Valuing oil service companies, continued.
Thanks,Chuzzlewit, for taking the time to compose your "meaty" response to my "meaty" (your phrase) questions.
So, meaty or not, here are some more questions.
1) You define "free cash flow" as "operating cash flow less interest, taxes and provisions for sinking funds." Sinking funds? Excuse my ignorance, but what's that?
The rough-and-ready definition I go by (because it is the one generally used by the financial web services that supply free cash flow numbers) is "operating cash flow plus depreciation and amortization, minus necessary (as against discretionary) capital expenditures."
Of course, I am aware that this is not the only definition. So as not to elaborate on this at needless length, here are some URLs for two posts (one the introductory post) to the now deceased Free Cash Flow thread. (One of the reasons for its demise is that although participants loved to expatiate on "the discounted stream of future free cash flows," they didn't want to discuss competing methods of determining PRESENT free cash flows. Frustrating!)
talk.techstocks
talk.techstocks
2) You say "the heavy debt load of many of the drillers is the reason for the disparity between operating cash flow and free cash flow."
Your comment inspired me to do a little research. What I turned up was this: a) the oil service/driller companies do NOT have a heavy debt load, as a group (compared to other industries); and b) there appears to be no correlation between debt and free cash flow (that is, if one uses the conventional definition mentioned above).
For example: I ran one screen to locate the companies in the sector with the highest debt load (highest possible debt/equity ratio, current ratio in "show only). Then I ran a screen to locate the companies in the sector with the lowest debt load.
Well, only 14 companies in the sector have a debt/equity ratio of over 1.0, and only 6 of them are over 1.5 (TOK, DXPE, KEG, SCSWF, DALY, and PKD). By contrast, there are 15 companies with no debt load at all (0.0 ratio). (For the record, they are MDCO, SMV.B, SDC, GIFI, MIND, BTJ, TESOF, WNS, HOFF, DWSN, GGY, TBDI, SMV.A, CDIS, GEL.) And more than half of the companies in the sector have debt/equity ratios way below 0.5. As a matter of fact, according to MarketGuide, the average debt/equity ratio for companies in the industry is .4. Very respectable, especially in comparison to such truly high-debt industries as car & truck manufacturing (debt/equity average -- 4.5!!).
At the same time, some of the companies with relatively high debt also have good free cash flow (e.g., MDR, which with a debt/equity ratio of 1.2, scores in the 96th percentile for free cash flow; or, TOK, which with a debt/equity ratio of 6.4 - !! - scores in the 81st percentile for free cash flow). Again, look at the car manufacturers: Ford (which I almost bought, but its debt put me off) has a debt-equity ratio of 5.5, but scores in the 98th percentile for free cash flow.
That might make sense, in view of the fact that companies often borrow precisely in order to improve (at least temporarily) their free cash flow situation.
The trouble is that, in the oil service/drilling industry, as many of the high-debt companies have negative free cash flow as have positive free cash flow. KEG, for example, not only has a debt/equity ratio of 2.5, but also scores near the bottom (11th percentile) for free cash flow.
The same thing is true of the zero debt companies: where free cash flow is concerned, they range from a high of 87th percentile (GEL) to a low of 3rd percentile (MIND).
I don't see any correlation here between free cash flow and debt -- unless your definition of free cash flow is so radically different from the one I have been using that these numbers are not meaningful to you.
3) You say there's no reason to favor a supermarket (high inventory turnover/low profit margins) over a jewelry store (low inventory turnover/high profit margins), all other things being equal. Quite so -- because the supermarket and the jewelry store will have almost identical Return on Assets, right? But what if a company (or an entire sector) has much higher-than-average ROA?
Well, on balance, you and I seem to be using (or trying to use, in my case) very similar methods for determining which companies to buy(or not to buy). But it would sure help if there were some universally accepted definition of both cash flow & free cash flow!!
Regards,
jbe
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