Buffett Piles It

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

Last year's $44 billion buyout of Burlington Northern transformed Berkshire Hathaway 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 (NYSE: COP  ) , or General Electric (NYSE: GE  ) , 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 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 that 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. Yet the company's bank account has been growing fatter and fatter with each passing year.

Free cash flow: Who's got it?
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:

Company

Reported Earnings

Actual Free Cash Flow

Starbucks (Nasdaq: SBUX  )

$568 million

$1.1 billion

Caterpillar (NYSE: CAT  )

$895 million

$4.0 billion

Boeing (NYSE: BA  )

$1.3 billion

$4.4 billion

3M (NYSE: MMM  )

$3.2 billion

$4.0 billion

Google (Nasdaq: GOOG  )

$6.5 billion

$8.5 billion

Data from Finviz.com and Capital IQ refer to trailing -12-month results.

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.

This article was originally published Feb. 1, 2010. It has been updated.

Fool contributor Rich Smith does not own shares of any company named above. Berkshire Hathaway, Coca-Cola, and 3M are Motley Fool Inside Value picks. Google is a Rule Breakers selection. Berkshire Hathaway and Starbucks are Stock Advisor recommendations. Coca-Cola is an Income Investor pick. The Fool owns shares of Berkshire Hathaway. The Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (10)

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 March 03, 2010, at 8:53 AM, GCF007 wrote:

    How do I, as a current new subscriber, get access to the information you are offering in this article?

  • Report this Comment On March 03, 2010, at 2:33 PM, TMFDitty wrote:

    Heh. You'll have to be more specific GCF007.

    Which information, precisely, are you looking to "get access" to?

    If it's just the free cash flow data, for instance, you can get a general idea by checking out the cash flow statement page for any company on Yahoo! Finance.

    To get precise figures, you could visit the SEC site and review the 10-Q and 10-K forms.

    TMFDitty

  • Report this Comment On March 03, 2010, at 7:22 PM, DaytonFlyers wrote:

    GCF007,

    Use Google Finance instead of Yahoo

  • Report this Comment On April 24, 2010, at 3:56 PM, comissar wrote:

    This is a somewhat oversimplified description of the difference between profit and cash flow. The real question is, "how much are assets really worth" at a particular point in time, the question asked repeatedly during the recent financial collapse.

    The assumption behind GAAP depreciation is that the assets are really worthless at the end of the depreciation period. You can rig the numbers either way by using overly optimistic or pessimistic assumptions about future valuation that are sometimes hard for outsiders (or insiders, even) to validate.

    Let's assume that 10 years is about right, and POORs equipment, buildings, etc. are worthless in 10 years. In that case, $100m went in and $5m were cash was generated in each year, but they are left with worthless facilities, so they really did lose $5m a year as GAAP said.

    Now we all know that land rarely becomes worthless, and most buildings tend to go up or remain stable rather than go down. But if much of their investment was in fancy manufacturing equipment, that gear WILL be worthless at some point - they'll need something better to retain that healthy gross margin as competitive pressures mount, and of course that equipment will eventually just wear out.

    For some industries, this capital management is most of the game - think GM vs. Ford, or Intel vs. AMD, spending billions of dollars on facilities that may have an economic life of 2-3 years before the technology is obsolete and must be completely retooled.

    There are other, intangible assets involved that are created over the years, like a a recognizeable brand name, a skilled workforce, and an established distribution channel, but these are notoriously difficult to value.

    So reality is somewhere between the two extremes. Exactly where is a major part of that discipline known as "fundamental analysis".

  • Report this Comment On April 24, 2010, at 4:09 PM, comissar wrote:

    This is a somewhat oversimplified description of the difference between profit and cash flow. The real question is, "how much are assets really worth" at a particular point in time, the question asked repeatedly during the recent financial collapse.

    The assumption behind GAAP depreciation is that the assets are really worthless at the end of the depreciation period. You can rig the numbers either way by using overly optimistic or pessimistic assumptions about future valuation that are sometimes hard for outsiders (or insiders, even) to validate.

    Let's assume that 10 years is about right, and POORs equipment, buildings, etc. are worthless in 10 years. In that case, $100m went in and $5m were cash was generated in each year, but they are left with worthless facilities, so they really did lose $5m a year as GAAP said.

    Now we all know that land rarely becomes worthless, and most buildings tend to go up or remain stable rather than go down. But if much of their investment was in fancy manufacturing equipment, that gear WILL be worthless at some point - they'll need something better to retain that healthy gross margin as competitive pressures mount, and of course that equipment will eventually just wear out.

    For some industries, this capital management is most of the game - think GM vs. Ford, or Intel vs. AMD, spending billions of dollars on facilities that may have an economic life of 2-3 years before the technology is obsolete and must be completely retooled.

    There are other, intangible assets involved that are created over the years, like a a recognizeable brand name, a skilled workforce, and an established distribution channel, but these are notoriously difficult to value.

    So reality is somewhere between the two extremes. Exactly where is a major part of that discipline known as "fundamental analysis".

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