"Cash Flow", "Free Cash Flow", "Cash Burn"; what's what?

[Palm]

I note on Yazoo that this quarter after doing the same Free Cash Flow calculation that I have for the last couple of years (because it was agreed that it was a good indicator of "cash burn"), and resulted in a "Shout Out To Palm" from EHS as being a good calculation, the one I just did for the YE Dec 31 2011 is suddenly not an accurate measure of cash burn. The reasons given? The 3rd qtr 2011 calc supported EHS's estimate of $25 million/qtr burn, but then for the 4th qtr his estimate was $40 million/qtr and the same free cash flow calculation is now NOT a good measure to use, since it does NOT support his $40 million estimate, and it should include debt payments. He states that the best calculation is now just the simple difference between beginning cash and ending cash because it includes debt payments, etc. Given that, for 2011 that means IOC burned $160 million in cash, so $40 million/qtr. Very confusing for many reasons, and one is, back in 2010 when this issue came up he provided a link to Wikipedia for "free cash flow" and that definition states, "In corporate finance, free cash flow (FCF) is cash flow available for distribution among all the securities holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on.", so debt payments should not be included. From that whole "discussion" the spreadsheet I have been doing has been accepted as a good calculation of cash burn, so I have done it for every qtr since. Today it has been declared as inaccurate.

So should we go with the much more simple "Increase/(decrease) in cash and cash equivalents", which is the difference between beginning and ending cash? I don't believe so. But if we did, for the last 4 years IOC would be looking stellar! Looking back at the YE 2010 Cash Flow statement it shows figures for 2008-10, then we have the just completed 2011 year. For 2008 the "new" cash burn calculation shows that IOC had an INCREASE in cash of $5,108,810, for 2009 a DECREASE of just $2,520,753 and for 2010 a huge increase of $187,127,002. Then we have 2011's DECREASE of $168,735,217 (thus his $40 million/qtr for 2011). In total then for the 4 years IOC has net INCREASE of $20,979,842 and so an avg qtrly of an INCREASE of $1.3 million (using 16 qrts). Then to also use the EHS extrapolation/projection method IOC should never have to borrow money or do a public offering again because they are a cash generating machine.

Except I feel that is wrong. Fact is the Free Cash Flow calculation as presented has been agreed to be a good measure of "cash burn". Perfect, no. As with any company you MUST (as a finance person) look at all of the financial statements, including the notes to get as good an understanding as can be gleaned about what went on in a company up to that point from a numbers standpoint. For instance, 2010 was a hugely successful year from a net cash standpoint; $187 million net increase. Except you MUST review the line items and see that 2010 was when they did the very successful public offering. Then in 2011 we had the huge use of cash. Guess what? That was the plan. IOC did the public offering to raise necessary cash to carry out project work. So in 2011 we can't just look at the $160 million net use of cash and say, "WTF?!!, they just burned a ton of cash and it's gone." Not so. Looking at lines such as Expenditures on Oil and Gas Properties ($135 million which is now on the balance sheet for the most part), Expenditures on Plant and Equipt ($42 million which includes the construction equipment and goes to the balance sheet) and Repayments of Working Capital Facility ($35 million which goes to the balance sheet) tells a whole different story. Those items all net increase the balance sheet net assets. The cash is not "burned", it has been converted to balance sheet increases (assets) and decreases (liabilities). So using just the net increase/decrease in cash does not give an accurate picture.

I will stick with the Free Cash Flow spreadsheet. If there are things that should be added/deleted, no problem. But I will NEVER just use the net increase/decrease in cash for year/qtr; too many games can be played with that. When I have taught/mentored someone in accounting/finance I always tell them that they MUST understand how to read the complete financial statement; the balance sheet reflects the complete history of a company from day one, the operating statement gives you a current look at a qtr/year just completed, the cash flow statement tells you what the company is net doing with its cash, and the notes should serve to clarify specific line items, plus tell you about other matters the company is dealing with and planning for.

Some might say just looking at the cash flow statement and the net source/use of cash is a great barometer for understanding what is going on, but I don't feel that is accurate. Just my opinion. But it's also my opinion that using consistent measures when analyzing a company is crucial; otherwise you could just be using numbers to have them say what you want. Not a good idea.

[sageo]

Palm-Thank you for your very informative post.I think I speak for others as well. If we look at a multiyear time frame rather than a qtr to qtr period,your words are very sound.At times,"patience"and frustration can be very difficult for folks to handle.(Including me!!) GLTY

[admin]

In any case, they build infrastructure and drill resources, I think the return on these are many times the cash so I really fail to see the problem. But I realize that economists have a habit of seeing some stuff differently than accountants (including opportunity cost in profits comes to mind..) and now I realize that not even all accountants see things the same

[sltibbs]

Investing is both an art and a science.
Let me begin by saying the value of any investment is all the future cashflows (CFs) discounted back to today.
While this seems fairly straightforward, it requires further clarification. When I say CFs I am referring to the cashflows that will be received by the investor. For an IOC stock investor that refers to the Free Cash Flow to Equity holders (FCFE), which I will define as Operating CFs minus capital expenditures. Notice that this covers the Operating and Investments section of the CF Statement. The Financing section will just balance out the other two aforementioned sections after adjusting for cash balance changes by showing how capital was distributed (Outflows/uses: Paying dividends, repurchasing stock, or reducing debt vs. Inflows/sources: Issuing stock or issuing debt).
Currently for valuation IOC should be viewed as two separate businesses. A resource development business and everything else. The potential for the resource development investment is many multiples more valuable than everything else (Refinery, distribution assets, etc.). In my opinion, the resource development portion should be valuated based on its ability to generate sufficient CFs and its ability to get there. During the getting "there" phase I believe it is necessary to look at its cash burn rate because such endeavors inherently have large negative CFs upfront and the business must stay funded. So for the resource development side the cash burn, defined as decline is cash and cash equivalent balance
(note this is a little flexible, for example IOC has some short term notes from the Bank of PNG that are classified as investment grade, which is not surprising since PNG's sovereign credit rating is below investment grade, and because of that rating they are not listed as investment grade, however, I would consider them as cash equivalent noting that if they are not cash equivalent then there is a lot more to worry about, but I believe it is a wise method to store funds that IOC expects to need in the local currency)
must be monitored first. That being said, if you believe the beginning negative CF phase can be adequately funded, then one must then value the business (this is true whether they will develop the resource themselves or it will be sold to someone else or some combination of the two, which is the most likely). To value the business one should use the operating CF minus Capital Expenditures. You may do this for a fast growing business and generate a surprising small or even negative number. This is because ideally one must be able to separate the Capital Expenditures to sustain the Operating CFs you are comparing them to and the Capital Expenditures that are being invested to generate future operating CFs. The larger the difference between the sustaining Capital Expenditures and total Capital Expenditures the larger growth in Operating CF that one should expect in the future (assuming management is competent and the market is reasonable predictable). Very few businesses report their sustaining Capital Expenditures (see pipeline companies as a great example of such disclosure), so generally you have to estimate.
Since the refinery, distribution, etc. business is beyond development stage it is most appropriate to monitor the Free Cash flow to Equity holders (FCFE). And while that business is marginally FCFE positive, it is not enough to fully fund the Resource Development business, but it does help some financially and a lot politically (honestly I am glad of the benefits it is able to provide to the people of PNG and I look forward to that increasing).
There was mention of a sort of Free Cash flow to all equity holders and debt holders. In my opinion, that is not meaningful to discuss in any real world situation that I am aware.
And of course, there is always noise in the numbers. This always makes looking at a single quarter or short period of time messy.
In closing, let me state the obvious, IOC will need to raise capital. It could raise some debt, but would get expensive quickly, it could issue shares, but I believe the most likely is they draw down some of the existing lines, they rattle their debt capacity sabers a little more, then they accept a sell down. Equity issuance would be stupide given the average price per mcf that IOC can likely expect relative the 0.50/mcf that IOC currently trades at.
Forgot to add, I think the money IOC has been spending has been spent very wisely and will greatly benefit shareholders. Time will tell.
Hope this helps. Let me know if you have any questions.
Best,
Sam

P.S. Sorry for any typos. Time for bed here.

[Palm]

"I think the return on these are many times the cash so I really fail to see the problem."

The problem(s) can be many. I would guess that very conservatively 85-90% of non-finance/accounting people have no or a very limited understanding of how to read a complete set of financial statements and then listen to a CC and "test" what is being said against those financials. So that creates the possibility of huge judgement errors in one's own business or when deciding to invest, loan, stay invested in a company. That's one reason the average investor does very poorly when managing his/her own portfolio and why experts say that if you do, you should own a small diversified basket of companies you know and understand. If average Joe investor reads somewhere that a good guage of an O&G exploration company is to look at its net source/use of cash, he's going to be jubilant one quarter and crying the next. Or he may hold when he shouldn't or bail when he shouldn't. That's where I give hedge funds and top money managers a tip of the cap many times. These guys tend to be "experts" in understanding financials, and the similarities/differences in what management says and what the numbers "say". I see it all the time when presenting financials to owners, boards, etc. Many want to look at the bottom line to see if they "made" money or "lost" it. Then you look at the balance sheet and they want to know how much cash WAS there at the end of the period. Then out comes the DREADED Cash Flow statement. If you want to see eyes glaze over VERY quickly try and get past the Net Operating Income/Loss and start explaining how different items produce or use cash. Glazed eyes all around the room.

So people try and rely on quick answer parameters to base decisions. It goes downhill from there. Using different parameters from quarter to quarter then make it worse. "Oh well, when you look at it THAT way things are much better/worse than I thought", but basically clueless.

To blindly trust in a company's "story" (which usually comes from management, so-so analysts and the press) will get you in a lot of trouble. The "story" must line up with what's in the financials. If management says, "Last quarter we used a gazillion dollars is cash, but it's all in this unbelievable asset", do most people know where to look in the financials to see if that statement is reasonable? I don't think so. There's no doubt in my mind that Eric is a very intelligent person and is obviously well liked by students, etc. It just gets frustrating when an agreed upon measuring tool is suddenly a rusty worthless screwdriver.

I try and help clear the fog for people with some of the financial analysis and that's what's great about the board; people from all walks that we can rely on to bring the Big Picture into focus, not make it more blurry. We have a lot of people that understand different pieces/parts of it, and I know I wouldn't still be invested if I only understood the financials. Through many long-timers here it helps me line up the numbers with the "story" and have a very good feeling that IOC will get this done, and this investment may be that one in a lifetime.

[Palm]

Great info Sam, thanks. I agree with what you say and hope people understand that Free Cash Flow is just one measure of a company's financial health. Here's a fairly easy to understand definition from Investopedia on what Free Cash Flow is and what it's used to measure:
"
Investopedia explains 'Free Cash Flow - FCF'
Some believe that Wall Street focuses myopically on earnings while ignoring the "real" cash that a firm generates. Earnings can often be clouded by accounting gimmicks, but it's tougher to fake cash flow. For this reason, some investors believe that FCF gives a much clearer view of the ability to generate cash (and thus profits).

It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run."

Your then look into the future to ask what is to be expected to come back in today's dollars from all of this "investment". With all of this ammo it sure makes evaluating an investment that much easier.

[admin]

Palm, my "fail to see the problem" wasn't a general remark (or stab at accountancy), but one within a specific context, that is:

1) The cash outlays for the resource and infrastructure will generate a return many times over.

2) Even then, cash outlays could be a problem if the company didn't have access to cash sources, which I don't think is the case for IOC and more importantly, such would assume hugely irrational capital markets given 1) above

3) Economist (unlike accountants) have a habit of including opportunity cost, that is, looking at the next best alternative of a course of action. Would we really be better off not having spend that cash on infrastructure and drilling? Given my resounding NO on that, it sort of reinforced my undoubtedly rather cavalier attitude to the cash flow situation.

4) I could add that accountants often have considerable difficulty valuing what is often the most important part of a venture, the intangibles. There are ways of approximation of these, but that's far from an exact science.

Now, in general I agree with you and I'm not saying any pondering about the amount of cash outflow is not useful or necessary, but the margins in the returns are such that I can't be particularly worried about it, not even after your useful lecture.

[sltibbs]

Palm,

First, I wanted to thank you for sharing your numbers. (I meant to earlier.) The information is helpful and it obviously took some time to put together.

Next, the ultimate question to all of this is, are the funds that are being invested (call it burned if you wish, but that places a negative spin on it) wisely? Will they add meaningfully to shareholder wealth? I obviously agree otherwise IOC wouldn't be my largest holding. Let me add, STP and others have made this point as well.

So thanks to the worked you shared, we do have a better understanding of the capital that IOC will need. The question is now how will they raise the capital? Again, given the discounted price per mcf that IOC trades and the much higher selling prices that exist for physical ownership in the field (i.e., a sell down of E/A), and PNG's stated desire for a major partner, a share issuance just doesn't make any sense.

Best,
Sam

[Palm]

I know we are in agreement on a good deal of this; including opportunity costs concepts and the possibility of the very high return on these investment dollars. I do have some concern however with what the Free Cash Flow and actual balance of restricted cash is at this point, and their ability to go to the markets for debt financing. Fortunately I am one of those few non-auditor, non-tax season corporate accountants that has done a fair amount of financing for large, risky capital projects. :-D

If all continues as it looks now, I have a fairly small concern that we will need to seek debt, which Colin attempts to address in the presentation. However, we have seen globally and in PNG specifically things can get turned upside down very quickly. Should the unexpected happen IOC is obviously planning what it might do, otherwise Colin would not have mentioned it. I'd be concerned if he didn't plan for the worst.

So, should that unexpected occur, what options does IOC have? They feel, and I agree that they probably should seek debt and not another stock offering. The BIG question is the amount they could reasonably seek without paying 15% (for example) interest. Colin presents this gearing ratio of 50% possibility which equates to $600 million of availability. This amount seems excessive, and I also think they would have a very hard time getting that much from the markets.

To consider the debt question we have to start looking at EBITDA factors and probably use the "core" EBITDA he presents on slide 4 of $50.4 million. To obtain that $600 million debt using that EBITDA number represents a 12x EBITDA multiple. That's pretty rich. They already have approx $100 million in debt (as shown by Colin), and in today's market you mmight be able to secure a 3x multiple reasonably, and at most 4x but that would likely be higher interest rate.

So on top of what we have now we might reasonably be able to borrow another $100 million, which probably does a lot. The other important factors I mentioned before are the IPI Investors and Mitsui. They need to make regular cash calls to be sure these parties are funding what they are supposed to, and with drilling going on that should be a given.

I'd love to be able to jump right from where we are to SDs and discounted cash flows, but we have this unexpected that we must also be very aware of.

[Palm]

Didn't see your post Sam, but thanks also to you for the great work on the DCF spreadsheet. That's far more complex that what I did. And as far as your comment on an equity offering, we obviously agree. Debt would be the way, and I just presented what I think they could reasonably raise in today's markets. But with things moving as they seem to be now, they should not have to do that.