Warren Buffett makes no secret about what he is looking for in a company: the ability to generate cash by the wheelbarrow load. Here are just a couple quotes from his letters to shareholders over the years.
"[O]utstanding businesses by definition generate large amounts of excess cash." -- 1984.
"However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash." -- 1980.
If Buffett pays that much attention to generating cash, then it's certainly something that you as an investor should understand as well. Let's look at offshore rig operator Transocean (NYSE:RIG) and see if it's got the cash-churning power to impress an investor like Buffett.
Cash flow in context
A cash flow statement is kind of like the Playboy Magazine of financial statements: it's way more revealing about what's going on at a company than the balance sheet or the income statement. That's because it can't be manipulated with accounting tricks like the income statement can. Also, we all might not be knowledgeable about the intricacies of depreciation and amortization, but we all know what cash looks like.
There are three key things about analyzing cash flow and a company's stock based on cash flow: quality, efficiency, and value. Here's how Transocean stacks up.
Not all cash flow is created equal. Free cash flow can come from a company's continuing operations or the sale of assets. Obviously, cash from continuing operations is best because it has no strings attached. A quick look at the quality of a company's cash flow involves dividing its operational cash flow by capital expenditures. At a minimum we would like to see 100% operational cash coverage, but the bigger the better. Also, be sure to look at this number on an annualized basis to avoid being misled affected by quarterly discrepancies.
|Company||Operational Cash Coverage of Capital Expenditures|
|Diamond Offshore Drilling||74.1%|
As you can see, Transocean and most of its offshore rig peers haven't generated much free cash lately. This is largely because almost all of them embarked on significant fleet expansion projects a few years ago and still have many of these new rigs under construction. To finance these projects, many have taken on debt or sold or spun off some of their rigs. This could be a red flag for owners of these companies, but it might be worth watching how these numbers develop as those fleet expansion projects finish up.
Another important indicator is how efficiently the company can convert revenue to cash flow. This can be measured in two ways: unlevered and levered free cash flow margins. These metrics are quite similar --free cash flow divided by total revenue -- but there is one small difference. Unlevered free cash flow margin is calculated before debt payments, so it gives a hint of how the company's assets perform at generating cash. Levered free cash flow includes debt payments, so it more accurately describes the actual performance you see as a shareholder. It's important to know both, because the unlevered free cash flow margin can show the potential of the company as it unshackles itself from debt.
|Company||Unlevered Free Cash Flow Margin||Levered Free Cash Flow Margin|
|Diamond Offshore Drilling||(15%)||(15.9%)|
Well, that looks ugly. However, if we look back up at the operational cash flow coverage for capital expenditures it makes sense that free cash flow is negative right now. As with cash flow quality, Transocean and everyone else in the space will need to take a mulligan on this one until those rig orders are cleared up.
All of the measures above are indicative of the company's quality, but the equation for value includes more than just quality; price needs to be considered as well. The standard bearer for measuring the price component of the equation is the price to earnings ratio. Remember that earnings numbers can be dressed up and made to look pretty by accountants. Another way to look at a company, though, is by checking the price to levered free cash flow ratio. This is the total market capitalization of the company divided by that same levered free cash flow from above. A way of thinking about this is the price you pay for $1 of free cash flow generated annually.
I could show you the table with the price to levered free cash flow ratio for Transocean and its peers, but it's easier to say that none of them have a price to free cash flow ratio right now because free cash flow is negative. Just as you can't have a negative price to earnings ratio, you also can't have a negative price to cash flow ratio.
What a Fool believes
Trying to evaluate Transocean and its peers on a cash flow basis feels an awful lot like picking through the trash: the numbers stink. Considering that they are all in the middle of a major rig building phase, it's probably better to evaluate these companies in another way, such as assets or returns. Based on these numbers, though, it seems like Warren Buffett would stay away from Transocean and its rivals in the rig industry.
The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.