Livewire | Why cash flow is king

And not just in the current market environment.
David SteinthalChief Investment Officer | L1 Capital International
11 mins
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This article was first published by Ally Selby in Livewire Markets on 14 December, 2023.

From time to time, companies pull the wool over investors’ eyes, “cooking the books” to convince investors things are far better despite a worsening economic environment.

According to a US-based accounting society, there are 10 ways companies may distort their financial results.

These include, but are not limited to, improper revenue recognition schemes (when a company shifts revenue from one period to another), fictitious revenue (when it recognises revenue related to fake contracts or nonexistent sales), channel stuffing (when a company inflates sales by sending excessive amounts of products to distributors ahead of demand), third-party transactions (the non-kosher kind), the improper capitalisation of expenses (overstating net income and understating expenses), and more.

Cash flow, however, is vastly more simple.

"Cash flow is a lot purer than revenue or earnings. To some extent, you can just buy revenue and earnings and overexpand. Cash flow is really what's left after having actually paid all your bills and funded what you need to do to sustain the business," L1 Capital International's David Steinthal said.

It’s also “fundamentally important” to the valuation of businesses, Steinthal argues.

In this episode of The Pitch, Steinthal provides a deep dive on assessing cash flows across various businesses, some examples within the portfolio, as well as some of the traps that investors should look out for.

Livewire Markets | This interview was recorded on Thursday 23 November 2023.

Edited transcript

Ally Selby: Hello, I’m Ally Selby and welcome to Livewire’s newest show, The Pitch, where we interview fund managers from across the country for their ideas and insights. Today we’re talking all about positive cash flow and to do that we’re joined by L1 Capital International’s David Steinthal. Thank you so much for joining us today, David.

David Steinthal: Great to be here, Ally.

Ally Selby: L1 Capital International invests in businesses with growing free cash flow among other factors, of course. Why is that important in today’s market environment?

David Steinthal: I think cash flow is fundamentally important all of the time. It drives the valuation of a business. If you go back a step, it enables a company to hire the right people, invest in its business, make acquisitions when it needs to, buy back shares when they are cheap, and pay dividends. It’s always really important.

It’s funny because we’ve come out of this environment over the last couple of years where companies could borrow for practically nothing. Interest rates were near zero and there was a lot of capital available. Companies that didn’t really have great business models could get funding without having their own cash flow. Companies like WeWork spring to mind. Those business models haven’t survived an environment where you actually need your own cash flow on a sustainable basis. We think that’s going to really continue in this environment.

Ally Selby: In your view, how much should companies be growing their cash flows annually to be worthy of a look in the portfolio?

David Steinthal: That’s a really interesting question because we don’t think that way – that companies need to meet a certain minimum amount of growth. The whole industry talks about growth or value and it’s not how we think. We think about quality and value and the rate of growth really depends on the company. We have high-growth businesses like Intuit Inc (NASDAQ: INTU). Intuit owns QuickBooks, which competes with Xero (ASX: XRO) and MYOB (delisted) in Australia. QuickBooks is mainly in the US, and Turbo Tax is software used to file your own tax return.

The QuickBooks business is fantastic. It dominates that industry in the US, but it’s much less mature than Australia. Here every business uses something like Xero and MYOB, but in the US only about a third of businesses use software.

The opportunity is 10 to 15 times the size of Australia. We think that company can grow its cash flow at more than 20% for many, many years to come.

We also have businesses that have much lower growth cash flow but are steadily compounding businesses like Coca-Cola Europacific Partners (NASDAQ: CCEP). It bottles Coke. It actually bought Coca-Cola Amatil in Australia a couple of years ago and that’s a steady compounding business.

We also have cyclical businesses in the portfolio and sometimes the best time to invest in cyclical businesses is when they’re not producing a lot of cash flow. The cycle is at a down point. They look expensive. They look like they’re not generating a lot of cash, but you’re investing with an eye to the future.

So, there’s no short answer about how much they need to grow cash. It really depends on the business and the industry that they’re in.

Ally Selby: You alluded to it there, but are there any traps that investors should look out for when assessing companies by cash flows?

David Steinthal: Cash flow is a lot purer than revenue or earnings. To some extent, you can just buy revenue and earnings and overexpand. Cash flow is really what’s left after having actually paid all your bills and funded what you need to do to sustain the business, but still, some companies do cheat.

One of the things that a lot of technology companies do is pay a lot of their staff in shares. They say, “Oh, it’s not a cash cost. It’s not a real cost.” We think that’s nonsense. We adjust for that. We don’t give them the benefit of not paying staff in cash and just using shares.

Then, we’re really detailed in terms of how we assess valuation and cash flow. We get into the weeds. To give you a couple of examples, we look at businesses that need cash flow for their working capital. In this environment that we’ve been in with a lot of inflation, a lot of companies have actually used a lot of their cash flow to fund their working capital inventory and receivables. Businesses that get paid before they have to pay their suppliers have positive cash flow and that’s a real advantage.

Another one would be tax. During COVID times, a lot of governments gave companies tax holidays and they said, “Times are tough. You don’t have to pay your tax today,” but it wasn’t indefinite. A lot of companies are now having to pay a lot higher cash tax than what they did in the past. Those are some examples of how we get into the weeds to work out what’s the real sustainable cash flow of a business.

Ally Selby: Thank you so much for your time today, David. I really enjoyed that deep dive into cash flows. If you enjoyed that too, don’t forget to subscribe to Livewire’s YouTube channel. We’re adding so much great content just like this every single week.

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