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Friday, December 4, 1998

An Investment Opinion
by Warren Gump

Will Cash Flow at U.S. Filter?

A tidal wave of an opportunity could be rising for companies associated with water. As the global population continues to grow and concerns about water quality increase worldwide, enormous investments will undoubtedly be made in the worldwide water infrastructure. Just this week, President Clinton released almost $1 billion in grants for states to invest in improving water treatment facilities and protecting watershed areas. The companies serving this market have been consolidating rapidly, with one of the main acquirers being Palm Desert, California-based U.S. Filter (NYSE: USF). You gotta give management some credit simply for putting their headquarters there.

Never heard of U.S. Filter? That could be because only 2% of the company's 1997 revenue came from retail and consumer customers. Most of the company's business has been (and will continue to be) for industrial and municipal customers. Services offered include the design and manufacture of customized industrial water treatment systems, the operation of outsourced municipal water systems, and selling equipment such as water pipes and fire hydrants.

In June of this year, however, the company made a big splash into the consumer segment with the $1.5 billion stock purchase of Culligan. Yup, you know them for the Culligan man. They've installed about 3 million water treatment systems in the U.S. homes. In addition, they sell products and services to well known consumer firms like Coca-Cola, Nabisco, and Colgate-Palmolive. This acquisition jump-started the consumer segment with arguably the most powerful brand in the business.

Culligan isn't US. Filter's only takeover. Since 1991, over 150 acquisitions have been brought into its portfolio, with several major ones over the past year. Last December, the company picked up two important acquisitions, Kinetics and Memtec. Kinetics makes high-purity process piping systems that handle gases, water, and chemicals used in the microelectronics, pharmaceutical, and biotech industries; it posted fiscal 1997 revenues of almost $400 million. Memtec, an Australian company with $244 million in fiscal 1997 revenues, designs and manufactures membrane-based systems that filter gas and liquids using proprietary microfiltration technology.

U.S. Filter's reported operating earnings have been very strong over the past three years, rising from $0.54 in fiscal 1996 (ended March) to $1.20 in fiscal 1998. These figures, reported by First Call, exclude the numerous acquisition and other "one-time" charges. The future looks bright as well, with First Call estimates of $1.44 and $1.61 for fiscal 1999 and 2000, respectively. These kinds of numbers really peaked my interest. A company in a field where I could envision tremendous growth over the next couple of decades and strong reporting profits to boot!

I then Foolishly took a look at the company's cash flow statement. That's right, I wasn't going to listen only to what the Wise had to say about earnings. I wanted to see how much of the green stuff was making it out of the income statement and into the company's coffers. It is especially important to do this when investing in acquisitive companies, as special charges have a way of not being considered by analysts, although they can help boost future earnings. The picture on the cash flow front hasn't been very pretty. In fact, it was U-G-L-Y. A company without strong cash flows can be likened to kid not eating vegetables... somewhat unhealthy.

In 1996 (all data is for fiscal years and has been restated for pooling-of-interest acquisitions through March 31, 1998), the company posted revenues of $1.1 billion. Reported net income was $31 million, but cash flow from operations was only $7 million. Results in 1997 were even worse. Sales jumped to $1.8 billion, net income nudged upward to $33 million, yet cash flow from operations was a negative $16 million. Cash flow for 1998, although improved, was still lackluster as sales jumped to $3.2 billion, net income (adding back the non-cash portion of write-offs) was $52 million and operating cash flow was $36 million. What's the alibi for these low cash flows numbers? Increases in several balance sheet accounts: prepaid expenses and other assets, costs in excess of billings on long-term contracts, and inventories.

It is understandable that these accounts would rise some due to the company's rapid growth, but I'm not enamored with companies with working capital increases so big that operating cash flow is really low (or negative). Call me a member of the old school (you know, those folks who worry about cash flow and valuation when looking at stocks), but $3.2 billion in 1997 sales and operating cash flow of only $36 million? Doesn't sound too appetizing to me. Perhaps investors recognition of these poor underlying economics, accompanied by concern over international turmoil, explain the stock's decline from $30 last December 31 to $11 7/16 at its low point in early October. (The stock has since rebounded sharply to $23 5/8.)

Could the cash-flow draught be ending? Yesterday, Dow Jones Newswire ran an article on a meeting between U.S. Filter management and the Wise of Wall Street. A CS First Boston research report was quoted as noting that U.S. Filter "set the stage for a permanent transition to a cash-flow orientation... USF emphasized that growth would be supported by cash flow." Those words are music to my ears. Poor cash flow has been the missing link that made it difficult to invest in the company unless the stock became ridiculously cheap. You can't, of course, get too excited the moment a company's management discusses a new initiative. There are many examples where goals and objectives have never been met. On the other hand, if the company's management gets large amounts of green flowing through net income down to operating cash flow, the outlook for company shareholders will be much more nourishing.

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