Cautions In Using Free Cash Flow

Scrutinize a company with hefty free cash flow - better take a close look at its capital leases.

Free cash flow is usually in vogue on Wall Street. It is supposed to reflect how much cash an owner can pull out of a business and thus how much a new owner would pay for it.

For example, a while back Jack In The Box nearly tripled free cash flow in just two years, an impressive accomplishment for a company that's essentially a hamburger joint. There was a catch: Jack in the Box didn't subtract from its free cash flow $10 million that it had spent on restaurant buildings and equipment. Doing so would have lowered its free cash flow to $80 million. Jack in the Box, which said it was following the rules and disclosed its leases, was still on the hook for the $10 million, but the sum didn't show up as part of the company's capital expenditures.

Instead the costs were being financed with a "capital lease," a perfectly legit accounting move which delivers all the effects of a heavily mortgaged asset but keeps the asset's cost out of the free cash flow calculation.

Free cash flow is always inflated when capital leases are used, because companies don't have to subtract these very real costs of doing business as cap-ex and instead can bury them in the financials. That makes the stock look cheaper than it really is.

Say a company needs to acquire $10 million worth of stoves to outfit several new restaurants but doesn't have the cash. So it leases the assets through a finance company by using a capital lease with an underlying interest rate of 8%. Lease payments run for five years and total $2.5 million per year. In the first year $800,000 of this sum is interest and $1.7 million a repayment of principal.

With a capital lease the equipment user treats the transaction more or less as property purchased with a mortgage. That is, the $10 million of equipment gets booked as an asset, the future payment obligations get booked as debt, and the company reports both depreciation and interest expense. So far this is how the books would look if the company purchased the equipment for cash and then took out a bank loan. The screwy part comes in the flow-of-funds statement. There the equipment acquisition in a capital lease simply fails to show up--either in the first year or in later ones--as a capital expenditure. The somewhat tenuous logic of omitting the $10 million cap-ex from the cash flow statement is that no cash changed hands when the lease was signed.

Capitalized leases don't affect earnings. Rather they boost free cash flow. Investors who want an accurate free cash flow number have to create it themselves by reading the footnotes.

Jack in the Box shares appeared to be trading at 15 times free cash flow. But if you made the necessary adjustment to the latter figure, the ratio went up to 17.

Companies can artificially reduce their reported cap-ex-and thus boost their free cash flow-by financing their equipment purchases and calling the resulting leases "capital leases."

Flowers Foods makes packaged brand-name bakery goods like Nature's Own and BlueBird. The company had free cash flow of $77 million in fiscal 2004. Deduct the cost of its capital leases and its free cash flow falls to $59 million. Flowers says capital leases are a financing tool that can be appropriately used, and it discloses them.

Grocer Safeway boasted free cash flow for 2003 (it has yet to release fiscal 2004 figures) of $815 million, giving it a price/free cash flow ratio of 10. Had it subtracted newly signed capital leases for equipment, free cash flow would have been $701 million, and its multiple would have been 12. Safeway says it's following the rules....