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No. of Recommendations: 8

All else being equal, a company will be more profitable on a defensive basis than accrual basis when depreciation is greater than capex (which you don't see too often). So in CMVT's case, if there is no increase in net working capital and accrual taxes equal defensive taxes (sometimes the case, but not always), then CMVT's defensive profits will be $35 million higher than accrual profits.

Eventually, CMVT's depreciation expense will converge with capex, which means the two earnings figures in future years will be the same (provided management doesn't extend the useful life of its fixed asset base). For this reason, I would be cautious about assuming that an abnormally high level of defensive profits will be the norm.

The other reason why a firm's defensive profits can exceed accrual earnings is when management is able to make negative investments in working capital. A negative investment in working capital means working capital assets (receivables, inventory) build at a slower rate than working capital liabilities (payables, accrued expenses). You want to find and own companies that make negative investments in working capital--they are more efficient employers of capital (and hence, better investments) for the same reason that a car that gets 33 miles per gallon is more efficient than a car that gets 28 MPG (assuming, of course, no sacrifice in comfort, safety, space, etc.)

One of the hallmarks of Dell Computer during its high growth phase of the mid-90s was combining a ferocious growth rate in topline sales with a decline in net working capital. To wit, in fiscal 1999, Dell generated $18.2 billion of revenue, versus $890 million in 1992. Meanwhile, ending working capital was a negative $(537) million, compared with $128 million at fiscal year-end 1992. Thus, revenues surged 20-fold while working capital declined...a remarkable accomplishment.

Hope this helps. Also, perhaps you can re-phrase the question in your last two sentences.


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