Problems with free cash flows

Advisors often look to free cash flows when valuing a company, or assessing the suitability of a company’s payout ratio. Unfortunately, most people don’t pay attention to how the definition of free cash flow (FCF) varies among companies.

Last month’s column (“Accounting choices impact reported cash flows,” AER February) touched on how management’s accounting choices can materially impact cash flow reporting within audited financial statements. When dealing with FCF, this already-lenient reporting environment is even more unregulated.

FCF exists outside the realm of audited statements, meaning that auditors don’t have to look at the figures reported by management. Further, Canadian securities regulators haven’t provided a standard definition of FCF for financial analysis and valuation. That means nothing stands in the way of what management reports to investors in terms of purported FCF.

The standard calculation of FCF taught in school is: take cash flow produced from operations, and deduct cash spent on capital expenditures and other long-term investments. Depending on when a company is investing in different projects, cash spent on capex can be irregular or lumpy.

Complications occur when cash flows are normalized for investment purposes. For instance, a company’s payout ratio is important to analyze annually because it demonstrates what portion of cash flows are being paid to investors as dividends. A company with a payout ratio of close to 100% will have no room for performing additional investment or unforeseen maintenance, and cannot absorb a hit to revenue or cash flows without eventually impacting dividends.

With so much attention focused on payout ratios, investors cannot forget the divisor in the equation (FCF) is open to interpretation. Some companies will find ways to maximize FCF in order to reduce their payout ratios, making it appear they have greater cash flow coverage for dividends.

BCE Inc.

For example, BCE Inc. excludes what it calls “voluntary” pension contributions when it calculates its version of FCF. Over the past five years, BCE has made $2.75 billion in voluntary payments, reducing the size of its normal payments for pension costs. But only normal payments are deducted in the company’s FCF calculation.

M&as are sluggish

Retail, real estate, utilities and pension fund activity

were not enough to fill the gap left by a dearth of deals from Canada’s oil patch and mining companies last year, says PwC. Even life sciences chipped in with large deals in Q4, but it wasn’t enough to prevent 2013 from being the slowest year since 2009. In 2013, 2,500 deals worth US$162 billion were announced. Also, in Q4 2013, there were 716 deals with an aggregate value 26% below Q4 2012.

BCE aims to pay out 65% to 75% of its FCF as dividends. By ignoring its voluntary cash payments into its pension plan, the company has reported higher FCF, which has helped to justify increasing its dividend nine times over the past five years. BCE hiked its dividend in February to “maintain its dividend payout ratio at the midpoint of its target policy range.” Had the company included a normalized amount for its voluntary pension contributions in its FCF calculation, it would not have had the same room to raise its dividend.

The biggest problem occurs when advisors compare BCE’s reported payout ratio to peers in an attempt to assess which companies have more FCF to spend on growth or further dividend increases. Peers that include all spending in their FCF calculations seem worse off than BCE.

BCE chose to separate its cash pension costs between normal and voluntary payments, with the categorization making all the difference in terms of calculating FCF. Similar choices are made when companies decide to split cash spent on capital expenditures between maintenance and growth initiatives.

Shaw Communications

Shaw Communications is currently in the process of excluding $500 million in spending on certain accelerated capital expenditures from its calculation of FCF. The amount excluded will increase the company’s reported FCF by the same amount over fiscal 2013, 2014 and 2015. Shaw has said the funds will come from selling other assets, and not from operations. But if the company doesn’t provide a reconciliation, the current funded status of the accelerated capital program is open to interpretation. It’s difficult to determine which projects, acquisitions or divestitures are considered accelerated.

Shaw plans to exclude $240 million in spending from its definition of FCF in fiscal 2014. Similar to BCE, Shaw also excluded a $300-million contribution in fiscal 2013 to an executive pension plan, which would normally be classified as an employment expense when calculating FCF but wasn’t because of its lump-sum nature.

Northland Power

Northland Power is another example of why advisors should be wary of FCF labels. Its definition separates spending on capex between maintenance and growth initiatives, and excludes the latter. Since 2009, Northland has spent $1.4 billion on capex, but has deducted just $11.7 million from its FCF calculation—that’s only $2.5 million per year to maintain its diverse plants and properties.

Northland is currently in the midst of a major transition. The company owns or manages a number of power-generating facilities with attractive power purchase agreements in place for now. However, a significant proportion of those attractive agreements will expire over the next three to seven years, and the company plans to replace the expected loss of revenue with new projects. Therefore, the real question is: what portion of capex spending on “growth” initiatives is actually needed to maintain existing cash-flow levels?

In the end, advisors have to assess the reasonableness of management’s FCF claims. Northland’s tally, for instance, ignores more than 99% of its capex spending. Even deducting a quarter of that spending results in Northland’s payout ratios ballooning to more than 300%. This underscores the challenge investors face when dealing with non-standardized and wide-open reporting metrics, like free cash flow.