Negative free cash flow is (often) a good thing

I tweeted the following half-jokingly

This is in response to comments from investors and analysts where they raise a red flag on a company with negative free cash flow, without further analysis.

What’s free cash flow

Let’s define free cash flow for a business

Free cash flow = Operating cash flow (including depreciation) – Maintenance capex

Maintenance capex is defined as capital required by a business to maintain its unit volume and competitive position. This capex would be in the form of working capital and fixed assets.

Let’s take a simplified example to illustrate it. Let’s say you own a house on your own piece of land (a rarity but go with me on this one). After a few years, you decide to get the house repainted as the old paint is peeling off and there are cracks in the wall. Let’s say you spend 5 lacs on the whole thing.

After the house is painted and repaired, you feel good about it. Keep in mind that the value of the house hasn’t gone up. If you were to list the house it would not sell for more (though it could have sold for less if the repairs had not been done).

Let’s fast forward a few years. You decide to extend your house and build a new room. The square footage of the house goes up by 15%. If you decide to sell the house now, you will be able to get a higher price for the house as the area of the house has increased.

The first scenario is that of maintenance capex – money spent to maintain value of the asset. The second is the case of growth capex – money spent to increase the value of the asset.

No published numbers

The same point holds true for a business/ company. The only difference is that a company will rarely break out the annual investment into maintenance and growth capex. This is something an investor has to figure out based on a study of the business.

Investors look at the cash flow statement with the following math

Operating cash flow + depreciation – working capital investment – fixed asset investment

If the above number is negative, they flag it as an issue. The problem here is that the investor is not distinguishing between growth and maintenance capex.

Any money spent on maintenance capex does not increase the value of the business. If all the investment in the above equation is maintenance capex and the resulting number is negative, then it is a red flag.

A lot of businesses, especially in the commodity space, have to keep investing just to stay in the same place from a competitive position. That’s the main reason why these businesses do not create value for their investors over a business cycle.

A company in growth phase and investing into growth capex, will also have negative free cash flow which could create value down the road.

How to evaluate growth capex

This requires a detailed understanding of the business and competence of the management.

There are businesses which requires very little maintenance capex (almost equal to depreciation) and re-invest all their free cash flow for growth and at high rates of return. Such businesses create a lot of wealth for their shareholders in the long run.

The key point to evaluate is whether the investment is being above the cost of capital (including debt). If yes, then you want the management to invest as much as it can (within reasonable limits) as these incremental investments will create value for us down the road.

The main job of the analyst is to figure out whether the management is truly investing above the cost of capital. That unfortunately cannot be accurately estimated to a decimal point, though there are indicators which can help you make an educated guess. You need to ask questions on the attractiveness of the industry, the opportunity size and capability of the management (based on past performance) and come up with a rough guess.

The next time you hear someone talk of negative free cash flow without an analysis of growth v/s maintenance capex – you can recall my tweet above. Such a person is implying that spending on education is a red flag as there no free cash flow being generated in the present.