2 Things You Can Learn From HP About Strong Cash Flow

As the trading days of the current year dwindle away, Hewlett-Packard (HPQ 0.69%) shareholders are left trying to understand the ramifications of 2012's massive writedowns of goodwill and intangible assets. If you include this year's amortization of intangible assets, HP incurred close to $20 billion of expense against goodwill and intangible assets in its four most recent quarters.

Most spectacularly, the company wiped $8.8 billion off its balance sheet when it devalued the goodwill and intangible assets associated with last year's purchase of Autonomy, which the company labeled a "non-cash goodwill and intangible asset impairment charge" in its fourth quarter 2012 earnings release.In the last earnings call of the fiscal year (roughly three weeks ago), CEO Meg Whitman took some time to get around to a discussion of the Autonomy fiasco. She first crowed about the $10.6 billion of operating cash flow HP generated during the fiscal year: "To put that number in context, $10.6 billion is more than some of the most respected companies in the world, such as Coca-Cola (KO 2.14%), Disney (DIS 0.16%), FedEx (FDX 1.37%), McDonald's (MCD 0.37%) and Visa (V -0.59%), generated in operating cash flow in their most recent fiscal years."

For those of us who thought HP was struggling, this was quite a surprising statement. One can imagine that it also struck a dissonant note with the analysts on the call. There are two lessons about cash flow we can learn from HP in 2012, and the first comes directly from Whitman's statement.

Lesson No. 1: Operating cash flow should be efficient
HP's 2012 operating cash flow looks good on paper because it carries heft in terms of absolute dollars. How much revenue did HP need to generate to create that cash flow? $40 billion? $60 billion? More like $120 billion. How did this stand in relation to the companies Whitman compared HP to? The following is a table based on data from the most recent fiscal year-ends of the corporations Whitman refers to:

Source: YCharts. Figures in billions.

HP chose to compares itself against some seriously blue blood. And at first glance, it seems to come armed with credentials. In terms of revenue, HP is over 250% bigger than its nearest neighbor (Coke) and over 1,100% bigger than Visa. However, using a metric known as the operating-cash-flow-to-sales ratio, we can set apples to apples. This ratio simply exhibits operating cash flow as a percentage of sales. It shows how efficient a company is at generating cash flow from its revenue.

Source: YCharts. Dollar figures in billions.

The operating-cash-flow-to-sales ratio tells us that of the above companies, HP was the least efficient at turning its top line into operating cash. In fact, all but FedEx were at least twice as efficient as HP in turning sales into operating cash flow.Notice that on its gargantuan revenue, HP lost $12.6 billion. All five comparison companies are profitable, and in most cases, strongly so. And they are all highly efficient cash-generating machines. During its most recent fiscal year, McDonald's produced 70% of the operating cash that HP did, on only about one-fifth of the revenue. Coke created roundly as much cash flow as HP from one-third the amount of HP's sales. Visa blew past all companies, with an astounding $5 billion generated from just $10.4 billion in revenues.

There is a reason that the organizations Whitman named are marquee investments, envied for their ability to turn consistent profits while realizing generous operating cash flow year after year. Part of HP's current year cash flow derived from the severance of 11,500 employees, out of a planned reduction of 29,000. Unfortunately, it's been years since HP could be mentioned in the same breath as these market leaders. One cringes to see HP reduced to trying to find a bright spot in its earnings reports by sharing the stage with the likes of Disney and Coke via semantic trickery.

Lesson No. 2: "Non-cash" writedowns of goodwill are never really non-cash
It's tempting to see HP's 2012 fixing of its balance sheet simply as a much-needed recognition of inflated value in its goodwill and intangible assets accounts. The company is technically correct to call the adjustments "non-cash." That's because due to a timing difference, there is no cash involved -- this year.

Looking back at financials from 2011, HP garnered $12.6 billion of operating cash flow from its revenue. Out of this juice from operations, approximately $10.5 billion of cash went directly to acquisitions, and the bulk of that cash paid for the $11 billion purchase of Autonomy. This year's "non-cash" charge of $8.8 billion related to Autonomy isn't some vague, amorphous accounting number with no relation to present reality. While indeed it signifies an over-payment for an acquisition last year, it also represents $8.8 billion of cash which was sitting in HP's pocket just 15 months ago, and which has been torched in one of the most spectacular conflagrations we are likely to see in our investing lifetimes.

Parsing future numbers
It turns out that there is much we can learn from HP about cash flow, but the tale is a cautionary one. Potential investors would do well to stand by and monitor HP's statement of cash flows over the next several quarters: if the company's fortunes improve, cash is one of the first places where positive trends will emerge. Stay skeptical of this management team's spin; read and analyze the numbers for yourself.