Mind the Gap

Cash flow from operations isn't keeping pace with net income at many companies, and investors are beginning to notice. Our exclusive study of the Standard and Poor's 500 reveals which companies have the widest gaps between the two measures.

But other companies whose cash flow from operations has lagged far behind their net income have employed less meaningful means of reporting their results. DuPont (#79), for instance, switched from accelerated to straight-line depreciation in January 1995, which boosted its earnings without any improvement in its operating cash flow, according to Paul Leming, an analyst for ING Barings. What’s more, says Leming, DuPont “constantly” uses nonrecurring items such as restructuring charges to make its net income look better than cash flow would suggest. Citing quarterly statements that are typically accompanied by dozens of explanatory footnotes, Leming says DuPont is “one of the worst abusers of recurring nonrecurring items,” though he is quick to note that “it’s all GAAP.”

DuPont declined to comment.

Honey, We Shrunk the Revenue

Elsewhere, restructurings have produced earnings boosts that have yet to be matched by operating cash flow growth. Consider PepsiCo’s results. While the company’s moves to spin off its restaurant division in 1997 and take public 60 percent of its bottling operations last year have improved its bottom line, cash flow from operations hasn’t kept pace.

To be sure, the restaurant division itself was performing dismally. With operating cash flow growth trailing net income by almost 4,000 percent, Tricon Global Restaurants, as the division is now known, ranked fourth in the S&P’s Compustat study. Yet PepsiCo’s own performance hasn’t been anything to write home about, with operating cash flow growth trailing net income growth by 82 percent.

In fact, restructuring moves shrank PepsiCo’s revenue growth by about 11 percent from 1995 to 1999, according to CFO Indra Nooyi. And while that has improved the company’s return on invested capital by 5 percentage points, she concedes that “it’s the easiest thing in the world to shrink a company.” She notes, however, that operating cash flow has also increased from $1.4 billion to $2 billion, and that its growth will accelerate in the near future as other moves, including the acquisition of Tropicana last year, produce more profitable top-line growth. Nooyi says PepsiCo’s entire focus since 1995 has been on maintaining a “quality earnings-growth rate in a capital-efficient way.”

The key, she says, is to have a “maniacal” focus on innovation, which she says PepsiCo now works hard to maintain. “We don’t want to run out of good ideas in two or three years,” she says, adding that such a failure would leave the company “dependent on one-time charges or taking costs out of the system.”

Of course, as Nooyi points out, since operating cash flow lags new expenditures on growth initiatives, comparing it against net income in any given year can be misleading–what she calls “a tailpipe indicator.” And despite its relative purity as a measure, operating cash flow can still be distorted by nonoperating items, including, for instance, the generous accounting treatment of the tax benefits of stock options. Here practices vary widely. Microsoft (#51), for one, includes such benefits in cash flow from financing activities, as opposed to operations. But Lucent Technologies Inc. does the opposite, which provides a nonoperating boost to its operating cash flow. (Lucent did not have the requisite 12 quarters’ worth of reported data to qualify for the S&P’s Compustat study.)

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