Friday, November 07, 2008

Running on Fumes

Cash flow generation is a key element of the selection criteria I have used for Crystal Equity Research. Even among the companies in early, developmental stages when cash usage is common, we carefully watch capital adequacy. I believe this is one of the reasons that none of the companies in our current coverage universe are in any particular trouble beyond having lost considerable market capitalization. For example, Darling International (DAR: NYSE) recorded record cash flow in the first nine months of 2008, converting 10.1% of sales to cash. The winner for the year is Phase Forward (PFWD: NASDAQ), which had a cash conversion ratio of 41.6% for the first three quarters of 2008.

Why then are valuations of these companies depressed? One factor is the precarious condition of the large capitalization companies that is weighing valuation metrics across all sectors. The most recent dire predictions focus on the automotive manufactures. General Motors (GM: NYSE) and Ford (F: NYSE) are running out of cash and have appealed to the government for financial support.

The automotive manufactures are quite literally running on fumes. Rather than migrate their product lines to fuel efficient models or adopt new technology for vehicles powered by alternative fuels, the automotive industry has stubbornly continued to produce the same old gas guzzlers. Now they are willing to make the change as long as the government is willing to foot the bill.

The situation contrasts sharply with the conventional wisdom that holds large capitalization companies out as stronger than small companies. Larger companies have more ample resources, access to capital and are typically operating with fully development business models that generate cash. At least that is the conventional wisdom. There is no accounting for poor management decisions.

The auto makers are quick to blame their problems on labor unions who demand higher wages and health care benefits that drain manufacturers’ profits. It is a handy excuse as it refocuses attention from the hard reality of product lines that are no longer marketable. Sales have been dwindling for some time as the more nimble-thinking Asian and European auto designers have given consumers what they are looking for - fresh designs and fuel efficiency.

So what does this tell us about stock picking among small caps. First, it says quite a bit about the level of discounts for size and seasoning that are typically applied to smaller companies. It also reminds us that the business model and growth strategies are just as important as sales estimates and profit margins in determining if a company is a good investment.


Neither the author of the Small Cap Copy web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein. Crystal Equity Research has Buy ratings on both DAR and PFWD shares.

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