To gain a better view of the cash flow generation ability of a business, a lot of focus has been put on free cash flow and, in many instances, EBITDA in various valuations as price-to-earnings has become less and less meaningful in a market where earnings visibility is at a minimum and valuation multiples are volatile.

One aspect that many investors overlook, however, is working capital. Most retail investors view working capital as strictly current assets – current liabilities and view it as a glorified quick ratio. Working capital analysis, however, is much more useful than simply a measure of solvency.

If one defines working capital as current assets ex cash minus current liabilities, then the resulting “working capital” determines an important characteristic of the business and its ability to generate liquidity through its operations.

Positive working capital (ex-cash) businesses maintain current assets in excess of their current liabilities. This implies that, in order to maintain operations, a business must invest siginificantly in inventory or pre-paid expenses before being able to receive cash from its customers. An example might include a rapidly growing retailer like Urban Outfitters (URBN). As of January 31, 2009, the Company had $167 million in working capital (ex-cash) which would represent more than 50% of its cash balance. This build up of assets requires some form of funding either by consuming the Company’s cash on hand or forcing the issuance of long term liabilities (debt).  The assumption is that, by investing in these assets, the Company will be able to drive increased sales (and consequently increased cash flows). 

Negative net working capital businesses are able either maintain current liabilities in excess of current assets. An example of this might be a computer manufacturer which is able to book sales and receive cash from customers before actually buying materials to make their computers (i.e. Dell). Thus, instead of having fund increasingly larger investments in parts inventory or other expenses, the company can simply sell and collect payments from customers and use these to buy the parts necessary to complete orders (thus creating significant current liabilities). 

Working capital analysis is important in understanding just how a business operates and creates value. Further, in a recessionary market, it gives an idea of the cash need or cash generation ability of a business’ operations when under stress. Positive net working capital businesses require significant funding through cash on hand or through credit markets in order to continue growing, but will not be as seriously affected by declining revenues as they can liquidate current assets on hand to meet operating obligations.  Negative net working capital businesses can scale without consuming cash or forcing the company to access external financing. They are more dangerous in downturns, however, and require the business to have sufficient capital to plug potential working capital needs. For example, in the case that a Company like Dell finds that customers stop purchasing computers altogether, they will no longer be able to use cash from purchases to fund continue to fund new production. Instead, it will have to use cash on hand to purchase the necessary parts and services to complete orders. This is why in my analysis of Apple and Dell, I subtract negative net working capital from the company’s cash and short term investments to determine how much “excess” cash the companies are truly carrying. 

Full Disclosure: Author is long shares of AAPL at the time of writing. No positions in other stocks mentioned. 

* To be completely fair, significant value in property can often be unlocked to stave off bankruptcies or generate tremendous shareholder return through sale-leasebacks which generate plenty of cash or potentially attracting buy out firms interested in getting a piece of the real estate. 

Warren Buffett’s consumer products and retail business picks are typically mature businesses with a proven cash flow. But, a look at the top ten returning stocks over the ten years leading up to the peak of the markets in 2007 finds that 30% would have been significant retail or consumer facing businesses – Chico’s (CHS), Apple (AAPL), American Eagle (AEO). Arguably 40% with Dish Networks (DISH). The only other industry or sector with similar representation in this list was oil and energy stocks and this was due to the commodity price bubble more than any thing else. Admittedly, retail stocks take a beating in recessions, but CNN Money’s recent article highlighting stocks which have bucked the trend in the decade ending in 2009, is similarly heavy on retailers Apple, Autozone (AZN), and Carters (CRI). 

The appeal of retailers is that they are simple, easy to understand businesses. Investing in such businesses, however, requires more nuance than just solid financial analysis. Value for these businesses can be transient ebbinging and flowing with consumer tastes and management execution which ultimately drives demand. This also means that, in many cases, investing in these kinds of businesses is never just a buy and hold proposition. Yes, some companies like Coca-Cola have significant moats around their businesses and the type of brand value that its hard to imagine any situation that could affect its ability to sell product and throw off cash. But, most of the time, a long term investment in a retailer or other consumer products business is really a form of “educated speculation.” As such, here’s my framework for how best to “speculate” in these businesses.

1. Know your target
I use a simple four question framework when first approaching a retail or consumer product business known as VRIO. 

1. Value – What is the firm’s value proposition to its consumers? Is this compelling? 
2. Rarity –  Is the firm uniquely able to provide value to its consumers? What competition is the firm up against?
3. Imatibility - Is the firm’s ability to deliver on its value proposition easily imitated? What barriers to entry are there?
4. Organization - Does the firm have the core competencies to continue to execute its value proposition? Is it organized, ready, and able to do so? 

Businesses which provide a unique and high value product to its consumers, have limited competition, and significant barriers to entry with the in-house talent to continue to adjust and execute will always be able to defend their earnings power, an important factor in protecting the value of your investment. In addition, firms with these qualities are usually in the best position to act as market leaders, growing and scaling their businesses faster than other market participants.

2. Determine relative value 
As I’ve re-iterated, my belief is that assigning an exact value to these types of stocks. As such, I spend time researching comparable businesses and their valuations. Businesses with strong VRIO characteristics are potential market leaders and investors typically reward them with better than average valuation premiums. As a result, your best bets will be to find strong VRIO characteristics in businesses that have not yet been bid past their peers on a valuation basis.

Metrics of particular interest to me are P/E and PEG (see article: PEG Analysis). Also, because many of these businesses use significant amounts of debt to finance growth, some attention must be paid to EV to EBITDA as well as Debt-to-equity ratios in order to ascertain whether or not the business can continue to support capital expenditures and other investments necessary to execute their business models.  

3. Let the trend be your friend
Just as consumer interests ebb and flow, so will interest in your favorite retailers and consumer products. And, so will investor interest in their corresponding stocks. The positive benefit here is that positive headlines and other seemingly innocuous events can prove to be strong catalysts for your target investments. The negative is that the bottom can just as easily fall out of these stocks as investors lose interest for seemingly unexplained reasons. 

As such, while I am not typically a market timer, I don’t make a habit of trying to average down into these types of businesses. Instead, I’d prefer to give up some early return for the security of being able to identify clear support (for me, stop loss) points and with the benefit of a long term trend. For those interested in how I do this, check out my articles on How to Draw Trendlines  and Technical Analysis for Fundamental Investors. 

Full Disclosure: Author is long shares of AAPL at the time of writing. No positions in any other stocks mentioned. 

Investment Return = Dividend + Change in Valuation * Change in Profitability

The dividend portion of this formula is simple, as mentioned in my last post on capital allocation decisions, management of a business can always decide to return any profits made to the investors. 

The next two portions of the investment return formula are less concrete. Growth in profitability typically results in increasing value in your investment. For example, whenever a business reports EPS growth, we usually see a corresponding increases in share value. Unless, of course, if marke valuations already anticipate said growth or if recessionary pressures are decreasing risk appetite and driving down valuations regardless of profit success. This has happened to many good companies during the current recession. 

For mature businesses, the likelihood of multiple expansion or outsized earnings growth is generally slower and less relied upon for returns, but, for growth businesses like the ones VCs typically invest in, it is this part of the equation which generates the bulk of returns. This is also true of growth businesses – retail, tech, alternative energy – that average investors can access in the public markets. Investments by a business’ management in head count and other overhead may hurt profitability in the short run, but they create a platform for creating scale in the business. As Fred argues in his article, profitability can be attacked through the management of costs and typically it can be done quickly whenever management decides it needs to focus on this side of the equation. That is why a lot of startups, like Facebook and Google, focus instead on scaling revenue and service offerings. Google, already dominant in search, continues to invest in new ventures and products and continually increasing its revenue (and ultimately it’s profit) potential. Yes, some companies like Craigslist, are able to handle operating margin in excess of 90% through a super lean cost structure, but they offer just one specialized product and, while organic growth is abundant now, they will eventually plateau and so will valuation.  

Don’t start buying into Dot-Bombs just yet
Am I arguing a 90s-tech-bubble style “paradigm shift”? I admit that there’s a real slippery slope in the arguments laid out above. If you believe valuation multiple expansion and likelihood of growth in profitability can be derived simply from metrics like revenue growth, then why not completely non-cash metrics like users, eyeballs, and hits? I would never recommend going this far in trying to anticipate future performance of your investments. But, this is where I believe due diligence and familiarity with the industries you invest in are necessary and provide an advantage when investing in growth businesses. Asking the right questions of and demanding the right results from management is critical to monitoring growth businesses during the time that they focus more on revenue growth than profitability. My focus would be on the following:

• In the event of a downturn or the maturation of the market, could the business quickly cut excess capacity and operate profitably?
• How defensible is the current revenue level under a leaner cost structure? 
• How quickly are new investments expected to payback?

The answers to these questions are typically addressed during earnings calls or in quarterly and annual reporting. Analysis of historical return on invested capital both for the business as a whole and on a project by project basis can help you to determine how much to expect as return for marginal spending and at what point you should expect to see results hit the bottom line (usually after the valuation of your investment has already appreciated).

As a shareholder, always remember that you have a right to your portion of the Company’s profits. But, as it wouldn’t make sense from a planning perspective to distribute profits each quarter based on the whims of a disparate shareholder group, management and the board of directors is given the fiduciary duty to determine what to distribute and what to keep as retained earnings. As a non-control investor, you must decide whether or not these decisions can create value for you as a shareholder.

Using the example of a savings account, if you chose to put $100 in a savings account, you’d likely demand a return of 3% or more. In the same sense, if management of a Company you’re invested in came to you with the proposition, “We can give you every dollar the Company earns this year or you can let us reinvest the profits and build a bigger more valuable company next year,” you’d have some demands as far as how much more value they can deliver to you. Not to mention the fact that by allowing them to control the Company’s earnings, you’re also giving up the opportunity of taking the money and putting it into a risk free savings account. So, how can you tell if management is effectively reinvesting your dollars or how much to expect from their efforts going forward??

Return on Equity
The simplest measure of investment efficacy is:

net income / shareholders’ equity

Basically, for the capital that shareholders invest in this business, how much profit is returned? As retained earnings are held on the balance sheet within shareholders’ equity, this simple ratio gives you proxy for how well the Company has generated return on equity investments so far and the incremental net income growth you should expect on each dollar of earnings you allow them to retain.

Return on Invested Capital
ROE is inherently weakened by the fact that businesses can secure investment capital in more ways than just equity. If the Company borrows a lot of money to fund growth, it can juice its return on equity numbers pretty significantly. A better metric might look like:

net income / (shareholders’ equity + longterm debt)

This number, for any business that has long term debt will be lower than, return on equity. But, it is likely a more accurate picture of the return you can expect for each marginal dollar that management spends to grow the business.

Is higher ROE or ROIC always better?
Remember that ROE and ROIC are inherently backward looking formulas. They can only be used  for you to evaluate how management has invested capital historically. The law of diminishing marginal returns implies that return on each new dollar invested will fall in the future.

The best management teams do one of two things.

1. They maintain or grow on their historical ROIC rates.
2. Or, they recognize the diminishing value of their efforts and move quickly to distribute profits to shareholders as opposed to waste it in ill conceived attempts to grow the business.

Large acquisitions, the start up of new non-core businesses, ever increasing headcounts, and continual purchase of new equipment are all examples of red flags. Remember that sometimes you won’t see net income growth immediately but, if return on invested capital remains at depressed levels or continues to decline over a several year period, it may be time to get out of Dodge.

Nowhere is revenue visibility more of a problem than for apparel retailers. After all, it’s easy to defer clothing purchases especially when consumers are feeling poorer and poorer. And, it’s anyone’s guess when pocketbooks will open up again and where that money is going to flow. The trendiest retailers before the recession may not necessarily be the trendiest retailers after. Take a look at the following table: 

I’ve divided the table into three categories. Growth retailers – Urban Outfitters (URBN), The Buckle (BKE), and J. Crew (JCG). A turn around story – Gap (GPS). And, established “mature” retailers – Abercrombie (ANF), Ralph Lauren (RL), and Guess (GES). You’ll notice a decided growth premium being paid for the growth group with P/Es in the high-20s just a year ago. And, for the more well established retailers, P/Es were just in the low to mid teens.

Interestingly enough, stock performance has hardly been correlated to EPS performance. Using forward earnings like I discussed in my previous post on multiple valuation, we find that forward P/E premiums are all over the place and no longer neatly in their general categories. Has something fundamentally changed about the retailers in the list? Or, is something else at work here? 

The first culprit is probably the fact that analyst estimates are all over the place. No one really knows how much these retailers will make next year. Will there be a rebound? Will they have fresh designs despite massive inventory build ups? Will they be able to win back old customers? But, even in trying to smooth this by averaging P/Current FY earnings and P/Forward earnings, we still see rather skewed multiples being paid. 

The truth is, a lot of these companies are not fundamentally changed by the recession. Their inability to sell clothes is not unique to each store but a result of a systematic scaling back of consumer spending. If and when apparel demand returns, the fundamental growth vs. mature vs. turn around stories will remain in place yet Mr. Market seems to care little about this fact right now. That means there have to be some great opportunities for someone who can see through the haze.