Cash Management

As Capex Slows, Free Cash Margin Rises

Companies have hit the brakes hard on capital spending, resulting in improved free cash flow as a percentage of revenue, according to a new study.
Marie LeoneDecember 23, 2009

Free cash margin, a measure of cash-flow performance, improved for 11 of 20 industry sectors during the 12 months ended in September, according to a new report from the Georgia Tech Financial Analysis Lab. The authors of the report, which was released last week, say the improvement reflects an upward trend that began in the first 3 months of the year.

Collectively, free cash margin for the 20 industries reached 5.36% for the period. That is the highest level recorded by Georgia Tech researchers since they began tracking the metric in March 2000 (see chart at the end of this article). The previous high was 5.14%, reached during June 2004.

But the improvement stemmed primarily from reductions in capital spending, says the report. Indeed, measured as a percentage of revenue, capital spending for the latest reporting period was lower than it had been for any other period since March 2000 (see chart at the end of this article). Capital spending at nonfinancial companies dropped to 3.02% for the 12 months ended in September. By comparison, the metric never dipped below 4.68% during the 2001 recession.

Ultimately, when capital spending does rise again, free cash margin could fall unless other factors compensate, such as reductions in taxes paid, better inventory turns, and more efficient collection of receivables.

Free cash margin is a cash-flow profit margin, derived by dividing free cash flow by revenue. In practical terms, the metric measures what percentage of revenue is left for shareholders in the form of free and discretionary cash flow. The Georgia Tech lab monitors the free cash margin (and its drivers, such as inventory, taxes, operating profit, and cash flow) for 3,704 nonfinancial companies with market caps greater than $50 million.

“What is especially remarkable about the improvement in free cash margin is that it is coming despite a continuing weakness in revenues,” says Georgia Tech accounting professor Charles Mulford, director of the lab and co-author of the report. Normally, profit margins, including free cash margins, should decline along with revenue. Mulford says median revenue for the sample companies peaked at $751.1 million for the 12-month period ended in September 2008 and have been declining ever since. Median revenue for the 12 months ended in September 2009 was $528.4 million, a 29.7% decline from a year ago.

“Firms have been quite adept at wringing as much cash flow from operations as possible,” says the report. The 11 industry sectors that improved their free cash margins included materials, capital goods, automobiles and components, consumer durables and apparel, retailing, household and personal products, and food, beverage, and tobacco. Eight industries, including energy, transportation, software and services, and utilities, had stable free cash margins, while one industry — pharmaceuticals, biotechnology, and life sciences — had a declining free cash margin.

The report makes special note of several “standout” sectors and companies regarding changes to their free cash margins. For instance, the automobiles and components industry sector improved its free cash margin to 2.94% for the 12-month period ended in September 2009, up 2.17% from a year ago. In particular, Ford Motor Co.’s free cash margin improved significantly, jumping to 5.61% from 0.27% in September 2008, even though its capital spending rose from 4.17% to 4.61% during the same period.

Contributing to Ford’s improved free cash margin was a reduction in the company’s cash cycle, in which the automaker dropped its inventory days to 21.19 in the third quarter, compared with 27.44 a year earlier. (Inventory days are the average number of days goods remain in inventory before being sold.)

The food, beverage, and tobacco industry registered an increase in free cash margin from 3.40% in September 2008 to 6.29% in September 2009. The report singles out Kraft Foods Inc. in that sector for dramatic improvement: its free cash margin rose from 5.97% to 9.09%. Kraft’s capital spending remained relatively stable. Like Ford’s, the food company’s improved free cash margin was attributable to a decline in inventory days, from 40.05 to 36.88.

Free cash margin for the household and personal products industry sector was 9.99% for the 12 months ended in September, up from 6.47% a year ago. That was the highest level for the industry since December 2002, when free cash margin was 9.27%. Notable in that industry is Kimberly-Clark Corp., which improved its free cash margin from 8.62% to 12.68%. According to the Georgia Tech researchers, the margin improvement was driven by a rise in operating profits (revenue minus the cost of revenue, SG&A, and R&D expenses) from 17.92% in September 2008 to 20.41% in September 2009. Further, Kimberly-Clark reduced inventory days from 47.92 to 39.25 in a year, while capital spending remained stable.

By contrast, free cash margin for the pharmaceuticals, biotech, and life sciences industry sector dropped in the 12-month period ended in September, from 9.15% a year ago to 4.80%. Pharmaceutical giant Eli Lilly and Co.’s free cash margin shrunk dramatically, from 30.16% to 18.66%. Yet its free cash margin remained “noticeably higher than the low point reached in 2006,” observes the report, and the decline “belies a certain underlying strength in the company’s cash flow generation.” The drop in free cash margin can be blamed on an increase in inventory days, from 37.86 in 2008 to 54.08 in 2009. However, improved operating profit and a decline in capital spending at Eli Lilly helped keep the margin from sinking any lower.

Meanwhile, in the transportation industry sector, free cash margin remained stable, hovering around the 3% mark. But a “substantial increase in capital spending” caused Union Pacific Corp.’s free cash margin to fall from 7.14% to 4.50%. Measured as a percentage of revenue, the railroad company’s capital spending rose from 14.94% in September 2008 to 17.68% in September 2009. But the railroad’s outlook is positive, says the report: “Given a noted improvement in operating [profit], the company should be on track for improving cash flows once revenue begins to grow.”


Free Cash Margin