2004 To our shareholders: Our ultimate financial measure, and the one we most want to drive over the long-term, is free cash flow per share. Why not focus first and foremost, as many do, on earnings, earnings per share or earnings growth? The simple answer is that arnings don’t directly translate into cash flows, and shares are worth only the present value of their future cash flows, not the present e value of their future earnings. Future earnings are a component—but not the only important component—of future cash flow per share. Working capital and capital expenditures are also important, as is future share dilution. Though some may find it counterintuitive, a company can actually impair shareholder value in certain circumstances by growing earnings. This happens when the capital investments required for growth exceed the present value of the cash flow derived from those investments. To illustrate with a hypothetical and very simplified example, imagine that an entrepreneur invents a machine that can quickly transport people from one location to another. The machine is expensive—$160 million with an annual capacity of 100,000 passenger trips and a four year useful life. Each trip sells for $1,000 and requires $450 in cost of goods for energy and materials and $50 in labor and other costs. Continue to imagine that business is booming, with 100,000 trips in Year 1, completely and perfectly utilizing the capacity of one machine. This leads to earnings of $10 million after deducting operating expenses including depreciation—a 10% net margin. The company’s primary focus is on earnings; so based on initial results the entrepreneur decides to invest more capital to fuel sales and earnings growth, adding additional machines in Years 2 through 4. Here are the income statements for the first four years of business: Earnings Year 1 Year 2 Year 3 Year 4 (in thousands) Sales $100,000 $200,000 $400,000 $800,000 Units sold 100 200 400 800 Growth N/A 100% 100% 100% Gross profit 55,000 110,000 220,000 440,000 Gross margin 55% 55% 55% 55% Depreciation 40,000 80,000 160,000 320,000 Labor & other costs 5,000 10,000 20,000 40,000 Earnings $ 10,000 $ 20,000 $ 40,000 $ 80,000 Margin 10% 10% 10% 10% Growth N/A 100% 100% 100% It’s impressive: 100% compound earnings growth and $150 million of cumulative earnings. Investors considering only the bove income statement would be delighted. a