Negative Free Cash Flow, Debt, is allowed to, as long as...

investingdeck
3 min readJun 7, 2021
source: freepik

From 1972 to 1986, even before the rise and dominance of e-commerce, Walmart has operated with negative free cash flow (far from Warren Buffett's favorite), and its debt expanded at 34% CAGR for that period.

But Walmart still beat the market. In this period, the largest retailer in the world record a 29% annual return, capping the S&P500 with its 11% annual return.

1972 to 1986 is 14 years — we can’t call it short-term.

During that interval, revenue and earnings grew at almost 40% annually, outpacing its debt rate. When we include the dividend, its return is more satisfying. In 1975, Walmart paid its first dividend and as the earning grow, the dividend followed.

So, as long as the company could turn its debt into earnings, we believe it is okay to invest in it.

Into Negative Free Cash Flow

We believe that numbers in financial reports can’t be judged black or white. It always depends on...

A negative free cash flow could be good or bad.

By definition, Free Cash Flow is real hard cash earned by operating activity or company core business (in accounting we called it Operating Cash Flow )minus spending things supporting the operation (we call it CAPEX ) and the dividend paid.

In Walmart's case, we believe that the negative number is due to its high level of Capital Expenditure (CAPEX)expansion. At that time, as a fast-growing company, Walmart expanding rapidly by opening a new branch every year. Surely this soaked the cash in hand and ballooned the debt. It is painful in the beginning but paid off later.

Another example is Home Depot. Having a similar business with Walmart but specific to home improvement products, Home Depot experience the same cash flow situation. During the period 1985 to 2001, The second-largest retailer recorded negative free cash flow.

And again, like Walmart, Home Depot invested its cash into its business — accelerating its future revenue and earnings.

source: freepik

Interestingly, the market read this issue — during its negative free cash flow cycle, the stock price of the company gets higher and flattened when the free cash flow turns positive.

Investing in Business That Investing in Its Business

So, the lesson is..

Seek a company that has a sustainable competitive advantage that invests heavily in its business. In another word, we are looking for a company that in its early phase of growth — not a mature one.

Note that I mention competitive advantage at the first line since it is mandatory — it will reduce the risk that the negative territory of cash flow goes bad. Thus, I will avoid Tesla, OCZ, Molycorp, Rubicon tech since the absence of sustainable competitive advantage (aka economic moat) in their business.

And, there is another catch...

Do not take it too far and keep skeptic

The negative free cash flow is a precursor of the early phase of business — before it takes off — but, we need to keep rational and gain a wider perspective. Take Microsoft as an example, it has negative free cash flow and it invested its money in business — acquiring LinkedIn, Bethesda, Github — but the level of CAPEX and acquisition is equal with its dividend and buyback policy thus we can say that Microsoft is not giving full power in business reinvesting. Detail here.

In the end, negative free cash could be one of your investing weapons, and as another thing in the world — it can’t be used as a stand-alone strategy. Accompany it with complete perspective to get the optimal return.

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