Capital Markets

Have Cash, Won’t Borrow

A new free cash flow metric reveals which companies can grow without going to the bank or the capital markets.
Marie LeoneJanuary 9, 2009

In what world is Google being outgunned by or is Microsoft being left in the dust by Autodesk? In the realm of free cash flow — or at least that of a relatively new metric called a “free cash growth profile.”

The metric reflects the ability of a company to generate free cash flow while increasing revenue or “growing,” says a new Georgia Tech Financial Analysis Lab report that looks at 59 information technology companies and five IT industry sectors. The measurement is particularly important during the current credit crunch because it shows which companies may be able to grow without the help of outside funding, say authors Charles Mulford, director of the Georgia Tech lab, and Sohel Surani, a research assistant.

Free cash flow is the discretionary stream of money that a company can put to work in making acquisitions, retiring debt, declaring dividends, or buying back shares. In general, together with earnings growth, analysts see cash-flow growth as a way to verify an increase in a company’s value. Free cash flow comes “with no strings attached,” say Mulford and Surani in their study.

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By their lights, free cash flow “is truly discretionary. Spending it does not impact the company’s ability to generate more.” Even if it’s necessary for their health, revenue growth is frequently a cash drain on companies, according to the authors. Although sales growth “is desired, it is often viewed as something that needs to be financed,” they say. In contrast, a corporation with a positive free cash growth profile may not have to finance its growth. Instead, it may be able to generate increasing amounts of cash flow as growth accelerates, claim the authors.

The metric is calculated by dividing free cash flow by revenue. So if a company’s free cash growth profile is 10 percent, that means it generated 10 cents of free cash flow for every sales dollar. Simple as it seems, the calculation can yield some topsy-turvy results. For instance, Google’s profile dropped by 6.93 percentage points, to 16.26 percent, between the end of 2005 and the second quarter of 2008. But, another company in the IT-services sector, improved by 29.63 percentage points, reaching 35.74 percent in Q2 2008.

Similarly, Microsoft’s profile has remained relatively stable, jumping slightly from 49.28 percent in 2005 to 51.57 percent in Q2 2008. But software maker Autodesk surged from 22.34 percent to 40.60 percent during that time.

As those comparisons suggest, the free cash growth profile is probably best used along with other yardsticks of corporate value. But it can yield a unique perspective by which to evaluate a company’s worth. It can, for instance, be particularly relevant during times such as these, when borrowing is tight and companies may be able to sustain growth only by tapping in-house funds. “A company with revenue growth will eventually lose the favor of investors if it never finds a way to generate earnings. In a similar way, a company with profits that is unable to generate cash will also experience waning investor enthusiasm,” the authors write.

Companies whose profiles have “improved” since 2005 — and therefore may not need outside cash to spur growth — include Sun Microsystems, Autodesk, IBM, Apple, Hewlett-Packard, and SunPower. Meanwhile, companies with “deteriorating” profiles — including Canon, Electronic Arts, Winpro, Motorola, and Linear Technology — may have to rely on the capital markets or lenders to fund their growth.

The study looked at IT companies that each had a market capitalization of more than $100 million and filed annual reports for 2007, 2006, and 2005 and interim results for the 12-month period ending with the second quarter of 2008. The IT industry was chosen for this first-look study because IT companies are usually “excellent” cash generators, and tend to have high operating margins but low inventory needs, say Mulford and Surani.

From a sector perspective, the telecom-equipment industry topped the list with a 15.76 percent median free cash growth profile for 2007. The semiconductor sector came in fifth, with the lowest profile in 2007, generating 4.12 cents of free cash flow for each dollar of sales.

A company with a negative cash flow growth profile, which in the second quarter of 2008 included Canon, Motorola, Cognizant Tech Solutions, Computer Sciences Corp., STMicroelectronics, and Suntech Power Holdings, requires other sources of cash to support growth.

Mulford told that his lab expects to produce a series of other cash-flow reports using third- and fourth-quarter data as soon as it becomes available. He says his aim is to show how corporate cash flows — and their cash flow profiles — deteriorate as the current recession deepens.