Unlike many other industries, construction is boosting inventory at the expense of free cash flow.
For those worrying whether sustained growth will ever return to the U.S. economy, the construction industry may represent a beacon of hope. Devastated by the recession, builders have been seeing their sales rising ever since they hit the bottom of the downturn more than three years ago. Better yet, the way construction companies are investing in their businesses suggests they expect it might soon be time to party like it’s 2006.
In that year – March, to be precise – the industry hit its current eight-year high of $4.7 billion in median revenue, according to a recently released Georgia Tech Financial Analysis Lab quarterly review of cash flow trends. (The review looks at 2,979 non-financial, public U.S. companies with a current market cap of at least $50 million. Of those companies, 50 were in the construction industry.)
While construction is currently far below that median sales peak, hitting $1.5 billion in September 2013, it’s been climbing steadily out of its September 2010 nadir of $701 million. In other words, the construction industry has more than doubled its median sales since bottoming.
At the same time, builders have been allotting almost none of those revenues to free cash flow, the stuff that makes for dividends, share buybacks and funding for the mergers that can lift stock prices. The industry’s median free-cash margin (free cash flow divided by revenue) dropped for the third straight quarter for the twelve months ending September 2013, according to the report. Currently, the industry is putting a median of just 0.02 percent of its sales into free cash flow, compared to the 4.68 percent median for the sample as a whole.
Although construction’s operating profit rose over the last year, “the industry seems to have a cash management issue,” the authors of the Georgia Tech report conclude.
Yet in many respects, the industry’s free-cash margin, is “declining for the right reasons,” says Charles Mulford, the lab’s director and a Georgia Tech accounting professor. Instead of holding on to free cash, builders are doling it out to capital expenditures and, especially, inventory increases.
Indeed, the industry’s median days sales of inventory soared from 14.56 in September 2012 to 23.50 in September 2013 (figures are calculated based on the 12 previous months). The accumulation of inventory is an indication that builders, especially residential home builders, “expect [revenues] to continue to grow,” according to Mulford.
“The irony is that investors want free cash flow. What is it that creates value for a company’s shares? The only thing that a company can give its shareholders, really, is free cash,” Mulford notes. “You would think, then, that CFOs [would] be focused on trying to generate free cash.”
But the report shows that “managers know that while free cash is important, [they] also have to invest for growth,” according to Mulford.
Nevertheless, at some point, construction industry CFOs will turn their attention back to growing their companies’ free-cash margins, he predicts. “That can’t stay at zero, because that’s not going to support free cash,” he says. “And in the long term it won’t support the share price.”
By: David M. Katz