Buffett Piles It

On Nov. 3, 2009, Warren Buffett bagged his elephant.

Last year's $44 billion buyout of Burlington Northern (NYSE: BNI  ) transformed Berkshire Hathaway (NYSE: BRK-B  ) into one of the nation's largest railroad barons. But it also fulfilled one of the Oracle's oldest promises: To put his company's enormous treasure trove to work.

A delightful dilemma
Berkshire Hathaway, you see, generates anywhere from $8 billion to $10 billion a year in cash -- cash that, as Buffett laments, just "piles up." Here at Motley Fool Stock Advisor, we think that generating too much free cash flow is an enviable situation, but for Buffett, it's always posed a problem. You see, unlike many of the companies he invests in – Coca-Cola, ConocoPhillips, or General Electric, Berkshire does not pay a dividend.

With the dividend outlet firmly corked, Buffett has for years wrestled with the problem of how to put his vast profits to work effectively. That's a problem a lot of us wouldn't mind having, I suspect. But first, we have to make those profits.

Free cash flow: What is it?
At its simplest, "free cash flow" is the cash profit that a company has left over after paying its expenses. It is money the company can use to pay dividends to shareholders, build new factories and hire new workers, or simply sock away for a rainy day (or decade.) What free cash flow is most definitely not, though, is the "profits" that most Wall Street analysts focus on when deciding whether a company is a "buy," "sell," or "accumulate strongly with an option to hold."

An example may help to illustrate the concept. Consider a hypothetical company: Peoria Occidental Orthodontic Robotics (Ticker: POOR), a manufacturer of electric toothbrushes. Incorporated with $100 million in start-up capital in 2010, POOR embarks upon its business by pouring $100 million into building a toothbrush factory in Peoria, Ill. By 2019, POOR is selling $10 million worth of toothbrushes annually, toothbrushes that cost it $5 million to manufacture and sell.

POOR generates $5 million in annual cash flow. Because its factory has already been built, is highly automated, well-oiled, and so requires almost no maintenance, its capital expenditures are negligible. Thus, every year that POOR makes $10 million in sales, it deposits $5 million in the bank. So POOR's profitable, right?

Not according to Wall Street. You see, bright and shiny as it looks from the outside, POOR's accountants "depreciate" $10 million of the value of its factory every year for 10 years, to account for the initial expense of building it. As a result, at the same time as POOR is putting $5 million in the bank, it's telling the IRS, Wall Street, and pretty much everyone else who focuses on GAAP accounting, that it lost money for the year. And yet the company's bank account has been growing fatter and fatter with each passing year.

Free cash flow: Who's got it?
Now POOR is, of course, a fictional company (and really, any investment banker who let a company go public with a ticker symbol like this one would find himself flipping burgers at Mickey D's in short order.) But there are a whole lot of companies that offer the same rich investment opportunity in the real world, as POOR does in the imaginary.

Some of them look unprofitable, but are actually cash-rich; others look to be doing OK under GAAP, but are actually churning out gobs of cash far in excess of what many people expect:


Reported Earnings

Actual Free Cash Flow

MedcoHealth Solutions  (NYSE: MHS  )

$1.2 billion

$3.1 billion

Qualcomm (Nasdaq: QCOM  )

$2.1 billion

$4.3 billion

Cisco Systems (Nasdaq: CSCO  )

$5.7 billion

$7.9 billion

Apple (Nasdaq: AAPL  )

$6.8 billion

$10.8 billion

Hewlett-Packard  (NYSE: HPQ  )

$7.7 billion

$9.7 billion

Trailing 12 month results. Data from and Capital IQ, a division of Standard & Poor's.

Buy when Wall Street won't
At Motley Fool Stock Advisor, we'd love to own a stock like POOR -- indeed, we already do own many stocks like it, including a couple of those named above.

Why? In POOR's case, because things are going to change big time in 2020, when POOR's 10-year drought of GAAP profits will suddenly come to an end. After "depreciating" the final $10 million of its start-up factory costs, POOR will emerge into profitability. Its "losses" a thing of the past, all of a sudden, POOR will acquire a positive P/E ratio -- and a lot of professional investors will begin wondering whether that P/E ratio is low enough to make the stock a "buy."

Foolish investors, of course, knew that POOR was a rich investment all along. Because like the companies named above, and like Buffett's Berkshire, POOR suffered from the happy dilemma of making too much money.

The moral of the story
Wall Street's piled high with accounting degrees and CFAs. If it makes them happy to obsess over GAAP profits -- let 'em. Meanwhile, we'll just keep counting the cash.

Would you like to find a company like POOR in real life? Maybe one running the same kind of cash-rich business as the companies named above -- but at a more reasonable price? Sure you would. Grab yourself a free trial of Motley Fool Stock Advisor now, and we'll show you how.

Fool contributor Rich Smith does not own shares of any company named above. Berkshire Hathaway and Coca-Cola are Motley Fool Inside Value selections. Apple, Berkshire Hathaway, and MedcoHealth Solutions are Motley Fool Stock Advisor picks. Coca-Cola is a Motley Fool Income Investor choice. The Fool has a financial position in Berkshire Hathaway. The Fool has a disclosure policy.

Read/Post Comments (7) | Recommend This Article (54)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 01, 2010, at 4:17 PM, henryking54 wrote:

    <<Wall Street's piled high with accounting degrees and CFAs. If it makes them happy to obsess over GAAP profits -- let 'em.>>

    "Ten Guidelines from Richard Bernstein on His Final Day at Merrill

    7. Investors should focus strongly on GAAP accounting, and should pay little attention to “pro forma” or “unaudited” financial statements."

  • Report this Comment On February 01, 2010, at 6:02 PM, knighttof3 wrote:

    Good advice, but needs a grain of salt. POOR will need to build out another factory or improve existing one. Depreciation is not all phantom, at least part of it reflects the reality of aging machines and plant.

  • Report this Comment On February 01, 2010, at 7:56 PM, wwsailor wrote:

    I have to agree with knighttof3, there are some additional costs that will have to be added (e.g. - increasing maintenance) to the current model, over time. [Is free cash really free? :-)]

    However, I'll take putting cash in the bank over losing money... anytime. At least you have the money needed to make rational decisions.

  • Report this Comment On February 01, 2010, at 7:57 PM, wwsailor wrote:

    I have to agree with knighttof3, there are some additional costs that will have to be added (e.g. - increasing maintenance) to the current model, over time. [Is free cash really free? :-)]

    However, I'll take putting cash in the bank over losing money... anytime. At least you have the money needed to make rational decisions.

  • Report this Comment On February 02, 2010, at 9:37 AM, d4winds wrote:

    I agree w/ the general thrust of your sentiments--free cash flow is the most important variable to consider--but disagree w/ your specifics. knighttof3 is correct about the need to recognize depreciation.

  • Report this Comment On February 08, 2010, at 1:49 AM, radicalaccountin wrote:

    Great article! Let's keep talking about various accounting practices, and empower us to extract meaning from financial reports.

  • Report this Comment On February 08, 2010, at 5:12 PM, ddagostino wrote:

    Your can't IGNORE GAAP acounting, however, you do need to look at GAAP depreciation and replace it with the true economic depreciation of the factory and equipment. After this adjustment you will have a more true picture of how the company has done. Then you can look at the cash flow and determine how much is really 'free' and how much will be needed to replace or maintain the initial investment in the business' factory and equipment.

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Rich Smith

I like things that go "boom." Sonic or otherwise, that means I tend to gravitate towards defense and aerospace stocks. But to tell the truth, over the course of a dozen years writing for The Motley Fool, I have covered -- and continue to cover -- everything from retailers to consumer goods stocks, and from tech to banks to insurers as well. Follow me on Twitter or Facebook for the most important developments in defense & aerospace news, and other great stories besides.

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