Show Me the Money

There are few things I like more than buying a great company at a fire-sale price, so I'm always on the prowl for fallen growth stocks that I think are likely to regain momentum.

When I analyze these companies -- in fact, when I examine all companies, but it's especially true in a turnaround situation -- my motto is, "Show Me the Money!" Specifically, show me the cash -- ideally, gobs and gobs of net cash on the balance sheet as well as high and increasing free cash flow. How often do I see this in a beaten-down stock? Rarely. But I'm very patient.

I find that every company in need of a turnaround has a story -- some are good and most are not so good -- for how it will rekindle its growth and why its future is so bright that everyone is wearing sunglasses. But in my experience the best bets -- and that's all successful investing is: making high probability bets over and over again -- are generally those companies with a big cash hoard that they are adding to rapidly.

Cash really is king -- companies can use it to fuel growth, buy back shares, or any number of things that can get a stock moving up again.

Last month, I examined whether Costco might be a good bet, and regretfully concluded it wasn't quite cheap enough, especially given some worrisome signs on the cash-flow statement. (And the situation hasn't improved much. Two weeks after my column, Costco released its 10Q -- a quarterly results report filed with the SEC -- for the third quarter. Despite a 14% increase in net income, operating cash flow declined 21%, and free cash flow was again negative.)

Today, let's look at two more companies, Staples (SPLS:Nasdaq - news - boards) and Robert Half International (RHI:NYSE - news - boards). Like Costco, Staples is a low-margin, high-asset-turn retailer whose stock has fallen out of favor. This office-supply retailer dominates its market and was one of the great growth stocks of the 1990s, compounding at more than 45% annually to its peak in April 1999.

Since then, however, the stock has declined nearly 60% to $14 today. Trading now at 21 times current earnings per share, 20 times this year's estimates and 15 times the 2001 estimates -- and with projected EPS growth of 28% annually over the next five years -- is it a buy?

No way. Unlike Costco (COST:Nasdaq - news - boards), which continues to grow profitably and where the decline in free cash flow can be explained by the company's spending to boost its growth rate, Staples' financials are declining in an alarming way. Let's examine the numbers.

Look for the Cash

Recall what I wrote in my Costco column:

"Whenever I consider investing in a stock that has declined precipitously, the first things I look at are the company's balance sheet and cash-flow statement, not the income statement. Why? Management has wide discretion when it comes to the income statement. ..."

While Staples' income statement isn't pretty -- EPS declined last quarter and is projected to fall even more in the upcoming quarter -- the balance sheet and cash flow statement are even uglier, and the trends are in the wrong direction.

This graph shows Staples' net cash position over the past six quarters (cash and cash equivalents minus short-term and long-term debt):

Staples: Net Cash Position * (in millions)

Source: Company Reports

Driving this decline is worsening free cash flow. This graph shows Staples' current 12-month free cash flow (cash flow from operations minus capital expenditures):

Staples: Free Cash Flow * (in millions)

Source: Company Reports

With Costco, much of the decline in free cash flow can be accounted for by rising capital expenditures -- which will presumably fuel future growth. But in the case of Staples, the measure of past-12-months capital expenditures has only increased 16% -- from $322 to $375 million -- from the fourth quarter of 1998 to the first quarter of this year. Thus, most of Staples' decline in free cash flow is driven by a drop in operating cash flow -- a worrisome sign.

Conclusion for Staples

I won't invest in a situation with numbers and trends like these unless a stock is screaming cheap, and Staples isn't even close. Sure, it has a story for how it will rekindle its growth -- cutting losses at Staples.com, increasing profits overseas, etc. -- but as I noted above, every company has a story. I think Staples' story is better than most, but -- call me closed minded -- my attitude is: Show me improving financials first, and then I'll be willing to invest the time to understand the story.

Does this mean I'm certain that Staples will be a poor investment? Not at all. This is a well-run company that generates good returns on capital and dominates its market. I'm simply arguing that at today's price, Staples is not among the highest probability bets available in the market today.

Robert Half International

In contrast to Staples, Robert Half International illustrates what I believe was a high-probability bet when I purchased it in January.

Over the past 51 years, the company has become the world's largest specialized staffing service. It focuses on providing temporary and full-time professionals in accounting, finance and information technology (its largest division is Accountemps).

Like Staples, Robert Half International was one of the best growth stocks of the decade, whose price compounded at 43% annually through June 1998. Then, growth decelerated dramatically. Year-over-year earnings-per-share growth dropped from 42% -- roughly its average over the previous 15 years -- to almost flat over the most recent five quarters:

Robert Half Int'l: EPS Growth Rate (year-over-year)

Source: Company Reports

Not surprisingly, the stock crashed, falling from a high above $30 in June 1998 to a low of nearly $10 last October. But unlike Staples, net cash (the company has always had miniscule debt levels) continued to grow, despite large share repurchases:

RHI: Net Cash Position * (in millions)

Source: Company Reports

And 12-month free cash flow continued to rise:

RHI: Free Cash Flow * (in millions)

Source: Company Reports

Now those are financials I like to see in a company whose stock has fallen by nearly two-thirds! So did I immediately rush out to buy Robert Half International? No, but with numbers like those, I was very willing to believe management's story.

And it was a good story. They reported that demand for services remained strong and there was no evidence of declining market share, but the economy was so white-hot that its labor pool of specialized temporary workers had dried up. After due diligence, I thought this was a plausible story -- and it didn't hurt that margins and returns on capital remained high. It helped that the company was buying back huge numbers of shares.

I was also attracted to the idea that Robert Half International, unlike most other companies, might benefit from a slowing economy. Last year and early this year, I wasn't worried about my stocks if the economy continued to boom; instead, I was looking for stocks that might cushion a decline in my portfolio if the economy slowed.

On the Rebound

As the economy has slowed a bit, Robert Half International's growth has rebounded. Earnings -per-share growth bottomed out at 3% year-over-year in the third quarter of 1999. Its EPS growth in the past three quarters has been 8%, 24% -- and in the latest quarter reported a couple of weeks ago, 37%. Net cash and free cash flow have also continued to rise. Not surprisingly, Robert Half International's stock has responded, rising 139% this year.

With the stock now trading at 38 times its earnings per share, 35 times this year's estimates, and 29 times 2001 estimates, is it still a buy? Well, it's hard to argue that it's significantly undervalued, but I still believe in the company, so I'm not selling. If Robert Half International continues to execute and grow at anything like the rate of the past, it will be a fine investment going forward.

Conclusion

I believe many investors today too easily become enamored with a company's story, and are willing to overlook financial weakness. I think in most cases, they would be better off by making financial strength an absolute must-have. Only when that criterion is satisfied should they consider the company's story.

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Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. At time of publication, Tilson Capital Partners held positions in Robert Half International, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Mr. Tilson appreciates your feedback at [e-mail]. To read his other writings, click here.