Free Cash Profiles: The Computer Hardware Industry

The secret ingredient in a recipe for sustainable growth? Getting paid in advance.
David KatzSeptember 7, 2011

Computer users are always on the lookout for upgrades of their desktops and laptops. The technology sector as a whole is one of the few buoyant areas of the economy. Household names abound: Apple, Hewlett-Packard, Dell, and more.

You don’t have to look beyond those facts for an explanation of why the computer hardware industry is one of the nation’s most reliable engines of growth. But drill down into the industry’s smaller and less famous names, and you’ll find other causes for these manufacturers’ ability to produce cash as they expand, rather than consume it. Most prominent is their aplomb in managing the elements of working capital: outstanding bills, inventory, and money owed.

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Indeed, CFO’s first Free Cash Profile (FCP) industry snapshot, based on a sample of 79 publicly traded computer hardware makers, suggests that top-flight working capital performance may be the key driver of these companies’ ability to spawn free cash flow as they grow – the essence of what the FCP measures. Specifically, the ability to get customers to pay in advance seems to be a huge factor.

Out of all the hardware companies studied, CFO and Charles Mulford, a Georgia Tech accounting professor who developed the FCP metric, focused on the 11 firms that reported between $300 million and $800 million in revenues for the 12-month period ended nearest to June 30, 2011.  Also included in the study, for purposes of comparison, were the 5 largest computer hardware firms. (Each month, CFO will look at the FCPs of a different industry or sector group.)

Even though it lacks the economies of scale that made Apple perhaps the nation’s most prominent cash generator, Blue Coat Systems, the top FCP performer among the target group studied, beat out Apple by 52.35% to 50.59%. Propelling Blue Coat’s stellar FCP was an even more impressive operating-working-capital-to-revenue percentage of -34.36%. Similarly, STEC Inc., the company with the lowest FCP (-3.35%), also bore the heaviest working capital load (22.32%) by far.

Overall, the industry shows a median FCP of 4.6% of revenue – meaning that it has the capability to generate that percentage of free cash flow per dollar of sales as it grows. (To learn how FCPs are calculated, see “How the Free Cash Profile Works” below.)

The computer hardware industry’s median FCP puts it within hailing distance of the all-industry median profile of 4.95%. Nevertheless, Mulford had expected better from an industry with such a good reputation for cash generation. What weighed the sector’s median FCP down, however, were the lackluster profiles of many smaller companies.

Because of their size, the smaller firms had lower profit margins and more cash tied up in working capital, he says, noting that those factors lessened the companies’ ability to produce free cash flow.

The companies studied, however, did much better – better, even, than a great many companies across the industry spectrum – by scoring a median FCP of 16.15%. By getting their clients to pay in advance, largely through the use of service contracts, they’re able to offset the costs of carrying inventory and waiting to reap the benefit of sales, according to Mulford.

To be sure, these companies tend to have relatively low levels of inventory and correspondingly low capital expenditures. Even those hardware companies with “normal levels of inventory [are] financing all that with other people’s money,” says Mulford.