During Earnings Season, Don't Forget Cash Flow
During earnings season the spotlight shines brightest on per-share profits, a crucial but malleable metric that can be manipulated using accounting tricks. As a check against such machinations, consider cash provided by operations.
To approximate operating cash flow — the cash a company generates by running its business — noncash costs (including depreciation and amortization) and changes in working capital (such as inventory) are added back to net income. For most healthy companies, operating cash flow is greater than income. A reasonably stable relationship between operating cash flow and net income lends credibility to reported earnings growth, suggesting it reflects actual operations rather than financial maneuvering. Seasonal factors can produce temporary fluctuations between the two statistics, but the divergence should even out over time.
U.S. companies are producing cash in record amounts. Nonfinancial companies in the S&P 500 Index with 10 years of data reported an all-time high $1.05 trillion in operating cash flow over their last four fiscal quarters, up 14% from the year-earlier period — marking the strongest growth since the period ended March 2008. Trailing 12-month cash provided by operations for these companies has advanced in seven straight quarters.
If operating cash flow reflects a company's pool for capital reinvestment and dividends, then free cash flow shows what is available for future dividend growth, share repurchases, and expansion moves. Free cash flow is operating cash flow minus cash used for dividends and capital projects. In addition to the better-known price/earnings ratio, we like to use price/operating cash flow and price/free cash flow to value stocks relative to their cash-generating ability.
Consistent with our strategy of pursuing growth at a good price, we screened for stocks that have grown operating cash flow and also look cheap relative to both operating cash flow and free cash flow. We list 17 such stocks in the table below and review three.
Agilent Technologies ($43; A), a maker of measurement and testing equipment, illustrates the virtues of cash flow. For eight consecutive quarters, it has grown both operating cash flow and free cash flow at least 35%. Some of that cash went toward the repayment of long-term debt, but much of it remained on the balance sheet, lifting net cash per share to $3.82 from a negative $1.17 two years ago. The confluence of surging operating momentum and a revitalized balance sheet encouraged management earlier this month to initiate a quarterly dividend of $0.10 per share.
Better yet, the stock hasn't kept up with that cash-flow growth, despite rebounding 49% from its October low. Shares trade at 12 times trailing cash provided by operations, a 25% discount to their five-year average. At 14 times trailing free cash flow, the stock fetches a 29% discount to its peer-group average.
Agilent seems poised to deliver more growth, with the consensus projecting 15% higher per-share profits in the January quarter. Revenue growth is likely to exceed 8% for an eighth consecutive quarter. Agilent has a history of managing Wall Street expectations, having topped the consensus profit estimate in each of the last 10 quarters. Scoring above 50 in all six Quadrix categories and earning an Overall rank of 97, Agilent is a Focus List Buy and a Long-Term Buy.
Google ($581; GOOG) shares retreated after the company said it earned $9.50 per share in the December quarter excluding special items, up 9% but $0.99 short of the consensus estimate. Revenue increased 25% to $10.58 billion while cash provided by operations rose 11% to $3.92 billion, marking the 10th straight quarter of growth for both metrics.
The number of clicks on Google's search ads surged 34% in the quarter, but the average cost per click — what Google charges advertisers — dipped 8%. Rates for mobile ads tend to be lower than those for traditional digital ads, causing some analysts to wonder if the shift toward smartphones will cannibalize Google's more-profitable business. And some worry that Google is squandering its prodigious cash hoard — $44.63 billion at the end of 2011 — on Google TV and other unprofitable indulgences.
However, CEO Larry Page has worked to weed out superfluous ventures since taking the helm last April.Â And some of those pet projects might begin to pay off. Social networking site Google+ experienced a 125% surge in membership to 90 million users in the last three months of 2011. Moreover, operating cash flow consistently exceeds net income — affirming the quality of Google's profits. The stock remains a Focus List Buy and a Long-Term Buy.
Oracle ($29; ORCL) is one of just eight companies in the S&P 500 Index that has produced at least 5% higher operating cash flow in each of the last eight fiscal years (Google also accomplished that feat). Given Oracle's size — only five U.S. technology companies have produced more operating cash flow in the past 12 months — it is impressive that the company keeps finding ways to move the needle.Â Operating cash flow soared 45% in the 12 months ended November, nearly double its five-year annualized growth rate. Some of that cash funds Oracle's aggressive acquisition campaign, but cash assets have also climbed 25% in the past year to $31 billion, while long-term debt has held steady at roughly $15 billion.
Up 11% in so far in 2012, Oracle shares are within 3% of their price in late December, when company reported disappointing November-quarter results. At 13 times free cash flow, shares trade 19% below their five-year average and 22% below the average systems-software stock in the S&P 1500 Index. Based on operating cash flow, the stock looks even cheaper, trading at a 22% discount to its five-year average and 34% discount to its peer-group average. Oracle is a Buy and a Long-Term Buy.