September 15, 1998

An Investment Opinion
by Dale Wettlaufer

Cash Flow Review, Part 1

If net income is like the cover of the book, then the cash flow statement is its text. And just as you can't judge a book by its cover, you can't judge a company by its earnings. There are lots of things that can be learned from notable stock blowups and outperformances this summer, and many of the these issues can be interpreted better from the viewpoint of the cash flow statement rather than the income statement.

For a growing company that is generating no earnings, we can tell what kind of earnings-less company this is. Is it the kind of company that has to spend $100 to lose $10? Or is it the kind of company that has to spend $10 to lose $10? This isn't supposed to be a riddle. The issue at hand is the company's free cash flow. For a younger company, the magnitude of the cash outlay to produce net income can tell what sort of free cash flow the company might generate in the future and the extent to which the current owners of an enterprise will participate in the free cash flow.

A company's free cash flow is its earnings plus depreciation and amortization minus capital expenditures plus or minus working capital changes plus or minus cash outlay for taxes. In measuring earnings in this way, one can see through accounting policies that understate or overstate earnings when companies under- or over-depreciate or amortize assets. Investors can also see through accounting policies that overstate earnings when the company is ravenously sucking in capital through a working capital buildup. For instance, let's look at a company with lots of earnings growth but an even more hearty appetite for working capital and other items:

Here we see Revlon's net income line for the last three years:

                     1997    1996   1995 
 Net income (loss)   $43.6    18.2  (41.2) 
 (in millions)
Excellent earnings growth, right? Let's go to the next part of the cash flow statement, which is the real meat of the situation, anyway.

Adjustments to reconcile net income (loss) to net cash provided by (used for)operating activities:

                                 1997    1996   1995 
 Depreciation and amortization  $103.8   90.9    88.4 
 Extraordinary item               14.9    6.6    ---
OK, nothing special in the depreciation line. Looks like a normally growing company. We see a couple of credits to cash flow that were originally debits (reductions) to net income.

A couple more items before getting to the good stuff:

                               1997   1996   1995 
 Gain on sale of                
   subsidiary stock            (6.0)   ---    --- 
 Gain on sale of certain   
   certain fixed assets, net   (4.4)   ---   (2.2)

Alright, now for the bigger items:

                                     1997   1996   1995 
 Increase  in trade receivables     (70.3) (67.7)  (44.1) 
 Increase in inventories            (21.4)  (5.3)  (15.1) 
 Decrease (increase) in prepaid 
   expenses and other current assets  2.3   (7.1)    4.5 
 Increase in accounts payable        21.6   10.8    10.2 
 Decrease in accrued expenses and 
   and current liabilities           (4.2) (10.2)  (12.2)

So far, operations have generated $79.9 million in cash. We're not done yet, though. In Revlon's cash flow statement, there's a recurring "other" line:

                  1997       1996       1995 
 Other, net      (73.0)     (45.8)     (40.4)
Deduct that from the cash flow quoted above, and last year Revlon generated $6.9 million in net cash from operations:

                                    1997    1996    1995 
 Net cash provided by (used for)  
   operating activities            $6.9    (9.6)   (52.1)
So before we even get to the part where we look at the cash outlays that Revlon has to make to maintain and increase its competitive position, the company's not generating much cash. On Friday we'll look at how much cash the company is generating and what this does to its value.