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.

Capital Exceptions

By the same token, some analysts contend that focusing on cash flow from operations penalizes profitable and fast-growing but capital-intensive businesses. “Many companies with decent profitability will chew up cash if they’re growing by 25 to 30 percent,” says Bruce Hyman, a credit analyst for Standard & Poor’s. On the other hand, says Hyman, “they’ll throw off cash if growth is slow.”

Hence the huge gap between net income growth and operating cash flow at companies like Texas Instruments. Following a series of divestitures and acquisitions that have repositioned TI in faster-growing markets, the company doubled its capital spending last year to take advantage of growing demand. If anything, it had underinvested previously, according to CFO Aylesworth: “In hindsight, we wished we had spent even more, because now we’re up against some capacity shortages.” But because of TI’s spending, he says, there’s been a lag between cash flow from operations and net income. “TI’s gone through a very considerable transition in the last four years,” he notes. “Our performance during that time hasn’t been as consistent as we think it will be in the future.” Nevertheless, he is committed to strong capital investment, calling it “the lifeblood of the company.”

But why does TI eschew an obvious alternative–outsourcing its manufacturing operations? Many high-tech companies have done just that, leaving everything but chip design to contract manufacturers. Aylesworth responds that TI prefers to do its own manufacturing because it gives the company more control over the quality and supply of its products, and because the “synergies we get from integrating process technology with product technology provide enhancements in our return on capital.” The CFO says TI’s competitors that outsource “are companies that don’t have the capital to invest in billion-dollar wafer fabs.”

In fact, the S&P’s Compustat study suggests that outsourcing one’s manufacturing may not be the panacea that some think it is. One chipmaker renowned for the practice, Xilinx, ranks high (#14) on the list. While CFO Kris Chellam stands by his company’s practice of outsourcing as “the best use of our capital,” that hasn’t eliminated the need for significant expenditures. In fact, Xilinx recently saw fit to retool a testing facility in Ireland to help sustain its growth, allowing Xilinx to test lower-cost versions of its programmable logic chips.

But with testing typically accounting for 10 percent of Xilinx’s production costs, the expenditures on the Dublin plant have caused Xilinx’s overhead expense to rise from 29 percent of revenue to 35 percent. Meanwhile, notes Chellam, net income has been boosted from items not reflected in Xilinx’s operating cash flow, including options-related tax benefits and investment gains on sales of equity interests in two key contract manufacturers.

Others besides TI, Xilinx, and PepsiCo are counting on such strategic changes to yield significant improvement. While heavy capital outlays have cut into Ryder’s cash flow from operations, the company has recently realigned its incentive system to favor marketing and sales of higher-margin services. “We’re no longer rewarding people for unprofitable sales,” says CFO Nelson.

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