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Follow The Cash Flow To Find Hidden Value

By Glenn Curtis

Tickers in this Article: LOW, SHLD, WYNN, SPF, HOV

A company's net income and earnings per share can provide insight into its well being and progress over time. That's why these metrics get the headlines. However, there are times when a company's "bottom line" doesn't tell the whole story.

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The problem with looking solely at a company's earnings number is that sometimes earnings are impacted by one-time events or depreciation, which can muddy the waters. So that's where cash flow comes into play. The cash flow statement simply tracks where the company's money goes and may provide a clearer picture of its health. (For related reading, check out Fundamental Analysis: The Cash Flow Statement and The Essentials Of Cash Flow.)

The Basics of Cash Flow
Suppose there are two individuals. The first makes $50,000 a year. The second makes $60,000 but also has an asset that has depreciated in value during the year by $15,000 giving a bottom line of $45,000 ($60-$15). Which individual is better off? If we were looking only at the bottom line, we might say the one who made $50,000, but is that accurate? The person who made $60,000 isn't really any poorer because that was a non-cash charge. In fact, this person has more income to buy things and perhaps open a business!

Cash flow statements are no-nonsense. They depict money outflows and inflows and may be a better measure in determining whether the company has the money to cover the important things like its interest payments on a loan or if it has extra money it can spend on a share repurchase program.

Its also important to note that there are times when a company might currently be losing money in terms of its net income, but generating positive cash flow. Under some conditions such a company may be a good investment candidate. If the earnings do turn positive, other investors may start to take notice and the stock could take off. With all of that in mind, here are some companies that have generated operational cash improvements and deserve attention:

Cash Flow Kings
• Hovnanian (NYSE:HOV)
The New Jersey-based homebuilder reported a second-quarter loss of $5.29 per share, and for the six months ended April 30, it lost $7.43 per share. However, a quick gander at its cash flow statement reveals that net cash provided by operating activities was just north of $50 million. That compares to a decrease of more than $235 million during the same period last year.

Keep in mind that the housing market remains quite fragile; however, I think that the cash flow is a good sign, and down the road if things continue to improve I think that retail and institutional investors could take notice. (Learn more about the volatile housing market in our related article Why Housing Market Bubbles Pop.)

• Standard Pacific Homes (NYSE:SPF)
In its first quarter ended March 31, the California based homebuilder posted a hefty loss of $3.34 per share, which was well off of the 63 cents it lost in the comparable period last year. However, net cash provided by operating activities was $228.9 million. That compares to $156.6 million in the previous year.

Again, this is a homebuilder, so the state of the housing market is an issue, but there is the potential for upside opportunity over the long haul. As far as earnings go, Wall Street expects the company will lose $4.21 per share this year. However, in 2009 analysts are expecting a narrower loss of 69 cents per share. (For more on analyst expectations, read Analyst Forecasts Spell Disaster For Some Stocks.)

• Wynn Resorts (Nasdaq:WYNN)
A quick history lesson is in order when to properly analyze this casino operator. In year ended December 2005 the company lost $90.8 million, or 92 cents a share. However, net cash from operating activities totaled $48.5 million. Those that paid attention to this were rewarded. Net cash from operating activities soared to $240.8 million in 2006. And in that same year, its income soared as well to $628.7 million or $6.24 per share. The stock closed at $58.55 on January 3, 2005. On December 29, 2006 it closed at $89.54.

Again, the purpose of this mention was to show what has happened in the past. Because of the stiff competition its been facing both in the U.S. and abroad in Macau where it operates, I'm a bit reluctant to pull the trigger on the shares at the current moment.

• Sears (Nasdaq:SHLD)
The well-known retailer has hit a rough patch as of late, but, over time, it has known for generating solid cash flow. According to it's latest 10-K, it generated cash flows from operating activities of $857 million in 2005, almost $1.5 billion in 2006, and $826 million in 2007.

I'm not a big fan of Sears right now because I'm worried about its future. After all, the consumer isn't spending and competition in this space remains tough. However, if it continues to produce consistent cash flow, analysts could be drawn to it.

• Lowe's (NYSE:LOW)
The environment for home improvement retailers is lousy right now. After all, it doesn't appear that interest rates will go much lower, so new construction may be stifled. Consumers aren't spending big bucks on home renovations these days.

In its first quarter ended May 2, Lowe's earned 41 cents per share, which is down from the 48 cents per share it earned in the comparable period last year. In addition, its sales declined some 1.3% from $12.2 billion in the comparable period last year to $12 billion in the most recent quarter. Yet, net cash provided by operating activities increased from roughly $2.1 billion in the comparable period last year to $2.5 billion in the most recent quarter. It's possible that Wall Street is overlooking this fact, and not giving Lowe's the credit it's due.

Bottom Line
There is an old adage: "It takes money to make money." Cash flow is the metric that lets you see how a company spends its cash, and where it is coming from. Sometimes a company looks sicklier than it actually is, and cash flow can help you discern if there is a turnaround opportunity in the works. Not all of the stocks we've looked at are guaranteed to rebound, but having examined their cash flow, it's likely that we could be looking back at them in a year from now and wondering how Wall Street misread their true health.

For related reading, check out Analyze Cash Flow The Easy Way.

By Glenn Curtis

Glenn Curtis started his career in the 1990s as an equity analyst for a regional firm in New Jersey. There, he covered companies in the technology, entertainment, and gaming industries. Curtis has since worked as a financial writer at a series of both web and print publications, including TheStreet.com and Registered Rep Magazine. He has held his series 6,7,24, and 63 securities licenses.

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