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MagicDiligence (< 20)

Cash Flow Vs. Income - Why It Matters to Investors

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February 09, 2011 – Comments (0) | RELATED TICKERS: AFAM , IDCC

Suppose you agreed to sell someone your used car for $5,000. Would you prefer the buyer pay you with an IOU, or in cold, hard cash?

The answer is simple, right? You can take those greenbacks to go make a down payment on your new vehicle, or buy a new Magic Formula stock, or take a Caribbean vacation, or whatever. You can take the IOU and... write your grocery list on it, maybe? The fact is, until a payment is liquid, it is not of much use in furthering your cause.

This little example is an illustration of an oft-neglected part of stock analysis: determining how well a company generates cash as opposed to accounting earnings. While the business and investing media focuses on the latter in their quarterly estimates, it is really the former that drives shareholder value. It takes cash, not accounting earnings, to fund growth, buy back shares, or pay a dividend. This is why the cash flow statement is even more important than the more prevalent income statement.

How big of a difference can cash flow be from reported earnings? Let's have a look at 2 current Magic Formula Investing (MFI) stocks that illustrate how business models affect cash flow. We'll list trailing twelve month (ttm) and the past 5 fiscal year values for reported net income, reported operating cash flow, and the percentage of cash to earnings. In the red corner, home healthcare provider Almost Family (AFAM).

Almost Family (AFAM)

Net Income (ttm, yr0, yr1, ...):
30.53, 24.56, 16.29, 7.60, 4.24, 7.87

Cash from Operations:
37.74, 27.22, 9.46, 7.34, 5.41, 5.36

Cash to Earnings Ratio:
124%, 111%, 58%, 97%, 128%, 68% (entire period = 102%)

So, 102% of earnings is collected as cash over the long run - not bad, and about what we would expect, right? Okay, let's look at a different MFI stock. In the green corner, wireless technology patent licensor InterDigital (IDCC).

InterDigital (IDCC)

Net Income:
158.18, 87.26, 26.21, 20.00, 225.22, 54.69

Cash from Operations:
151.34, 320.69, 85.81, 152.73, 314.81, 33.67

Cash to Earnings Ratio:
96%, 368%, 327%, 764%, 140%, 62% (entire period = 185%)

185%?! That means InterDigital has collected almost double the cash they have reported as net earnings over the past 5+ years! How is this possible?

The key is to understand the difference between how a business accounts for earnings and when the cash is actually collected. Almost Family recognizes revenue when they perform a service, but in order to collect the cash proceeds, the firm has to wait for their Medicare claim to be filled, which can take some time. AFAM uses rate schedules which may or may not be accurate, and some patients may end up not qualifying for reimbursement. All of these things lead to a relatively long cash conversion cycle. In short, as a rule, AFAM reports revenues before they collect the associated cash.

InterDigital's business model is much different. Although its agreements vary, the firm's largest contract with Samsung (closed in early 2009) was for $400 million, and granted Samsung a 3G license through 2012. Samsung paid the amount in four installments over 18 months ending in Q3 2010. However, InterDigital is amortizing the amount over the full term of the deal (i.e., through 2012). This means Samsung has already paid cash in full, but InterDigital has not yet realized the full amount in revenue (they recognize about $26 million a quarter). Similar deals existed with LG and Casio. So, in effect, InterDigital is collecting cash before reporting revenues, in many cases. This is how cash far outstrips reported earnings.

Why It Matters To Investors

A business that collects cash before reporting revenue is better than the reverse. InterDigital can use its un-amortized cash to acquire new patents, expand internal development, go after patent dead-beats, buy back shares, or pay a dividend - all of which management has done. While they are doing that, Almost Family is waiting for Medicare to process their claim.

Going full circle, let's consider a simple example. Person A sells a used car to a good friend who is down on his luck, accepting an IOU for $5,000 with no interest to be paid back in one year. Person B sells his used car for $5,000 to a buyer who pays him in cash. Person B puts that cash into a theoretical risk-free bond yielding 5% a year. By the time Person A gets his cash, Person B now has $5,250. And Person B did not face any risk of not getting paid.

Always pay attention to cash, not just earnings, when analyzing a potential investment!

Steve owns AFAM, IDCC

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