Are Profits Shakier Than They Look?

Slowing cash flows may be a sign of widespread trouble

When news leaked out early in July that a key cash flow measure at AlliedSignal Inc. appeared to be deteriorating sharply, officials at the Morristown (N.J.) industrial giant rushed to sound a reassuring note. Sure, Chairman Lawrence A. Bossidy had sent out a tough memo only weeks earlier warning his managers to watch their cash outlays. The memo came after Allied's internal projections showed that free cash flow--cash from operations left over after dividends and capital expenditures other than acquisitions--would tumble to a negative $134 million for the half.

But Allied was quick to argue that there was no cause for concern. It dismissed the problem as temporary, since the capital spending and inventory build-up needed to fuel Allied's strong sales growth comes early in the year, while cash pours in during the second half when customers pay for big orders. And on July 22, when Allied reported a 16% gain in net income for the second quarter, excluding special items, it announced that by tightening ship, it had already cut the free cash shortfall to $90 million. For the year, free cash flow should hit $300 million. "There's no problem with cash flow here," says a spokesman.

Ask Jeffrey D. Fotta, president of Boston's Ernst Institutional Research, what he makes of that explanation, and he lets out a whoop. Fotta earns his living searching for signs of trouble or turnaround in the quarterly cash-flow statements offered up by Corporate America--and he has had Allied on his hit list since mid-1995.

JITTERY STREET. Why? Fotta argues that Allied's growing sales and earnings mask a serious problem. Over the past year, the rush to boost sales has left Allied with deepening difficulty in meeting its cash needs from operations. "They're growing too fast and not getting the returns from capital investments they used to," says Fotta. "Allied peaked in mid-1995, and returns have been deteriorating since." Without major changes, he predicts, AlliedSignal will have increasing difficulty keeping up its double-digit earnings growth.

Allied may not be alone. After four years of spectacular profit growth, questions abound concerning the stability of Corporate America's earnings. With Wall Street jittery and the Federal Reserve's direction uncertain, confusion has spawned a worried search for signs that the momentum behind profits is slowing. And two key indicators of earnings strength--operating and free cash flows--are clearly flashing yellow.

Even as Corporate America's sales and earnings continue to advance, Fotta and others who closely track cash see slippage. "Companies have worked extremely hard to cut corporate fat throughout the recovery, and that has generated great cash flow," says Jason J. Wallach, senior portfolio manager for Systematic Financial Management, an investment firm that picks stocks based on cash flow. "But with earnings peaking, free cash flow is starting to deteriorate." For the four years ended in fiscal 1995, for example, free cash flow for Standard & Poor's industrials jumped an average of nearly 17% annually. But so far, for the four years ending with fiscal 1996, free cash flow is up just 8.2%.

The most worrisome sign comes from a regular screen of companies in the Russell 1000, an index of the U.S.'s largest-cap stocks, done by Fotta. Using an adjusted measure of operating cash flow (OCF) devised by his firm (box), Fotta tracks changes in quarterly cash flows. The latest news isn't good. While Ernst's measure of OCF was growing at 80% of the Russell companies 12 months ago, the proportion has dropped steadily since. Today, OCF is falling at 55% of the companies. "That's a fundamental sign that things are not healthy. Last time they looked this bad was early 1990," says Fotta. "A lot of companies are not in as good shape as people think."

As with Allied, the main culprit appears to be cyclical overexpansion. That could mean trouble ahead, since changes in cash flow tend to precede changes in earnings by several quarters. Case in point: Hewlett-Packard Co. After it warned on July 11 that poor third-quarter sales mean it's unlikely to meet analysts' earnings estimates, the stock tumbled. Anybody watching its OCF had a hint of future woe. In mid-1995, HP's operating cash flow fell from its normal level of more than $600 million to just $22 million combined for the second and third quarters.

Why the lag? While both income and OCF figures measure underlying operating performance, companies have more wiggle room in how they report income. Under generally accepted accounting principles, managers in a bind have plenty of leeway to massage income through "noncash" items such as depreciation and amortization, and by the timing of when they book sales or expenses. Such finagling is far harder with OCF, so it's the first place trouble shows up. "When a company starts to see a downtrend in cash flows, poor profits will likely follow," says Howard M. Schilit, an accounting professor at American University in Washington who specializes in detecting gimmickry in corporate reporting.

Yet to Fotta, even the way receivables and payables are accounted for offers executives room to maneuver. So, unlike most analysts, he also removes them from OCF. By doing so, he can pinpoint binds of the sort that he says AlliedSignal faces. As demand has soared for its goods since the early 1990s, Allied has poured money into capital spending, new equipment, and inventories. But according to an analysis of dual cash flow done by Fotta's firm, the higher sales Allied has gained from the buildup haven't offset the increased costs they've added. Growth rates for Allied's return on sales--measured by retained earnings added to shareholders' equity--are dropping, not increasing.

As a result, Ernst's operating-cash-flow figures for Allied turned negative by spring 1995. Since then, says Fotta, Allied hasn't met its cash needs from operations and has increasingly turned to balance- sheet maneuvers such as drawing down accounts receivable instead. "They've invested money but aren't getting returns out of it," he says.

Allied hotly disputes that contention. "It's not an accurate overall picture of the quality of our cash flow," says a spokesman. But if Fotta's methods are controversial among companies he covers, they've won fans among investors. "He's a trailblazer, he allows you to catch turning points in stocks," says Garry M. Allen, president of Virtus Capital Management, the money-management unit of Signet Banking Corp. "It's so easy to distort earnings, but this offers a much closer sense of the underlying cash-flow dynamics."

Indeed, Fotta's screens are turning up a surprising number of warning signs at companies that otherwise look healthy. Although Merck & Co. just posted a 13% hike in second-quarter profits, it, too, is on Fotta's don't-touch list. The problem again is over-investment. Merck, he argues, has steadily increased capital spending and inventories, but gains in Merck's OCF, as measured by Ernst, are slim. The capacity is adding little growth to retained earnings. Merck refused to comment.

General Motors Corp. appears headed for trouble, too. With growth rates for sales and retained earnings falling fast, Ernst's measure of operating cash flow growth is tumbling. Yet GM is piling on capital spending and inventory. GM argues that its returns have been temporarily hurt by a strike early this year, as well as by a nonrecurring charge it made to fund its pension plan. Another reason is the heavy long-term spending it's making to fuel foreign growth. "That's not investment that gets a 12-month payback," says a high-ranking GM financial executive. "I'd have trouble saying we're not getting returns on our investment."

But Fotta believes that "GM is growing right into its problems. It's adding liabilities to make up for operating cash-flow shortages--not a healthy thing to do when sales and earnings growth are dropping." It could be one more sign that behind strong numbers, bad news can sometimes lurk.

Before it's here, it's on the Bloomberg Terminal.