cash flow

cash flow

Yesterday’s post probably contained more than you will ever need to know about depreciation.  Today’s topic is cash flow.  Tomorrow’s will be a discussion of whether cash flow or net profits is a better indicator to use in evaluating a stock.

four possible sources

What makes cash flow important is that it is a broader measure of a company’s ability to generate money from operations year after year than net profit is.  Professional investors normally consider four sources of funds in calculating cash flow. They are:

–net profit

–depreciation and amortization (which is essentially depreciation under another name)

–deferred taxes

–changes in working capital.

The four items should be found either in a company’s cash flow reconciliation statement or in the footnotes to the balance sheet.   In the US, all are contained in the “cash flows from operating activities” section of the cash flow statement.

I stick with two

Not everyone uses all four items.  There’s universal agreement (or as near as you can get in any human endeavor) that a cash flow calculation should include net profit + depreciation and amortization.  The question is whether to include the other two. And the issue is whether they provide a recurring source of cash.  My own opinion is, except in heavily government subsidized industries like mineral extraction where taxes always seem to be deferred, to exclude both deferred taxes and changed in working capital.

The worry about deferred taxes is that they arise from differences in the timing of when the tax expense is shown on the financial reports to shareholders and when the cash is ultimately paid to the tax authority.  So they often reverse themselves in relatively short order.

How can this happen?  One main reason is that governments often give companies a tax incentive to invest by allowing them to take rapid depreciation deductions.  In most countries (Japan is the only exception I can think of) financial reports use straight line depreciation, which slows and smooths the depreciation deduction.

An example:  For a $1000 item with a 5-year life and no salvage value, where government allows double declining balance depreciation, the yearly deprecation expense for taxes vs. for financial reporting looks like this:

tax     400     240     120     120     120

fin      200     200     200     200     200

Δ        200      40      (80)     (80)    (80).

Let’s assume (to keep things simple) that there are no other differences between the tax books and the financial reporting accounts.  If so, in year 1 the financial reporting accounts will deduct 200 from revenue for depreciation vs. 400 on the tax books.  Therefore, the report to shareholders will show pre-tax income that’s 200 higher than the tax books will show to the government.

What to do about the 200 in “phantom” income on the financial reporting books.  Not to worry, the financial reporting accountants will make a tax provision of 70 (assuming a 35% corporate tax rate) for the “extra” income.   They will label the 70 as deferred taxes and establish a balance sheet entry to hold the phantom tax payment.  They will also enter the 70 as a positive cash flow from operations on the consolidated cash flow statement, to show that the 70 hasn’t actually been paid to the tax authority.  (I’m not making this up.  This is what they do.  Don’t ask me why.)

In year 2, the procedure is similar to that of year 1, but the amount is 14.

In year 3, the depreciation deduction for financial reporting purposes is higher than that for the tax authority, so more actual taxes–an extra 28 per year–are paid.  Financial reporting accountants handle this by reversing their prior procedure–subtracting 28 in deferred taxes each year from the balance sheet, the tax entry on the income statement and the cash flow statement.

The details–bizarre as they are–aren’t so important.  The point to remember is that unless a company is continually investing, the deferred tax additions to cash flow will soon reverse themselves.  So they can’t be counted on as recurring sources of cash flow.

The other iffy item, in my view, is changes in working capital. There are negative working capital businesses.   Public utilities, restaurants, and hotels are examples.  Their customers pay for the companies’ products either in advance or very quickly after using them.  The companies, on the other hand, pay their suppliers only with a time lag, say, 30 days after delivery.  So such companies enjoy a “float” equal to perhaps 20 days worth of sales.  As long as sales are increasing, this “float” not only persists–it gets bigger!  The increase in payables minus receivables shows up on the cash flow statement as cash coming in from operations.  The amounts can be very large.

This isn’t exactly risk-free money, however. If sales begin to contract, so too will payables–meaning the company will have to return part of the float it has enjoyed from its suppliers.  And it better have the cash to be able to do so.  This is my reason for not counting working capital changes either.

(One other note about working capital, which I really consider a separate item for analysis.  There are firms whose market position is weak enough that their suppliers don’t give them much trade credit and they are also compelled to finance their customers’ purchases for long periods of time.  The worst I ever recall seeing was the Japanese sporting good company, Mizuno, which in the Eighties was giving its customers two years to pay.  In order for the company’s sales to grow, this trade financing–a use of corporate funds–had to grow as well.)

cash flow vs. free cash flow

Analysts often try to distinguish between (gross) cash flow as described above and (net or) free cash flow.  The latter is what’s left from profits + depreciation after all corporate calls on that cash have been satisfied.  These calls are generally:

–capital expenditure, i.e. reinvestment in maintaining and expanding plant and equipment

–working capital needs

–repayment of debt

–dividends to shareholders.

sounds good, but a somewhat nebulous concept

Although the concept of free cash flow is clear, arriving at a practical figure–especially when analyzing the company as an acquisition target–is a lot murkier than it might sound.  First of all, if you or I were acquiring a company, we probably wouldn’t pay dividends any more (we’d cancel our jet rentals and ride around on the corporate plane instead; we might have the company “invest” in a golf course in a resort area, too–and inspect it frequently).

We might think that the current owners’ capital spending plans were too aggressive or wasteful.  In either case, we could pare them back.  We might also think that the firm’s working capital management is very inefficient.  And we might feel we could refinance existing debt at a more favorable rate.

the unenviable case of utilities

However fuzzy the actual calculation may be,  we can probably best see what the distinction wants to highlight by considering a (highly simplified) public utility, like a local gas or electric distribution company.  Regulators in most countries grant such utilities a maximum allowable profit that’s calculated as a percentage of the utility’s net (meaning still undepreciated) plant and equipment.

Let’s say the allowable return is 5% and the net plant and equipment is 1000.  In the first year, the company is permitted to achieve a profit of 50.  During that year, the company records depreciation expense of 25.  Cash flow is therefore 75.

But starting out in year 2, absent any new building, the net plant is only 975.  Therefore the maximum allowable profit is 48.75–a fall of 2.5%.  In order to keep profits flat from year to year, the utility has to reinvest its depreciation to get the net plant back up to the prior year’s level.  To have, say, a 2.5% profit increase, the utility has to make its net plant grow by that amount–meaning it has to reinvest depreciation + another 25 (half its profit) back into the business.

This is the ultimate case of a company whose cash flow is not free.  Looking at the utility sections of stock services like Value Line, which calculate cash flow and price/cash flow ratios will show you what stunningly low multiples of cash flow pure utilities trade at.  The fact that most of the cash has to be plowed back into the business just to keep the ship afloat is the reason why.

That’s it for today.


depreciation

I want to talk about subscription services and about cloud computing in particular.  This and the next couple of posts will lay some groundwork.

depreciation

As as investor, I’m interested in depreciation in the accounting sense–the expense on the income statement that represents the allocation of part of the cost of a capital asset (that is, an asset that lasts a long time, like a factory or a piece of machinery) against revenues in a given period of time.  (In an economic sense, which I’m not going to write about here, depreciation is the wearing out or obsolescence of a capital asset.  The two senses of depreciation aren’t the same thing.  In the accounting sense, for example, the laws in a given country or accounting convention determine what can be written off, and by how much.  A factory building, for instance, amy be allowed to be written off over 40 years.  At the end of that time, the carrying value on the balance sheet will be zero, or very close.  But the structure itself may be economically usable for another 20 years.  A further aside–this difference can be very pronounced when dealing with the depletion of mineral reserves.)

a non-cash charge

Depreciation doesn’t represent an outlay of cash during the period it is charged against income.  The factory is already built and the machinery is already installed before anything is made for sale.  It actually represents an inflow of cash which the company is not considering to be profit, but rather recovery of a portion of the capital investment it has made in plant and equipment.

figuring what the quarterly depreciation expense is

To determine the depreciation expense in a given accounting period, a company needs several pieces of information.  They are:

–the cost of the capital item

–its estimated useful life

–estimated salvage value, and

–the method to be used in allocating the depreciable cost (cost – salvage value) over the useful life.

Two allied concepts to depreciation are amortization and depletion. Depletion is the cost allocation procedure for the value of mineral reserves;  amortization is the procedure for intangible assets.

depreciation methods

straight line

The most commonly used method of depreciation in financial reporting is straight line. This means that the depreciable cost is spread in equal amounts over the estimated useful life.  Let’s assume, for example, that an asset has a cost of 1,000, a useful life of 10 years and a salvage value of zero.  The the depreciable value is 1000 – 0 = 1000.  1000/10 years = 100/year.  This means depreciation expense of 25 per quarter or 100 per year.

accelerated

Sometimes companies feel that assets, like computer systems, lose value faster than the straight-line method allows for.  So they will voluntarily use a depreciation method that writes off a larger amount of the asset’s cost in the earlier years of its life.  More often, governments will give companies a tax break by allowing them to use an accelerated depreciation method for writing off a given type of investment on the company’s tax return.

two accelerated techniques

There are two main methods of accelerating depreciation.  They may not make a lot of intuitive sense, but since they’re mostly intended as tax breaks, that shouldn’t matter too much.

1)  declining balance

Declining balance is the name for a family of depreciation schemes that key off the straight line depreciation method.  Specific declining balance schemes are designated as, say, 2x declining balance, 1.75x declining balance, etc.  The number in front refers to the multiple of straight line depreciation that’s applied each year to the depreciable balance for the asset.  “Declining balance” refers to the fact that the the gross depreciable amount declines.  It is reduced each year by the value of the prior year’s depreciation, before the new depreciation is calculated.

For example, let’s say we’re going to use double (2x) declining balance to depreciate the above ten-year life asset with original cost of 1000 and no salvage value.  For a ten-year life asset, straight line depreciation is 10% of the value each year.  Using 2x declining balance means using two times the straight line percentage, or 20%, as the percent of the asset value that we’ll depreciate in each year.

In year one, this means our depreciation is 20% of 1000, or 200.  For year two, we first subtract last year’s depreciation from asset value; that is, 1000 – 200 = 800.  Second year depreciation is 20% of 800, or 160.  In year three, the depreciable balance is 800 – 160 = 640.  Depreciation is 20% of 640, or 128.  And so on.

One quirk–the declining balance method can never get the asset fully depreciated, because you’re always taking only a fraction of the depreciable balance each year.   So accountants made up a fudge to get the system to work.  At some point, declining balance gets you a smaller depreciation expense than using straight line would.    In our case it’s at year six (where 2x declining balance = 20% of the depreciable balance; straight line = 25%).  At that point, you switch to using straight line for the remaining years.

3) sum of the years digits

This method, which doesn’t have any rationale that I can see, is nevertheless pretty straightforward.  Take the estimated useful life in years.  Add together all the digits from one through that number.  That gets you the denominator of a fraction.  Assign the highest digit of the series to the first year of depreciation, the next highest to year two, etc.  That get’s you the numerator.  For each year, multiplying  (the gross depreciable amount) x (the digit assigned) /(sum of the digits) = that year’s depreciation.

For example, in our ten-year lived asset, the sum of the digits 1-10 is 55.  Therefore, first year depreciation is 1000 x 10 /55 =   181.82.  Second year depreciation is 1000 x 9 /55 =  163.64.  And so on.

Two points:

–depreciation is a key element in the calculation of cash low, which is the topic of the next post in this series, and

–the difference in between the taxes on profits as shown in a given financial report to shareholders and the (often much lower) amount actually paid to the tax authority gives rise to deferred taxes, which can be a key element of cash flow as well.

More about these topics in the post on cash flow.

Rabobank’s latest fundraising: Europe trying to define bondholders’ responsibility in default

the problem

To an American, one of the striking aspects of the financial crisis has been the reluctance, both of politically powerful bondholders (many of them state-controlled entities) and of country governments, to accept any impairment in the value of the debt securities of ailing financial institutions.  The prevailing thinking seems to have been that, no matter how the debt documents read, there was an implicit social promise that the negative consequences of default should fall entirely on shareholders or government.

(In the US, in contrast, it’s very clear that bondholders, too, participate in the losses from a bankruptcy–though with the quirk that the treatment a class of bonds receives is more dependent on its size and the bargaining power of its representatives than the explicit promises in the bond indenture.)

contingent convertibles

The European way of doing things has proven to put excessive strain on public finances.  One of the possible solutions being discussed to this problem is issuance of contingent convertibles or “CoCo” bonds.  Cocos would spell out in the issuing documents specific circumstances of deteriorating issuer finances that would trigger conversion of part or all of the bond capital into equity.  Conversion would simultaneously reduce the amount of debt on the balance sheet and shore up shareholders’ capital.

The idea really hasn’t gotten off the ground so far.

contingent capital bonds

However, Rabobank of the Netherlands sold a contingent capital bond last weeks that pundits are hailing as an instances of a successful CoCo bond.  The issue, $2 billion at a yield of 8.375%, was more than 3x oversubscribed.  If Rabobank’s equity falls below 8% of total capital, the value of these bonds automatically shrinks–even to zero–until Rabobank’s equity ratio reaches the 8% level again.

Although I’ll admit the issues is interesting, I’m not sure it’s a harbinger of anything.  Why?

–Perhaps least important, this isn’t really a coco at all.  Rabobank is a cooperative society.  It was formed two centuries ago by a large number of agricultural banks, which hold its ownership interests.   So there’s no publicly traded stock for the bond to convert into.  The bond principal vaporizes instead.  I’m not sure there’s a big difference, though, between getting a share of stock in a dud bank or getting nothing, other than how fast you get to recognize your loss.

–Rabobank has a AAA credit rating (although S&P has put it on watch for downgrading) and is mostly a retail bank.  So it has a very different risk profile from the troubled big universal banks of the EU.

–According to the Financial Times, 70% of the issue was taken up by individual investors.  My guess is they don’t have much of a clue about what they’ve bought.  They see a high coupon from a conservatively managed bank–and little else.

the question of pecking order

This bond brings up another question.

Rabobank already has second contingent capital bond outstanding, this one about $1.7 billion and issued last year.  Its terms call for holders to lose 75% of their capital, and have the remainder returned to them, if Rabobank’s equity ratio falls below 7%. (By the way, Rabobank has just over $50 billion in equity, which makes up about 14% of capital).  Because the newly issued bond’s vaporization clause is triggered prior to the 2010 bond’s, it gives some protection to the latter.  That should mean an uptick in price for the 2010 issue.  The question I have is that this seems so arbitrary. Could investors in 2010 have known in advance that they would receive this extra protection?  Probably not.

On second thought, if they had an optimistic enough disposition a year ago, maybe they could.  Rabobank seems dedicated to continue to issue its coca bonds.  One would assume that the cooperative will try to make the vaporization line as high as possible.  This desire will likely be tempered by the thought that, since its retail customers may be large holders of the cocas, the line should be set at a level where there’s only the remotest possibility that the vaporization clause will be triggered.  Last year that number was 7%.  This year it’s 8%.  My guess is that as/when confidence continues to build in Europe, Rabobank will push the vaporization threshold higher.

Maybe the Rabobank cocas will become a bellwether for retail investor sentiment in the EU.  But it seems to me their success will be very little indication of prospects for other banks’ issuing cocos–particularly to institutional investors.

is retail money coming back to the stock market? …yes and no

the news

There have been numerous reports in the financial press over the past month or so that, after two+ years on the sidelines, retail investors are beginning to return to the stock market.  The latest of these appeared in the Financial Times yesterday.  The FT article is a bit selective.  It points out that Charles Schwab added $26.2 billion in new assets in the December quarter, the largest amount in one quarter for the past two years.  It reports that competitor TD Ameritrade added $9.7 billion to its books for the period, but doesn’t mention that this is about average for the firm over the past year and that it added more than $10 billion to its books in the June 2010 quarter.

The latest ICI figures–the Investment Company Institute, the money management trade association, which seem to have been a lagging indicator, are finally starting to confirm the trend that newspapers have been reporting.  The weekly figures for January 12th show $3.78 billion flowing into domestic-oriented equity funds, continuing flows into international/global stock funds, and moderation in the (still positive) flow of money into taxable bond funds.

One significant point is beginning to emerge.  According to the FT, the money flows to the discount brokers are primarily day traders, not buy-and-hold investors.  This latter, much larger, group remains firmly in the highly defensive posture it adopted over two years ago.  The speculative orientation of the recent assets opening brokerage accounts is confirmed by TD Ameritrade’s comment that the use of margin loans by its clients is up 31% year over year.

consequences

The new inflow of retail money likely gives Wall Street a further gentle upward bias.

The fact that there is still considerable private investor money on the sidelines suggests there is more positive news to come on funds flow front.  In other words, the new money doesn’t appear to be a harbinger of the end of the bull market.

The day trader character of the new money suggests that short-term volatility in the market will increase.  To the extent that day traders concentrate on mid- and small-cap names, the volatility in this area should be most affected.  For a long-term investor, this is good news, since it means better buying and selling opportunities for anyone willing to exercise patience.

The use of margin suggests inevitable corrections in the market will be swifter and deeper than they would be otherwise, as high leverage works against traders.