INVESTMENT

Fresh revenue, cash conversion cycle and free cash flow


Like it or not, companies are judged by faulty values.

GAAP sometimes misrepresents business realities. Let’s use that fact to create some alpha.

Continuing from the first memo, we will start by examining the revenue recognition, cash conversion cycle and free cash flow.

“Revenue” is not revenue, it is the time of the contract.

Revenue is recognized when an agreement is executed between a business and a customer.

Here’s how it’s done according to FASB:


Revenue recognition process

1. Mark the agreement with a customer.

2. Identify performance obligations (promises) in the contract.

3. Determine the value of the transaction.

4. Assign transaction value to the performance obligation in the contract.

5. Acknowledge revenue when reporting agencies meet performance obligations.

Source: FASB


There are several areas where GAAP revenue recognition can cause a problem and you may find an opportunity.

1. Multiparty transactions

In a multi-party transaction, “revenue” means the total earnings in a transaction in dollars or a subset that can be recognized as a company’s net revenue. Your last $ 20 Uber ride probably earned $ 16 for the driver and Uber’s net revenue of $ 4.

Net revenue can be distorted if multiple parties transact before an end customer receives a product. Imagine that a drug manufacturer controls a distributor and the distributor increases his order in anticipation of the last customer’s demand. These new orders increase the manufacturer’s net revenue. But what if the last customer’s needs are not met? The manufacturer’s reported organic revenue growth is likely to drive future revenue forward and it is filling the distribution channel. The definition of this category could present the potential alpha for game growth investors traps and shorts.

2. Changes in performance standards

When performance criteria change, reported revenue can be an unstable metric. For example, selling the same software may result in different GAAP revenue numbers depending on whether it is structured as a license or subscription. Subscriptions show low GAAP revenue at first but may decrease customer churn over time. Decreasing GAAP earnings does not look good in public markets. That’s why the perpetual-license-to-sauce transition is a popular private equity play: you can take a company private to change an accounting standard out of the spotlight, then bring the company to the public with a freshly cleaned book and a new story. Companies that make such changes while in the public domain, such as Adobe, can offer meaningful alpha opportunities for investors who understand what future calculations will look like.

Financial Analyst Journal Current Issue Tile

3. Multi-year contract

Is it important if the transaction is accepted on December 1 or January 1?

Companies want to report strong growth year after year for each period. Intelligent customers wait until the end of a quarter and then ask for a discount to book the transaction before the end of the period. It’s like buying used cars from used dealers after Christmas, who are desperate to make their year-end quota. In the worst case scenario, a company can pull off the demand for discounts every quarter to chase last year’s numbers. In the worst case scenario, that company will run out of demand in the future and their sales pipeline will be flattened.

But GAAP does not make it easy to differentiate between temporarily drawn forward contracts (noise) and increasing customer demand (signals). This is also true in the opposite case – GAAP revenue does not differentiate between declining customer demand (signals) and temporary sales delays (noise).

Private investors can see what I would call a “contract term structure”.


Contract term structure

Chart of contract term structure
Source: Lambus Capital

What you want to see in GAAP is the Annual Contract Price (ACV) and Total Contract Price (TCV). ACV is the amount of business currently under contract for that year – it is already recognized as revenue, invoiced but not executed, or contracted but not yet invoiced. TCV includes contracts and invoices for future years. With ACV and TCV, you can see revenue recognition in the context of full sales photos.

However, any FASB proposal to add a contract framework to the GAAP would be met with stiff resistance. The school will be much easier if you can grade your own homework. Imagine a high school motivation to give their parents “direct guidance” for this semester’s report card. Even the best students will want to keep their performance secret – why tell the competition how you are doing? So the term structure of the contract will probably remain secret and thus, would be an excellent place to look for opportunities.

Revenue only during GAAP agreement. As long as public investors overweight these reported numbers, the contract-to-revenue recognition process should be a recurring alpha source.

Tiles for SBBI summary version

The cash conversion cycle should be measured as a percentage and should include delayed revenue.

The Cash Conversion Cycle (CCC) measures how many dollars are invested in the process of producing and selling the average capital of each transaction.

The idea is to track the capital efficiency of the cash collected from the customers from the cash paid to the supplier.


Cash Conversion Cycle (Current Source)

Cash conversion cycle chart (current formula)
Source: Treasury Cafe

CCC is like a mini return on equity (ROE). Each driver can be improved to maximize the return on working capital. But unfortunately, there are two flaws with the current CCC metric.

The first problem is that CCC days are counted. What we are really measuring is capital efficiency over a period of time, usually one year. It’s a ratio. No one calculates the ratio in days. We should measure CCC as a percentage.

The second and more serious problem is missing a word. CCCs currently include accounts receivable (accounts receivable from customers), accounts payable (cash from suppliers), and inventory (suppliers pay in advance).

What is missing is the current delayed revenue (advance cash collection from customers). CCC monitoring is easy to see when we look at other effective capital line items related to customers and suppliers:


Cash conversion cycles should include delayed revenue

Delayed revenue should be included in the chart of the cash conversion cycle
Source: Lambus Capital

Updated CCC makes it easy to identify capital-light businesses.

Businesses that collect cash (deferred revenue) from their customers before executing a contract can be highly cash-efficient. But if the CCC excludes delayed revenue, investors may ignore the fact that these businesses could expand into a loss of GAAP net income without raising passive equity. This omission could explain why SaaS and the consumer subscription business were misjudged five years ago. If you can find parallels today, you can be like the public SaaS investors of 2016, far ahead of the curve.

The updated CCC also makes it easy to flag the awesome SaaS Death Spiral. Fast-growing companies can be quite fragile when they rely on delayed revenues to meet ongoing cash demand. If their GAAP revenue growth slows, they may quickly find themselves in a cash deficit. Surprisingly, these firms can show excellent GAAP revenue numbers during times of excitement on the brink of bankruptcy. If the CCC does not include delayed revenue, you will not be able to see the canary in coal mines.

Image tiles the basis of high yield analysis

“Free cash flow” is not free cash flow, it is an earned metric.

“Free cash flow” is not always equal to the actual cash generated by a business.

This creates a problem for academic finance because the key stone model of stock valuation is John Burr Williams’ Discounted Cash Flow (DCF) analysis. You may ask, if investors cannot reliably measure free cash flow (FCF), how can they reliably discount and value cash flow? Good question.

Here is the standard definition for free cash flow:


Standard Free Cash Flow Equation

Factor Location
+ Cash flow from operating activities Cash flow statement
+ Interest expense Income statement
– Tax shield on interest expense Income statement
– Capital Expenditure (Capex) Cash flow statement
(Cash flow from investment activities)
= Free cash flow

Source: Investopedia


All of this seems plausible until you look at how discreetly the numbers acquired for a given period of time and how much those accumulated numbers affect the FCF.


Why “free cash flow” can’t be free cash flow

The chart explains why
Source: Lambus Capital

Internally developed indomitable resources are the danger zone in today’s market. Most investors agree that we should capitalize on some of our R&D and SG&A spending, but no one is sure how long these indomitable assets will last. Google’s search engine will have to endure in one form or another for the next few decades; AskJeeves, probably not as. How can we come up with a consistent rule for pre-adjusting Google and AskJeeves engineering efforts?

To make matters worse, indomitable capex may be hidden in line items that are not included in the FCF calculation. If you look closely, the indomitable and funded leases acquired by a company can only be capex in disguise. Properly accounting for internally developed intangibles may be GAAP’s most significant unresolved issue.

Investors who focus on free cash flow often compare equity dividends to bond coupons, rightly or wrongly. But since the current FCF is complemented by these earned estimates, we cannot project the current FCF without hesitation to make general FCF estimates. There is a strong incentive for companies to pump those perceived equity coupons. That juiced FCF yield resembles a shaky bond with a high yield, also known as a fool yield

Normal FCF will differ significantly from current FCF when alpha chance is detected. Stocks where the company needs to reduce its equity yield – be it dividends, stock buybacks, or debt repayments – can be good shorts. Long opportunities can arise when the current capex, R&D, or a large portion of sales is reversed at an unaffordable fixed cost. The real downside is making sure that the fixed assets you are betting on don’t get stuck – lest you support AskJeeves instead of Google.

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Leaving the balance sheet

Here’s how the puzzle piece starts to fit together for longs, shorts, and entrepreneurs:

The chart paints a picture of CCC, revenue recognition and the opportunities for different investors in cash flow
Source: Lambus Capital

We can also rearrange the balance sheet. From there, we can reconsider the weighted average cost of capital as well as the market value of equity and share-based compensation.

You can read more from Luke Constable Librays Capital Library.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

Pictures of Dario Martinez-Battle in Unsplash


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Look Constable

Luke Constable is a founding and managing member of Lembus Capital, a public-private investment firm. Lambus looks for companies with charisma – quality business with accelerated cash flow and optimal capital flows. Before Lambus, Luke invested in special situations, growth and crossovers in several hedge funds and a private family office. He received his AB in History from Duke University and his JD from Stanford Law School. He was a champion Civilization IV Players and members of the California Bar Association. Originally from Philadelphia, Luke now lives in New York, where Lambus is headquartered.



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