Talking To Management: Gleaning Subtleties

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This was originally published on RealMoney on April 17, 2007:

Financial Questions

What proportion of your earnings are free cash flow, available to be invested in new opportunities, stock buybacks, or dividends?

(Note: The free cash flow of a business is not the same as its earnings. Free cash flow is the amount of money that can be removed from a company at the end of an accounting period and still leave it as capable of generating profits as it was at the beginning of the accounting period. Sometimes this is approximated by cash flow from operations less maintenance capital expenditures, but maintenance capex is not a disclosed item, and changes in working capital can reflect a need to invest in inventories in order to grow the business, not merely maintain it.)

Again, a good analyst has a reasonable feel for the answer to this question. If management oversells its ability to deliver free cash flow, that’s a red flag. With companies that I am short, I often ask about when they will increase the dividend or buy back stock. Alternatively, I ask about the prospective rate of return on their new projects, but more on that in the next section. You can ask a management team outright what proportion of the company’s earnings is free cash flow and then analyze that for reasonableness.

As an aside, you can stay clear of a lot of blowups by avoiding companies that have strong earnings and weak or negative free cash flow. If a company has to plow a lot of cash back into the business to maintain it, it’s often a sign of costs that aren’t reflected in the current profitability of the business. At the edge, big deviations can indicate fraud; for example, I avoided investing money in Enron as a result of this analysis.

What’s your best reinvestment opportunity for free cash flow? Or, what’s your most promising new project?

Questions like this can flesh out the intentions of management and give longer-term investors a new avenue of inquiry in future quarters; follow up on the answers. The idea is to judge whether the new projects are valuable or not, or big enough to make a difference. Another thing that will be learned here is what time horizon management is working on, and whether the investments targeted are cash-consuming or cash-generating.

It’s possible that management might let drop the anticipated rate of return on the new project, or even their target hurdle rates for new projects in general. You can ask for that figure, but don’t be surprised when you get turned down; rather, be surprised if you get it. I wouldn’t hand that information out if I were a company because competitors would like to know that information.

How is the turnover rate for your employees? How many suppliers have left you over the last year? What percentage of your business comes from repeat customers?

These questions can apply to any key relationship that the company has. If the company has difficulty retaining employees, suppliers or customers, that can be a warning sign. On the other hand, it is possible for the company to have too low a “quit rate.” This could imply that it isn’t extracting as much from the relationships as it possibly could.

Consider two examples for insight into how high and low employee turnover can affect a business. The first insurance company I worked for, Pacific Standard Life, had a 50% employee turnover rate. The place was a mess because institutional memory, particularly among mid- to lower-level employees, was forever disappearing. It was a wild ride for me, as the company grew by a factor of 10 in the 3½ years I was there, before it became insolvent in 1989 due to a bad asset policy forced on it by its parent company. (Trivia: At $700 million in assets, it was the largest life insolvency of the 1980s. The ’80s were kind to life insurers.)

Then there is a college that I know of that has a turnover rate of nearly zero. Many of the employees there stay because it’s the best place that would have them; they might not have other opportunities. As a result, productivity in some areas is low and new ideas are few.

A healthy organization tends to have at least 5% turnover. Depending on the industry, a turnover rate between 5% and 15% strikes a good balance between institutional memory and new ideas.

The same logic can apply to suppliers. Long-term relationships are good, but there is value in testing them every now and then to see whether a better deal can be struck in price, quality or other terms.

Repeat customers work the same way. Too low a repeat customer rate means that marketing costs will be relatively high. Too high a repeat customer rate, and the company might be missing out on additional profits from a price increase.

By David Merkel, CFA of alephblog

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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