FOOL ON THE HILL
Calculating Lucent's Cash Flow

To reveal cash flow by quarter, a number of adjustments to the cash flow statement are needed. Lucent provides a good case study of a company where cash flow has significantly trailed net income.

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By Whitney Tilson
November 28, 2000

When analyzing a company, it's critical to understand how much free cash flow it is earning from its operations. This is the excess cash the company is generating that can be taken out of the business for the benefit of shareholders via dividends, share repurchases, new investments, acquisitions and the like. Free cash flow is what you should care about most as an owner -- and as a shareholder, that's what you are: a fractional owner of a business.

After last week's column on the importance of the cash flow statement, many readers asked me to take an actual cash flow statement and walk them through it. You know what they say about being careful what you wish for. Fasten your seatbelt and prepare to be barraged with numbers. But don't worry if you're not a CPA -- all I'm doing is copying figures from SEC filings and doing some simple addition and subtraction.

I'm going to use Lucent (NYSE: LU) as my example because it's a well-known company and its stock is widely held. (At least it used to be. Since its peak less than a year ago, Lucent's stock has fallen 80% from $84.18 to $16.75, as of yesterday's close. That's more than $200 billion of shareholder wealth wiped out!) I also picked Lucent because it provides a good case study of a company where cash flow has significantly trailed net income.

Background
The cash flow statement has three components: operating activities, investing activities, and financing activities. With a few exceptions, discussed below, there aren't many mysteries about where different items go on the cash flow statement. Things related to a company's operations -- net income, changes in working capital and the like -- fall under operating activities. Capital expenditures, as well as buying and selling stocks, bonds and other companies, fall under investing activities. Paying dividends, as well as issuing or buying back the company's own debt and stock, fall under financing activities.

In general -- again, with a few exceptions -- the figures under operating activities tell you how much cash the business is generating. Financing and investing activities simply tell you how the company is allocating its operating cash flow (or financing its operating cash deficit). While a company can sometimes generate meaningful cash flow from its investing activities -- the extremely profitable venture capital investments by many high-tech companies like Intel are a good example -- the free cash flow generated by a company's operations are of paramount importance.

Lucent's cash-flow data
Here is Lucent's cash flow from operating activities from its 10-Q for Q2 00. I'm using this quarter as an example since Lucent's subsequent financial statements have been restated to account for the recent spinoff of Avaya (NYSE: AV), and cannot be compared precisely to those from earlier periods. (All figures in millions of dollars.)

Operating Activities                              Q1-Q2 00
Net income $2,004
Depreciation and amortization 1,046 Provision for uncollectibles 83 Tax benefit from stock options 909 Deferred income taxes 30 Purchased in-process research and development 11 Adjustment to conform pooled companies' fiscal years 11 Increase in accounts receivable (784) Increase in inventories and contracts in process (614) (Decrease) increase in accounts payable (386) Changes in other operating assets and liabilities (882) Other adjustments for noncash items -- net (960) Net cash provided by (used in) operating activities 468

Cash flow by quarter
The figures in cash flow statements are cumulative, so the numbers from Lucent presented above cover six months, not just the second quarter. What I really want to know is what happened in each of the first two quarters, so I can see what the trends are. To do this, one must have the cash flow statement from Lucent's 10-Q for Q1. Here's the data for each of the first two quarters for FY 00. The second column contains the figures presented above.

                                                   Q1 00   Q1-Q2 00 
Net income $1,250 2,004
Depreciation and amortization 505 1,046 Provision for uncollectibles 38 83 Tax benefit from stock options 456 909 Deferred income taxes 102 30 Purchased in-process research and development 0 11 Adjustment to conform pooled companies' fiscal years 11 11 Increase in accounts receivable 14 (784) Increase in inventories and contracts in process (309) (614) (Decrease) increase in accounts payable (719) (386) Changes in other operating assets and liabilities (654) (882) Other adjustments for noncash items -- net (570) (960) Net cash provided by (used in) operating activities 124 468

So now we can see what happened in each quarter, right? Wrong! There's one more step. Since these are cumulative numbers, to see the cash flows in Q2, we need to subtract the Q1 figures (column 1) from the cumulative numbers from Q1-Q2 (column 2). Doing this simple subtraction yields the following:

                                                  Q1 00   Q1-Q2 00
Net income $1,250 754
Depreciation and amortization 505 541 Provision for uncollectibles 38 45 Tax benefit from stock options 456 453 Deferred income taxes 102 (72) Purchased in-process research and development 0 11 Adjustment to conform pooled companies' fiscal years 11 0 Increase in accounts receivable 14 (798) Increase in inventories and contracts in process (309) (305) (Decrease) increase in accounts payable (719) 333 Changes in other operating assets and liabilities (654) (228) Other adjustments for noncash items -- net (570) (390) Net cash provided by (used in) operating activities 124 344

(Note: doing the same calculations for Q3 00 yields a significantly negative operating cash flow. I did not include a column for Q3, however, due to Lucent's financial restatements noted above. Lucent will report restated data for Q2 00 next year, so until then we cannot accurately determine Q3's cash flows. I think it is likely, however, that the general direction of the operating cash flow -- a significant turn for the worse in the quarter -- is correct. As a current or potential investor, not being able to see exactly what happened to cash flow in Q3 would concern me. I'll share some thoughts on how to handle a not-uncommon situation like this in a future column.)

Conclusion
So, now that we've calculated operating cash flow for each of the first two quarters, we're done, right? Unfortunately not. Free cash flow is not the same as net cash provided by operating activities. A few adjustments must be made, and I'll address those in next week's column.

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for the Motley Fool and other writings, click here.