By Ronald Fink
Corporate earnings look increasingly vulnerable to a lack of revenue growth, as companies have cut capital spending about as much as they can and are now dependent on cost reduction to sustain their profitability.
That's the conclusion of the latest quarterly report by the Georgia Institute of Technology's Financial Analysis Lab on operating cash flow for all publicly traded non-financial companies with a market capitalization of at least $50 million.
The report found that median free cash flow for the 3,848 companies increased by about 10 percent during the 12 months ending March 2010, compared with the 12 months ending December 2009, although revenue growth was flat for the latest period.
Companies were able to achieve that feat by growing free cash margin, according to the study. That metric, which the lab has tracked for over 10 years, continued its ascent, though at a slightly slower pace than in previous periods. Free cash margin, or free cash flow as a percent of revenue, increased to 6.69 percent during the twelve months ended March 2010, from 6.56 percent during the twelve months ended December 2009 and 4.60 percent for the twelve months ended March 2009. Free cash margin is now at the highest level the lab has ever observed.
In addition to overall sample, the study looked at 20 industry sectors. Six sectors-energy, capital goods, automobiles and components, consumer services; pharmaceuticals, biotechnology and life sciences, and semiconductors and semiconductor equipment-saw improving free cash margin and 1 (telecommunications) a declining cash margin, while the rest showed a margin that was relatively unchanged.
In recent quarters, companies have boosted their cash margin and flow through reductions in capital spending. But that is no longer the case, observed Charles Mulford, an accounting professor at Georgia Tech who directs the lab and serves as an advisor to CFOZone.
"Companies did not return to that well," Mulford wrote in an email to CFOZone.
At 2.83 percent of revenue in the March 2010 period, there was essentially no change in capital expenditures from the December 2009 reporting period. While that level of capex is significantly down from the 4.15 percent of revenue reached as recently as the September 2008 reporting period, the decline seems to have reached bottom, Mulford said.
"They've done everything that can be done on capex," Mulford said in an interview. "That's been cut to the bone."
A minimal level of capex is considered necessary for maintenance purposes alone.
In the March 2010 reporting period, companies instead boosted free cash margin through cost control, as their operating cushion-operating profit before depreciation-increased thanks to a reduction in cost of goods sold and SG&A expenses as a percent of revenue. Small declines in taxes paid to revenue and inventory days also boosted free cash margin.
Such cost reductions can go on for only so long, Mulford noted.
"What we're waiting to see now is whether our sample companies can once again begin to grow revenues," he wrote. He pointed out that revenue increases will allow the companies to spend more on cost of goods sold, SG&A and capital expenditures while maintaining free cash margin.
"However," Mulford added, "if these costs grow faster than revenue, something we wouldn't be surprised to see with capital spending, then free cash margin will suffer."