Free Cash Flow: More Than Meets the Eye
What will owners ultimately receive in exchange for the cash being invested today?
One of the most common refrains in the financial media this quarter has been that many of the largest technology companies in the United States are “no longer generating any free cash flow.” While on the surface the statement is true, there is much more to consider.
Free cash flow is the cash a business generates from its operations minus its capital expenditures, such as spending on buildings, equipment and technology. For most of the past decade, tech behemoths were gushing free cash flow. They were known as asset-light companies whose businesses required relatively little investment in plant and equipment. However, in the last two years, their capital spending has risen dramatically due to heavy spending on computing capacity for the artificial intelligence buildout. This rise in capital spending means there is far less free cash flow left over.
The widespread implication is that these businesses – until recently among the most cash generative in corporate history – are no longer as financially attractive as they once were. While the near-term decline is real, what it means for the long-term owners of these businesses is much less obvious. And although today’s free cash flow debate is about technology and AI, the question underneath it applies to every profitable business: How much of this year’s cash should be paid out to the owners, and how much should be invested to produce more cash in the years ahead?
What Management Does With the Cash
Free cash flow is one of the most important measures we use when evaluating a business. Over time, a successful and profitable business must generate cash for its owners. This is ultimately what we believe drives intrinsic value.
As a business generates cash, its CEO must decide what to do with it: Reinvest in the business through capital expenditures, acquire other businesses, pay down debt, or return it to shareholders through dividends or share repurchases. These decisions are of critical importance and will often be the determining factor between a successful and unsuccessful investment.
The best management teams aim to utilize the cash where it is likely to generate the highest return on investment (ROI) for the owners of the business franchise. Sometimes this is heavy spending on internal investment through capital expenditures, which puts downward pressure on free cash flow. In other scenarios, the internal investments are less attractive and avoided, and free cash flow surges higher. Therefore, a single year of free cash flow can only tell us so much.
Not Every Dollar Spent Is the Same
Here is a simple example. Imagine a retailer with one successful store location. After a profitable year, the owner spends half of her cash profit repairing a dilapidated roof and replacing the aging HVAC system at the existing store. She spends the other half opening a second store on the other side of town.
Accounting rules treat these two expenditures identically: Both are capital expenditures, subtracted in calculating free cash flow. Economically, they could hardly be more different. The roof and the HVAC system had to be replaced simply to keep the current store running. That spending does not help the business grow – it keeps the business from shrinking. On the other hand, the second store reaches customers the first never could, and if it succeeds, it becomes a second source of cash flow for the owner for many years.
We refer to the first kind of spending as maintenance capital expenditures and the second as growth capital expenditures. The line between them is not always clean, but the distinction matters a great deal to a long-term business owner. At the end of that year, the cash flow statement shows exactly how much cash she spent, but it tells us nothing about what she bought with the cash.
More Free Cash Flow Today Is Not Always Better
It is tempting to assume that more current free cash flow is always good and less is always bad. We do not think it is that simple.
A company can increase current free cash flow by reducing or delaying investment. In some cases, that may be the correct decision. But a business can also make its current results look better by underinvesting in its operations, allowing its competitive position to weaken or passing up attractive opportunities for profitable growth. That company may be harvesting the success of past investments while damaging its long-term future.
The opposite can also be true. A company may depress current free cash flow by investing heavily in projects that will generate an attractive ROI by expanding its earning power over time. The owners receive less cash today in exchange for the possibility of substantially more cash in the future.
Of course, heavy investment does not automatically create value. Management teams throughout history have spent enormous amounts on projects that never produced adequate returns. A project does not become attractive simply because management calls it a “growth investment.” The relevant question for us is not whether management is investing more or investing less. It is whether the expected return on that investment is attractive relative to the alternatives. If highly attractive opportunities are available, reinvesting heavily may be the best decision. If they are not, the cash might better be used to reduce debt or returned to shareholders.
Management Matters
When a company we own enters a major capital investment cycle, we are really being asked to trust the people making the decisions. This is why our assessment of management quality is one of the critical pillars of our investment philosophy.
We must always be comfortable that the CEO thinks and acts like a long-term owner, but especially during a period of elevated internal investment spending. We consider their historical track record – were they successful in their past capital allocation decisions? We do not simply give management the benefit of the doubt merely because it labels spending as long-term or strategic. Confidence must be earned through a history of rational decisions, transparency, humility, and adaptability – and even then, there are no certain outcomes. Talented managers can make mistakes, and attractive opportunities can develop differently than expected. The returns from a large investment program may take several years to become clear.
We must also consider the consequences if management is wrong. A competitively advantaged and profitable company with a strong balance sheet may have the time and flexibility to recover from an overinvestment. A highly leveraged or financially fragile company may not.
Financial strength does not transform a poor investment into a good one. It does change the consequences of being wrong.
The Beginning, Not the End
Free cash flow remains indispensable to how we evaluate a business. Over time, a business must produce cash for its owners – ideally a growing stream of cash – or it is not worth owning. But the cash left over in any single year is only one piece of information about a stream of cash flows that stretches over decades. Maximizing that number every year is not the same as maximizing what the business is worth. The cash flow statement tells us objectively how much was spent but not what that spending will earn.
Warren Buffett made a version of this point in his 1982 letter to Berkshire Hathaway shareholders, explaining why the company’s reported earnings understated what its businesses were actually worth:
This is not a criticism of accounting procedures. We would not like to have the job of designing a better system. It’s simply to say that managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.
We think that idea is getting lost in today’s debate about the massive capital investment being made by large technology companies attempting to capture the AI opportunity they see ahead. The accounting number tells us where the cash went. Whether management is underinvesting, intelligently building the future earning power of the business or wasting the owners’ money is a question the accounting number cannot answer. We think there is nuance in analyzing each company’s statement of cash flows.
The returns from today’s AI investment cycle might not be known for several years, but they will not be invisible in the meantime. Productive investment shows up in customer demand, in whether the new capacity is actually used, in a stronger competitive position and, eventually, in more cash for the owners. Those are the things we spend our time thinking about, analyzing, and watching. We will also be watching for something less comfortable: The possibility that some of these businesses have permanently become more capital-intensive, so that what is called growth spending today becomes the maintenance spending of tomorrow.
Our goal has never been to own businesses that maximize the cash left over next quarter or next year. It is to own outstanding businesses, led by intelligent capital allocators, that grow the cash they produce for their owners over very long periods of time. That remains the best path we know to compounding our clients’ wealth over decades.
Thank you for your partnership with Baird Trust. We remain committed to serving you and your family with our very best efforts.
Baird Trust Company (“Baird Trust”), a Kentucky state- chartered trust company, is owned by Baird Financial Corporation (“BFC”). It is affiliated with Robert W. Baird & Co. Incorporated (“Baird”), (an SEC-registered broker dealer and investment advisor), and other operating businesses owned by BFC. Past performance is not a predictor of future success. All investing involves the risk of loss and any security may decline in value. This is not intended as a recommendation to buy any security and views expressed may change without notice. Baird Trust does not provide tax or legal advice. This market commentary is not meant to be advice for all investors. Please consult with your Baird Financial Advisor about your own specific financial situation.
