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Operating cash flow sounds great, right? Visions of greenbacks wending their way down the river for you to grab, like a bear fishing a salmon-filled stream. When all is said and done (and when is that, I ask?), OCF is the green available for management to use for good or for ill.
But is it real money? Not when the cash flow statement adds back alleged noncash charges that are really claims on future cash. What really burns my toast is adding back stock-based compensation. What, are stock options mere confetti to use at an investing party? Cakes and ale all around? Maybe for the recipients.
Stock-based comp is an IOU issued by the company to employees, and you, as an investor in the company, hold that IOU. It's your ownership that's going to be diluted when the stock-based comp -- the options -- are exercised. You will own less of the pie without selling a share. Diluted ownership is cash out of your pocket.
Of course it's cash, but it be pickpocketed today, tomorrow, or down the road! If employees didn't consider it an IOU, they wouldn't accept it as compensation. It's potential dilution, and it's not really available to run the business. The best practice would be to not add back stock-based comp to cash on the cash flow statement. Most of the time, all it does is give Popeye's Wimpy what he asked for: a hamburger today for which the company will gladly pay you on Tuesday.
A matter of scale
A little stock-based comp is not a big deal, of course. But when the IOUs are 50% or more of OCF, say, there's a real problem. What about 100% or more? The company produces no operating cash flow other than adding back its stock-based compensation. That's one big honking IOU.
We're going to count down the 10 worst offenders on the list over three days, going backward from No. 10 (bad) to No. 1 (the worst). Here are the first four:
Cash Flow Statement (all TTM, $ in millions)
No. 10: Zynga
No. 9: Alkermes
No. 8: Exelis
No. 7: Cepheid
|Stock Based Comp||$782||$31||$23||$22|
|Stock Based Comp as % of OCF||119%||183%||189%||235%|
|Earnings per Diluted Share||($0.99)||($0.63)||$1.72||($0.07)|
Source: S&P Capital IQ, data as of market close, Sept. 24, 2012. TTM = trailing 12 months.
No. 10: Zynga (Nasdaq: ZNGA ) , the virtual world game maker beholden to Facebook (Nasdaq: FB ) , is seriously -- not virtually -- on the ropes. You could say it gets a pass here, because management can't get out the door fast enough. They clearly don't believe their options are worth anything today or down the road.
The catch is that when those IOUs walk out the door, the company will have to issue those or larger IOUs to new hires walking in. At No. 10 on the list, with TTM stock-based comp at 119% of OCF, Zynga lives in Funny FarmVille, where it doesn't pay investor-players with cash.
No. 9: Alkermes (Nasdaq: ALKS ) is a biotech, an industry I fell for years ago when I lacked antibodies to it. Fortunately, my system has developed immunity. Part of that came from watching the fraud a decade ago at Elan, whose drug discovery unit Alkermes acquired a year ago. As far as generating any real operating cash? With TTM stock-based comp at 183% of OCF, Alkermes has no elan.
No. 8: Exelis (NYSE: XLS ) is an interesting company to investors who, as I do, love special situations. It's the government contractor spinoff from ITT, it has gobs of revenue -- $5 billion TTM -- and yet, where is the OCF? Worse, where is the OCF minus stock-based comp? Whereas at Zynga and Alkermes at least there are no earnings to mislead us, Exelis claims $1.72 per diluted share. All the more reason to read the cash flow statement. TTM stock-based comp at 189% of OCF at Exelis? The reverse of excellent.
No. 7: Cepheid (Nasdaq: CPHD ) is known for its biothreat detection technologies, something we certainly need (remember the anthrax scares of 2001?). Investors who had the savvy to buy on either side of the March 2009 crash low of $5.90 have made some serious money if they held on to the $30s and $40s the stock has held since April 2011. Not that the company has produced any profits, but hope springs eternal. Don't bounce on that spring. With the company's TTM stock-based comp at 235% of OCF, be freed of Cepheid.
Investors in these companies think their ownership floats on a river of greenbacks, but they are merely IOUs. Someone will collect, and while it may not be the Mob, your pockets will most definitely get picked.
Steer clear of these four, which are far below the deep waters where you'll find contrarian investors. Facebook may deign to improve Zynga's prospects. Alkermes may hit the drug approval lottery. Exelis may produce green from military camouflage and Cepheid from protection from biothreats. But there are better investments -- heck, there are even better speculations!
I'd recommend selling or avoiding these four stocks on the cash offender countdown. Join me tomorrow when the countdown continues with offenders No. 6, 5, and 4.