Buffett Piles It

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

Last year's $44 billion buyout of Burlington Northern transformed Berkshire Hathaway (NYSE: BRK-A  ) 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 has 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, it's highly automated, well-oiled, and so requires almost no maintenance, so 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 soon be flipping burgers at Mickey D's). 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

Harley-Davidson (NYSE: HOG  )

negative

$421 million

Yahoo! (Nasdaq: YHOO  )

$598 million

$876 million

Ford (NYSE: F  )

$2.7 billion

$11.5 billion

Disney (NYSE: DIS  )

$3.3 billion

$3.9 billion

Johnson & Johnson (NYSE: JNJ  )

$12.3 billion

$14.2 billion

Target (NYSE: TGT  )

$2.5 billion

$4.2 billion

Data from Finviz.com and Capital IQ (a division of Standard & Poor's) 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, Walt Disney, and Coca-Cola are Motley Fool Inside Value recommendations. Berkshire Hathaway, Walt Disney, and Ford Motor are Stock Advisor picks. Johnson & Johnson and Coca-Cola are Income Investor selections. Motley Fool Options has recommended a buy calls position on Johnson & Johnson. The Fool owns shares of Berkshire Hathaway. The Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (12)

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 April 07, 2010, at 6:01 PM, jpaa74 wrote:

    Every company needs to make repairs and upgrades every 5-10 years to keep staying in business, so your fictional company with absolutely no capital expenditures is not realistic.

    If you look at most companies net earnings and their free cashflows, they are actually pretty similar. Since it's impossible to predict how much capital expenditure a company would need in the future, to me net earnings is actually a pretty good estimate.

    Snowballinvestor

  • Report this Comment On April 08, 2010, at 7:43 AM, jpaa74 wrote:

    And as both Keynes and Buffett would say "I'd rather be approximately right, than precisely wrong."

    Using cashflow instead of free-cachflow (which you in reality you are doing, since this fictional company apparently doesn't have any capital expenditures (which is completely unrealistic). At least not now, as it's a startup company, but you can be sure it will some time in the future) would be "precisely wrong." Buffett has said this many times, not only in his letters to shareholders.

    Not mentioning this, and using the terminology "free-cashflow" in this way, for a company that doesn't have any capital expenditures, are both incorrect usage of this very important cashflow statement calculation, and to me it's completely misleading the readers.

    Just a fool's (lowercase f) two yens' worth.

    Snowballinvestor

  • Report this Comment On April 08, 2010, at 8:15 AM, jpaa74 wrote:

    And as both Keynes and Buffett would say "I'd rather be approximately right, than precisely wrong."

    Using cashflow instead of free-cachflow (which you in reality you are doing, since this fictional company apparently doesn't have any capital expenditures (which is completely unrealistic). At least not now, as it's a startup company, but you can be sure it will some time in the future) would be "precisely wrong." Buffett has said this many times, not only in his letters to shareholders.

    Not mentioning this, and using the terminology "free-cashflow" in this way, for a company that doesn't have any capital expenditures, are both incorrect usage of this very important cashflow statement calculation, and to me it's completely misleading the readers.

    Just a fool's (lowercase f) two yens' worth.

    Snowballinvestor

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