Cash is a fact, profit is an opinion

“Cash is a fact, profit is an opinion” – Alfred Rappaport

The usefulness of cash flow in valuation is debatable, but cash flow analysis often provides a better picture of business reality.

As an example, let’s look at three diversified industrial electronics companies, Hitachi (6501), Mitsubishi Electric (6503) and Toshiba (6502).

Firstly, the conventional accrual based Operating Income and Operating Margin history over the last 28 years.

HITACHI – OPERATING INCOME

MITSUBISHI ELECTRIC – OPERATING INCOME

TOSHIBA – OPERATING INCOME

Hitachi and Mitsubishi Electric follow a similar pattern, although the latter has higher margins. Toshiba has had two horrible years in the last ten, but otherwise appears to be following a different cycle or at least have a different mix of dominant businesses. The current year forecast can be ignored.

The picture changes when we look at what we consider to be the ‘true’ bottom line, “Comprehensive Income’. This includes Non-Operating Income, Minorities as well as the Other Comprehensive Income items that are excluded from Net Income. It is Comprehensive income and not Net Income that articulates directly with shareholders’ equity in the Balance Sheet and so should not be ignored.

HITACHI – COMPREHENSIVE INCOME

MITSUBISHI ELECTRIC – COMPREHENSIVE INCOME

TOSHIBA – COMPREHENSIVE INCOME

Mitsubishi Electric starts to pull ahead now. Although volatile, Net Operating Income is the largest component of Comprehensive Income, Net Non-Operating Income is mostly positive and Minorities are a modest drag.

Hitachi struggles to make a 4% margin from Net Operating Income and its more profitable group companies make Minorities mostly a negative contributor.

Toshiba now has 9 negative years and has never achieved a 4% margin.

Lastly, we turn to cash flow.

In the Japan Analytics App, we derive cash flows directly from the (fully comprehensive) Income Statement and Balance Sheet in order to ensure a proper ‘clean-surplus’ relationship.

Cash Flows are then apportioned to Operating, Investing, Financing and Shareholder Cash Flows, with the first two together comprising Free Cash Flow. Add in Minorities & Adjustments and the total is Change in Cash.

Cash flows are then accumulated over the period to provide a 5-line ‘timeline history’ of the cash evolution of the business.

HITACHI – CUMULATIVE CHANGE IN CASH

MITSUBISHI ELECTRIC – CUMULATIVE CHANGE IN CASH

TOSHIBA – CUMULATIVE CHANGE IN CASH

The differences are now clear.

Hitachi is Free Cash Flow negative (even cumulative Operating Cash Flow was negative in 2010) but has matched this with large-scale borrowing, more than twice Toshiba’s at its peak. The recent surge in Free Cash Flow is due to a large reduction in fixed assets – a good example of why Free Cash Flow alone can be misleading.

Mitsubishi Electric has added over ¥1t in Free Cash Flow since 2003 which helps explain its popularity with ‘gaijin’ investors.

Toshiba’s colorful plate of spaghetti is a window into a highly volatile and unpredictable business but one which has had no difficulty mirroring negative cash flow with debt finance.

Shareholders were rewarded by a constant raiding of the cash piggy bank until 2009 when they were suddenly tapped for more equity as debt levels spiked.

Ironically, the most consistent cash generation at Toshiba has been from group company losses that were ‘shared’ with minority shareholders.

Toshiba’s woes and malfeasance are now well documented. A simple glance at their 28-year cumulative cash flow chart would have given ample prior warning of the pressures that management were under to make their highly volatile mix of businesses meet market expectations.