September 22, 1998

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

Cash Flow Review, Part 3

In Part 1 and Part 2 of this series on free cash flow, we looked at the mechanics of assessing the free cash flow of Revlon in fiscal 1997. We looked at how the company's balance sheet, cash flow statement, and income statement interact and how to calculate free cash flow off that. However, free cash flow is colored by the financing decisions that a company makes. Theoretically, a company's value should not be affected by financing decisions, according to Miller & Modigliani (M&M) theory. Practically, the IRS and Congress pose some challenges to that theory, but its usefulness is gigantic to investors.

When we look at free cash flow, then, we have to make further adjustments than just looking at net income plus depreciation and amortization of purchased intangibles plus/minus working capital changes minus capital expenditures and acquisitions/divestitures. To get closer to the real value of the company, we want to look at how much cash it can generate before paying its investors, whether those investors are lenders or owners of equity (shares of common stock). Both require a certain rate of return, and equity holders usually require a higher rate of return because their return is often uncertain and because equity holders are last in line when it comes to liquidating or recapitalizing the company when it has declared bankruptcy.

To start with, we want to find out the entire value of the enterprise. And just as a sidenote, this is where mistakes are often made in looking at the value of a company. Just looking at EPS estimates and the share price distorts the value of a leveraged company. Just as a house with $100,000 left on the mortgage and $40,000 in equity value doesn't sell in the market for just the price of its equity value, a leveraged company's price isn't just comprised of its equity value.

Sure, one can decide on the value of an enterprise according to the cash return to equity and the price of equity, but in the end that can lead to bad decision-making and the destruction of equity value. Witness such episodes as the real estate bubbles in California in the last twenty years, the S&L crisis, and lending to emerging nations over the last thirty years. As we have pointed out -- possibly to the point of exhaustion -- the value of an enterprise depends on return on invested capital. So we don't just look at return on equity in most cases. We look at return to all investors.

In the case of Revlon, we have cash flow from operations of $6.9 million and negative free cash flow of ($101.5) million. We need to make a couple of adjustments to the elements of this free cash flow to arrive at a cash flow that is uncolored by the company's choices of financing the business. We can work back from the net income figure to get to the adjusted free cash flow, but again, this is a Ron Perelman company with lots of weird things below the operating income line. This includes the use of net operating loss carryforwards that the company uses to reduce its tax bill. So rather than working up from the net income line, we'll work down from the operating income line. In this way, we make the same adjustments that we would make going up the income statement -- unwinding the effects of interest expenses on taxes, scrubbing out extraordinary gains, and scrubbing out investment income when this is not a core part of the business.

In 1997, the company reported operating income of $213.3 million. Using a standard tax rate of 35%, after-tax operating income would be $138.6 million. Now we go back to the cash flow statement, adding back the numbers not in parentheses and subtracting the numbers in parentheses:

($ in millions)

After-tax operating income......$138.6 inflow plus 
 Depreciation and amortization...$103.8 inflow minus 
 Increase in trade receivables...($70.3) minus 
 Increase in inventories.........($21.4) plus 
 Decrease in prepaid expenses  
 and other current assets..........$2.3 plus 
 Increase in accounts payable.....$21.6 minus 
 Decrease in accrued expenses 
 and other current liabilities....($4.2) minus 
 Other, net......................($73.0) 
                                 ======= 
                                  $97.4 inflow
Less capital expenditures of $56.5 million, the company generated free cash flow from operations of $40.9 million. With total debt of $1.934 billion and a market cap of $1.624 billion and no excess cash, the company's enterprise value is $3.558 billion. As a multiple of operating free cash flow before financing decisions, that's 87 times. Not cheap. As a multiple of after-tax operating income, that's 25.7 times. That's more in line with the rest of the cosmetics industry. If one were to decide that 20 times after-tax operating income were more appropriate, then the enterprise value would be $2.772 billion. Taking the $1.934 billion in debt out, $838 million in equity value is left. With 52.597 million diluted shares, that's equity value of $15.93 per share, significantly less than the current quote of $30 7/8.

On a total free cash flow basis, the company is still free cash flow negative:

($ in millions)
After-tax operating income......$138.6 inflow plus 
 Depreciation and amortization...$103.8 inflow minus 
 Increase in trade receivables...($70.3) minus 
 Increase in inventories.........($21.4) plus 
 Decrease in prepaid expenses  
 and other current assets..........$2.3 plus 
 Increase in accounts payable.....$21.6 minus 
 Decrease in accrued expenses 
 and other current liabilities....($4.2) minus 
 Other, net......................($73.0) 
                                 ======= 
                                  $97.4 inflow minus 
  
 Net cash used for  
 investing activities............(108.4) outflow 
                                 ======= 
 Free cash flow..................($11) outflow
Referring to Part 2 of this series, there are some significant "other" outflows in the company's cash flows that aren't well identified. The treatment of these outflows is up to the investor's judgment, then. More clear disclosure would allow the investor to assess whether these are recurring sorts of outflows or if they will be cleared up at a certain point in the future. For instance, if the company is clearing up an unfunded pension plan, then we add that debt to the current enterprise value and not include the outflow used to fund the plan as an operating outflow. The multiple to free cash flow and operating cash flow, then, would change significantly, as would the valuation one would be willing to accord the company. If one were considering an investment in this company, asking about this line item in the cash flow statement would be a primary point of discovery.

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