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FCF... deducting total capex or maintenance capex?


Homestead31
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i have a question for the group... when you are reading an interview with a well known investor etc and they talk about XYZ spitting of $ABC in free cash flow, do you assume that they are talking about operating cash flow - all cap ex?  or do you assume that they are talking about operating cash flow - maintenance cap ex?

 

obviously every case is different, but i have noticed that very rarely does what an investor say line up with what the financials actually say if you go by a strict definition of FCF...

 

so what do you assume?

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that is my point... when i go to verify, it rarely if ever lines up.

 

but what do people assume (knowing full well that they will go double check themselves)

 

Any investor that you see quoted in a paper/magazine/book/interview etc. is probably making adjustments to the numbers. If they're investing a large sum, they're not simply going to take GAAP at face value - there are shortcomings with standardized accounting and these investors will make adjustments to those figures based on their estimates to help correct for those shortcomings. You'll probably never back into the same numbers as them.

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i have a question for the group... when you are reading an interview with a well known investor etc and they talk about XYZ spitting of $ABC in free cash flow, do you assume that they are talking about operating cash flow - all cap ex?  or do you assume that they are talking about operating cash flow - maintenance cap ex?

 

obviously every case is different, but i have noticed that very rarely does what an investor say line up with what the financials actually say if you go by a strict definition of FCF...

 

so what do you assume?

 

I use operating cash flow minus maintenance cap-ex. A lot of times cap-ex isn't broken down into growth and maintenance, so I use capex but know that some of it is allocated for growth.

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If I plan to invest, I calculate it myself. ;)

 

 

 

According to my definition, total capex and acquisitions should be deducted.

But I guess some people define it differently.

So I just have to do the work myself. ;)

 

What are you trying to measure with this? This seems to be just cash piling up on the balance sheet or net shareholder yield (dividends + buybacks + debt repayments). For Apple, in the Jobs, era, how valuable was the FCF that wasn't reinvested? It's still sitting offshore earning a pittance.

 

The ability to reinvest at high rates of return is extremely valuable, but you seem to be undervaluing any firm that is reinvesting. For a growing firm, "real" FCF by your definition will be hurt by:

- Growth OpEx spent in advance of growth (sales, marketing, R&D)

- Increasing Working Capital to support growth

- Growth CapEx

- Acquisitions

 

So a company that is growing 20% per year (Cimpress) has $0 FCF by your definition, but a dying company (Outerwall) has $200M. So Outerwall is more valuable than Cimpress?

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Jurgis, I don't have the answers. I am just trying to understand the comments you made on the Cimpress thread (or more specifically Schwab711's explanation for your comments).

 

I guess what I am trying to understand is how you, Jurgis, value a company that is reinvesting 100% of earnings. Schwab711 made a pretty convincing defense of your approach. But then you are left with the challenge of valuing a company with $0 in Real FCF.

 

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FCF is just one of the tools I use for valuing company, obviously. I look at sales, sales trend, P/S, earnings, earnings trend, P/E, DCF, Discounted Earnings, E/EV, etc. Plus qualitative factors: management, business area, etc.

 

Regarding FCF, you somewhat answered your question yourself: would AAPL at Jobs's time have been bad investment because it could not reinvest all cash back into business? Was FCF for AAPL useless metric just because it showed accumulating cash earning nothing? Would you have preferred if Jobs plowed that cash into subpar businesses to diworsify?

 

OK, AAPL and Jobs are possibly extreme examples, but there are others. ;)

 

Another reason (related to above) for looking at FCF: cash is power, cash is optionality. The fact that management does not plow it back into business right now does not mean they won't use it later to buy back shares, buy businesses for cheap, get through a downturn (like Buffett said about GM, I believe that they should keep cash instead of bowing to activists and buying back shares), etc. Sure, management can blow up cash, but they can blow up growth too. So if we trust them with growth as you suggest, perhaps we should trust them with cash.

 

I have passed on Cimpress and Outerwall. This does not mean they won't be good investments. In case of Cimpress, I'd like to see better capital allocation (if management is spending CF, it should be spent well). I appreciate their candor of indicating that past acquisitions did not work well. Numbers don't work for me personally, but I have no issue if they work for you. In case of Outerwall, I don't usually invest in declining businesses. Also I don't think their management is good. But we should not make this thread about specific companies IMO.

 

Peace.

 

Edit: maybe short answer would be: ideal company would be growing and throwing off FCF. Such companies are few and usually very expensive though.

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Edit: maybe short answer would be: ideal company would be growing and throwing off FCF. Such companies are few and usually very expensive though.

 

A few obvious places to look (with historical examples):

- Negative cash conversion cycle (Apple, enterprise software)

- Toll booths (Mastercard, Moody's)

- Asset Light (SiriusXM, broadcast TV in the old days)

- Pricing power (Philip Morris, See's Candy)

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I would push back on the belief that an ideal company is growing AND throwing off FCF.

 

Option #1:

 

Company creates large amounts of cash flow that it can then reinvest into growth of the existing company or prudently allocate into related/unrelated companies via wholesale purchase or partial purchase on the public markets. In my opinion, this is the best kind of company.

 

Option #2:

 

Company creates large amounts of cash flow that cannot all be reinvested into growth of the existing company or prudently allocated into related/unrelated companies via wholesale purchase or partial purchase on the public markets. Then you have to decide what to do with the cash.

 

Share repurchases are good because there's no tax leakage, but then you have an issue as to how good those repurchases are based on the market prices versus the intrinsic value of a company. Is management good at that? If so, then you're maybe in the same category as Option #1.

 

Alternatively, you can distribute the cash to shareholders, but then the shareholders are forced to pay the dividends tax (unless it qualifies as a return of principal somehow) and you're left in a worse-off position than if you could have reinvested the money at a high reinvestment rate. Highly probable that this is worse than Option #1.

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I would push back on the belief that an ideal company is growing AND throwing off FCF.

 

Option #1:

 

Company creates large amounts of cash flow that it can then reinvest into growth of the existing company or prudently allocate into related/unrelated companies via wholesale purchase or partial purchase on the public markets. In my opinion, this is the best kind of company.

 

Option #2:

 

Company creates large amounts of cash flow that cannot all be reinvested into growth of the existing company or prudently allocated into related/unrelated companies via wholesale purchase or partial purchase on the public markets. Then you have to decide what to do with the cash.

 

Share repurchases are good because there's no tax leakage, but then you have an issue as to how good those repurchases are based on the market prices versus the intrinsic value of a company. Is management good at that? If so, then you're maybe in the same category as Option #1.

 

Alternatively, you can distribute the cash to shareholders, but then the shareholders are forced to pay the dividends tax (unless it qualifies as a return of principal somehow) and you're left in a worse-off position than if you could have reinvested the money at a high reinvestment rate. Highly probable that this is worse than Option #1.

 

+1. And oftentimes Option #1 has great tax advantages for the company itself.

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Short answer: Maintenance capex.  Read Bruce Greenwald's books/works. Maintenance capex is simply replacing the plant, property and equipment back up to its original, beginning of year state.  In most cases maintenance capex = depreciation.  This makes sense right since accountants spend a lot of time trying to figure out what the economic life of an asset is, so they can apply the correct depreciation schedule.  I say most cases, because there are exceptions, such as in an inflationary environment.

 

Let's go through a simple example, ignoring taxes.

 

You're entering the courier service (taxiing documents around the city).  You go and buy a car for $25,000, using the savings you've accumulated out of patience and good conduct in the past, and hire an employee to do all the actual work.  After the end of the first year your P&L looks as follows:

 

Sales: $50,000

Operating Expenses (excluding depreciation): $40,000

Depreciation: $5,000 (5 year life)

Total Expenses: $45,000

Net Profit: $5,000

 

How much money have you made, and what was your return? Well your return on sales (pre-tax profit margin) was 10% ($5k / $50k); your return on capital (also your ROE since there's no debt) was 20% ($5k/$25k).  Since you have no receivables or payables your operating cash flow was $5k net income + $5k non-cash depreciation = $10k.  So, you laid out $25k and got $10k back, wasn't your actual return $10k / $25k = 40%? 

 

Let's fast forward to the end of five years...At the end of year 5 your operating asset, your car, has been so beat up and abused that it's no longer worth anything.  You can't even trade it in for anything it's so beat up, you've literally wrung the life out of it.  You see in your bank account $50,000, representing the $10k/year accumulated cash flow.  In order to stay in business you must - must - buy another vehicle.  We were lucky to not have had any inflation over that time so your vehicle still costs $25k.  You outlay the money and look at your account: $25k.  You've earned 20% per year.  Your true "owner earnings" was your pre-tax income. 

 

Now. Let's make this business grow.  Instead of buying just one vehicle, replacing the old one, you buy two.  $50k goes out the door.  Now your P&L doubles (I'll leave you to do the math).  Has the money spent on the second "growth" vehicle actually been wasted? Is it worthless? No.  Assuming it earns the same return as the first you can enjoy a 20% return on a larger pool of capital.  The returns (%) have stayed the same, but the amount of capital employed has gone up.  This is why Buffett is not impressed with "record" earnings.  He cares most about ROIC.

 

The business just described would, according to Buffett, be described as close to the ideal business.  You can just keep adding and reinvesting capital into it and it keeps on keeping on.  In the real world what happens is returns go down, there is competition, technology changes.  What should we do with that surplus cash at the end of the day? Should we reinvest, return cash to shareholders, buy another company? This is the art capital allocation.

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I would push back on the belief that an ideal company is growing AND throwing off FCF.

 

Option #1:

 

Company creates large amounts of cash flow that it can then reinvest into growth of the existing company

 

 

And of course the company magically is in the business where it produces exactly the cash flow that it can reinvest into the growth of the existing company at the same ROE.

 

This is possibly true for small growth companies. Actually they probably produce less FCF than they could reinvest into their growth. So they are not that good according to you?

 

or prudently allocate into related/unrelated companies via wholesale purchase or partial purchase on the public markets. In my opinion, this is the best kind of company.

 

Haha. Any company can do that if they have a capital allocator at the head.

 

So you are saying that Jobs should have hired Buffett wannabe to allocate his FCF and AAPL would have been perfect.

 

Edit: BTW, your "prudently allocate ... via ... partial purchase on the public markets" would not be considered capex or acquisition. So you are actually saying that ideal company could be "throwing off FCF". ;)

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Has the money spent on the second "growth" vehicle actually been wasted? Is it worthless? No.  Assuming it earns the same return as the first

 

Yes. Assuming. Most managements' growth capex is not producing the same return as the first. Even for best companies. Even for Buffett companies. It is very hard for large companies to produce the same ROIC on incrementals. I'm pretty sure KO has not produced the same return on growth capex for ages.

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Has the money spent on the second "growth" vehicle actually been wasted? Is it worthless? No.  Assuming it earns the same return as the first

 

Yes. Assuming. Most managements' growth capex is not producing the same return as the first. Even for best companies. Even for Buffett companies. It is very hard for large companies to produce the same ROIC on incrementals. I'm pretty sure KO has not produced the same return on growth capex for ages.

 

Jurgis - I'd agree with you that a good many businesses do not earn on their incremental investments a return better than that of the original business.  This is partly due to the fact that rarely have those at the top been schooled in capital allocation and, therefore, they invest based on another metric, such as growth in market share, or simply growth in sales.  The other part is because growth opportunities in "home" markets get saturated.

 

But to say that ALL growth capex is wasted is incorrect.  Yes, growth is hard to value.  Yes, management's can (and many do) invest in sub par projects.  Yes, many people misunderstand growth and think that it's all good, which it's not.  Growth adds value if invested above the cost of capital; at the cost of capital value is neither added nor destroyed; and below the cost of capital growth is a negative. 

 

Do you have a savings account? If so, do you take out the interest every month, for fear that it will be lost? No, of course not.  Your interest become "growth spending" increasing your asset base, and therefore the earnings power of your saving account.  A company is an asset that is made up of a collection of other assets (machinery, equipment, people, processes) that can be added to for growth. 

 

Based on what you've described as ideal, I'd guess that your portfolio is made up entirely of cash cow blue chips? What else could reasonably satisfy your desire for high payout ratios yet still maintain a reasonable value based solely on discarding all growth spending?

 

Jurgis - as we've met before I hope none of the above comes off as disrespectful or otherwise misconstrued.  Just trying to understand your logic, and hopefully, contribute to this conversation.

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I would push back on the belief that an ideal company is growing AND throwing off FCF.

 

Option #1:

 

Company creates large amounts of cash flow that it can then reinvest into growth of the existing company

 

 

And of course the company magically is in the business where it produces exactly the cash flow that it can reinvest into the growth of the existing company at the same ROE.

 

This is possibly true for small growth companies. Actually they probably produce less FCF than they could reinvest into their growth. So they are not that good according to you?

 

You used the word ideal. Dictionary definition as follows:

 

i·de·al

īˈdē(ə)l

noun

1. a conception of something in its perfection.

 

If you used another word, we'd be having the discussion you think we're having, but you didn't, so we're not. :)

 

There are companies that approach this ideal though. For example, my guess is that Mid-American can deploy large amounts of capital (pretty much all it generates) into 15% pre-tax returns or higher for a pretty significant amount of time. (Other companies in the industry cannot do so at the same level because they utilize a completely different capital structure and philosophy -- contrast Vodafone vs. Liberty Global and their dividend vs. reinvestment philosophies.)

 

or prudently allocate into related/unrelated companies via wholesale purchase or partial purchase on the public markets. In my opinion, this is the best kind of company.

 

Haha. Any company can do that if they have a capital allocator at the head.

 

So you are saying that Jobs should have hired Buffett wannabe to allocate his FCF and AAPL would have been perfect.

 

Indeed, any company can do that if they have a capital allocator at the head, and, yet, there are not so many capital allocators at the head of many of these companies. Management and capital allocation are not necessarily overlapping skill sets. It is rare to find both operational excellence and capital allocation excellence within the same individual or even the same management team.

 

Apple is actually a perfect example of that. It has been a fantastic company to own given that it has had a very long runway for growth, but because of the fact that it was unable to effectively deploy its large amounts of prodigious cash flow, it falls short of the Platonic-Fisher ideal. (No one is saying that you cannot get rich off a company that is not quite the ideal, btw. You can. But you used the word "ideal" and words have specific meanings.)

 

If Jobs had heeded Buffett's advice to sink their truly "free" cash flow into share repurchases, the return would have been even more phenomenal than it already has been.

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But to say that ALL growth capex is wasted is incorrect.

 

I never said that. I wonder why you think I did.

 

The fact that I subtract growth capex from FCF does not mean it's necessarily wasted. It just means that for that particular metric I want to know how much cash company can put in the bank (or spend on buying cheap stocks ;) ). I also look at other metrics so this discussion is rather misdirected IMO. :)

 

Based on what you've described as ideal, I'd guess that your portfolio is made up entirely of cash cow blue chips? What else could reasonably satisfy your desire for high payout ratios yet still maintain a reasonable value based solely on discarding all growth spending?

 

Ideal company does not necessarily make ideal investment. There is always a question of price. ;)

 

Securities of very non-ideal companies may result in better returns than securities of ideal ones.

 

Long term, sure I probably would love something like AAPL or MSFT in the old days. However, I'll admit that I am too cheap and I usually don't buy the ideal companies when they are young and growing fast.

 

BTW, looking at this board, I have a feeling that there's not much discussion of organic FCF-for-growth-capex companies either. Mostly I see people talking about rollups or special situations. Maybe this is misperception though.

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You used the word ideal.

 

Oh well, we are down to word sense discussion. :)

 

I'll parry with

 

Edit: BTW, your "prudently allocate ... via ... partial purchase on the public markets" would not be considered capex or acquisition. So you are actually saying that ideal company could be "throwing off FCF". ;)

 

But, yeah, I am probably overconservative and would prefer that the company was throwing of FCF as well as growing because the next seven years might not be as good as the past.

 

Though to be fair you said "prudently allocate" ;)

 

Take care

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All conversations with former lawyers sooner or later degenerate into word sense. Call it Godwin's Law of Lawyers only with definitions rather than Hitler. :P

 

And it's about to happen again, lol.

 

I think the problem is that we've been a bit fast and loose with the definition of "free cash flow." Some people are using that to mean operating cash flow minus all capital expenditures (regardless of whether it's maintenance cap ex or growth cap ex). Others are using it to refer to what might commonly be called "owner's earnings," which might be operating cash flow minus maintenance cap ex. (And now we're full circle to the OP.)

 

From your description of wanting both growth and free cash flow, I inferred that you were using the former definition rather than the latter -- though I could be totally wrong about that. (It's difficult, though not impossible, to have growth without incremental capital expenditure spend.)

 

The big problem that I think many investors are running into at this point is that it's difficult at any given time to accurately pinpoint a given executive's capital allocation abilities until you've spent some considerable time examining them up, down, backwards, and forwards. Who among us can say honestly to themselves that they would have been able to pinpoint greatness in WEB in 1965? It's easy in hindsight in 2015, but Hindsight Capital is always a winner.

 

At some point, you have to look at your collection of data and make a decision as to whether you're comfortable at the executives' decision-making process w/ capital allocation and then be done with it. And reasonable minds can disagree on this -- look at VRX.

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But to say that ALL growth capex is wasted is incorrect.

 

I never said that. I wonder why you think I did.

 

The fact that I subtract growth capex from FCF does not mean it's necessarily wasted. It just means that for that particular metric I want to know how much cash company can put in the bank (or spend on buying cheap stocks ;) ). I also look at other metrics so this discussion is rather misdirected IMO. :)

 

Based on what you've described as ideal, I'd guess that your portfolio is made up entirely of cash cow blue chips? What else could reasonably satisfy your desire for high payout ratios yet still maintain a reasonable value based solely on discarding all growth spending?

 

Ideal company does not necessarily make ideal investment. There is always a question of price. ;)

 

Securities of very non-ideal companies may result in better returns than securities of ideal ones.

 

Long term, sure I probably would love something like AAPL or MSFT in the old days. However, I'll admit that I am too cheap and I usually don't buy the ideal companies when they are young and growing fast.

 

BTW, looking at this board, I have a feeling that there's not much discussion of organic FCF-for-growth-capex companies either. Mostly I see people talking about rollups or special situations. Maybe this is misperception though.

 

It was your "Yes. Assuming." that lead me to believe you were sticking with your original statement in hard form.  Bottom line is this: growth requires capital, the more invested = further away from cash = riskier.  It's our job to risk-adjust investments ala the pari mutuel system. 

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All conversations with former lawyers sooner or later degenerate into word sense. Call it Godwin's Law of Lawyers only with definitions rather than Hitler. :P

 

OK. :) Sometimes this is useful, sometimes not so much. At least we are not discussing what is the definition of "value investing". :P

 

I think the problem is that we've been a bit fast and loose with the definition of "free cash flow." Some people are using that to mean operating cash flow minus all capital expenditures (regardless of whether it's maintenance cap ex or growth cap ex). Others are using it to refer to what might commonly be called "owner's earnings," which might be operating cash flow minus maintenance cap ex. (And now we're full circle to the OP.)

 

From your description of wanting both growth and free cash flow, I inferred that you were using the former definition rather than the latter -- though I could be totally wrong about that.

 

Yes, you are correct, by FCF I mean operating cash flow minus all capital expenditures (including acquisitions actually).

 

The big problem that I think many investors are running into at this point is that it's difficult at any given time to accurately pinpoint a given executive's capital allocation abilities until you've spent some considerable time examining them up, down, backwards, and forwards. Who among us can say honestly to themselves that they would have been able to pinpoint greatness in WEB in 1965? It's easy in hindsight in 2015, but Hindsight Capital is always a winner.

 

At some point, you have to look at your collection of data and make a decision as to whether you're comfortable at the executives' decision-making process w/ capital allocation and then be done with it. And reasonable minds can disagree on this -- look at VRX.

 

Completely agreed.

 

The problem for me is not professional capital allocators. I can decide that I like Mr. Cafe as capital allocator and invest in their company, but I don't like Mr. Provolone and not invest in their company. (Names chosen at random and do not represent any real or imagined individuals. :P)

 

The problem is generic CEOs that usually have one or two approaches to capital allocation and just stick to them. And if you want to buy stock in regular companies (not run by professional capital allocators), you have to evaluate these CEOs. This might be somewhat easy if you believe that their capital allocation method has a long runway for their particular business and will work for a long time. Or it might be not easy if you are not sure or think that they are stuck with suboptimal approach and it's not clear whether they will change/improve/etc.

 

One solution is not to buy stock in such companies at all. My solution is to buy stock, but demand lower price based on variety of metrics involving FCF, for example. Of course, like you said, others might judge the same CEO and their approach to be great. Or they might use other metrics to evaluate the margin of safety in such situation. AXP, IBM, or Cimpress might be examples of such situation.

 

Note, that as much as I love companies run by professional capital allocators, I think that companies run by great business focused CEOs with some (limited?) capital allocation skills have higher potential. In other words, Microsofts, Starbucks, WalMarts usually outperform Berkshires, Clarkes and FRMOs. But it is just gut feeling. I may be wrong. And I sidestepped the question of where I would put Transdigm, Danaher, etc.

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