Wednesday 18 October 2017

Cash is always king for the true survivors of global stock markets

 

Tesla’s recent performance is encouraging, but close attention should be paid to its business model. Photo: Reuters
Tesla’s recent performance is encouraging, but close attention should be paid to its business model. Photo: Reuters

David Holohan

Free cash flow (FCF) is one of the most powerful indicators of a business's health. It is essentially a measure of how much cash a business generates after accounting for capital expenditures - such as buildings or equipment. Those companies that consistently generate meaningful FCF are inherently stronger than those that struggle to do so.

It's no surprise then that companies with a high FCF yield (calculated by dividing the FCF by the market capitalisation of the company) are likely to draw the attention of investors as potential investment opportunities.

Typically, if a FCF yield is greater than between 5pc and 6pc, the company merits further investigation - even more so if the company has a track record of generating consistent levels of FCF through a business cycle.

Gilead, a world leader in the treatment of HIV, is an excellent example of a company generating enormous annual FCF of $10bn (€9bn). Gilead is trading with a FCF yield of 13pc.

Gilead has a long-established track record of introducing best-in-class medicines that treat the HIV infection. As there is no cure for HIV/Aids, patients using Gilead's products provide an attractive recurring revenue stream.

In 2012, Gilead acquired Pharmasset for $10.6bn (€9.7bn). Pharmasset's main asset was a potential cure for Hepatitis C that had shown excellent clinical trial results.

That drug, Sovaldi, and its successor, Harvoni have generated revenue of $46bn (€42bn) since being launched in late 2013, making the acquisition one of the most impressive of any corporate in history.

However, all of that success comes at a cost for Gilead - namely that as the company was curing sufferers of Hepatitis C, there was a large revenue stream upfront, but not on a recurring basis.

As more patients have been cured, the potential patient pool has decreased, leading investors to question what the longer term value for Gilead is. This has led to the share price declining from $100 to just below $70 since 2015.

Ultimately though, Gilead is one of the highest-quality biopharmaceutical companies in the world. Given its strong FCF generation and excellent balance sheet, there is significant potential for it to seek to bolster growth beyond HIV and into another disease category.

By contrast there are several companies that generate negative FCF and show no immediate signs of this changing.

Both Netflix and Tesla can be categorised as momentum stocks, supported by investors wholly on the promise of significant profits at some point in the future while valuation multiples are at truly epic levels.

Netflix, while offering a popular service at a relatively cheap price, is generating negative FCF of between $1bn and $2bn per year in order to generate content for users.

Net debt is forecast to increase from $1.6bn (€1.4bn) in 2016 to over $4 bn (€3.6bn) in 2018 in order to fund the company's activities.

To fund production facilities for the company's electric car offerings, Tesla is also generating negative FCF of approximately $1-$2bn annually. Equally concerning is the rapid increase in net debt that is forecast to increase from $3.4bn (€3.1bn) in 2016 to $6.4bn this year.

Looking at the share price charts for both Netflix and Tesla, investors can be very happy with the recent performance but should be very aware that debt-funded growth is easy to achieve in the short run - however, if a company can't generate FCF annually over several years, the business models that they are following are deeply flawed.

David Holohan is chief investment officer with Merrion Capital

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