FOOL ON THE HILL
Lucent's Free Cash Flow

The income statement is useful, but Whitney Tilson prefers the cash flow statement when trying to gauge a company's financial power. In this article, he continues his discussion of how to figure a company's free cash flow, using Lucent as an example.

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By Whitney Tilson
December 12, 2000

Revenues (to some extent) and net income (to an increasingly large extent in this market) are opinions, but cash is a fact. That's why I spend so much time focusing on companies' cash flow statements. The key number I look for is free cash flow, which is the excess cash the company is generating from its operations that can be taken out of the business for the benefit of shareholders via dividends, share repurchases, new investments, acquisitions, and the like. To calculate this figure, a few adjustments must be made to the cash flow from operating activities shown on the cash flow statement.

In my column two weeks ago, I showed how to calculate Lucent's (NYSE: LU) cash flow from operating activities for each of the first two quarters of FY '00. Now let's make the necessary adjustments to arrive at free cash flow. (Note that if you put 10 analysts in a room, gave them identical financial statements, and told them to calculate free cash flow, you might get 10 different answers. There's a lot of judgment involved, so you shouldn't necessarily take my approach as gospel.)

Adjusting for taxes
There are often items in the cash flow statement under operating activities that have nothing to do with a company's actual operations. Do you think the tax deduction a company gets when its employees exercise stock options should be counted as cash from operating activities? I don't, so while new SEC regulations require companies to report this under Operating Activities, I always move "Tax benefits from stock options" to Financing Activities whenever I see it under Operating Activities. (Unfortunately, many companies do not break out this line item separately, so you can't make the adjustment. In addition, some companies continue to report this figure under Financing Activities.)

Similarly, I don't believe that changes in "Deferred income taxes" have anything to do with operations either, so I move this line item as well.

Adjusting for cap ex
The most difficult adjustment is for capital expenditures, which reflect spending to maintain and build property, plant and equipment. (For some companies, other items such as "Software development costs" or "Purchase of software licenses" would also be included in cap ex). These expenses are depreciated over many years, but since depreciation reflects cap ex in the past, it's not a cash cost today. Thus, it is added back on the cash flow statement under "Depreciation and amortization." (Depreciation is for tangible assets; amortization is for intangible assets such as goodwill.) But to balance adding back the non-cash cost of depreciation, you must subtract the real cash cost of cap ex, which appears under Investing Activities in the cash flow statement.

This is easier said than done, however. The goal is to subtract what a company must spend to maintain its existing operations and market position. But what if a company decides to invest in a new line of business and makes big capital expenditures -- funded from its free cash flow -- to do so? This growth cap ex is not a requirement of the business, as the cash could have been returned to shareholders, but management determines that it can generate a high rate of return from this additional cap ex. In this case, one must estimate how much of a company's cap ex is for maintenance -- and subtract this amount to arrive at free cash flow -- and how much is for growth, which should not be subtracted when calculating free cash flow.

I don't have the space in this column to give this subject the treatment it deserves, so I have posted further thoughts on the Fool on the Hill discussion board. For simplicity's sake -- and to be conservative -- I generally deduct all cap ex to arrive at free cash flow unless I have a concrete reason to do otherwise.

Other thoughts on cash flow
Depending on the company, other adjustments to free cash flow may be warranted. For example, there may be line items beyond those I've mentioned that appear under Operating Activities in some companies' cash flow statements that you feel don't truly relate to operations. You may also want to adjust for unusual or one-time gains or charges. For example, American Power Conversion (Nasdaq: APCC) in Q2 '00 had a one-time litigation payment of $47.2 million, which I excluded from my calculations of operating cash flow. I'm afraid there are few hard rules -- you just have to use your judgment.

Lucent's adjusted free cash flow
We can see how important these adjustments are in the case of Lucent, as modestly positive operating cash flow was in reality significantly negative free cash flow, due mainly to cap ex and huge tax benefits from employees exercising stock options ($909 million in the first half of FY '00 vs. only $394 million for the entire previous year).

Incidentally, I always worry when I see a big jump in this number, as it can -- though it doesn't always -- mean employees see storm clouds on the horizon (or simply believe the stock is overvalued) and are consequently exercising their stock options and selling. I have posted further thoughts on this topic and how it relates to Lucent on the Fool on the Hill discussion board. 

Here are Lucent's figures for each of the first two quarters of FY '00 (all of these figures are taken from my column two weeks ago except net cap ex):

                                                   Q1 '00   Q2 '00
Net cash provided by operating activities             124      344
Adjustment for tax benefit from stock options        (456)    (453)
Adjustment for deferred income taxes                 (102)      72
Adjustment for net cap ex                            (585)    (634)
Free cash flow                                     (1,019)    (671)

(Note: doing the same calculations for Q3 00 yields even greater negative operating cash flow. I did not include a column for Q3, however, because of Lucent's financial restatements due to its spin off of Avaya. In next week's column, I'll share some data on what happened to Lucent's cash flow in Q3 and how to handle not-uncommon situations in which there is imperfect data.)

Lucent provides an excellent case study of how important it is to adjust operating cash flow to determine free cash flow. The former was $468 million in the first half of this fiscal year, while the latter was more than $2 billion lower at negative $1.69 billion. 

Now that we have the numbers we need to begin our analysis of Lucent's cash flows -- I haven't done any analyses yet -- I'll stop and let you think about what these numbers mean. Ask yourself: Why have Lucent's cash flows been so weak? What items on the cash flow statement are driving this? (See my column two weeks ago for a detailed look at Lucent's entire cash flow statement.) How has Lucent been funding its negative free cash flows? At what point might analysts and investors have realized that something was seriously amiss? I'll share some of my thoughts regarding these questions next week.

Conclusion
Keep in mind that free cash flow is not the only way -- and often not even the best way -- to evaluate and value a business. A company might choose a strategy that results in declining or negative cash flows in the short run, but creates immense shareholder value in the long run. However, understanding and being able to calculate free cash flow is a critical tool that every investor should possess.

Finally, don't let all these numbers intimidate you. This isn't calculus -- it's copying data and then doing some basic addition and subtraction, nothing more. Just take your time, since it's easy to make a careless mistake.

-- 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.