www.invast.com.au | 1800 468 278 at one point in time which can be manipulated by lowering costs or unsustainable revenue. So how do we measure this timing more appropriately? Fortunately a few days before reading the Dick Smith press report, we were reminded that Free Cashflow per share is an important measure of business performance by the very smart folks over at The Motley Fool. They run an independent research service. Free Cashflow per share measures cash generated by a business though its operations in one year. It then subtracts money put aside for capital spending, money used to fund working capital and the payment of taxes. Free Cashflow is essentially what is left over in the cash piggy bank after all commitments are made. This differs very much from earnings because the money set aside to invest is not capture on the profit and loss statement. The Motley Fool wrote their note in the Sydney Morning Herald; you can click here to read it. We think it is a great conversation around why the chief executive and founder of Amazon.com focuses only on Free Cashflow per
  • www.invast.com.au | 1800 468 278 share as the key method of benchmark performance for his business. Amazon.com doesnt really care if it earns a low margin on its sales. What really matters to the business is increasing sales and cash on an absolute basis. Amazon.com would rather earn 1% return on large sales than 5% returns on average sales. Absolute returns are what matters. What matters is the amount of cash flowing through to its bank account and this cash ultimately helps Amazon.com decide on how it grows and how to reward its shareholders. Profit margins are a relative measure, cash is absolute. Amazon.com CEO Jeff Bezos knows a thing or two he started Amazon.com in the mid 1990s from humble beginnings after many years in the finance industry, his last role in a quantitative hedge fund. His sole focus on Free Cashflow per share has seen his operation grow to become one of the largest global retailers and the leanest in the industry, employing best of practice technology.We all know the story.
  • www.invast.com.au | 1800 468 278 In Australia, Telstra shows why Free Cashflow is more important than actually earnings. Telstra spent large amounts of cash in technology under its previous boss, Sol Trujillo. This ensured service was superior to rivals. Cashflows started to improve after the investment was made. Because of the large investment, Telstra needs to book depreciation onto its numbers and so the earnings number understates the amount of cash the business actually generates. The infrastructure is built so as of the time of writing Telstra is investing very limited amounts of money to generate cash from its mobile operations. We all know how good the network is. Free Cashflow per share is a better measure of the ability to pay out dividends or make acquisitions than does the earnings base. Telstra generated $5bn of Free Cashflow in 2013 compared to earnings of $3.9bn a huge difference of $1.1b. Retailer JB Hi-Fi will be used as the perfect comparison against Dick Smith, even though their businesses are miles apart. The investment banks and IPO marketers will be using the solid rise in JB Hi-Fis shares to justify an earnings multiple for Dick Smith. Which one do we prefer? We wouldnt be buying any
  • www.invast.com.au | 1800 468 278 any of them at the moment based on the Free Cashflow generation of the whole sector. Lets take JB Hi-Fis numbers as an example. On our estimates the business generated Free Cashflow of around $125m last year. As it rolls out more stores and as many of its existing stores hit their maturity profile, it will need to spend more money and so the Free Cashflow growth profile is probably not as good as what many expect. JB Hi-Fi is a leader in its segment, but that doesnt always make it a good investment. It is already admitting t