Free Cash Flow

Three questions to ask in uncertain times

Published on:
April 11, 2020
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There is no better time to reflect on portfolio holdings than today [1]. This week's essay is about the three questions you should ask as you spring clean.

The first question is whether the business will survive for the next few years. The second question is whether the company generates free cash flow. And how essential is the business is the third question. To illustrate the concepts, I will use examples from my portfolio. 

The 3- to 5-year survivability 

It is going to be challenging to refinance debt and to raise equity. And any business that relies on capital markets to fund its on-going business operations is going to face a large number of rejections. 

A friend of mine, a founder of a start-up company, told me she is now spending the bulk of her time in understanding  (1) how long can her business run until cash reserves are depleted, and (2) what can she do today to better prepare for that day. 

The same mindset is applicable to portfolio holdings. If you own a company that has a sizeable maturing debt over the next year or two, you should reflect on how likely will it be able to refinance the mortgage, at what terms, and how it will affect operations.

Here is a summary of what I learned about some of the stocks I bought in 2019: 

Graftech reports $1,812 million in long term debt. And on page 80 of the 2019 annual report, you can read that the debt facility will mature on February 12, 2025. In other words, Graftech has five years of breathing room. 

Teva Pharmaceutical reports on $24,562 million of long term debt. The company will have to pay down $5,263 million, an average of $1,023 million each year until 2025. But I don't foresee that an issue as the company has $1,975 million in cash on hand and $5,676 million in receivables.

Micron reports on long term debt of $4,541 million and holds $7,152 million in cash and $3,195 in receivables. And on page 58 of the 2019 annual report, we read that most of Micron's debt is due after 2025. 

Visit my essays on Graftech and Teva Pharmaceutical

Two companies that will face challenging times ahead are Seritage Growth and Gulfport Energy. Seritage Growth Properties reports on $1,598 million in fixed debt with Berkshire Hathaway Life Insurance as the lender. The loan matures July 31, 2023. Gulfport energy reports on $1,978 million in long term debt. Where $329 million in due 2023 and $603 million is due in 2024, and $529 million is due in 2025.

In the case of Gulport, current cash and receivables will not cover the pending debt obligations. So either Gulfport will sell assets (it reports on $10,595 million of oil and natural gas properties), or somehow it will manage to refinance the debt miraculously. 

Visit my essays on Seritage Growth and Gulfport Energy

Free cash flow 

Investors usually accept negative free cash flow when the business promises growth. But future growth always comes with a present cost: either the right side of the balance sheet increases or current shareholders will be diluted. 

Consider Ormat Tech (Ora on Nyse) as an example. The Israeli-based, geothermal company reported negative cash flows between 2015 and 2019 [2]. So, the company issued more debt and diluted shareholders. (Long term debt in 2015 was $856 million and increased to $1,035 in 2019. Common shares were 49 million in 2015 and went up to 51 million in 2019.) 

Yet positive, free cash flow is one of the most useful antidotes to keep a healthy balance sheet. Positive cash flow allows management to remain independent of capital market woes and fury and to grow the business without niceties to lenders. 

There are two ways to find free cash flow. The CFA Institute defines free cash flow [3] as net income plus non-cash charges plus interest minus capital expenditures minus working capital expenditures 

FCFF = NI + NCC + Int(1-T) -FCinv - WCinv  

Another approach is to use cash flows from operations. To find the free cash flow, you take the cash flow from operations, add back interest less capital expenditures. 

FCFF = CFO + Int(1-T) -FCinv

Consider Whirpool as an example. On page 37 of its 2019 annual report to shareholders, management reports on $1,230 in cash provided by operating activities less $532 in capital expenditures. It reports on $912 million in free cash flow

If management does not report on free cash flow, it is because there isn't any.  

Is the business essential? 

If you can't reasonably estimate today where the business will be in ten years, you shouldn't invest in it. The 10-year outlook is important because of two reasons, a pragmatic one and a psychological one. 

The pragmatic reason is that if you can't estimate the business outlook, you can't estimate the earnings. And if you can't estimate the earnings, how could you determine the value of the business? 

The second reason is psychological. When capital markets freeze, when investors are selling, and the quoted price of your stocks drops, understanding the future of the business will allow you to better weather the storm. A few examples will explain this statement. 

I bought Carriage Services in January 2019 for about $20. The stock went up to $28 by year-end 2019 and now trades at $15, a 46% drop from the peak, and a 25% discount from my cost basis. But instead of selling the position, I remind myself that the business outlook for Carriage, who is a funeral home company, is invariably the same. Just because markets are discounting the business does not mean the business fundamentals deteriorated. 

Another example is Teva Pharmaceutical. Two months ago, I explained Teva's tailwinds: 

"Other trends in global healthcare include an aging population, chronic diseases, and growing pressures from governments to provide affordable healthcare solutions." 

I don't believe the tailwinds changed. 

But I have made mistakes by overlooking the 10-year outlook criteria. For example, I bought Weight Watchers in March of last year. I didn't have the slightest idea then, and I don't know how the business will look like in a decade from today. This business falls in the "too complicated" bucket. 

Visit my essays on Carriage Services, Teva Pharmaceutical, Weight Watchers, and L Brands

Another mistake I made was buying L Brands in late 2018. In hindsight, there is no way to predict our clothing preferences in a decade (let alone next season.) Not only is it difficult to correctly predict what color will be fashionable next season. 

FOOTNOTES: [1] As we are ordered to stay home. [2] the 3-year average earnings per share were $2.23, and the 3-year average capital expenditures per share were $4.26. [3] Taken from understanding cash flow statements, chapter 25 level 1.

Why I bought a few CLUB shares

Published on:
September 22, 2019
Last Update:

"Gyms need their members not to come, but they can't just lock the doors," notes Caitlin Kenney in Planet Money, NPR's economics podcast. "So they have to rely on consumer psychology to get you excited enough that you'll sign up for a gym membership, but not so excited that you'll get up an hour early to do some crunches before work."

Indeed, ask any physical trainers and Yogis: owning a fitness center is a straight forward business model. You lease 2,000 to 20,000 SF space, buy or lease some fitness equipment and get as many customers signed up. 

The fitness industry's rule of thumb is that if you can sign up 20 times the capacity of the studio, you will be in good shape [1]. 

But it's a tough business. First, not unlike the hotel business, customers' expectations and standards increase with time. Hotel guests now demand flat-screen TVs and a queen-sized bed at a minimum.  And gym members expect Peloton machines and shiny, new barbells. In short, you always reinvest cash in the business.

The fitness business is tough. Owners have to reinvest earnings and customers are unwilling to pay more for the upgrades.

Another drawback is that the operating costs - specifically, lease payments and labor wages - increase over time. And while these expenses rise, customers are unwilling to pay more than roughly $40 a month.

If gym owners increase prices, there are plenty of alternatives. People can exercise outside at no cost; they can subscribe to an app [2] for a fraction of the cost, or they may go on a diet and give up on physical exercise.

Buying a few CLUB shares      

While the fitness business is competitive with little barriers to entry [3], I bought a few shares in Town Sports International Holdings (CLUB on Nasdaq), a fitness company with a pygmy market capitalization of $54 million or about $2 per share.

I calculated the 2018 free cash flow to be $15.1 million or $0.57 per share and the 2017 free cash flow to be $18.9 million or $0.73 per share. In other words, if the last two years serve as a proxy, Town Sports' cash flow will pay back investors their original investment in less than four years.

Town Sports International: income statement snapshot
Snapshot of CLUB's income statement

There are a few publicly-traded fitness companies. A glance at Planet Fitness shows that buying Town Sports is for the bargain hunter.

In 2018, Planet Fitness traded as low as $29 and as high as $57. The company generated pre-tax earnings of $131.8 million, or $1.51 per share, which translates to price to pre-tax earnings ratio range of 19 times to 38 times.

Compare that to Town Sports, which earned $38.6 million in pre-tax earnings, or $1.45 per share. CLUB's stock traded as low as $5 and as high as $15 - a range of 10 times to 3 times the price to pre-tax earnings. Today, at about $2 per share, CLUB is trading at 1.4 times the 2018 earnings.

Trading at four times the enterprise value to free cash flow, Town Sports is for the bargain- hunters.

Where's the catch? 

CLUB's bargain stock price comes alongside serious red flags. The list of concerns includes:
(1) The company's CFO, Carolyn Spatafora, has been selling the stock. She sold about 96 thousand shares this year [4], over 60% of her vested interest in the company.
(2) The company's debt matures in August 2020. Read: if the U.S. economy is in recession in a year, it is questionable whether lenders will finance the operations.
(3) Two-thirds of CLUB's gym members are on a month-to-month basis. To me, this shows that there is hardly any brand loyalty and that customers are unwilling to commit.
(4) Management decided this year to hide critical information from the financial statements. For many investors, that act alone would deter investment. I hope that management action is because it would like to hide information from competitors.

Town Sports International debt to assets ratio is high
CLUB's alarming debt to assets ratio

But that is probably wishful thinking. Michael Shearn, who wrote the excellent The Investment Checklist: The Art of In-Depth Research would be appalled by my action. In his words: 

I have learned that if the strategy of the business is based more on hiding information from competitors rather than outperforming competitors, it is far less likely that the business will have a long term success.

Careful readers of CLUB's prior annual reports would detect a deterioration in key metrics. So, it is little surprise why management would want to hide them.

A few examples: in 2013, the average revenue per member was $78 per month. As of 2017, the metric dropped by 24%, to $59. In 2013, the annual attrition [5] was 41.9%, while in 2017, it was 47%.

Finally, in 2013, the revenue per weighted average club was $2.97 million. The revenue dropped to 11% in 2017 to $2.64 million.

Management decided this year to hide key information from readers of its financial statements. The action alone deters investment.

The remedies

Patrick Walsh, who Forbes Magazine describes as a "Warren Buffett enthusiast," writes to CLUB's shareholders that "patience is a minor form of despair, disguised as a virtue."

I take a less cynical approach and estimate that there are few things good happening now and a few things worthwhile to be patient for.

First, Walsh is fiercely buying the stock. He bought 643 thousand shares this year at a weighted cost of $2.5. This amount was added to his already 3.1 million shares, which represent about 14% of the common stock outstanding.

Second, managing gym clubs does not require sophistication or expertise. I believe it is a matter of time before financial results return to a net profit margin of 10%, with Walsh in leadership or without him.


A year ago, the sports center across the street from my office, increased by almost two-fold the monthly membership rate, from $32 to $57. Infuriated by the price increase, I said to Jillian, the members' relationship manager at the time, that I would take my business elsewhere.

I never did. The convenience of having the JCC across the street from my office, and the community of people I became friends with, far outweighed the price hike. It is my hope members of CLUB fitness centers have the same experience.   

FOOTNOTES: [1] No pun intended. [2] I recently downloaded XPT Life, an app designed by legendary waterman Laird Hamilton. [3] Barriers to entry are the obstacles that make it difficult to enter a given market. [4] If the shares are, indeed, such a bargain at $2, would she not have preferred to hold them?[5] Page 37 in the 2017 10-k report notes that annual attrition is total member losses for the year divided by the average monthly member count. Read: the higher the ratio, the worse it is.

Free Cash Flow Is Superior to EBITDA

Published on:
July 28, 2018
Last Update:

It took over ten years for people to get used to the idea of an automatic elevator; over 30 years to feel okay about eating shrimp [1]; and 20 years passed before passive investing, tracking the movement of an index such as S&P 500, was accepted [2].

This essay reflects whether it is time that we change how we look at the
operating performance of a business.

What's wrong with EBITDA

Earnings before interest, tax, depreciation and amortization (EBITDA) allows management to boast on theoretical, imaginative financial results. It is similar to a marathon runner explaining that he or she finished a marathon in less than four hours, if only they had not taken a 25-minute rest in the second hour. 

EBITDA figures are always higher than free cash flow numbers and result in a higher valuation for the company and a greater ability to take on debt. It should be of little surprise that it was popular in the ‘80s - the era of leveraged buyouts.

Net earnings are suspicious too. This is because management is acutely aware that Mr. Market [3] watches net earnings like a hawk. In addition, net earnings are subjective because expenses such as depreciation, goodwill and amortization  are dependent on management decisions. As a result, it is hard to compare the net earnings of one company to the next. 

EBITDA numbers are higher than net earnings. Little surprise they are popular in leverage buyouts.

While net earnings are influenced by management’ decisions, reported book value measurement is dependent on the accounting convention. And while intentions may be innocent for both the accountants and management, the reported book value often results in nonsensical numbers for the investor.

Consider goodwill as an example. This asset category represents the excess purchase price above the net fair value of the company acquired. While it is considered an asset, the chances the reported value will be realized is as real as the chances that another purchaser will price the goodwill account as reported on the balance sheet. That rarely happens.


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Free cash flow definition

The classic definition of free cash flow is cash flow from operations less capital expenditures. Investopedia.com provides guidance how to calculate free cash flow. With free cash flow, it is easier to compare the profitability of a real estate firm to a company that sells dairy products.

Both companies collect and spend cash and both companies require cash to maintain their operations. A real estate company will repaint the buildings it owns and a dairy products company will upgrade the manufacturing plant. For the investor, in both scenarios, there is really only one concern: how much cash will be left at the end of the day.

Free cash flow provides the true picture of how a business is doing. Free cash flow aims to answer one question: how much cash is left to the owner of the business after all required expenses and taxes have been paid.

If we can estimate how much cash flow a business will generate in the future, we can decide whether the current price of the stock fairly represents the expected future cash flow. (There are other uses of free cash flow. credit issues. Read on the importance of free cash flow here.) While this is a simple, fundamental concept to stock investing, it is also one of the hardest ones.

It is hard because the future is unknown, and because the future
economics of a company are dependent on many immeasurable variables.

Consider the case study below where I describe a company that sells dairy products. Its profitability is dependent on a consumer's preference; on the cost of raw milk; on changes in the competitive landscape; and on its distribution system and manufacturing capabilities.

Free cash flow example

Observing free cash flow was the reason why I bought the stock of Lifeway Foods (LWAY) a few weeks ago. Between 2017 and 2008 the company earned a total of $32 million.

But the reported earnings included $22 million of depreciation expenses. So I added those back. I also removed capital expenditures [4]  and the working capital expenses (such inventory). These were $38 million. The result was that Lifeway earned a total of $17 million in free cash flow over the past decade.

I estimated that over the next ten years the company's free cash flow will be $17 million too. And so we can say that on average the company's free cash flow each year will be $1.7 million.

(For simplicity sake, I assume no change in shares outstanding and used the current number of 16 million shares in my calculations.)

At the price of $4 a share, I bought $2 of tangible book value and an expected ten cents per share of free cash flow over the next decade. Grab your HP12C, and you will find this is an expected free cash flow yield of 10%.

[1] Shrimps were considered the ocean’s cockroach. 
[2] In the ‘90s passive investing was said to be "unAmerican."
[3] Mr. Market is an allegory created by investor Benjamin Graham. It was first introduced in his 1949 book, The Intelligent Investor.
[4] capital expenditures is reported in the cash flow statement, not in the income statement.