As you may know, I generally adopt a fairly quantitative process when looking for potential investments, at least at the screening stage. I first consider an excess cash position if there is one, both because it provides a source of primary liquidity and also because it often can be considered separately from the company’s operating assets and is free to be distributed to shareholders if management does not think of a clever way to waste it. I then compare the market value of the company’s operating assets to its free cash flow to equity and look for a nice fat yield. Of course, I also consider the free cash flow yield based on the actual market cap, because as I said managements have a tendency to regard excess cash as part of their empire, not something to be dissipated by returning it to the shareholders just because it technically belongs to them.
Of course, this is only the first step in the screening process; one must also consider the business’s competitive and economic context to determine the sustainability of existing cash flows. Value investors usually prefer to take the bottom-up approach, but there is no reason for ignoring the “-up.” And, of course, a coequal part of this analysis is the business’s capital structure and degree of leverage. As Marty Whitman, value investor and talented distressed investor, points out in his most interesting and perhaps controversialValue Investing, A Balanced Approach, value investors do not see risk in the abstract, the way modern portfolio theory thinks of risk as identical to volatility. Risk always has an adjective attached: default risk, revenue risk, margin risk, regulatory risk, lawsuit risk, etc. Note if you will that most if not all of these risks are attached to the company, not the market.
By way of illustration, I present you with Community Health Systems Inc., a company which shows up as very enticing on my screen, but which fails as a candidate for portfolio inclusion upon further analysis.
Community Health Systems (CYH) owns and operates more than 130 hospitals and a few care facilities in the United States, primarily in rural areas or in communities where they are likely to be the only hospital. The company has engaged in several acquisitions over the years, and apart from the above criteria the firm’s main targets, according to its own SEC filings, are nonprofit or municipal hospitals. I suppose in a time of municipal budget cuts, many counties and cities will be open to having the expense of running a hospital relieved from them. So, we have two points in CYH’s favor: it passes the initial screen for free cash flow yield on operating assets, and it is preying on sick and wounded hospitals, which is probably good for business, even if it may not be so good for society as a whole.
I believe also that these acquisitions, as they involve an entire hospital and not pieces of a hospital’s capital assets, are not necessary for the company to carry on operations at its existing hospitals. Therefore, these discretionary acquisitions should not generally be counted as capital expenditures for purposes of calculating free cash flow.
Turning to the specific figures, Community Health has $2.8 billion in current assets including $266 million in cash, and $1.7 billion in current liabilities, which means that all $266 million is excess cash and not necessary for the immediate operation of the business, particularly as the firm is cash flow positive overall. Subtracted from the market cap of $1.48 billion, this produces a value of the company’s operating assets of $1.21 billion.
On the free cash flow side, in 2010 sales were $13 billion, operating income was $1114 million, capital expenditures exceeded depreciation by $57 million, producing operating cash flow of $1057 million. Interest expense was $653 million, leaving $404 million in pretax cash flow to equity, which is $263 million after estimated taxes at a 35% rate. Subtracting noncontrolling interest charges of $68 million, we are left with $195 million in free cash flow to equity. This is a yield on the market value of operating assets of 16.1%, and 13.2% basic free cash flow yield.
In 2009 sales were $12.1 billion, operating income was $1069 billion, capital expenditures in excess of depreciation were $11 million, producing operating cash flow of $1058 billion. Interest expense was $653 million, leaving $405 million, or $263 after taxes. After noncontrolling interest deductions of $63 million, we have $200 million in free cash flow.
In 2008, sales were $10.9 billion, operating income was $972 mil, excess capital expenditure was $182 million, producing operating cash flow of $790 million. Interest expense was $659 million, leaving $131 million in pretax cash flows, or $85 after estimated taxes. Remove the minority interest deduction of $34 and we are left with $51 million in free cash flow.
If you want to spot the flaw in investing in Community Health from a value perspective, look carefully at the 2008 results. Operating cash flow was $970 million, but cash flows after interest were $131 million. Community Health is dangerously overlevered; against its market cap of $1.48 billion there is $8.8 billion in long-term debt. More disturbingly, unlike Supervalu where the managers are throwing all the cash they can spare into paying down this debt, Community Health seems to be just fine with the situation. In fact, the firm has been engaging in share buybacks recently, although they did recently exchange $1 billion in 8.875% bonds for a new $1 billion in 8% bonds, which I suppose helps, but it is not the aggressive pace of paying down debt that I would like to see. And even if the firm were bending all their free cash flow towards paying this debt down, it would take years for them to make a significant dent.
Even though running the only hospital in a region gives the company decent insulation against competition, competition is not the only risk a business faces. It is possible for Community Health’s earnings to be imperiled, particularly in the face of the fact that medical costs cannot keep increasing faster than inflation forever, and the calls for reducing Medicare reimbursements, which constitute a little over a quarter of Community Health’s revenue, are growing ever more numerous.
As such, I find it thoroughly impossible to recommend Community Health as a candidate for portfolio inclusion despite its good numbers and strong competitive position. Perhaps a massive debt for equity swap would change my mind, as would a Chapter 11 which would essentially amount to the same thing. But as things stand, value investing for me is about avoiding risk, not about being compensated for taking it, and so even the high free cash flow yield cannot move me towards investing in Community Health in its present form.
PS: I should also point out that Community Health’s 12-month high has been $42.50 against a current share price of $16.66, and of course that makes me think of the company as a short candidate–at least at $42.50, if not now. But the high degree of leverage in the company’s operations means that a small change in revenues or margins will be magnified greatly in actual earnings. Therefore, especially at these low prices and multiples, the company’s stock is likely to behave more like an option than a stock, and it is is never wise to have a naked short on an option.