The Importance of Cash Flow

	Paul Tracy Street Authority.com
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There's one deceptively simple question that all investors seek to answer: how much is a company worth? The bad news is that there's no one, single correct answer to that question.

There is, however, one, simple cardinal rule for investors: when purchasing a stock, all you're doing is purchasing a stake in the future stream of cash flows from that business. A company is only worth what it can deliver in the form of cash to investors over the long haul. This is the money that can ultimately be used to buy back stock, expand into new growth markets or pay out to investors in the form of dividends.

Many investors buy companies because they offer exciting or attractive stories -- a bright new technology or, perhaps, a promising cure for an important disease. In most cases, however, these types of "story stocks" don't stand the test of time. Instead, the real winners are often the boring, mundane "Old Economy" names that simply earn loads of cash year after year.

Remember, exciting story stocks aren't simply a 1990s tech-bubble invention. Back in the 1970s, Polaroid was a hot momentum stock. The company's novel instant cameras captured investors' attention and had some predicting the end of traditional film photography.

But while Polaroid cameras remain popular even today, the promise of a dominant global market share never came to pass. In fact, Polaroid ultimately went bankrupt. Some of the real winners since 1970 include boring consumer companies like razor-maker Gillette (G), American Express (AXP) and beverage maker Coca-Cola (KO). While these three stocks all operate in fairly ordinary, low-tech fields, all three share one thing in common: they tend to generate enormous piles of cash throughout both good times and bad.

Although it's extremely important to examine the actual cash a business generates, most investors choose to focus instead on a company's net income. And since these historical and estimated earnings figures are so widely available, it can often be tempting to use net income data instead of looking at cash flows. However, just as with any financial metric, earnings have their problems.

Earnings are really an accounting measure -- not a record of actual money received by a company. Contrary to popular belief, earnings do not represent the actual dollars a company brings in over a one-quarter or one-year period.

For example, although items like depreciation -- a way of spreading the cost of an asset over many years -- appear on a company's income statement, they don't actually reflect an exchange of cash in that particular period. In addition, companies can use a variety of accounting tricks to manipulate their earnings numbers. For example, so-called extraordinary items -- meant to refer to one-off gains or losses -- can be used to "hide" all-too-ordinary, recurring charges..

There's also the issue of revenue recognition. Companies can recognize revenues from a sale and book earnings even if they haven't yet been paid. If the firm then has trouble collecting those payments, then those earnings may never materialize. By recognizing revenues in creative ways, companies can shift their earnings from quarter to quarter.

For better or for worse, earnings management is an accepted practice in many large companies. Given that no company wants to disappoint Wall Street by missing its guidance, accounting "tricks" are often used to smooth earnings streams. Clearly, if earnings don't represent the actual cash available to shareholders, then they shouldn't be the sole basis for valuing a stock. Over the long term what really matters is how much cash a company generates, not how accountants measure profitability on a quarter-to-quarter basis.

Enter, Cash Flow
Fortunately, all public companies are required to publish a cash flow statement. Cash flows can help us to better examine companies by enabling us to bypass some of the problems inherent with earnings measures.

Cash flow measures the actual money paid out or received by a company over a certain period of time. This measure excludes non-cash accounting charges like depreciation. And, more importantly, cash flows are objective. There is no value judgment about when and how revenues are recognized -- the cash flow statement only recognizes the actual cash that flows into or out of a business.

My staff and I focus particular attention on operating cash flow when evaluating a company. Operating cash flow excludes extraordinary items from the cash flow equation. For example, if a manufacturing company sells a subsidiary for $1 billion in cash, then that money would show up as cash flow, but not operating cash flow. We believe that operating cash flows are a truer measure of a company's ability to generate value for investors over the long haul term.

Even more importantly, operating cash flows exclude cash flows from financing activities. In other words, if a company takes out a $5 billion loan in the form of cash, that $5 billion represents actual money flowing into the company. However, borrowed funds reflect little about the actual fundamentals of a company's business; in fact, a heavy reliance on borrowing can reflect underlying business weakness. Operating cash flow excludes these types of items.

Finally, operating cash flow excludes money from investing activities. Investing activities come in two broad types. One involves actual expenditures on a firm's the underlying business -- so-called capital expenditures (CAPEX). CAPEX usually involves the purchase of assets such as new plants, equipment or technology.

CAPEX spending is worth keeping an eye on. It's fine for companies to spend cash to expand their businesses. However, large recurring CAPEX are indicative of what analysts call a "capital-intensive" business model. Capital-intensive businesses require constant investment to fuel growth -- without access to the capital markets, such companies can run into serious financial trouble.

The second form of investing activity is actual portfolio investment -- buying chunks of other companies, stocks or bonds. These types of investments don't usually reflect the underlying quality of the company's business and, therefore, can sometimes be ignored.

Applying Cash Flow
But it makes little sense to simply look at cash flows in isolation. Always mindful of valuation levels, my staff and I like to compare a company's operating cash flow to its enterprise value. Enterprise value (EV) is a way of adjusting market capitalization to more accurately reflect the value of a firm. EV is calculated by taking a company's market capitalization (price per share times the number of shares outstanding), then adding debt and subtracting the firm's cash balance. This makes EV an excellent reflection of the total value an investor would receive if he/she purchased the entire firm -- the investor would have to pay off a firm's debt but would get to keep the cash on the books.

By dividing a company's operating cash flow by its enterprise value, we're able to calculate the firm's operating cash flow yield (OCF Yield). This measure reflects how much cash a company generates annually compared to the total value investors have placed on the firm. All things being equal, the higher this ratio, the more cash a company generates for its investors.

Companies like American Express and Coca-Cola are well known for generating a great deal of operating cash year-in and year-out. As such, both of these stocks have been outstanding performers over the long haul. Our chart to the right shows the operating cash flow yield for a select few well-known cash flow generators. These companies all sport annual operating cash flow of at least 5% of enterprise value.

My staff and I sifted through our database of over 10,000 companies in search of stocks with operating cash flow yields of more than 5%. We also excluded all companies priced under $5 per share or with enterprise values of less than $1 billion. (Since it's a lot easier for smaller companies to generate huge cash flow yields over a short period of time -- one or two fiscal years -- we decided to eliminate these stocks from our list.)

In addition, we eliminated any companies with an average operating margin of less than 10% over the past three years. This criterion helped us to identify companies with solid long-term profitability.

Finally, we required projected future annual growth of greater than +10%. Unfortunately, not all companies have published long-term cash flow forecasts. As such, we were forced to use earnings growth projections to look for companies that are likely to be decent growers over the long haul.

The table below shows a number of companies that fit our screening criteria. In the analysis that follows, my staff and I examine two of the most promising plays from this list.

TIMBERLAND (TBL, $72.12)

Business Overview
Timberland produces a line of shoes designed mainly for outdoor and adventure enthusiasts. In addition, the company recently expanded its footwear lines to include work boots and shoes designed for professionals. All told, footwear accounts for about 75% of company sales.

The remaining quarter of sales come from apparel. Specifically, the company produces a line of apparel aimed at the outdoor market and designed to complement its footwear lines.

Timberland distributes the majority of its goods to third-party retailers. The company also operates a chain of stand-alone retail stores that it uses to sell its merchandise directly to the public.

Competitive Advantages
The footwear business is highly competitive. However, Timberland has carved out a very powerful brand in a specific niche market. As with all consumer franchises, branding is key. Consumers will pay a premium price for their favored brands, yielding higher margins for the best names. And while it's easy to make shoes, it's hard to re-create a brand image in consumers' minds.

Year after year, Timberland's rugged shoe designs score high among outdoor enthusiasts. The company has focused almost exclusively on this market since its founding in 1973. Advertising for the shoes features a host of hiking and camping scenes, reinforcing that image.

Although the outdoor shoe market is smaller than that of athletic shoes, the market is growing rapidly. And, more importantly, there is less competition in this specialized niche. While Nike, Reebok and Adidas duke it out in the massive athletic shoe market, it would be tough for these company's to tackle the outdoor market where they have no existing brand awareness.

Growth Drivers
Overseas markets remain the most exciting avenue of growth for Timberland. Currently, 38% of Timberland's sales come from outside the U.S. market. However, this aspect of the business is growing far faster than domestic sales.

In the fourth quarter of 2004, for example, sales in the U.S. grew a respectable +5.3%. But internationally, sales were up nearly +20% and close to +12% in constant dollars (adjusting for depreciation of the U.S. dollar). In fact, over the past few years, international sales have been growing at roughly twice the rate of domestic U.S. sales.

Timberland already boasts over 135 stores in Europe and Asia. However, that merely marks the very beginning of the company's overseas expansion. For example, Timberland recently opened up a new procurement center in Hong Kong to help serve the rapidly expanding Asian marketplace.

My staff and I are particularly interested in potential growth from key Asian markets like China and India. American consumer goods like Coca-Cola have already seen solid growth in this region. And Timberland's existing success in Europe and Asia proves the company's appeal extends far beyond U.S. borders. We believe these nations will become even more important markets for the company as consumers in the region become wealthier and start demanding more expensive western goods.

Valuation, Cash Flow and Outlook
Timberland is a prodigious cash generator. The company offers an operating cash flow yield of 8.2% -- a ratio that has been remarkably constant over the past few years (even in the depths of the 2001/2002 recession). Operating cash flow has grown at an average annualized rate of over +50% in the past three years.

The company has a rock-solid balance sheet with about $9 in cash per share and absolutely no debt. This will make it easy for Timberland to expand overseas using internally generated cash. In addition, Timberland has been aggressively buying back stock in an effort to return additional value to shareholders.

On an earnings basis, Timberland is trading at about 14X estimated 2006 earnings. Meanwhile, analysts have pegged the company's long-term growth at +14% based on double-digit growth overseas and mid-to-high single digit growth at home. That gives Timberland a very reasonable PEG (P/E-to-growth) ratio of 1.0.

Looking forward, Timberland should earn close to $9 per share within the next five years. Nike, a shoe company with a similar long-term growth, currently trades at over 17 times forward earnings. Applying a similar multiple to Timberland would yield a price well north of $150 per share.

What's more, we believe there are two potential kickers for Timberland. First, the company's solid brand and strong balance sheet make it an attractive takeover target. We wouldn't be surprised to see a company like Nike decide to expand into outdoor footwear by purchasing Timberland. Secondly, thanks to the company's strong cash flows, the firm is capable of paying a nice dividend. With the new tax laws in place, dividend payments have become an even more attractive option for U.S. firms. As such, Timberland could potentially initiate quarterly dividends sometime in the near future. A solid dividend yield would make TBL even more appealing to investors.

MCAFEE (MFE, $23.98)

Business Overview
McAfee makes equipment and software designed to protect computer networks from hackers, viruses and other security threats. McAfee sells heavily to commercial and government clients; these customers need products designed to protect entire networks, authenticate users and monitor network activity. The company also targets the retail and desktop business with a line of anti-virus software and anti-spam solutions.

Competitive Advantages
There are just a few large players in the network and computer security space. McAfee's most direct competitor is Symantec, which is best known for its Norton line of antivirus software.

But two factors diminish the actual impact of that competition. First, demand is extremely strong in the Internet and network security business. As my staff and I will explain below, there has been enormous growth in the number of viruses that attack computer networks. In addition, any computer user can attest that spam has become an increasingly annoying problem in recent years. As such, there is plenty of room in these markets for multiple competitors.

Secondly, there is some stickiness in this business. Once a company licenses McAfee software for a period of time and pays for periodic updates to its virus software, it would be relatively expensive for them to shift to a competitor. As such, customers that choose McAfee are more likely to stick with the company than switch to a competitor like Symantec.

Growth Drivers
Unwanted, unsolicited e-mail, often referred to as "spam," has been rapidly taking over most consumers' e-mail inboxes. Symantec estimates that such unwanted messages accounted for 50% of all e-mail sent globally in July of 2003. By December of 2004 that figure had growth to 67%. Even worse, some of the most dangerous spam e-mails known as "Phishing" attacks are on the rise.

Phishing attacks involve e-mails sent from what looks like a legitimate source, such as a bank or credit card company. These e-mails ask for personal information such as social security numbers and bank account data. The spammers then use that information to steal identities and run up unauthorized credit card charges.

In addition to unwanted email, viruses are yet another problem facing computer users. Some viruses can be sent and picked up through e-mail and spread rapidly. A host of viruses have circulated the globe in recent years, causing major disruptions to commercial networks. And as more Internet users log on around the world and more businesses seek to expand their online presence, you can bet these threats will continue to multiply.

All of these factors should continue to power strong demand for Internet security software and systems; software to reduce the quantity of spam, as well as to find and destroy viruses before they create havoc. These trends should continue to power growth at McAfee.

Valuation, Cash Flow and Outlook
MFE trades at about 19 times 2006 earnings. Meanwhile, analysts expect the company to deliver long-term growth of approximately +15% per year, giving the stock a PEG ratio of about 1.25. Best of all, my staff and I believe that these growth estimates could well prove conservative. After all, MFE recently finished selling off some of its slower-growing product and business lines.

Looking out over the next five years, MFE is likely to deliver earnings of more than $2.20 per share. Based on a P/E in line with long-term growth, that yields a value in the mid-$30s. The company's operating cash flow yield stands at about 8%. MFE also sports no debt and over $3 per share in cash.

Recently, MFE stock has been hammered on concerns that Microsoft will enter the security market and take share from existing players. However, we believe these fears are overblown. McAfee should continue to deliver solid numbers in the years ahead thanks to the firm's strong installed base coupled with enormous growth in the Internet security business.

We sincerely hope you've enjoyed today's look at the importance of cash flow. Please stay tuned for our next full issue, which we'll publish on Monday, April 4th. In it, my staff and I will examine the income investing landscape and will introduce you to several companies that offer above-average dividend yields. Historically, dividends have accounted for about half of the market's total returns, making them an extremely important consideration for investors. Good investing in the week ahead!

Paul Tracy will be available to take your questions until Monday, April 4. Please use the form below to submit your questions.