Refreshing Revenue, the Cash Conversion Cycle, and Free Cash Flow

Like it or not, companies are judged by flawed standards. 

Investors and entrepreneurs can generate alpha by recognizing how a company’s GAAP performance will attract or rebuff capital from the investment community at large.

Let’s start with revenue recognition, the cash conversion cycle, and free cash flow.

 “Revenue” Isn’t Revenue (It’s Contract Timing)

Revenue is recognized when a contract between a business and a customer has been performed.

Here is the order of operations according to FASB, the standard setter.

Fig 1. The Revenue Recognition Process

Source: FASB

That final step of recognition is where GAAP can hit a snag. Three areas to watch are multi-party transactions, changes in performance criteria, and multi-year contracts.
 
In multi-party transactions, revenue can be confused between gross dollars in the transaction and net dollars recognized by a specific company. For a stark example, Visa takes in about $0.00235 in net revenue and $0.0016 in EBITDA per $1 in gross transaction volume. Visa is a 68% EBITDA margin business under GAAP. Calling it a 0.16% EBITDA margin business might be misconstruing the situation.
 
When performance is contingent upon new criteria, confusion can also arise. For instance, software licenses and subscriptions can result in different GAAP revenue numbers for the same sale. The perpetual license to SaaS transition is a popular private equity play in part because public equities are often penalized for cluttered accounting. The companies who do make this change while public, like Adobe, can present meaningful alpha opportunities for investors who understand how the future accounting will turn out.
 
The two prior situations tend to be one-off misunderstandings. In contrast, multi-year contracts are an ongoing accounting challenge.
 
Should it matter if a transaction is recognized on December 31 vs. January 1?
 
A delayed contract could signal a weak value proposition, or it could indicate nothing at all. Savvy customers understand the pressure to book revenue by quarter-end. A company’s highest NPV move might not be to give a discount to book a sale before the end of the period – so long as investors don’t punish the company for the delay. But public investors tend to overreact to disappointing revenue reports.
 
Private investors look at customer cohorts, the pipeline for new sales, and what I’ll call the contract term structure. Customer cohorts in insurance have long been reported in loss development triangles, and there is a growing movement to bring cohort analysis into mainstream GAAP. The sales pipeline is probably too speculative and confidential to be publicly disclosed. The contract term structure, if reported, would make revenue recognition much easier to understand.
 
Fig 2. The Contract Term Structure

Source: Lembas Capital

What public investors would really like to see is annual contract value (ACV). ACV is the amount of business currently under contract for that year – be it already recognized as revenue, invoiced but not performed, or contracted but not yet invoiced. This metric would give you a better sense if a weak GAAP revenue report is a minor blip or a cause for concern.

However, any FASB proposal to add the full contract term structure to GAAP would be heavily protested. Honest companies don’t want their competitors to know when to poach the biggest customers. Fraudulent companies would find it harder to misrepresent their businesses. So, revenue recognition misunderstandings should remain a significant alpha source going forward.

Long investors can buy companies where GAAP revenue understates the contract term structure and where delayed contracts are immaterial to a business’s long-term relationships. Companies are still grappling with the ASC 605 to ASC 606 standard shift. A number of those stocks will likely sell off after disappointing GAAP revenue reports and then rebound as the GAAP numbers normalize. One-off opportunities around multi-party transactions and contingent performance are also worth looking into.

Shorts can look for companies with dangerous upcoming contract expirations or companies playing with contract timing to manufacture artificially high revenue growth rates. Standard metrics like expiring patents and unstable customer concentration can work here, so long as GAAP revenue actually falls as a result.

For entrepreneurs, the alpha lies in protecting the downside – avoiding revenue recognition missteps and only pulling contracts forward that don’t set an impossible comp for the same period next year.

The Cash Conversion Cycle Should Be Measured in % and Include Deferred Revenue

The cash conversion cycle (CCC) measures how long each invested dollar of working capital is tied up in the production and sales process for an average transaction.

The idea is to track working capital efficiency from the cash paid to suppliers to the cash collected from customers.

Fig 3. The Cash Conversion Cycle (Current Formula)

Source: Treasury Cafe

The first problem is that the CCC is calculated in days. What we’re really measuring is capital efficiency over a period of time (usually a year). That’s a ratio. Nobody calculates ratios in days. Imagine how confusing it would be if analysts said that Nike’s net income conversion cycle will be -72 days instead of saying Nike’s return on assets will be 20%.
 
The CCC is almost like a mini-ROE. Each driver can be improved in order to increase the return on dollars invested into working capital. In this light, we should measure the CCC as a percentage.
 
The second, and more critical, problem is that there is a term missing. The CCC currently includes accounts receivable (cash owed by customers), accounts payable (cash owed to suppliers), and inventory (cash paid in advance to suppliers). We need to add current deferred revenue (cash collected in advance from customers). It’s easy to see the CCC’s oversight (highlighted in blue in Fig 4) when you look at the other line items related to customers and suppliers.
 
Fig 4. The Cash Conversion Cycle Should Include Deferred Revenue

Source: Lembas Capital

The updated CCC makes it much easier to model and screen for a whole class of capital-light businesses.

Long investors can find companies where an improving CCC isn’t understood as a cheap incremental capital source. Take the popular SaaS and consumer subscription models today. Because these businesses collect from their customers ahead of time (deferred revenue), they generate huge cash inflows as they acquire new clients. Properly modeled, they have hugely favorable CCCs.

Shorts can look for the flip side of this leverage – the dreaded SaaS death spiral. Subscription companies with flat or shrinking GAAP revenue collect no new cash from customers until the next year starts. Don’t let the name fool you. Any business with significant deferred revenue and annual billing, Saas or non-SaaS, could quickly face a cash shortfall if their GAAP revenue growth peters out.

For entrepreneurs, you can improve working capital efficiency to reduce your need for your next fundraise. Many operators already do this, but a surprising portion of private equity alpha is generated because some companies have overlooked this blocking and tackling. On the downside, you should also model the SaaS death spiral case of 0% revenue growth, just so you aren’t caught unawares.

“Free Cash Flow” Isn’t Free Cash Flow (It’s an Accrual Metric)

“Free cash flow” doesn’t always represent the actual cash generated by a business.

This raises a problem for academic finance because the keystone model for stock valuation is John Burr Williams’ discounted cash flow analysis. You might ask, if investors can’t reliably measure free cash flow (FCF), how can they reliably discount and value those cash flows? Good question.

Here’s the standard definition for free cash flow.

Fig 5. The Standard Free Cash Flow Equation

Source: Investopedia

 This all seems straightforward until you look at how much discretion goes into the accrual numbers for a given period.
 
Fig 6. Why “Free Cash Flow” Might Not Be Free Cash Flow

Source: Lembas Capital

Operating expenses are the danger area here. Most investors agree that we should capitalize some portion of R&D and SG&A expenses, but no one is sure how long individual R&D assets will last. Google’s search engine should persist in some form for decades to come; AskJeeves and Altavista, not as likely. GAAP expenses treat engineering R&D as if it will only last a year.

Although normalized free cash flow should emerge eventually, trades and valuations are done at a specific moment at a time. A decade’s worth of misconceptions can be crystalized into a single price. That’s why there’s alpha here.

Long investors can look for businesses with understated FCF and that plan to attract or temporarily scare off yield-focused investors. Apple’s decision to pay a dividend has attracted investors who analogize the equity, rightly or wrongly, to a cheap bond. Conversely, Dan Loeb’s call for Disney to cut its dividend and invest that capital in Disney+ is likely a smart decision that will rebuff yield-seeking investors. But it’s not like Disney won’t be able to use their massive Disney+ cashflows to reinstate the dividend a few years down the road.

Shorts can look for stocks where the yield needs to be cut – be it dividends, stock buybacks, or debt payments. Dishonest promoters are a good place to start. You could easily see how someone could make a few contracting and accounting decisions to boost “free cash flow,” use that juiced FCF measure to sell the business, and then leave the buyer to deal with the fallout. Without casting aspersions, the private equity flip of Dick Smith faces this exact accusation. A useful credit analogy is to a bond with an unstable high yield, also known as a fool’s yield.

Entrepreneurs, you might be surprised to find that turning your equity into a yield product can attract hordes of investors seeking GAAP net income or free cash flow. What’s more, you may only need to make a few minor business decisions to get there. It’s just worth noting that the investors who become hooked on yield may become forced sellers if it is cut.

Moving to the Balance Sheet

That’s how the puzzle pieces begin to fit together for the income and cash flow statements.

We can recharacterize the balance sheet too. From there, we can revisit the weighted average cost of capital as well as the market value of equity and share-based compensation.