Counting the cash in a company’s pocket
Cash flow is vital to the health of a company and its shares, says The Investment Reporter. But the numbers don’t always add up the right way.
To say stocks don’t grow without company profits is a bit like saying plants won’t grow without water. Seems obvious.
But plants don’t grow on water alone — they need certain nutrients in the soil. And corporate profits feed on another nutrient — cash flow.
As we have been working our way through the credit crisis, cash flow has taken on even greater importance. Or to put it another way, a heavy load of debt is more deadly than ever.
So value cash flow when you look at stocks, says The Investment Reporter. But treat the numbers with care. They can be misleading.
This venerable Canadian advisory, a specialist in equities, points to the promises and pitfalls that can lie just beneath the surface in a company’s income statement.
It illustrates with two firms whose cash flow is better than it looks at first glance — and two companies that are just starting to scrub the red ink off their books.
A classic goodwill case
“Profits matter, of course,” says this advisory. “The trouble is, the true earnings picture of a company is often obscured by one-time items.”
A company that writes off lots of goodwill, for example, may report a loss even though its basic business is doing just fine. Goodwill, of course, involves intangible assets, like the difference between the price of an acquisition and its actual book value.
A classic case of goodwill gumming up the works can be seen with the Jean Coutu Group (TSX-PJC.A). Up until its latest quarter, it had to include losses from Rite-Aid (the U.S. chain in which it has a minority stake) in its results. But those writedowns are pretty much off the books.
In the meantime, Jean Coutu’s Canadian drug stores have been thriving. Now all the cash flow from those stores will take its rightful place on the balance sheet. This stock is a buy, says the advisory.
The right story
Cash flow starts with a company’s earnings. “But then it excludes items — such as goodwill — that have no impact in cash,” says The Investment Reporter. “That’s one reason that we often look to see whether the cash flow statement supports or clashes with the income statement.”
Is a company’s cash flow high enough for it to re-invest and sustain itself? Is there enough cash left over to reward shareholders with dividends or share buybacks?
“A company with no cash flow or negative cash flow may survive for a while by, say, borrowing money or running the company into the ground,” says the advisory. “But ultimately, a lack of cash flow or negative cash flow will, over time, cause a company to atrophy and die.”
To make sure that it has the cash flow story right, the advisory examines companies’ cash flow over four full quarters. Each time a firm reports its quarterly results, it adds the latest quarter’s cash flow and subtracts the cash flow from the same quarter the year before.
Usually this works out fine. But even this can be misleading.
Better than the numbers
Take Brick Brewing (TSX-BRB). Its price-to-cash-flow ratio is high, much too high for comfort. Plus, its high net-debt-to-cash-flow ratio “might make you wonder whether it can service its debt.”
Quickly, the numbers are these. In the first quarter Brick generated cash flow of $1,147,000. The advisory then subtracted last year’s first quarter cash flow of $307,563. But toting up the past four quarters, Brick actually had negative cash flow of $781,138. Subtract that, and the cash flow is a measly $58,299.
Yet the cash flow picture is better than these numbers suggest. Summer is beer season, and Brick’s cash box will fill up over the next two quarters. Its price-to-cash-flow and net-debt-to-cash-flow ratios will come down to comfortable levels.
And there’s another figure to look at, says the advisory. The company’s total debt of $3,501,554 is just 16.5 per cent of shareholders’ equity of $21,284,832. That’ s just 16-and-a-half cents of debt for every dollar of shareholders’ equity. That doesn’t make a Brick a buy in the advisory’s opinion, but you can hold it with some confidence.
Paying the bills
The advisory cites two other companies with improving cash flow. But it doesn’t give them rave reviews.
Both soft-drink maker Cott Corp. (TSX-BCB) and juice and snack maker Sun-Rype Products (TSX-SRF) generated positive cash flow in the first quarter.
That was news, since neither had done so for a while. Both had piled up negative cash flow over the past four quarters.
Both companies face challenges. In Cott’s case, for instance, it has lost its role as Wal-Mart’s exclusive soft drink supplier.
But at least they can now pay the bills regularly.
The Investment Reporter expects both stocks to keep turning out positive cash flow in the coming quarters, but it suggests you treat them warily. They pose a number of risks for investors and may continue to do so for some time yet. Hold, don’t buy.
If a company looks like it has lots of cash on hand, make sure the figures don’t lie. And if it seems a bit short of cash but looks like a good company, you may find that it’s in better shape than it seems.
But your bottom line should be this. If it hasn’t got cash, you’re not buying.
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