Study Predicts 50% Cut in Free Cash Flow

A new study that tracks free cash margins says the metric is set to drop to recession levels.
Marie LeoneMarch 27, 2009

The median free cash flow for nonfinancial companies could sink by 50% during the next year, especially if the recession continues to choke revenue streams, a new report says.

Up until now, cash-flow margins — free cash flow measured as a percentage of revenue — have remained flat. But recessions have a way of eating away at that ratio, says Charles Mulford, director of the Georgia Tech Financial Analysis Lab and co-author of the study.

Mulford and two co-authors, graduate research assistants Sohel Surani and Jason Blake, analyzed the cash-flow trends of 20 nonfinancial industries, comprising 61 subindustries, for a series of rolling 12-month periods from the first quarter of 2000 through the third quarter of 2008. They plan to track the same indicators each quarter going forward.

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The first report, which will be released next week, notes that after bottoming out below 2.5% during the 2001 recession, free cash margin “improved markedly” and has remained relatively stable, hovering above 4.5% since 2002. During the 12 months ended September 2008, the margin dipped slightly below 4.5% to the low end of its recent range. But the authors expect that the current recession will push the margin down to the 2001 recession level or lower — which could mean a 50% drop in free cash flow.

Free cash flow has no strings attached: it is the discretionary cash that companies can use, without disrupting operations, to pay dividends, buy back stock, retire debt, or invest in an acquisition. As a percentage of revenue, the free cash margin is essentially a cash-flow profit margin that indicates what percent of revenue is left for shareholders in the form of discretionary cash flow, the authors say.

The study looked at 3,429 companies, each with a current market capitalization of $50 million or more. Despite the authors’ prediction that the median free cash margin is set to drop precipitously, they saw an improving margin in seven industries for the 12 months ending September 2008 compared with the year before. The industries? Energy, transportation, media, retailing, food and staples retailing, pharmaceuticals/biotechnology/life sciences, and technology hardware and equipment.

The report highlights the pharmaceuticals/biotechnology/life sciences sector, noting that free cash flow grew in that sector by nearly 2 percentage points, from 7.4% to 9.15% for the 12 months ending September 2008. What’s more, four Standard and Poor’s 500 companies from the sector boasted particular improvement: Abbott Laboratories, Bristol-Myers Squibb, Eli Lilly, and Millipore Corp.

In the other industries examined, five companies held steady, while eight groups registered declines in free cash margins: materials, capital goods, automobiles and components, consumer durables and apparel, food/beverage/tobacco, household and personal products, telecommunications services, and utilities. Of those that declined, the materials group stood out, with an overall free cash margin decline to 2.42% for the 12 months ending September 2008, down from 3.68% for the same period the previous year — and down from nearly 4% during the 2001 recession.

The materials group includes the subcategories of chemicals, construction materials, containers and packaging, metals and mining, and paper and forest products. Three companies in that industry were highlighted in the report: AK Steel Holding, Alcoa, and Weyerhaeuser.

All industries, 2002-2008


Materials industry, 2002-2008


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