Tuesday 27 December 2011

When Capital Spending Doesn't Generate Cash Flow

Company ABC.

1995  Earnings    $100,000        FCF -$7.0 million
1996  Earnings    $5.9 million      FCF -$28.0 million
1997  Earnings    $12.3 million    FCF -$57.4 million

Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.

Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  



Company OPQ.

1997  Earnings    $6,945 million     FCF  +$5,507 million
1998  Earnings    $6,068 million     FCF  +$5,634 million
1999  Earnings    $7.932 million     FCF  +$7,932 million 

Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.

Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.  




Company DEF

1996   Earnings   $1,473 million   FCF  - $2,532million
1997   Earnings   $787 million      FCF  - $2,347 million
1998   Earnings   $  28 million      FCF  - $2,187 million

Company DEF's revenues actually declined during this period.
FCFs were consistently negative for the same period.

Company DEF spends an amount equal to about 20% of its long-term assets in a single year.


What really hurts is when a company spends aggressively but its performance stinks.

If a company is spending like mad, it had better be increasing its sales - and its profits - at a rapid rate.  

Company ABC and Company OPQ pass that test.

Company DEF doesn't.

Company DEF is a mature company and for it to generate such meager free cash flows is bad enough.

But when a company spends an amount equal to about 20% of its long-term assets in a single year, you expect to see rapid growth.  Yet, Company DEF's revenues actually declined during this period; the company's long-term record of growth is poor when you consider how much money gets plowed into the company.

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