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Ever
wondered why investors prefer software plays over hardware stocks?
Several hardware firms-among them HCL Infosystems and Moser Baer-are
growing faster than some of the fancied software firms that everyone
who can spell 'returns' forever seems to be running after. Yet,
the PE ratios of these poor hardware stocks remain abysmal. Ever
wondered why? Well, the answer, or at least a large part of it,
lies on a single page in the annual report: the cash flow statement
(CFS). While the balance sheet and profit/loss account are supposed
to offer a snapshot financial summary of any business, the CFS enjoys
a special status as a much thumbed-to page.
If you haven't bothered about it so far, it's
about time you did. It explains a lot of the action on the markets.
Run through the CFSs of Infosys, Wipro and other such stars, and
you'll see ample cash surpluses even after the allocation of funds
for expansions. Infosys, for example, recorded cash from operations
of over Rs 645 crore last year, that too, after an outflow of over
Rs 162 crore towards expansion. Hardware company Moser Baer, in
contrast, is cash-strapped. It does not have sufficient internal
accruals to fund its expansion, and has been raising large amounts
of debt to engineer growth for itself.
Look at a wider set of data and you may well
conclude that the 'cost of staying in business', in Peter Drucker's
memorable phrase, is higher for hardware firms-which need to keep
ploughing cash into equipment and the like to beat obsolescence.
Software firms, in contrast, often have more cash than they know
what to do with. They are what CEOs everywhere want their companies
to be: cash-rich.
| Check Those Cash Flow Statements |
| Tata Motors:
It charged the development expenses incurred on its Indica project
to its cash reserves. This way, the mammoth sum of Rs 1,400
crore did not affect its p/l account, which continued to report
profits on all the other operations. Analysts are aware that
the automobile business involves large sums of investment in
platform creation and upgradation. So they expect to see the
CFS remain healthy enough to permit such expenditure in the
future-just to stay competitive.
Moser Baer: It has expanded
aggressively, reinvesting all its money. With equipment obsolescence
so high, cash needs to stay in the re-investment loop. So
despite its profitability (Rs 398.5 crore over the last three
years) and equity expansion (up from Rs 31 crore to Rs 48
crore), it also saw borrowings shoot up (from Rs 238 crore
to Rs 806 crore).
Mico: This cash-rich
auto ancillary has depreciated assets at rates considerably
higher than those under the Companies Act. In 2002, it reported
an operational cash flow of Rs 386 crore. After capital expenditure
of more than Rs 75 crore, it was left with a free cash flow
of Rs 195 crore. The company is now well-placed to expand
capacity with these accruals, unlike most other auto ancillaries.
Bharat Electronics: This
telecom and defence public sector company also has strong
cash flows. Last year, the cash on its books stood at Rs 328.6
crore. This is remarkable, since it reports an R&D expenditure
of close to Rs 90 crore (which is written off entirely in
the P/L account). The company has market capitalisation of
Rs 3,079 crore and debt of Rs 83 crore, making its valuation
cheap.
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Cash First, Tango Later
Free cash flow is literally what it sounds
like. It is nothing but the money that a company has taken in over
a given period, and has on its books after accounting for the expenses
that involve a monetary outflow. This last part requires some clarification.
Raw materials, office rents, staff salaries, media expenses, interest
and so on are payments that must be made. Depreciation, however,
is a notional charge (set aside for asset maintenance), a sum that's
deducted from the p/l account's profit figure-but involves no cash
outgo.
Cash can be generated by a company either through
its regular operations or through its investments and financial
activities. How it comes is not the issue. That it can be put to
good use, is. "The free cash flow parameter for investment
gives you a clear picture of the distributable cash the company
has," says Gurunath Mudlapur, Head of Research, Khandwala Securities.
To dividend-seeking shareholders, that's reason
enough to pay attention to the CFS. After all, it is from this money
that all dividends must flow. A cash-rich company can send fat cheques
in the mail. A cash-starved company cannot. As simple as that.
But that, of course, is not the only significance.
To Mudlapur, the CFS is "a very important part of any company
study that we do". It is, in other words, an analytical tool
to pick stocks, like any other.
Not to argue against such time-tested analytical
parameters as earnings per share (EPS) and-based on it-the PE ratio
(the price relative to earnings). There is no denying that these
metrics serve as vital inputs in stock selection decisions. The
challenge of investing, however, is not to go by the price-or even
relative-to-earnings price-but by an analysis of the company's future
prospects. And here, the CFS finds its not-so-obvious relevance.
"Free cash flow is of utmost importance while analysing companies,"
elaborates Motilal Oswal, Chairman and Managing Director, Motilal
Oswal Securities, "since one can gauge how much cash the company
has to re-deploy in the business so as to generate better returns
on capital in the future."
| Cash flows are a neat way to determine a business'
health |
Not just that, the CFS is a neat way to determine
the business' actual health. The reasoning: even if the company
grosses enough profits and has a decent marketshare, if it isn't
making enough cash for future deployment, all may not be hunky-dory.
Some analysts even see CFS as a more authentic picture of what's
happening at a company than the P/L account. This is because cash
records are not as easily manipulated, by and large. Yet-to-be-realised
revenues, for instance, cannot be part of the CFS. This sort of
thing can make the p/l account look good (all it means is an equivalent
sum in the 'receivables' portion of the balance sheet), but cannot
get past the stricter CFS norms.
Depreciation is the other strange part of the
P/L account that gives it its synthetic touch. Now, this is a sum
that's supposed to be deducted from the profit calculations as money
intended for the upkeep of machinery and the like. The rate at which
this is done, however, is government-mandated, and has no connection
with actual requirements. So if nothing is spent on actual asset
upkeep, this shows up only in the CFS-for it records every transaction
as it flows through the system. It also records expenses such as
principal repayments (on loans), which are real expenses that the
P/L account is blind to.
Making Real Sense
Like with every other parameter for analysis,
cash flow needs to be placed in the overall context of the business.
Different companies need cash for different purposes, and how the
money is deployed, really, is the real indicator of how strategically
sound the company is. "While some companies need the cash generated
to sustain the business, others don't need that all the money they
generate. One has to be careful of companies that invest the plentiful
cash in unrelated businesses," opines Oswal.
| At the end, it is a company's market strategy
that needs to be assessed |
At the end, it comes down to making a subjective
analysis of the company's strategic intent, and estimating the returns
thereof. Take ITC, for instance, a cash-rich company that tends
to invest its cash in sectors that it deems hot. As an investor,
you might prefer to have the cash returned to you by way of dividends,
but the company's management may have found an exciting business
opportunity in apparel that's expected to deliver good returns over
a longer time-frame. Your assessment of the company's cash deployment
decisions will influence your perception of how worthy the stock
is, and you will act accordingly.
The other thing to remember is that cash flow
is often the result of smart strategic moves made years ago, moves
that may have taken lots of money. So never dismiss a cash-starved
visionary company in investment mode. A market creation strategy,
for instance, is a long-term bet. Likewise, brand establishment,
the business of taking charge of a portion of the target consumer's
mindspace. At the end, it is the company's strategy-in the market
context-that needs to be assessed, and that is irreducible to a
set of easy metrics.
Just as taking a person's blood pressure is
no substitute for understanding his mind, so with CFS. Still, it
pays to keep a sharp watch on cash flow, the life force of a business.
In Warren Buffet's immortal words, "Profit is an opinion, cash
is fact."
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