Free Cash Flow and Shareholder Yield

New Priorities for the Global Investor

William W. Priest, Lindsay H. McClelland

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9780470128336
• eBook ISBN: 9781118045077
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Praise for Free Cash Flow and Shareholder Yield

" Free Cash Flow and Shareholder Yield provides a provocative solution to the profound paradigm shift now redefining valuation standards for markets around the globe. In commonsense terms, it defines how the investment community has begun the journey of shifting to the more dependable, robust metric of free cash flow."
—Rob Brown, Chief Investment Officer, Genworth Financial Asset Management, Inc.

This graph tells a singularly compelling story of the changing order of the drivers of total equity returns. In Free Cash Flow and Shareholder Yield, you will learn how this story is the key to informed investing in an evolving global marketplace.

PART ONE

Defining Free Cash Flow and Shareholder Yield

CHAPTER 1

Free Cash Flow

As a boy growing up in the 1950s, I was fascinated by the stock market. In the small Ohio town of my youth, my pals and I would cut lawns and trim hedges to earn spending money, but it seemed to me that the stock market provided an easier way to turn a profit. So, lured by the call of Wall Street, we devoured “How To” books on investing. Most of these books offered useless get-rich-quick schemes, variations of which can still be seen today on late night TV. There was no end to the bizarre trading techniques advocated by these authors; they touted stocks beginning with “x,” ending with “x,” stocks with no vowels. You name it, there was a book on it. In the more serious books, however, there was one variable that everyone seemed to agree on: That variable was earnings.

In the course of our studies, my friends and I learned everything we could about earnings and why they were endowed with the power to drive stock prices. We discovered that earnings represented the amount of revenues left over to the investor after all expenses were accounted for. If a company grew earnings, the company itself would become more valuable and this would be reflected in a higher share price. We also learned that, in order to arrive at a calculation of earnings, one needed to follow the rules of accounting. At the time, accounting was seen as a sort of divining rod that properly separated assets from expenses, actual revenues from contingent revenues, and liabilities from real shareholder capital. In other words, there were few who questioned the concept of earnings or the accounting processes from which they were derived. And my friends and I were no exception.

Time passed, however, and my boyhood interest in the stock market developed into a career on Wall Street. In my very early days as a security analyst, earnings were still considered the most significant driver of stock prices. In fact, my first college textbook on the subject, Security Analysis: Principles and Techniques by Graham and Dodd (McGraw-Hill, 1962), centered its analysis almost completely on earnings. The discussion of cash flow was confined to 8 pages of a 723-page book!

As a result of this singular focus on earnings, most of us who studied or worked in the investment field during those years believed that the “fundamental analysis” of a company was all about the bottom line. However, in most MBA programs, there was a quiet revolution taking place that subsequently led to an explosion of novel ideas in finance that would turn the traditional earnings paradigm on its head. This revolution would not only change the investment industry as a whole, but would also completely transform my own approach to security selection.

This new financial outlook was based on the notion of cash flow. Specifically, there was a growing belief among investors and analysts that cash flow—not earnings—was the true determinant of investment value. In fact, the seeds of this idea had been sown several decades earlier when, in 1938, John Burr Williams’s The Theory of Investment Value established the concept of “present value” in comparing investment opportunities. In doing so, he acknowledged the primacy of cash flow by describing “the investment value of a stock as the present worth of all dividends.”¹ Now, a new generation of investors and analysts were expanding on Burr’s ideas with the goal of developing fresh insights into the power of a cash flow-focused valuation methodology.

But these insights, however revolutionary, were not immediately embraced by the investment community. Because the cash flow philosophy flew in the face of those who continued to subscribe to the accounting/earnings paradigm, a gap was created between the traditional model of equity analysis and the model suggested by these new findings. For cash flow to gain widespread acceptance as a singularly valuable investment metric, it would take an event of great relevance to the investment community. It wasn’t until 1984 that just such an event occurred: an event that would transform the common perceptions of what determines investment value and stock prices.

In 1984, a little-known private equity company called W.E.S.Ray (founded by Bill Simon, a former secretary of the U.S. Treasury, and Ray Chambers, an accountant) bought a company called Gibson Greeting Cards. Before being purchased by W.E.S.Ray, Gibson had already been the target of several acquirers. In 1964, Gibson had been acquired by CIT Financial Corporation, which was acquired in turn by RCA in 1980. Soon after its acquisition of CIT, however, RCA shifted its strategic focus to its collection of core businesses, which included names such as NBC, Hertz, and several high-profile electronics and communications companies. As a result, RCA decided to sell Gibson Greeting Cards, one of its noncore subsidiaries, to W.E.S.Ray Corporation for $81 million.

At the time, many observers on Wall Street thought W.E.S.Ray’s purchase of Gibson was an ill-considered move. Even though Gibson was the third largest greeting card company in the United States with sales of $304 million, the company did not fit the model of what popular consensus deemed an exciting investment. Most of the investment community still adhered to the accounting methodology put forth by Graham and Dodd and, according to their earnings-based criteria, Gibson offered few indications of investment worthiness; there was nothing “flashy” about the company’s financial composition, growth potential, or strategic capabilities. But to those who had discovered the value of the free cash flow philosophy, Bill Simon and Ray Chambers among them, Gibson could not have been a more attractive investment opportunity.

In Gibson, W.E.S.Ray discovered a set of characteristics that have since become the holy grail of every free cash flow pundit. Specifically, W.E.S.Ray found that Gibson possessed:

• A stable revenue base that could take on a significant amount of leverage, and

• The ability to consistently generate high levels of free cash flow that could cover the cost of the acquirer’s debt and still allow the firm to grow.

With these characteristics in mind, W.E.S.Ray structured its acquisition of Gibson in the following manner: W.E.S.Ray gave Gibson management 20 percent of the company and, along with management, Simon and Chambers put $1 million toward the $81 million purchase price. The remaining $80 million was provided by various borrowings, including a $40 million loan from General Electric Credit Corporation and a $13 million loan from Barclays American Business Credit. To finance the rest of the purchase price, Gibson sold and then leased back its three major manufacturing and distribution facilities. Then, 18 months after the acquisition, W.E.S.Ray floated a public offering of 10 million Gibson shares at $27.50 per share. As a result of the cash generated by this offering, W.E.S.Ray realized a final payoff of $66 million on an investment of about two-thirds of a million dollars. In other words, W.E.S.Ray’s return was nearly 100 times its initial equity investment. As for the $80 million in debt, the newly public Gibson was now responsible for using its own free cash flow to repay these loans.

With the Gibson acquisition, Simon and Chambers had achieved something truly remarkable. In essence, they had acquired a company with the company’s own assets, and then pocketed a fair portion of the proceeds when the company was taken public. Investors, especially those who had previously ignored the importance of free cash flow, could not help but take notice.

The key to W.E.S.Ray’s success was its steadfast application of the cash flow model. Whereas traditional accounting metrics might have assigned Gibson to the dustbin, W.E.S.Ray understood that the company’s solid cash flow characteristics made it an extremely worthwhile investment. By using Gibson’s free cash generation to its advantage, W.E.S.Ray realized an incredible profit from an acquisition that no one else was smart enough to make.

The story of W.E.S.Ray and Gibson was important to me as an equity analyst and investment manager, and transformative for the investment community as a whole, because it brought to life the very concepts that had revolutionized and divided the field of academic finance decades earlier. Now, these concepts—which had all either asserted or implied the value of free cash flow-based investment metrics—had finally become practice. With W.E.S.Ray’s acquisition of Gibson, financial insights crowded out the accounting models that had once held all but unquestioned sway over Wall Street. Instead of merely focusing on earnings, the Gibson story showed us that so much more was at stake in our evaluations of publicly traded companies. Cash flow, specifically, was the metric that would soon change the face of investing.

Today, there are few people in finance—or in any other vocation or field of study, for that matter—who would dispute the importance of cash. Entire civilizations, philosophies, and social orders have been created or destroyed with the goal of harnessing the power of cash. Capitalism, for example, is perhaps the most efficient process yet devised that allows both individuals and organizations to gain access to and control over cash and other forms of liquid capital. As the old cliché goes, cash is king.

Within the current investment landscape, cash—in the form of free cash flow—enjoys growing popularity as a key metric for investment managers, largely as a result of the lesson provided by W.E.S.Ray and Gibson Greeting Cards and the thousands of similar transactions that followed it. In terms of both security selection and the evaluation of business management, free cash flow provides the most meaningful gauge of a company’s financial and operational health, and the most robust indication of share price performance.

We start this book with a discussion of free cash flow because of its essential place in the toolkit of the informed investor. But we are also using the concept of free cash flow as our jumping-off point because it is the cornerstone of this book’s central investment thesis: Shareholder Yield. The rest of this chapter is dedicated to clarifying and expanding our definition of free cash flow with an eye toward the introduction of the Shareholder Yield philosophy.

Free Cash Flow—A Working Definition

In this book, the term free cash flow has very specific connotations that differentiate it from the more generalized concepts of “cash” and “cash flow.”^a Professor Enrique R. Arzac, in his book Valuation for Mergers, Buyouts, and Restructuring, presents the demarcations between these separate, yet related, ideas in the following manner:

Why do we find it necessary to refer to a cash flow that is “free”? In practice, the term cash flow has many uses. For example, accountants define the cash flow of a company as the sum of net income plus depreciation and other non-cash items that are subtracted in computing net income. However, that cash flow is not available for distribution to investors when the firm plans to reinvest all or part of it to replace equipment and finance future growth. Free cash flow is the cash available for distribution to investors after all planned capital investments and taxes.²

A similar definition is provided by George Christy in Free Cash Flow: A Two-Hour Primer for Management and the Board: “Free Cash Flow = Revenues MINUS cash expenses PLUS nonrevenue cash receipts PLUS or MINUS cash changes in working capital MINUS capital expenditures.”³ He goes on to say that the “ ‘free’ in free cash flow means that, after the company funds cash expenses and the changes in receivables, inventories, and fixed assets required to generate the revenues, the remaining cash flow is ‘free’ to be used for whatever management decides is best for the company.”

In other words, free cash flow is a specialized concept that allows us to determine the true amount of cash available for immediate, discretionary, strategic use by a business. It is important to note that the definition of free cash flow used in this book (and in the books by Arzac and Christy) is not the same as the concept of cash flow as determined under generally accepted accounting principles (GAAP) accounting. While the GAAP version of cash flow may attempt to arrive at a number that approximates a business’ available cash, it is “nothing more than a reconciliation of the change in the balance of the ‘Cash and Cash Equivalents’ account to the changes in the other balance sheet accounts (and indirectly to the numbers in the income statement).” For investors, analysts, and managers, this is problematic because “both the GAAP balance sheet and income statement are ridd...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Foreword
• PREFACE
• Acknowledgments
• PART ONE - Defining Free Cash Flow and Shareholder Yield
• PART TWO - The New Investment Landscape
• PART THREE - Strategies for the New Investment Landscape
• APPENDIX - Continuous-Time Free Cash Flow Valuation Framework
• NOTES
• REFERENCES
• INDEX