Tuesday, 30 April 2013

Free cash flow (FCF)

So what is all this stuff about free cash flow (FCF)?


Cash flow is critically important to the well being of a company - to make a rather obvious statement it is cash that pays the bills and dividends, not earnings. 

FCF is important because it is the amount of cash that is available from cash received after paying for:

operating costs, working capital, finance costs, tax and capital expenditure (capex)

to spend on:

repayment of debt (improving the creditworthiness of the business), acquisitions (non-organic form of growth), repurchase of its own shares (at the right price, value enhancing to shareholders) and dividends (income to shareholders).

So where is this information found?  You can go to a company’s annual report, which you will find on their company web-site, or visit Investegate, search for the company in question and seek out results announcements. 

Here is one from Advanced Medical Solutions (AMS)


Year ended 31 December
Cash flows from operating activities
Profit from operations
Adjustments for:
Amortisation - intellectual property rights
- development costs
- software intangibles
Decrease / (increase) in inventories
Decrease/ (increase) in trade and other receivables
(Decrease) / increase in trade and other payables
Share based payments expense
Net cash inflow from operating activities
Cash flows from investing activities
Purchase of software
Capitalised research and development
Purchases of property, plant and equipment
Interest received
Acquisition of subsidiary
Net cash used in investing activities
Cash flows from financing activities
Dividends paid
Finance lease
Repayment of secured loan
New bank loan raised
Debt issue costs
Issue of equity shares
Shares purchased by EBT
Shares sold by EBT
Interest paid
Net cash from financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at the beginning of the year
Effect of foreign exchange rate changes
Cash and cash equivalents at the end of the year


The FCF of AMS is £8,482k (11,893+35-692-380-802-1,572), this compares to £2,385k in the previous year.  Some companies show interest cost & income within operating cash flow, so there will be no need to make any adjustment.

It is worth bearing in mind that sometimes, with capital intensive companies that are investing for future growth, you may need to make an estimate of maintenance capex and distinguish this from expansion capex.  A reasonable approach is to assume that the depreciation charge is equivalent to maintenance capex and the balance is expansion capex.  In these situations only maintenance capex is deducted from the operating cash flow to arrive at the FCF.  The expansion capex is then a use of free cash flow, rather like acquisitions, but organic.

Although short term numbers for FCF can be misleading, due to the cycle of funds through a business, over a period of say 3 years it becomes more meaningful and you can use FCF to compare to net income, it may highlight problems such as over optimistic valuations or accruals within the balance sheet or even manipulation by unethical management.  Also, since the valuation of a business is generally accepted as the discounted value of all future FCFs, its use in value investing is important.

If you want to short-cut all that number crunching, Morningstar provide a 5 year history of a company’s operating cash flow per share and capex per share so you can calculate their FCF per share.  You will find it under “Financials & Ratios” then “Cash flow” and its right at the bottom of the table.  The only minor shortcoming, is that due to the non-standardisation of interest costs & income, the operating cash flow per share may include or exclude interest, depending on how the company treats it.   

Unilever increased ownership of HUL

One of my companies from my income portfolio made an announcement today:

Unilever Logo

A manufacturer and supplier of fast moving consumer goods, with more than 400 brands focused on health and wellbeing, 14 of which generate sales in excess of €1 billion a year. I have a holding in my income portfolio (epic code: ULVR)

Today announced a voluntary open offer to increase its stake in Hindustan Unilever (HUL), its publicly listed subsidiary in India, from 52.48% to up to 75% at a price of INR 600 per share. The potential total value of the transaction at the offer price is approximately INR 292.2bn or €4.1bn.  ULVR is limited to a 75% holding if HUL whishes to retain its public listing in India.

With HUL producing earnings to 31 March 2013 of €536m, ULVR is paying 34x earnings for the additional 22.52%.  This is a high price, but assumes continued strong growth from this market - earnings of HUL grew 41% in 2013. CEO Pollman describes the market as a "...significant growth potential of a country with 1.3 billion people mak(ing) India a strategic long term priority for the business..."

Monday, 29 April 2013

Greggs, Aberdeen, Globo, Vodafone, Bhp Billiton

I will generally post on announcements from companies that I am watching, or have an investment in, as a guide to how I analyse results and important issues related to the businesses.  Other people will anlayse companies from a different perspective and may disagree with my views.  That is only to be expected and it is what creates a market - one investor may see value and opportunity, while another may see distress and risk.

Five of my companies made announcements today, I'll comment on each briefly:

Greggs the Bakers

The leading bakery retailer in the UK, with almost 1,700 retail shops throughout the country.  I have a holding in my income portfolio (epic code: GRG).

GRG released an interim management statement (IMS).  Total sales in the 17 weeks to 27 April 2013 was up 3.0%, with wholesale and franchise sales contributing 2.9% to overall sales growth, although own shop LFL sales in the first 17 weeks was down 4.4%. The most recent two weeks indicate an underlying rate of LFL decline of around 1.5%, so there is some improvement in the decline. It is clear that GRG was badly affected by the snow and cold weather as footfall declined across their locations.  Although they are only four months into the year, based on current own shop like-for-like performance they believe that profits for the year are likely to be slightly below the lower end of the range of market expectations, which is £47.5m to £55.2m, this compares to £51.9m pre-tax (excluding exceptionals) last year.  Assuming  say £46m pre-tax and a similar tax rate to last year EPS is likely to 34.7p (36.9p LY).  So a forecast dividend of 19.9p (19.5p LY) would be covered 1.7x.

Following this announcement the shares were down 8.4% in early trading at 423.7p, representing an historic P/E of 11.5 (423.7p/36.9p) and a prospective P/E of 12.2 (423.7p/34.7p).  The historic yield is 4.6% (19.5p/423.7p) and the prospective yield is 4.7% (19.9p/423.7p).

Despite what is a disappointing performance at the start of the year, their new shop openings remain focused on locations that have been less affected by lower footfall such as workplaces, travel and leisure destinations.  For example they have 16 Greggs shops now operating under license by Moto in their motorway services.  Overall profits have been affected in the first quarter of the year and are behind their plan and last year; contributing slightly to this is the sales of promotional deals that have been particularly strong, having a slight negative effect on margins and they expect this trend to continue.  They do reinforce the point that  the business remains highly cash-generative and maintains a strong balance sheet position - important for income seekers.

A global investment management group, managing assets for both institutional and retail clients from offices around the world. I have a holding in my income portfolio (epic code: ADN)

ADN released their interim ( 6 months to 31 March 2013).  They were announcing some very good interim results.  Revenue was £516.0m up 25%, underlying profit before tax was £222.8m up 37% [reported pre-tax was £188.2 up 51.4%], underlying earnings per share 14.9p up 43% [reported EPS 12.43p up 56.4%] and dividend per share 6.0p increased by 36%. Assets under management increased to £212.3bn as at 31 March an increase of 13.4% from their September year-end, a result of both the positive market and currency performance and net new business flows. They are measured in their outlook, but confident that their investment philosophy and process will remain well suited to the pursuit of further profitable growth on behalf of investors. Free cash flow was strong at £220.1m compared to £132.1m last year.

Following this announcement the shares were up 8.9% in early trading at 454.3p, representing an historic P/E of 25.6 and a prospective P/E of 15.  Their historic yield is 2.76% and prospective 3.38%.  Although on the basis of these numbers there may be an upgrade to earnings and certainly the dividend, as anlysts had pencilled in a full year dividend growth of 23%.

GLOBO A technology innovator delivering mobile, telecom and e-business software products and services.  I have a holding in my growth portfolio (epic code: GBO).

GBO is a small fast growing technology company, sales & earnings last year were €58.1m and €17.8m respectively.  They have an important footprint in the BYOD (bring your own device) market.  The market size is about $68bn and expected to grow at about 15% pa over the next 5 years, with North America representing approximately 36% of the total market. 
I do not normally take much notice of awards, but today's announcement was pleasing as it raises GBO's visibility in that important North American market - for a small company this is important.
GBO announced that their revolutionary enterprise mobility management solution for SMBs, GO!Enterprise Box, was named a finalist in the Enterprise Solution - Mobile Cloud category of CTIA's annual Emerging Technology (E-Tech) Awards competition in the US. This product allows companies with up to 150 devices to securely run and manage their BYOD (Bring Your Own Device) mobile workforce through the GLOBO cloud infrastructure.

Vodafone Logo

Vodafone the second largest ( behind China Mobile) mobile telecoms company in the world.  I have a holding in my income portfolio (epic code: VOD).

VOD announced that Mahindra Reva Electric Vehicles Pvt. Ltd., a part of the US $15.9bn Mahindra Group, has powered its recently launched e2o electric vehicle - the first truly 'connected car' - with Vodafone's machine-to-machine (M2M) communication services.  With its energy and environmental crisis, if electric cars are ever going to make sense, then India is probably the country to push it, through subsidies and infrastructure.
 BHP Billiton

BhpBilliton the largest mining company in the world.  I have a holding in my income portfolio (epic code: BLT)

BLT Signed a definitive agreement to sell its Pinto Valley mining operation and the associated San Manuel Arizona Railroad Company to Capstone Mining Corp. for an aggregate cash consideration of US$650m. It takes the transaction value of divestments announced over the last 12 months to US$5.0bn.   This open cast copper mine was only recently re-opened last year at a cost of $195m after being put on standby in 2002, so this would seem a reasonable deal selling a non-core asset. 

Oil service sector

Is there value in the oil service sector?

The decline in the oil price from a 52 week high of $120 a barrel for Brent Crude in May of last year to $103 on Friday, has meant that most companies associated with the oil industry have suffered.  Does this offer value within the oil service sector?  Three companies quoted on the LSE would appear to be at bargain prices compared to their growth prospects – Petrofac (PFC), Kentz (KENZ) and Amec (AMEC).  Although the price of oil will affect the earnings of the oil majors, such as Exxon and Shell, at the current price the majority of programmes and activities will continue with most of their plans built around a price of $80-90 per barrel.  They still need to spend money with these oil service companies.

Proof of this is the order book for future delivery of those three companies at 31 December 2012:

PFC - $11.8bn ($10.8bn last year) represents 1.9 times 2012 annual sales.

KENZ - $2.57bn ($2.4bn last year) represents 1.8 times 2012 annual sales.

AMEC - £3.6bn (£3.7bn last year) represents 0.9 times 2012 annual sales.

Market Cap £
Share price
Normalised EPS
2013 growth
P/E ratio
2014 growth
P/E ratio
Rolling PEG
Operating margin
5 yr NBV + Div return
FCF return on NBV
(a) Incl JV cash rec'd 45.7%

PFC by sales, earnings and market capitalisation is the largest of the three; this can be an important criterion as many of the contracts are substantial in size and do require investment in working capital.

AMEC has the highest forecast growth in 2013 of 15.8%, although what would appear to be the weakest order book compared to the other two at 0.9 times last year’s sales.  PFC has the highest growth for 2014 of 13.6% and it is worth mentioning that the management have set a target of $862m by 2015 a 3 year CAGR of 10.9% pa.  AMEC’s management on the other hand have set a target of 100p EPS by 2014 a 2 year CAGR of 14% pa.  There is no management target from KENZ.
KENZ offers what appears to be better value – a lower P/E ratio (that’s the price divided by the earnings per share) over the forecast two years, a lower PEG (so you are buying more growth for the P/E ratio you are paying) and a lower price to book value (PBV) that’s the price you are paying for the net assets of the company. The book value is also represented by the equity of the business where all the money from issuing shares ends up, along with all the earnings after paying any dividend.

PFC appears to have a higher quality business with a better operating margin of 12.1% and ROE of 47.5%.

The last two numbers in the table represent:

the 5 year CAGR in the NBV and the dividends paid (that’s what the long term investor receives – dividends and a share of the equity, remember the book value is represented by the equity)
and the second is the free cash flow (free cash flow is operating cash flow less capital expenditure) return on the NBV.

If the free cash flow number is a lot less than the other, then one should always investigate the reason. In KENZ’s case this is due to cash received from their joint ventures (they are part owners in various projects and the cash received, usually in the way of dividends, is not part of the operating cash flow of the business).
So with the adjustment for the KENZ JV cash being received, they have the better returns over the 5 year period.  Although it should be borne in mind that KENZ may not control those JV cash flows (2012 JV cash received was lower than 2011).

A further point to be borne in mind is that PFC over the past three years have not generated any free cash flow, due to the substantial working capital  and capital expenditure investments they have made over that period.
AMEC’s 5 yr NBV + dividend return has not been helped by their recently completed share buy-back (£400m of purchases), where they have gone into the market to purchase their own shares. This was started when the company had a PBV (price to book value) of 2.53, not a particularly attractive price.  Share buy-backs immediately deplete the book value of the business and earnings and dividends per share are improved over time.  I’ll comment on buy-backs more fully in a separate post.

Finally the outlook statement from their 2012 results:
PFC:  “…Overall, we are confident in our prospects for the coming year and beyond. We expect to deliver good growth in net profit in 2013 and remain on target to more than double our recurring 2010 Group earnings by 2015…”

KENZ:  “…We anticipate that 2013 will be yet another prosperous year for Kentz. The global economy continues to be uncertain, but I am impressed with the resilience of our organisation to adapt to these difficult conditions…”
AMEC “…We continue to expect good revenue growth in the conventional oil & gas market in 2013, offsetting softening in the oil sands and mining markets. We remain on track to achieve our targeted EPS of greater than 100 pence ahead of 2015…”

It may be a difference of style, but PFC and AMEC sound a little more bullish than KENZ.
So to summarise:

Both PFC and AMEC meet the requirements for my income portfolio, but KENZ fails as its prospective yield is less than 3% and it only has 4 years of dividend growth.
All fail for the growth portfolio, obviously on 1 yr relative strength and on an EPS 1 Yr rolling growth rate of 15% or greater, although AMEC at 14.4% is very close and any forecast upgrades from brokers may tip it over.

Despite the buy-backs I would probably plump for AMEC in an income portfolio, due to the concern over the 3 year free cash flow of PFC right now.
I do hold PFC in my growth portfolio having bought at 882p in February 2010 and sold half my holding in Aug 2010 at 1406p.  They are currently being reviewed for potential disposal.