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This evening I received an interesting email from Matt R. who wrote me regarding my comments on CVS. I would like to answer his question as well as I am able, but would invite other readers, especially accounting people, who might be able to address his question in a bit more knowledgeable fashion.
"Hey Bob, stumbled across your blog today. Great information! Thanks for doing what you do.Have a question for you...in your posting on 10/11/06 re CVS, you made the following statement...."Free cash flow, which was negative at $(153) million in 2003, and $(434) million in 2004, turned positive at $117 million in 2005 and higher yet at $308 million in the TTM."Why would you calculate FCF to exclude CVS's proceeds from their Sale-Leaseback transaction and also exclude dividends paid?My calc for 2003 yields....968.9 - 1,121.7 + 487.8 - 105.2 = +229.8Are proceeds from the Sale-Leaseback not traditionally included in Net Capital Investments?Thanks,-Matt"
"The research, conducted by the Financial Analysis Lab at the Georgia Institute of Technology, looked at 37 nonfinancial public companies that entered into operating leases through large sale-leaseback transactions over the last six years. booked Thirty of the companies booked the sale proceeds as cash from investing, while just seven reported the sale proceeds as cash from financing activities.
That's understandable, since companies that book the deals as cash from investing can include the proceeds in their free-cash-flow calculations. Companies that account for the deals as cash from financing can't do that.
The problem is that the choice of investing-cash treatment for sale-leasebacks can distort the reporting of free cash flow. For companies that used the cash-from-investing treatment, study co-author and lab director Charles Mulford subtracted the sale proceeds from free cash flow. The adjustment caused significant decreases; for example, companies such as AMC Entertainment, Carmax Inc., and CVS Corp. dropped from a positive to a negative free cash flow."
The article continues:
"Companies that view a sale-leaseback as an investing event — interpreting the transaction as generating funds from the sale of property or equipment — take that double benefit. They book the asset disposition as a straight asset sale, and therefore add the sale proceeds into their free-cash-flow calculation.
Companies that view a leaseback deal as a financing event, however, interpret the transaction solely as generating funds, not disposing of an asset, and don't include the proceeds in their free-cash-flow calculation.
The blame for the reporting disparity doesn't fall on companies, according to Mulford and his co-author, Amit Patel, a graduate research assistant at Georgia Tech's College of Management. Rather, it's unclear under GAAP how to account for sales proceeds arising from sales-leaseback transactions that involve operating leases, according to their report."
Thus, I believe that Morningstar.com apparently must attribute this cash as being from a financing activity and not as from an investment. Please correct me if I am wrong, but I believe you are getting into a current accounting controversy that is over my head.
You also asked about the role of dividends in the calculation of free cash flow. Since I am not an accountant, I needed to do a little bit of work. You suggested that they should be subtracted from the FCF figure, but I found another article that suggests that this is not standard treatment. The article explains:
"Some analysts refer to free cash flow (FCF) as a basis for measuring a company's ability to meet continuing capital requirements. Others argue that FCF should represent the cash available after meeting all current commitments, that is, required payments made to continue operations (including dividends, current debt repayment, and regular capital reinvestment to maintain current operating activities). Still others argue that FCF should represent the cash available after meeting operating expenses, including working capital additions and the cost of maintaining operating assets. This approach defines FCF as "CFO minus capital maintenance expenditures." International Accounting Standard (IAS) 7 recommends that FCF should be recognized as "cash from operations less the amount of capital expenditures required to maintain the firm's present productive capacity." Using this description, dividends and mandatory debt payments would not be subtracted to arrive at FCF. Thus, using this description, discretionary cash expenditures would include growth-oriented capital expenditures and acquisitions, debt reduction, dividends, and stock repurchases."
Thank you so much for writing! Your question has given me the opportunity to try to understand the numbers that I share with readers so easily yet without as much of an understanding of the methodology involved. Please let me know if this addresses your concerns about the free cash flow calculations!
If you have any other questions or comments, please feel free to leave them on the blog or email me at email@example.com. Also, be sure and visit my Stock Picks Podcast Site where I talk about many of the same stocks I write about here on the blog! Have a great week in the market!