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With the market focusing only on stocks with ‘quality earnings’, the focus on free cash flows (FCFs) of companies has sharpened. Popularised by investment gurus such as Warren Buffett, FCF is an important metric that investors need to pay attention to. “Most investors usually concentrate on three figures— revenue, net profit and earnings per share—given out by companies on a quarterly basis. That is not enough and they also need to look at balance sheets and cash flow statements,” says Rajeev Thakkar, CIO, PPFAS Mutual Fund.
FCF includes profit and cash flow and, therefore, gives a clearer idea about the company’s prospects. Positive FCF can be used for business expansion, dividend payout, share buyback, debt reduction, etc. Negative FCF, however, is a warning sign. “Companies with large negative free cash flow will be forced to either issue fresh equity—dilution for existing investors—or borrow, leading to higher debt obligation,” says Thakkar.
Of the BSE 500 companies, just 333 have had positive free cash flow over the past 12 month. While the stocks of positive FCF companies have appreciated by an average 17.24%, the average return of companies with negative cash flow is just 0.63%. So, there is no doubt that investors need to look at quality earnings. But if you focus just on FCF, you may miss out on promising opportunities. For instance, investors who avoided Reliance Industries one year ago because of its negative FCF must be ruing their decision. “Usually, you can avoid companies with negative FCFs. However, you need to see their business model first. There’s no need to avoid companies making transparent capital investments (such as Reliance Jio),” says Viraj Mehta, Managing Director, Equirus PMS.
Like other stock selection metrics, FCF also needs to be measured over a reasonable period of time. Companies need to augment capacity to maintain or increase market share and this involves capital expenditure. So, negative free cash flow may be due to a company building capacity, and if you avoid all companies with negative FCFs, you may lose out on several promising stocks. “Since capex and working capital issues usually don’t last for more than three years, ideally, one needs to do 3-year rolling FCF analysis,” says Mehta. Thakkar gives a slightly longer rope: “Investors can avoid companies that have reported negative FCFs in the past five years. Most green field or brown field expansion should be over within five years.”
There are several companies that have rewarded equity investors over the past year despite having negative FCFs. We took at a closer look at such companies and found that three such companies still offer a substantial upside.
The oil refining and petrochemicals business is Reliance Industries’ cash cow. However, the company turned FCF negative because of its investments in some core projects as well as in related divisions such as its telecom venture, Reliance Jio. Since the massive investment in Reliance Jio is already over, Reliance Industries is expected to become FCF positive once again in 2018-19.
Commissioning of mega core projects is another factor that will contribute to making the company FCF positive. More importantly, Jio is also doing well and has reported good results—strong subscriber additions, stable average revenue per user and net profit for the third consecutive quarter. The company’s another major division, Reliance Retail, is also doing well and has reported revenue and Ebitda (earnings before interest, tax, depreciation and amortisation) growth of 124% and 203% respectively in the first quarter of 2018-19, year-on-year.
Strong players like Reliance Retail are benefitting from the market shift in favour of bigger businesses due to the high compliance cost of GST. Reliance Retail’s long-term business prospects also remain bright. “We believe the strong growth momentum will sustain given the low penetration of organised retail (around 9%) in the overall pie. Reliance in particular will benefit considering it is one of the fastest growing and most profitable retail companies that continue to augment offerings and enhance scale across categories,” says a recent Edelweiss report. Due to the combined effect of the better performance of the petrochemical division, Jio and Retail, analysts are hopeful that Reliance will be able to double its net profit in the next four years.
Though Larsen & Toubro reported negative FCF in 2017-18, it is turning around fast and is expected to become FCF positive in 2019-20. Most of its capex projects, such as on the Armoured Systems Complex at Hazira, are over. The management’s plan on increasing the company’s return on equity (RoE) by exiting non-core businesses and turning asset-light will further help boost FCF. Larsen & Toubro is in the process of selling its electrical and automation business units to Schneider Electric for Rs 14,000 crore.
Since the company is not planning any big investment in the near term, the management has decided to reward shareholders in the form of share buyback. In addition to giving support to the counter in the short term, the Rs 9,000-crore buyback is in line with its long-term objective of improving its RoE. “After adjusting for share buyback, Larsen & Toubro’s consolidated RoE is expected to rise 100 basis points to 14.9% in 2018-19 considering full subscription of share buyback,” says a recent ICICI report.
More importantly, the company’s core business prospects are bright. Being India’s largest infra company and also due to its balance sheet strength, Larsen & Toubro is best placed to benefit from the expected broad based recovery in the private sector capex cycle. It should also benefit from government projects—smart cities, defence manufacturing, Metro, etc. Rating upgrade is likely because of the improvement in fundamentals such as FCF and RoE.
Increasingly analysts are recommending buy for the stock because of the improvement in the company’s business prospects. The national capital region has showed signs of a demand recovery. Around 60% of DLF’s inventory comes from this region and analysts are hopeful that due to this pickup, its ready inventory will get cleared in the next 5-6 years. DLF has already reported positive operating cash flow in 2017-18 and is expected to report positive free cash flow in 2018-19. “Existing inventory is majorly completed and DLF expects positive FCF generation from the second half of 2018-19,” says a recent HDFC securities report.
While cash flow-related parameters remain stable, investors need to be careful with DLF’s other numbers because of a major change in accounting norms for real estate companies from 2018-19. Some of the historical figures may not be useful now. Since the change has resulted in reversal of sales and profit reported earlier, DLF’s revenue and net profit for the quarter fell 82% and 76% respectively, year-on-year. Reasonable valuation is also why analysts are bullish on DLF. Since it has several divisions, analysts usually value DLF using sum of parts method. “We value the residential real estate business at Rs 31/share, commercial annuity assets at Rs 176/share, others at Rs 47/share, land bank at Rs 172/share and reduce net debt at Rs 148/share to arrive at the price target of Rs 279 share for the company,” says an HDFC securities report.
