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Free Cash Flow Isn't Always Free

By Timothy Green - Updated Feb 22, 2017 at 2:50PM

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Free cash flow can be extremely useful, but when it comes to some fast-growing companies, investors beware.

Image source: Pexels.

Cash is king, and when it comes to investing, free cash flow is often touted as a far superior measure of profitability than earnings. Earnings can be manipulated and managed and can include all sorts of one-time, non-cash charges that may have little to do with the true profitability of a company. Free cash flow, which simply takes the cash generated by a company's operations and subtracts capital expenditures, represents the cold, hard cash that a company is churning out.

In many cases, free cash flow does offer a better picture of a company's profitability. But when there's a large discrepancy between earnings and free cash flow, it's always a good idea for investors to understand the cause. A few examples of businesses with large gaps between earnings and free cash flow are fast-growing enterprise software and security companies such as Splunk (SPLK 2.08%), Tableau Software (DATA), and FireEye (MNDT 0.88%).

Company

2015 GAAP Net Income

2015 Free Cash Flow

Splunk

($279 million)

$104 million

Tableau Software

($84 million)

$92 million

FireEye

($539 million)

($18 million)

Data source: Morningstar. 

All three of these companies are wildly unprofitable on a GAAP basis. Attempting to value the stocks based on earnings is impossible, because there are none. Two of the three, Splunk and Tableau, generated positive free cash flow during 2015, and FireEye's small free cash flow loss looks a lot better than its massive net loss. Stock-based compensation, which is counted as a cost under GAAP accounting but added back when calculating free cash flow, explains part of these discrepancies. But there's another item -- growth in deferred revenue -- that further boosts the free cash flow.

All three companies sell subscriptions, or otherwise receive cash in advance, for services rendered over some period of time, typically a month or a year. This cash is booked as deferred revenue, which is a liability on the balance sheet, and recognized as revenue over the course of the subscription. If the company is growing, which all three are, a growing deferred revenue balance acts as a source of cash, boosting the free cash flow.

Company

2015 Change in Deferred Revenue

FCF Minus Change in Deferred Revenue

Splunk

$145 million

($41 million)

Tableau Software

$69 million

$23 million

FireEye

$174 million

($192 million)

Data source: Morningstar. 

It's tempting to simply slap a multiple on these free cash flow numbers in order to justify the stock prices. In fact, an analyst from BMO recently did just that, stating that his price target of $55 for Splunk put the enterprise value at 26 times expected free cash flow in fiscal 2018. That multiple is high, but not outrageous for a company growing revenue by nearly 50% each year.

However, when most or all of the free cash flow is due to a growing deferred revenue balance, using it to value a company makes absolutely no sense. Here's why.

Losing money, making cash
Let's imagine I start one of these subscription box businesses, like Graze, Birchbox, or BarkBox, that seem to be popping up these days. My service costs $100 per year for one box each month, and I bill annually. Unfortunately, it costs me $10 to fill and ship each box. I'm guaranteed to post a loss. I press on anyway. During the first year, I add 1,000 subscribers to my service each month. Assuming I have no other costs, and require no capital expenditures, here are my financial statements for year one.

Source: Author's calculations.

Net income is negative, as was expected, and my company's book value is negative because of obligations to deliver boxes that cost more than I'm taking in. But the cash flow statement tells a different story. Free cash flow is positive, exactly equal to the cash on the balance sheet.

This ridiculous business is indeed generating cash, but it's doing so by "borrowing" money from its customers, taking payment for services in advance. This is all well and good, as long as the number of subscribers keeps growing quickly enough. But once growth starts to slow, this business will quickly run out of cash and be unable to fulfill its obligations.

There are two things that should be clear from this example. First, the free cash flow being generated is not real, in the sense that I can't pull it out of the business without jeopardizing the company. That cash, and then some, is owed to the subscribers. In this case, the free cash flow is in no sense a measure of profitability.

Second, trying to value this company based on free cash flow is absurd. As growth slows, the free cash flow disappears.

This is an extreme example, but it demonstrates why valuing fast-growing companies like Splunk, Tableau, and FireEye based on free cash flow doesn't make any sense. Backing out the deferred revenue growth, Splunk is burning cash, Tableau's free cash flow drops by 75%, and FireEye goes from almost break-even to not even close.

Free cash flow is not always the best number to represent profitability, and in some cases it can actually be the worst number to represent profitability. Taking it at face value, slapping a multiple on it, and calling it a day is a great way to dramatically overpay for a stock. 

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Stocks Mentioned

Splunk Inc. Stock Quote
Splunk Inc.
SPLK
$98.90 (2.08%) $2.02
Tableau Software, Inc. Stock Quote
Tableau Software, Inc.
DATA
Mandiant, Inc. Stock Quote
Mandiant, Inc.
MNDT
$21.90 (0.88%) $0.19

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