An Example of the Analyst Course

It is 2006, and you want to know the true sustainable free cash flow of Mohawk because you love sleepy, mundane industries that are slowly growing. Why? Because people love to buy lottery tickets and glamour so you “go where they ain’t.”

So what is the difference between Mohawk’s GAAP earnings per share and your estimate of FREE CASH FLOW per share?    Use cash flow from operations and maintenance capex (which you need to roughly estimate). Be roughly right, not precisely wrong.

Can you explain the difference?   What is going on with Mohawk and the industry?   Note the ten-bagger or 25% CAGR for almost ten years (move over Buffett) from the 2009 lows.  Surprising or not?    MHK-2006 AR FCF Analysis.   Can you use this as a way to find other ten-baggers?

Of course, the above question is not hard for you since you have already read this 412 page book several times: Wiley Creative Cash Flow Reporting.  You do not have needed to read that book to answer the question. Use common sense and a small bit of accounting knowledge like (amortization of goodwill-hint!)

This an example of how the analyst course would teach. You have to do many case studies to practice learning concepts like free cash flow.  Like flying and sex, you have to practice.

Update: April 11, 2017: The price you pay

If you pay too much even for a great business, then you will have poor returns.

Take the three Value-Lines of Coke (KO).   VL KO and note the $80 + plus price, then track its free cash flow (as calculated by Value-Line which is After-tax earnings plus depreciation + amortization then minus capital expenditures), then earnings.   Track the price and those metrics: KO_VL_Jan 2013 and Ko_VL 2017.   You will see that on average cash flows and earnings and dividends rise from 1998 until 2017, yet returns have been just OK.   Paying too high a price hurts your total returns even with a strong, stable business like Coke. Investors were extremely optimistic over Coke’s growth prospects.  If you held Coke for a long time, your return would equal the company’s long-term return on equity.

Also, Buffett’s non-controlled public investments have generally lagged the S&P 500 Berkshire Hathaway AR 2016.

Good luck.    Those who do not provide the correct answer will have to spend time with my ex-wife:

18 responses to “An Example of the Analyst Course

  1. Taking a stab at this

    2006 2005 2004
    revenue 7,905,842 6,620,099 5,880,372
    net income 455,833 387,138 370,797
    shares 68,056 67,644 67,557
    CFO 782,045 561,544 242,837
    capex 165,769 247,306 106,601
    capex/rev 2.1% 3.7% 1.8% (2.5% average capex which i’ll approx maintenance capex)
    avg capex 201,475.19 168,708.88 149,857.42
    FCF 580,569.81 392,835.12 92,979.58

    eps 6.70 5.72 5.49
    FCF/s 8.53 5.81 1.38

    So FCF is now significantly higher than the EPS reported and the industry is consolidating and they are making acquisitions (they made a large acquisition of Unilin mentioned) which is driving up the amortisation costs?

    in 2006 they are at ~$80 a share and so the FCF yield is ~10.6% which seems pretty cheap?

    • You about have it. FCF per share is about $8.5 to $9 depending upon what you use as maintenance capex. You have to make an assumption between growth capex and MCX. I assumed about 150 mil or so for MCX.
      But you have the jist. Acquisitions are pushing up the amortization of intangibles which is an accounting charge and not a cash outflow.
      If you can find SUSTAINABLE FCF yields of 10% plus that can grow, then (I believe) that is pretty good.

      Yes, an industry that is consolidating helps the consolidators. Note railroads.

  2. Say you paid $75 in 2006, then today in 2017 you would have a 10.5% compounded annual return compared to the S&P 500’s 5.5% compounded annual return which is one of the best performing stock indexes over the past 11 years.

    So I would say a double return over the index looks good. 11 years of sitting.

    You would probably be in the top 99.9% of all money managers. Verify that by checking out ten of the top MMs like Buffett, Tweedy Browne, Pzena, etc.

  3. Here is where I get stuck. In hindsight, this looks like a great buy in 2006.

    But would I have even taken more than a cursory look?

    If I took a look in March or April, 2007, when the 2006 annual report was available, I would have noticed the company was growing revenue and net income.

    But then I would have seen debt made up 40% of total capital and that the company got only about a 9% return on total capital. Operating margins are okay, but not great. Plus they were buying companies. But it is a competitive industry selling a commodity like product.

    Not only that, the stock price just ran up from 80 to 108.

    At that point I would have said it was a mature company, adding debt to buy other companies, and not getting a great return. People are bidding it up to a level that they don’t deserve. Time to look at the next company. (And I would not even have had to contemplate what I thought about residential real estate or the business cycle with a company that is probably very cyclical.)

    Flash forward 10 years, and they expanded operating margins (but not really revenue, as it took them until 2015 to finally top 2006 revenue even though net profits exceeded the 2006 benchmark by 2013), lowered the debt burden, improved ROIC, and benefitted from P/E expansion.

    I would not have contemplated them achieving all that in early 2007.

    • David R:

      Good questions. If you take total assets of 8.2 billion and divide into pre-tax operating income of 0.8391 billion you have 10% pre-tax. So/so, about average for American industry.

      But using Joel Greenblatt’s definition of tangible capital, then
      CA (2.38) minus CL ($1.60) = 0.78 bil then add prop,. plant and Equipment of $1.89 for a total tangible capital of $2.67 bil. Then divide that into your pre-tax op. inc of 0.839 for a 31% pre-tax ROIC or using a 40% tax rate a 19% return. Not bad for such a mundane business–in my opinion.

      See page 140 of The Little Book That Beats the Market (in value vault)
      Note: INTANGIBLE assets, specifically goodwill, were excluded from tangible capital employed calculations, Goodwill usually arises as a result of an acquisition of another company. The cost of an acquisition in excess of the tangible assets acquired is usually assigned to a goodwill account. In order4 to conduct its future business, the acquiring company usually only had to replace tangible assets, such as plant and equipment. Goodwill is a historical cost that does not have to be constantly replaced. Therefore, in most cases, return on tangible capital alone (excluding goodwill) will be a more accurate reflection of a business’s return on capital goin forward. The ROE and ROA calculation used by many investment analysts are therefore often distorted by ignoring the difference between REOPORTED equity and assets and tangible equity and asset in addition to distortion due to differing tax rated and debt levels. –Joel Greenblatt.

      Also go to search box on this blog and type in Inflation Swindles the Equity Investor by Buffett–for an even better analysis.

      Now you also have to be comfortable with the sustainability of cash flow from operations. Say if Mohawk was extending its payables from 20 days to 45 days to 90 days over two to three years, then that trend will not be sustainable.

      Thanks for the questions–they help others learn.

  4. Capital spending during 2006 for the Mohawk, Dal-Tile and Unilin segments combined, excluding acquisitions, is expected to range from $290 million to $310 million, and will be used primarily to purchase equipment and to add manufacturing and distribution capacity

    In 2006, we invested approximately $166 million in capital expenditures to maintain our equipment and support growth initiatives. Highlights included dramatic expansion of manufacturing capacity for Dal-Tile and Unilin in North America. These investments support present and future demand, as well as enhance customer service and logistics support. We also continue to upgrade Dal-Tile’s sales service centers

    So we know that capex are primarily for expansion. Just how big part is not clear.
    More info can found in the segment reporting.
    We also know that there was a “dramatic expansion” for Dal-Tile and Unilin.

    Minimum case:
    Mohawk D&A: $ 95,089, CAPEX $ 71,793. Difference $ 23,000
    Dal-Tile D&A: $ 37,576, CAPEX $ 63,177. Difference – $ 25,500
    Unilin D&A: $ 135,337, CAPEX $ 28,688. Difference $ 107,000
    Total, $ 104,500

    But it doesn’t make sense that all of Dal-Tile’s capex was MCX because they were under a dramatic expansion. In addition, it is stated that capex is primarily for expansion and improvements which should mean that it is more than 50 %. Unilin in the previous year had capex of about $6 m. (Or could the low number be because the company was acquired during that year and is not for 12 months?).
    As another estimate I will use MCX of $6 m for Unilin and cut 60% from the other numbers as they state that Capex is primarily for expansion.

    Mohawk D&A: $ 95,089, CAPEX $ 28,717. Difference $ 66,400
    Dal-Tile D&A: $ 37,576, CAPEX $ 25,271 Difference $ 12,300
    Unilin D&A: $ 135,337, CAPEX $ 6,207. Difference $ 129,100
    Total, $ 207,800

    Earnings before income taxes $ 676,311
    Minimum estimate of $ 104,500 added: $780,811
    Higher estimate: 884,111
    After a tax rate of 32.6% is deducted, diluted EPS range from $7.73 TO $8.76.

    I used EPS as you asked for it but would it not be better to compare EBIT because you don’t tax the cash flow in the same way, or do you?
    Also, the book Creative Cash Flow Reporting suggest using CFO to calculate FCF, but would this not be a less accurate comparison?

  5. Vidyanshu Pandey

    Do we need to enroll John? Or by dint of being in the Deep Value course we automatically are a part of this course as well?

    • When the course is ready–I need time to format and organize everything–a few months. The site will be both a library and investing course. I will let you and everyone know.

      Thanks for your interest.

  6. Could we have another exercise, please?

  7. https://www.amazon.com/Inside-Investments-Warren-Buffett-Publishing/dp/0231164629/ref=sr_1_1?ie=UTF8&qid=1490712370&sr=8-1&keywords=20+investments+by+buffett

    You might want to buy that book, then reverse engineer the author’s analysis and valuations of 20 of Buffett’s investments. THAT will keep you off the streets and out of trouble, PW.


    Regarding EBIT or CFO. Both are subject to manipulation as described in EXHAUSTING detail in Creative Cash Flow Reporting.

    It really doesn’t matter as long as you adjust for sustainability and understand how the company is generating cash. You can use EBITDA but make sure the E (earnings) is sustainable, then understand the proper maintenance capex to subtract to arrive at pre-tax owner’s earnings. Don’t get hung up on jargon like CFO or EBIT or EBITDA but know what they measure and the flaws. The closer you arrive at economic reality, the better. And you don’t have to be “perfect” just slightly better than the market.

  8. OK, that sounds like a challenge. Thanks

  9. Steven Mitchman

    John,

    Where do you come out on the changes to working capital when gauging FCF? Most people factor it in every year, but I tend to ignore it when doing long term analysis, provided of course that it isn’t raising clues of possible distress (increased rec. over a multi year period,,,etc). Curious on what your opinion was.

    Thanks

    • Over a several year period, the changes in WC tend to even themselves/cancel out so I ignore as well. Except when I notice a large change in numbers. Say you see a big jump in inventory and the company is not expecting a big jump in seasonal sales, then I would adjust or beware.

  10. Steven Mitchman

    Thanks John, appreciate the answer and the blog. Looking forward to the full course!

  11. Hi John,
    Thanks for the above exercise to find multi-baggers by looking for sustainable FCF yields >10%.

    However, if the starting price is overvalued, wouldn’t my predicted compounding returns be overly optimistic?

    • Susie:

      I am sure I grasp your question, but look at the update to this blog post on Coke and paying too high a price. Does that help?

      • Thanks John, I think I understand your point not to take these computations in silo. The exercise above is to project the future potential of the business.At the same time, we need to also ensure that the price we buy is a reasonable price.

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