We often get queried by prospective clients why Cash Generation is a “Gate” in our stock selection and why we emphasize Cash Generation over Growth. After all, Flip Kart is being valued at many Billions of dollars because of growth prospects and burns boat loads of cash.
At Solidarity, our primary focus is the Long term. Hence, we value a company’s ability to do the distance over short term speed.
Cash Generation is the best metric to track quality of reported profits and a company’s financial integrity/reporting culture. At the simplest level, earnings can be managed through channel stuffing or booking of bogus contracts. The more innovative instances encountered have been where promoters have not stopped at booking bogus export sales. There has then been Capital Expenditure shown in the books …. and payments for the Cap ex has been re-routed back into the books as receipt from Sales while no physical Asset has been actually created. Hence, Solidarity emphasizes importance of not only “Cash Flow from Operations”, i.e. Cash Flow after reinvestment in Working Capital, but also “Free Cash flow”, which is Net Cash Generation after investments in WC and Capital Expenditure.
Our other reason for focus on Cash Generation over Growth is that it dramatically lowers the risk profile of a company and hence dramatically enhances long term attractiveness.
Speed thrills. As investor push for faster growth, companies draw up very aggressive plans. Unfortunately, speed also kills. There is a high degree of probability that in the quest for speed, a young company will be exposed to a life threatening mistake. Here are a few illustrations from companies I have been associated with as a Private Equity investor
- Pharma – an acquisition gone wrong; unhedged FX; mis-sold FX derivatives
- Packaging – an expansion mistimed, wrong bet on technology
- Broking – fraud
- BPO – a wrongly priced contract , dip in service standards during transition
- Infrastructure – wrongly priced bids, wrongly estimated working capital cycle
Cash generation in the core business allows a company to survive these mistakes as the company can fund losses required to recover from these episodes. A company which does not generate Cash, is relying on the mercy of investors to fund their cash burn. It is when errors strike that bankers refuse to extend further loans and equity valuations plummet making equity fund raising next to impossible due to difference in perceptions of what is fair value. Investors have a fiduciary mandate to grow capital and not be emotionally attached with a wrong bet. Many Infrastructure companies in India are basket cases primarily because the promoters are unwilling to raise equity at their current valuations.
Finally, history tells us that the most valuable businesses are those that have been built through internal cash generation and not through repeated round of Investor funding. So the advice we give companies we fund during the Angel or Venture stage, is to try and to get to cash break even quickly so their destiny is not in the hands of strangers. This may not happen in the Initial round…but surely, should not take more than 3 years.
So for those investors willing to enter Flip Kart at a valuation of USD 10-12 Billion, we wish you well, but we cannot share the ride!