24 CasH FLow Cash flow is the amount of money a company takes in asa result of doing ‘business. All companies take in cash, but some have to spend more than ‘others to get it. This isa critical difference that makes Philip Mortis such a wonderfully reliable investment, anda stel company such a shaky one Let’s say Pig Iron, Inc. sells out its entire inventory of ingots and ‘makes $100 million dollars. That’s good. Then again, Pig Iron, Inc. has to spend $80 million to keep the Furnaces up-to-date. That’s bad. The irs! year Pig Iron doesn’t spend $80 million on furnace improvements, it loses business to more efficient competitors, In cases where you have to spend ‘cash to make cash, you aren't going to get very far, Philip Morris doesn't have this problem, and neither does Pep Boys or McDonald's. That's why I prefer to invest in companies that don’t ‘depend on capital spending. The cash that comes in doesn’t have to ‘struggle against the cash that goes out. It's simply easier for Philip Moris to cam money than it is for Pig Iron, Inc. A lot of people use the cash flow numbers to evaluate stocks. For stance, a $20 stock with $2 per share in annual cashflow has a 10-t0-1 ratio, which is standard. A ten percent return on cash corresponds nicely ‘with the ten percent that one expects as a minimum reward for owning stocks long term. A $20 stock with a $4-per-share cash flow gives you a 20 percent return on cash, which is terrific. And if you find a $20 stock ‘with a sustainable $10-per-share cash flow, mortgage your house and buy all the shares you can find ‘There's no point getting bogged down in these calculations. But if cash flow is ever mentioned as a reason you're supposed to buy a stock, make sure that it’s free cash flow that they're talking about. Free cash flow is What's left over after the normal capital spending is taken out. It's the ‘cash you've taken in that you don’t have to spend. Pig Iron, Inc. will have Tot less free cash flow than Philip Morris. Occasionally I find a company that has modest earings and yet is @ ‘reat investment because of the free cash flow. Usually it’s a company ‘with a huge depreciation allowance for old equipment that doesn't need to be replaced in the immediate future. The company continues to enjoy the tax breaks (the depreciation on equipment is tax deductible) as it spends as litle as possible to modernize and renovate. SOME FAMOUS NUMBERS as Coastal Corporation is « good illustration of the virtues of free cash low. By all the normal measures the company was fairly priced at $20 a are. Its earings of $2.50 a share gave ita p/e of 8, which was standard for a gas producer and a diversified pipeline company at the time. But ath this humdrum opportunity, something wonderful was going on, ‘Coastal had borrowed $2.45 billion to acquire a major pipeline company, ‘American Natural Resources. The beauty of the pipeline was that they didn’t have to spend much to maintain it. A pipeline, afer all, doesn’t {demand much attention. Mostly it just sits there. Maybe they'd dig down to patch a few holes, but otherwise they'd leave it alone in the ground ‘Meanwhile they'd depreciate it. Coastal had $10-11 per share in total cash flow in a depressed gas environment, and $7 was left over after capital spending, That $7 a share was free cash flow. On the books this company could earn nothing for the next ten years, and shareholders would get the benefit of the $7-2-share ‘annual influx, resulting in a $70 retum on their $20 investment, This stock had great upside potential on cash flow alone. . Dedicated asset buyers look for this situation; @ mundane company ‘going nowhere, a lot of free cash flow, and owners who area’t trying 10 build up the business. It might be 2 leasing company with a bunch of railroad containers that have a 12-year life. All the company wants to do is contract the old container business and squeeze as much cash out of it 1s possible. In the upcoming decade, management will shrink the plant, phase out the containers, and pile up cash. From a $10 million operation, they might be able to generate $40 million this way. (It wouldn't work in the computer business, because the prices drop so fast that old inventory doesn’t hold its value long enough for anybody to squeeze anything out of it.) INveNToRIES There’s a detailed note on inventories in the section called “manage- iments discussion of earnings” in the annual report. I always check to see if inventories are piling up. With a manufacturer or a retailer, an inventory buildup is usually a bad sign. When inventories grow faster sales, it's a red flag