Thirst-Quenching Investments

Eric Fry explains the similarities between late night revelry and investing in the post-bubble era. Take heed: The following advice could save you a few extra trips to the medicine cabinet.

Cash flow is the alpine spring water of the financial world. Pure. Crystal clear. Free of impurities and pollutants. It is "la source" of every growing enterprise. And yet, like water, cash flow is so basic, so unassuming, that it is easily overlooked by investors — particularly during exuberant financial epochs.

Saturday night revelers will toss back martinis and margaritas, not water. But come morning, these same revelers will crave only water, repulsed by the very thought of another martini or margarita.

So it is in the financial markets. During the "party years" of the stock market bubble, most investors cared little about cash flow. Instead, they became intoxicated with New Era notions: that revenue growth, by itself, would lead to profit growth; that multibillion-dollar fiber-optic networks would inspire their own demand; that "page views" would some day lead to earnings; that options-incentivized managements would guide stocks ever higher; and, most importantly, that Alan Greenspan’s special interest rate would always prevent a falling stock market.

Cash flow did not matter to anyone except short sellers. Because investors did not focus on cash flow, corporations were only too happy to bury the information in their quarterly financial filings. During thousands of conference calls throughout the late 1990s, thousands of CFOs acted as if they’d never heard of cash flow. On those rare occasions when an investor raised the issue, most CFOs would say something like, "Uh, I don’t have the information readily available. But we’re very pleased with our growth. I could have someone get back to you on this after the call."

Instead of presenting the truth that these numbers impart, companies devised myriad schemes for hiding or obscuring the cash flow data. Specifically, accounting departments from coast to coast concocted various versions of the now-infamous "pro forma earnings" — a calculation designed to exclude as many expenses as possible from the reported earnings. Expert practitioners of the pro forma charade could paint a very pleasing picture of a company’s financial health, no matter how grim the actual cash flow trend.

Here’s a hypothetical example of how pro forma earnings can be used to mask deteriorating cash flow. Imagine for a moment that Eric Fry is a publicly traded company. Let’s say that I make $100,000 per year. Let’s further assume that my annual expenses consist of $25,000 in taxes, $30,000 in mortgage payments, $25,000 for food, insurance and all other miscellaneous living expenses, plus $80,000 for a new Porsche. As a public corporation, what is my pro forma net income? Answer: $20,000 — or $100,000 minus all the expenses except for the cost of the Porsche. You see, it’s inappropriate to include the Porsche because it’s a "one-time, nonrecurring" expense and, therefore, not a true reflection of my actual profitability.

On my quarterly conference call, I boast about my $20,000 pro forma net income and how I soundly beat the prior year’s $15,000 pro forma net income. All the sell-side analysts applaud my "strong organic earnings growth," and fall all over themselves to reiterate their "strong buy" recommendations. None of the analysts asks any questions about cash flow. That would be bad form.

The obvious irony is that my net cash flow – including the Porsche purchase – is a NEGATIVE $60,000. I own the Porsche, of course, and it remains an asset on my balance sheet with a substantial value. But this particular asset — much like a fiber-optic network — will gradually depreciate and will never produce any net income for me.

Does this hypothetical example sound absurd or far-fetched? Well, it is absurd, no doubt about it. But far-fetched it is not.

Consider the case of Interpublic Group, one of the world’s largest advertising and marketing conglomerates. Interpublic is a company that, as Apogee Research pointed out several months ago, demonstrated quite an aptitude for creative cash-flow accounting. (Faithful readers of the Daily Reckoning know that I also work for Apogee.)

Back in early January, IPG’s CFO, Sean Orr, told a group of institutional investors at a Salomon Smith Barney conference that his company was producing significant free cash flow. Accordingly, slide No. 31 in his PowerPoint presentation showed $249.6 million of free cash flow for the first nine months of 2001. There’s just one small problem. Based on a conventional definition (cash from operations less capital expenditures), IPG’s free cash flow for the nine months was a NEGATIVE $712.2 million — or, as Apogee Research pointed out, "[N]early $1 billion less than the amount claimed by Orr at the recent conference."

The Apogee Research team rang up Orr to ask him about the considerable gap between the two numbers. Orr responded, "There’s no publicly disclosed information that is going to allow you to do a clean reconciliation between the two sets of numbers you are talking about."

Interestingly, not a single Wall Street analyst questioned the company’s curious rendering of cash flow. Apogee did, and its subscribers are grateful: The stock has tumbled 43% since Apogee’s skeptical analysis of Interpublic.

Over the last two years, Apogee Research has identified numerous companies that reported rising net income in conjunction with a deteriorating cash-flow trend. Because the sell side focused on the reported earnings, the companies’ stocks often kept climbing even as their financial health worsened. These stocks made outstanding short-sale candidates, and Apogee subscribers cashed in on the observation numerous times.

On June 15, 2001, for instance, the Apogee team scored a direct hit on Tyco International, long before the company became a front-page scandal. Back then, when the stock was still hovering around $55 and was lauded by Wall Street as "the next GE," Apogee observed, "Even as Tyco International CEO Dennis Kozlowski stacks floor after floor on the Tyco revenue edifice, the structure’s financial underpinnings are rotting away.

Sure, Kozlowski’s GE wannabe has engineered some aesthetically pleasing numbers. But the numbers-behind-the-numbers give cause for concern. Essentially, Tyco is a growth stock without the growth. Free cash-flow growth pales next to the net cash spent on acquisitions, and the marginal increase in cash from operations also looks pretty skimpy alongside the increase in cash spent. Meanwhile, tangible book value – the stuff that you can put a real value on – has literally disappeared, falling from $701 million at the end of fiscal 2000 to a negative $4.4 billion as of the second quarter." Tyco shares have lost 77% since Apogee’s critical analysis.

A deft cash-flow analysis also uncovered difficulties at Maximus Inc. On Aug. 31, 2001, when the stock was trading north of $42 – it has since plummeted to less than $24. Apogee observed, "While operating income shows a fairly steady uptrend, since late 1999 cash flow has failed to follow. This generally is not something investors like to see."

The moral of this story is: Cash flow does not lie. Apogee’s timely cash-flow analysis of many other troubled companies like Tellabs, PowerOne and, yes, even Cisco Systems, led to excellent profit opportunities for its subscribers.

At the opposite end of the spectrum, rising cash flow is a powerful indicator of corporate health. So when buying stocks, it is crucial to examine a company’s cash flow, not just its earnings. Russian natural gas producer Gazprom, for example, despite the obvious risks associated with operating in Russia, generates a tremendous amount of cash flow. Therefore, investors who can stomach the country risk might find the company risk worth taking.

What is true at the micro level is also true at the macro level. When investing globally, it is wise to concentrate on countries that are producing positive cash flow — countries, that is, with a positive balance of payments. A country’s balance-of-payments account is where the rubber meets the road. The so-called current account balance shows whether a country is generating cash or consuming it.

The United States, a notoriously large consumer of cash, is running a current account deficit equivalent to more than 5% of its GDP. Put another way, every day we need to borrow nearly $1.5 billion from the rest of the world in order to maintain our opulent lifestyle. Anyone who invests in the United States today faces the prevailing headwind of a current account deficit — the kind of headwind that at any moment can become a capital-threatening gale known as a currency devaluation. Partly for this reason, the team at Apogee has largely shied away from recommending U.S. stocks. Instead, it favors investment opportunities in countries that produce a current account surplus.

In Hong Kong, for example, a region that boasts a robust current account surplus equal to 6.9% of GDP, Apogee recommends hotel operator Shangri-La Asia Ltd. In the Netherlands, a country running a current account surplus equal to 4.4% of GDP, Apogee advocates buying Grolsch, the brewer known for its excellent beer and its stylish green flip-top bottles. And in Canada, a resource-based economy with a current account surplus equal to 2.5% of GDP, Apogee favors real estate developer Intrawest. Other recent Apogee recommendations include companies located in Germany, Indonesia, Korea and France – all of which run current account surpluses.

The current account balance is not the be-all and end-all of global investing, of course, but by steering clear of deficit-ridden countries, investors will certainly save themselves a lot of grief. Almost every major foreign stock market meltdown of the past 20 years came in a country operating with a current account deficit.

All financial organisms – countries as well as companies – require cash flow to thrive. Cash flow, like water itself, is essential to an entity’s well-being. When investing, it’s best to seek out companies whose cash is flowing like Niagra Falls, not like Love Canal.


Eric Fry,
for The Daily Reckoning
August 13, 2002

Eric J. Fry, the Daily Reckoning’s "man-on-the-scene" in New York, is the editor of Apogee Research (formerly Grant’s Investor) an online investment publication devoted to hedge funds and other professional investors. Mr. Fry has been a specialist in international equities since the early 1980s. He was a professional portfolio manager for more than 10 years and authored of the first comprehensive guide to American Depositary Receipts, International Investing with ADRs. For investment ideas consistent with those you’ve read today, click here:

Apogee Research

Bonds are hitting new highs. What can it mean? A stretched-out economic slump and lower interest rates is our guess.

"The Coming of Deflation?" warns a Boston Globe article. But the Globe is just teasing. "Probably not," says the paper, because "we haven’t had it for 60 years." The Globe may be surprised. Just because a man hasn’t died in the first 60 years of his life doesn’t mean he won’t in the second half. Things like that happen.

Why might it happen here? Because "US Wages Stagnant" a N.Y.TIMES article tells us. Workers are getting less overtime and smaller raises…plus they’re paying more for health care. Result: less money to spend.

"We have is a grinding slowdown in the incomes that people have available to spend," explains Lee Price, chief economist for the Senate Budget committee.

Meanwhile, "Boomers’ Plans Hit Hard by Bear" is the message from the Dallas Morning News. The boomers are in a tight spot. They have to save money for their retirement. But many still have kids to put through school. And no other group lost more in the bear market.

And more bad news for the boomers. They thought their parents would take care of them — leaving them a fortune when they died. Instead, many boomers are finding that they have to take care of their parents! The Greatest Generation refuses to shuffle off this mortal coil. Instead, they just keep playing bridge and shuffleboard… and spending their kids’ inheritance. And the geezers have taken big losses in the stock market too — after junior suggested putting a little of their savings into those hot new stocks such as Dr. and Webvan. Thanks a lot, son.

So the Great Inheritance seems to taken up with the Federal Budget Surplus and left town together! Neither can still be found anywhere in the popular press.

But, Eric, what about stocks?


Eric Fry in the big, Big Apple…

– As the shares of USAir Group nose-dived yesterday, the stock market strained to maintain altitude. "Airlines swooped down in a missing-stock formation," joked SmartMoney’s Igor Greenwald. "US Airways shares plunged 80%… after the struggling airline filed for bankruptcy."

– Although the stock never actually traded during the regular New York session, a few thousand shares changed hands at fifty cents each in pre-market trading – a loss of 81% from the prior day’s close. (I’m proud to report that my father, an amateur investor, has been short US Air for several months. Nice call, Dad!)

– The news of US Air’s bankruptcy filing exacerbated fears that UAL, the operator of United Airlines, might be the next company on "final approach" to bankruptcy. UAL, which has burned though more than $3 billion in less than a year, admits to chatting recently with various bankruptcy lawyers. UAL shares plunged 27%.

– Bad news in the airline sector spilled over into the market at large, where the Dow dropped 57 points to 8,689. Meanwhile, the Nasdaq recovered from an early morning selloff to eke out a slim half-point gain to 1,307.

The stock market is full of stories… lots of very exciting stories. But there is only one story that investors should really care about: Cash flow. Airline companies, for example, are legendary consumers of cash. Investors in US Air ignored this fact to their peril.

– "Nothing tells shareholders more about the overall health of a company than a cash flow statement," writes Mike Tarsala of CBS MarketWatch, "which details how much cash a business makes from its operating activities." And yet, very few companies provide a cash-flow statement when announcing their quarterly earnings results.

– "Cash flow from a company’s operations holds the key to a company’s true performance – precisely why executives don’t want you to see it," Tarsala observes cynically (and we agree). "Unlike earnings or revenue, the cash a company creates is just that — cash. There is no fancy way to fudge it. Shareholders have a right to know what’s left over after companies pay the bills. But no law requires CFOs to provide such information in a release. As a result, many investors who focus on pro forma, or even GAAP net income results, may never realize how badly their companies are struggling to make money."

– Tarsala is dead-on. By focusing on cash flow, investors can more easily separate the wheat from the chaff. For more on this topic, take a peek at my essay… below.

– "What About the Housing Bubble?" Dan Denning asks provocatively in a weekly e-mail missive to his Strategic Investments subscribers.

– Denning writes: "Business Week, ever the author of inane questions, poses this latest doozy: ‘Housing: Is It a Bubble If it Doesn’t Pop?’" Denning’s answer is a definite "Yes."

– "The housing market appears to be strong," he concedes. "In June, new home sales hit an annualized rate of 1 million units for the first time ever. And figures show that at the current rate of demand, the stock of existing and newly built homes would be ‘consumed’ in 3.9 months."

– But Denning finds no comfort in the housing market’s blistering rate of price appreciation. Rather, he sees the troubling signs of a housing bubble about to burst. "Ceteris paribus, the housing market is like the Nasdaq in 1999 – growing to an infinite sky," he observes. "[Since] home prices are rising faster than incomes, new buyers must borrow in the belief that home prices will keep rising. In other words, new home buyers must count on a greater fool in order to make the investment profitable.

– "But rising home prices are already discouraging buyers from taking the plunge," says Dan. "In California, the front-runner in national trends, the California Association of Realtors reports that only 27% of those surveyed could afford to buy a median-priced home. Can anyone say ‘Unsustainable?’ About the only way to sustain consumption when such a large portion of income goes to mortgage payments is to withdraw equity from the house. It’s a Faustian bargain."

– During the second quarter of 2002, according to the gifted bank analyst Charles Peabody, 67% of households who refinanced their existing mortgages increased the loan amount by at least 5%. In other words, they extracted an additional 5%, or more, of equity from their homes.

– "The heart of the rising price trend is in the refinancing phenomenon," Denning continues, "which is the last remaining crutch to consumer spending in the U.S. economy. Something has got to give. As Peabody puts it, ‘Leverage against an asset that can deflate in value is a recipe for disaster.’ Houses can fall in value just like stocks. And when they do, those who have bought too much house and extracted too much equity will find themselves paying for an asset whose resale value is less than the value of the mortgage. Upside down, out of luck, and no more trips to Home Depot."

– Thanks for the uplifting observations, Dan. See you in the bread lines.


Back in Paris…

*** "The prisons are filling up with people who really shouldn’t be there," a tall young woman named Julie opined as the Eris Society continued. Mandatory minimum prison sentences are a bad idea, she believes: her own brother got 5 years (there is no longer parole in the federal system) for growing a few marijuana plants in his garage. He could have gotten 15…but he copped a plea…served his sentence and has since gone into the computer business.

"These are people who pose no threat to society, who have decent jobs and otherwise good lives. They could be honor students. But they get caught up in the drug trade and given mandatory sentences that have no relation to the actual crime.

"Nothing good comes out of it. It costs a fortune to keep a guy in prison. And there is no evidence that it has any affect on the drug trade."

But one attendee rose to contradict her.

"I’m a criminal lawyer," he explained, "the minimum sentences just give prosecutors a way to put people in jail without a trial. The minimums are so long that no one wants to risk a trial. Instead, they cut a deal with the prosecutor and plead guilty to a lesser charge.

"I’ve dealt with all the players in the drug war," he continued. "And I’ve only found one group that really supports it — and that is the drug dealers. Every time we put a drug dealer in prison, we increase the profit margins for the guys who didn’t get caught.

"It’s a huge industry. Look, if you put a rapist in jail, it’s a great thing; one fewer rapist to worry about. But put a drug dealer in jail and two more step up to take advantage of the business opportunity. It’s just simple economics. The more you try to suppress it, the higher the prices. The higher the prices, the more profit there is for the dealers. The more profit there is, the more people want to become dealers.

"Let’s face it," he concluded, "these guys running the war on drugs are morons."

The Daily Reckoning