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Changes in operating assets and liabilities:


scorpioncapital
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I have looked at many a cash flow statement , more generally to determine free cash flow generation.

 

I am often stymied by the "Changes in operating assets and liabilities:" line that appears within operating cash-flows. Can these safely be ignored?

 

For example, I just use the net income, backout any charges other than these operating asset/liability movements and deduct certain capital expenditures...

 

 

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Few comments about working capital and the impact on CFO.

 

-There is an inherent bias to improve the cash flow position and so to "take advantage" of working capital end of period adjustments but I think that these adjustments are likely minor in most cases and are inconsequential in the long term.

-In a typical business (more complicated if many different subs), the ratio of working capital to assets should remain relatively constant. What I look for is a tendency for small but incremental decrease in this ratio or a rapid regression to the mean after an acquisition or major expansion. An argument could be made that relentless improvements in accounts receivables and inventory mangement can contribute to the free cash flow number over time. Not many firms can achieve this.

-Otherwise, unless there are liquidity/distress issues, I just remove the non-cash working capital adjustment in order to estimate free cash flow. I have also used a three year rolling average.

 

The challenge is more with "certain capital expenditures". Disclosure, even in the MD&A, does not usually, allow a precise estimation of free cash flow after "maintenance" capex. Dissection of the depreciation expense vs fixed assets vs capex over time can be helpful. I find that firms that report free cash flow measures tend to be optimistic. 

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That's very interesting. It sounds like there are various flavours of capex, depreciation and amortization. Some are more desirable than others. Just wondering what some differences would be. Amortization I remember Buffett saying was more likely not to be a real expense but in fact the asset could be worth more than purchase price , much less a depreciated sum. An example  - some countries allow depreciation of domain names. I guess maintenance capex is less desirable than growth capex, unless the capex results in no growth!

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Evaluating the amortization of defined-life intangibles can be tricky. It can go both ways.

 

Going to the initial transaction that gave rise to the intangible recognition and following up on profitability can help but acquired operations are often melted into something else. It may take a while before trends appear.

 

I don't see aggressive amortization of intangible value as a serious problem because the earning power should eventually be recognized in retained earnings. I much prefer too rapid amortization to the sudden realization that a massive write-down is necessary. A point can be made that well established pattern of excessive amortization could result in an upward adjustment to the free cash flow estimate.

 

There is one non-cash cash flow item that I often stumble upon: the amortization of share-base expense and its tax implication. It is clear that the item does not affect present free cah flow but it clearly affects the free cash flow per share down the line. Many ways to deal with this. Instead of trying to estimate eventual share dilution, I tend not to add it back. This "looks like a free lunch" item can be particularly costly over time if the hard earned cash of the firm is used after to buy back overvalued shares.

 

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Changes in operating assets and liabilities also relate to capital efficiency:

- A business with low levels of net working capital (as a % of revenue) is more capital efficient compared with a business with higher levels of net WC. It would require less capital to grow

- A business with negative working capital (e.g. retail) generates cash from WC when it grows. This is a huge plus at times of expansion

The above reverses if the business contracts: the positive WC business generates cash flow while the negative WC business requires CF (paying to suppliers for past purchases higher sums than what's being collected from customers on a smaller revenue base).

All told I think it's safe to say that a business with low levels of net WC is better than a business with high levels of net WC. A business with negative WC is even better, it uses WC as a source of capital to fund growth (a retailer charges customers in cash and gets credit from suppliers, the delta can be used to buy inventory, for Capex etc.)

The above affects ROIC which should affect the multiple (businesses with higher ROICs should generally be assigned higher multiples)

 

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When we say positive net working capital, it means the line "Changes in Working Capital" is a positive number vs negative? I've seen companies swinging from positive to negative based on the year, so over time I guess you can net it out. When we say a low % of net working capital to revenues, is there a figure that is considered pretty good or kind of high?

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NWC should be calculated from the balance sheet. Generally speaking:

Inventory + Accounts Receivable + Other Operating Assets - Accounts Payable - Other Operating Liabilities = NWC

Please note that the Other Assets/Liabilities part varies between companies. Each asset/liability in the balance sheet should be examined in order to determine whether it's an operating asset/liability.

The "Changes in WC" line in the cash flow statement represent the delta between balance sheet dates. For example:

-NWC 12/31/2016 USD100m

-NWC 12/31/2017 USD120m

2017 Changes in WC in the cash flow statement: ($20m) or negative cash flow of USD20m

No good figure for NWC as a % of revenue, generally speaking the lower the better. Having said that, when liquidation value is concerned negative NWC is a bad thing. All of the above refers to a going (and growing) concern situation.

 

For further reading I highly recommend the McKinsey valuation book

 

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When we say positive net working capital, it means the line "Changes in Working Capital" is a positive number vs negative? I've seen companies swinging from positive to negative based on the year, so over time I guess you can net it out. When we say a low % of net working capital to revenues, is there a figure that is considered pretty good or kind of high?

 

A "positive net working capital" business model means that the business needs more working capital (e.g., inventory or accounts receivable) as it grows.  Think of a typical retailer -- as it opens more stores, it has to stock each one, leading to more overall inventory on the balance sheet.  Therefore, as this type of business grows, the "changes in working capital" line on the cash flow statement will be negative, because a portion of net earnings is being reinvested in additional working capital, rather than converted into cash that can be distributed to shareholders.  When this type of business contracts, it should free up working capital as inventory is converted to cash and not replaced with new inventory, resulting in the "changes in working capital" line to be positive.  The ultimate example of this being a liquidation in which the business is closed and all working capital converted to cash.

 

A "negative net working capital" business model has the opposite characteristics.  For a current example, look at the 2016 and 2015 balance sheets of Wayfair and its 2016 cash flow statement.  Then ask yourself what would those financial statements look like if Wayfair's sales started to decline, rather than rapidly increase.

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Interesting case of a firm that went from a positive working capital balance in the direction of a negative one is Dell in the 1990's. The cash conversion cycle went from 50 days in 1994 to minus 43 days in 2004. (!)

This was achieved through improvements in AR receivables management to some degree but mostly through significant improvements in inventory management and stretching of AP.

This provided no cost financing at a time of growth and improved return on capital.

However, for Dell, at some point, maximum improvement was reached. When close to privatization, the cash conversion cycle was minus 41 days.

 

Concerning Wayfair, I haven't looked into details but their model is interesting. They invest a lot in publicity and marketing and I wonder if the return on that will, in the end, be more profitable than the traditional brick and mortar furniture store model. I would say that these days, tight working capital management may not be top priority if growth-hungry cheap capital is ready to fund your venture. That may change. I still like to sit on the sofa or test the mattress before I buy it. Maybe Millenials will change that. :)

 

 

 

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Concerning Wayfair, I haven't looked into details but their model is interesting. They invest a lot in publicity and marketing and I wonder if the return on that will, in the end, be more profitable than the traditional brick and mortar furniture store model. I would say that these days, tight working capital management may not be top priority if growth-hungry cheap capital is ready to fund your venture. That may change. I still like to sit on the sofa or test the mattress before I buy it. Maybe Millenials will change that. :)

 

Wayfair is essentially an internet marketplace plus a logistics company.  They largely sell third-party manufacturers' goods on their website, getting the cash from consumers on day 1 and then remitting the manufacturers' cut sometime later.  So, they carry essentially no inventory and have low accounts receivable, but high accounts payable due the timing of when they are paid versus when they pay the sellers of goods on their websites.  It's those working capital dynamics that have allowed the company to grow so quickly.  A traditional bricks-and-mortar retailer could never get the funding to grow that quickly.

 

As you note, Wayfair spends a ton on marketing.  I don't know if that will ultimately pay off, but I think Wayfair's business model has already hurt is going to continue to hurt competing retailers with more traditional capital requirements.  See the discussion on the Williams Sonoma thread for more details.

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Fwiw I think there's no easy 'formula' to determine how to treat changes in working capital - you actually have to think a bit about the company and what is happening. Inventory buildup can happen because the company is ramping up production or because nobody wants to buy their crap products. Sometimes changes in working capital are seasonal, sometimes they're just random, sometimes they are due to the company growing, shrinking, due to changes in accounting or even due to management manipulating earnings. Changes in working capital have different implications for different types of companies, etc.

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I think the ratio of operating cash flow to capital expenditures will become increasingly important to pay attention to if inflation intensifies. The change in this ratio, let's call it, real return on investment, as far as I can piece together from my readings will be the key determinant of whether a bond or a stock will be a better value. Taken to the extreme, a business that makes increasing amounts of money without requiring much money (sort of like the negative working capital example) would be the ideal business in any environment but more so if you keep having to plough back your profits and capital just to tread water.

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"Taken to the extreme, a business that makes increasing amounts of money without requiring much money (sort of like the negative working capital example) would be the ideal business in any environment but more so if you keep having to plough back your profits and capital just to tread water."

 

Agree. A good scenario is a great business with high (and durable) returns on capital and low capital requirement. The high returns result in excess cash. How the cash is deployed is another input to consider. Buybacks make sense at relatively high levels only if the moat is maintained over time.

 

Long term compounders that require capital to grow and that produce adequate returns are interesting in the sense that the capital allocation decision is retained with the earnings.

 

http://basehitinvesting.com/buffetts-three-categories-of-returns-on-capital/

 

I would add that, in inflation or deflation, relatively high returns on capital will do the trick over the long term.

In his 1977 Fortune article "How inflation swindles the equity investor", Mr .Buffett argues that, in an inflation scenario, there is no fundamental reason to think that return on capital should be higher. However stocks are less swindled than bonds.

 

The ideal is to find compounders that require a lot of capital to grow. Simple but not easy.

 

Interesting comparison of Costco and Alphabet.

http://www.scuttlebuttinvestor.com/blog/2016/12/10/return-on-capital-and-other-diversions

 

 

 

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Do you mean to find compounders that don't require a lot of capital to grow? Or do you mean there is the ideal and the reality?

 

One big issue is scaling up. You might have a great business with little capital and pricing power but it just can't scale up so you can't put the cashflow to work and usually return it to the shareholders who now have the problem of finding something intelligent to do with it.

 

The other issue is I see several opportunities that are not permanent holdings but cyclical. I.e. a teleco like T-mobile or a composites manufacturer like Hexcel that have had  - or are having a large capital spending cycle. The purpose of this of course is to increase earning power in future periods. This cycle could last a few years. If inflation hits, then obviously you can produce your product , increase the price and you have the infrastructure done. But after some time, you have to do it again - at the higher costs to build later on. I'm not sure if these businesses are good for a period of time and then lousy for another.

 

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Investing in cyclical capital intensive businesses is tough.

Other cycles are easier to ride: underwriting cycles, sentiment/fundamentals cycles, but profits may be lumpy and long coming.

The goal is to find the firms that will earn high rates of return on high required incremental capital. The challenge is to figure out how much of a premium is reasonable for the embedded growth option. Graham vs Buffett type of discussion.

 

The discussion has drifted to return on capital and that validates, like writser suggested earlier on, that going through specific working capital items (unless there is something specific to look for) may not be where most of the money is.

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  • 1 month later...

This thread was initiated on the idea of free cash flow analysis and changes in operating assets and liabilities.

 

Looking at an interesting example: Carlisle Companies (CSLN), a global US-based diversified manufacturer.

During the previous CEO tenure (DA Roberts), many good capital allocation decisions were made but a significant amount of free cash flow was generated, over a few years, from "working capital management" as the WC/sales ratio significantly came down. Some of this was linked to an evolving profile from acquisitions and divestitures but at least some of the improvement came from pro-active measures to better manage inventory levels (increased turnover) and receivables collection (decreased DSO).

I tend to give credit to management who relentlessly focus on free cash flow generation, whatever the source.

 

The company's profile has changed somewhat with recent acquisitions and a new CEO. Will start a separate thread on the company if I come up with reasonable insights and if I can identify a valuable proposition.

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"I've seen this line in cash flows statements too - "Pension and postretirement benefit plan contributions"

 

Is this a real cost, like expensing for stock options? I do notice it is a bit lumpy year to year. It obviously can be a huge number for large companies."

 

Usually get involved with the pension numbers once I get really interested and feel I need to read from cover to cover.

 

It seems that even pension funding is cyclical as many firms, in another era, had significant overfunding (potential source of extra income and cashflows) but now underfunding seems to be the order of the day (Have you seen the numbers? See at the end of this post). The funding decision is influenced by legal and tax considerations but it is very much a managerial decision. Just a step away from "managing" earnings and cashflows. The funding part is clearly not an operating item and that part needs to be reclassified as a financing cash flow every year.

 

Otherwise, I will tend to use the pension expense number without adjusting for the expected (vs actual) and amortization components as the fluctuations will tend to cancel out over time and adjustments may introduce unnecessary mark-to-market volatilty (with the potential exception mentioned below) and I see this as an operating and very real expense.

 

I understand that some only use the service cost as an operating expense and reclassify the interest cost and the return on pension asset numbers to the non-operating sections but I haven't found this to be useful.

 

Outside of this reclassification exercise, I do take into account the potential effects of "optimistic" pension assumptions on the potential free cash flows going forward. Often, with conservative assumptions about how markets "behave" under normal circumstances, for certain companies with large pension liabilities and incompletely matching assets, it is not difficult to see scenarios where an entire year's worth of normalized free cash flow capacity may be negated by less than a terribly adverse scenario on the asset side. I recently reviewed CNR (Canadian National Railway) and that is certainly a potential scenario. Interesting because, in such a situation, the market reaction would probably be out of proportion to the underlying intrinsic value because removing even an entire year of free cash flows does not really change the value of the business (if you think in a discounted type of way).

 

https://www.mercer.com/newsroom/january-2018-pension-funded-status-increased-by-two-percent-in-2017.html

And that's during one of the greatest bull market (stocks and bonds) of all times since we put some distance between pension assets and the 100% funded status.

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Thanks for the link. Seems one has to check funding status and flow of funds. It seems more like a non-operating expensive but most certainly a liability over time if not funded.

 

The reality is that working capital is not predictable. We CAN model it based on past behaviour, but a predicted number +/- 20% is not particulary useful. For ratio purposes treat it as negative debt at money market rates, & common size the historic financials. Most of the working capital distortion will disappear.

 

Pension and postretirement benefit plan contributions. It's an indicator of a DB pension plan, is the sponsors contribution, & is based primarily upon payroll. To predict, you must know how the DB plan works, and how demographics affect these plans. About once every 10-20 years DB plans will become 'overfunded' relative to their obligations, and the 'overfunding' will be shared equitably amongst plan participants as contribution holidays, discounted service buybacks, etc.

 

SD

 

 

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"The reality is that working capital is not predictable. We CAN model it based on past behaviour, but a predicted number +/- 20% is not particulary useful. For ratio purposes treat it as negative debt at money market rates, & common size the historic financials. Most of the working capital distortion will disappear."

 

Agree. Would only add that, in certain selected instances when the going concern assumption becomes a topic of discussion, the working capital distortion may reappear.

 

"Pension and postretirement benefit plan contributions. It's an indicator of a DB pension plan, is the sponsors contribution, & is based primarily upon payroll. To predict, you must know how the DB plan works, and how demographics affect these plans. About once every 10-20 years DB plans will become 'overfunded' relative to their obligations, and the 'overfunding' will be shared equitably amongst plan participants as contribution holidays, discounted service buybacks, etc."

 

Again agree mostly but my understanding is that sometimes (often?), firms may use the surplus as sort of cookie-jar reserve. The once invincible behemoth GE who used to be masters at financial engineering were reported to "fatten" earnings when certain numbers needed to be met. Let the good times roll.

 

If you like to think in terms 10-20 year time-spans, in the early 1980's, many corporate pension plans were overfunded (some by a lot). A relatively popular way to "share" was to terminate the overfunded plan and starting a new one, with the surplus being dstributed to...

https://fraser.stlouisfed.org/files/docs/publications/frbnyreview/rev_frbny_1984_v09n01.pdf

 

See section on pensions, p.19-27.

The first part is also interesting as the Federal Reserve candidly admits that there are still unresolved issues in monetary policy. :)

 

Just to link to what happens to an asset that becomes a liability (and then what?), GE is now facing some headwinds on how to "manage" a certain level of uncomfortable underfunding.

 

http://money.cnn.com/2018/01/18/investing/ge-pension-immelt-breakup/index.html

 

From the article:

2001:        14,6 billion surplus

end 2008:  6,8 billion deficit

end 2016:  31,1 billion deficit

 

In the article, it is said that the massive shortfall should be discounted in a way as the problem, if there is one, may show up only in the distant future. Just in case though, they will borrow a few billion to contribute to the pension plan. It is hard to see scenarios where the future free cash flows will not be impacted.

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There are lots of ways to distribute a pension 'overfunding'. It's typically split 50/50 between sponsor/contributor; for sponsors it typically means a 'contribution holiday' for a few years - which will inflate earnings, EPS, and produce a higher share valuation. Nothing wrong in that, but as shareholder - you need to realize its impact. Most shareholders prefer not to.

 

Contributors also get a contribution holiday, with remaining funds typically spread over discounted service buybacks and modest 'inflation protection'. Inflation protection being discouraged as its used to offset fraud (grandma 'forgot' to tell the plan that grandpa has died [over-payment], and families 'forgeting' to tell the plan that grandma has died [fraudulent payment]). Service buyback discounts of 75% are not unusual.

 

SD

 

 

 

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Thanks for the perspective.

 

Moving away slightly from the basic spirit of this thread, there has been some noise (opinion: this will become more noisy, when?) about how to "share" what is shaping up to be the mother of all underfunding episodes in pension and other entitlement plans (public and private).

 

Compromises can be reached. Not always elegant though.

It may be easier to "share" surplus vs deficiency.

Certainly more to come.

 

Conceptually (thinking about cash flow implications) this specific firm issue, whose off-balance sheet impact only shows up only tentatively in the recorded assets and liabilities, has become "guaranteed", in a way, by public entities, themselves using off-balance sheet type of accounting to back projections. ::)

Cans can be kicked down the road.

 

As you say, at some point, pension plans will become overfunded.

How we'll get there, as usual, will be interesting.

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Keep in mind that Financial Statements are severely over-rated.

We use them only because they are better than nothing.

 

Where's the asset called 'reputation'? To most people, a good reputation/brand is essential to repeat business. But if it isn't valued on a financial statement, why shouldn't a CEO trash it to drive earnings as high as possible? The CEO is being paid to pollute, bend ethics and flout the law as much as he/she possibly can - and will be fired if he/she doesn't do it. We get the Enrons, Worldcoms, LIBOR scandals, etc, because WE WANT THEM.

 

Where's the expense line called 'bribes'? To most folks looking at international businesses, this is part of the operating environment. If you couldn't report them, then where did you hide those expenses on the Financial Statements?

 

Where's the UW disclosure? Major accidents/scandal at nuclear power plants, hazardous waste disposal, arms manufacture, or GM food crops are covered by the tax payer - not the company's insurance. Yet it's very rare that you will see any of that mentioned in the note disclosures, or why (to make the 'essential product' affordable).

 

Point is that nothing will change, because it is not convenient to do so.

All we can do is position ourselves to benefit.

 

SD

 

 

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