Free Cash Flow -- The Real Bottom Line
We all know somebody with a big-time job and an even bigger-time lifestyle. No matter how much you make, you can spend it all and then some if you wish.
To discern whether a person is getting wealthier, don't look at his or her salary, but at what's left of earnings after all the spending. Apply that same rule to companies, and you'll understand the power of free cash flow.
Free cash flow represents what a company has left after covering production and sales costs, cash operating expenses, taxes, and interest, plus capital spending and dividends. Such free cash flow can be saved up, reinvested in the business, or distributed to shareholders via dividends or stock buybacks. Not surprisingly, we appreciate companies growing free cash flow.
Marketwide, free-cash-flow growth has slowed in recent years, much like revenue and profit growth. The 1,056 companies in the S&P 1500 Index with 10 years of cash-flow data combined to increase their free cash flow 4% to $561 billion over the last four quarters. Over the last 12 quarters, free cash flow declined 5%. In such an environment, companies with strong free-cash-flow growth stand out.
Like sales and earnings, free cash flow can also be used to value companies. The price/free-cash-flow ratio has proved an effective predictor of stock returns in our Quadrix stock-rating system, though it has drawbacks.
Nearly 16% of the companies in the S&P 1500 Index generated negative free cash flow over the last 12 months. For plenty of those firms, negative free cash flow is not an anomaly but a regular occurrence, rendering the price/free-cash-flow ratio useless. In addition, many financial and utility companies don't report free cash flow on a quarterly basis. Because of negative free cash flow and missing data points, we can only compute a price/free-cash-flow ratio for 72% of S&P 1500 Index stocks.
While free cash flow won't work as a universal measure of growth and value, we regularly consider free-cash-flow growth and price/free-cash-flow ratios in our individual stock analysis. With that in mind, in the table below we've listed 13 A-rated stocks with strong free-cash-flow trends. Most also posted growth in other key metrics such as sales, operating profits, or cash from operations.
Below we review five of our favorites. Three have more than doubled their free cash flow over the last year, while one of the others has seen trailing 12-month free cash flow rise year-over-year in every quarter for the last 14 years.
CBRE Group ($33; CBG) boosted its free cash flow more than 150% in the 12 months ended June, jumping to a new all-time high of $674 million. The shares trade at just 16.6 times that free cash flow — 61% below the average for S&P 1500 real estate developers and 31% below their own five-year average.
With investors pumping cash into global real estate markets and CBRE's profit margins rising, we see catalysts for continued growth in free cash flow. Demand for real estate management outsourcing is on the rise, and acquisitions should also support growth. CBRE is a Buy and a Long-Term Buy.
F5 Networks ($119; FFIV) generated free cash flow of $622 million in the year ended June, up 23% from the same period a year earlier. F5 has posted higher year-over-year free cash flow in every rolling 12-month period since the one ended September 2001. No other company in the S&P 1500 Index can match that streak.
Sales of F5's software-networking and traffic-management products rose 10% in the June quarter and 13% over the last year, reflecting robust demand, particularly from large U.S. businesses. Security is F5's strongest growth driver. We expect sales, profits, and cash flows to keep rising over the next few years, helped by new cloud, security, and mobility products. F5 is a Focus List Buy and a Long-Term Buy.
Gilead Sciences ($111; GILD) boosted its free cash flow 150% to $17.19 billion in the 12 months ended June, lifted by sales of hepatitis C drugs. During that 12-month period, sales rose 67%, per-share profits 114%, and operating cash flow 155%.
Partly reflecting fears that such growth can't continue, Gilead trades at a discount to its peers and its history. The trailing price/free-cash-flow ratio of 9.9 is 77% below the average biotech stock in the S&P 1500 Index and 43% below its own five-year average. Gilead is a Focus List Buy and a Long-Term Buy.
HCA Holdings ($85; HCA) saw its free cash flow decline in the June quarter, in part because of the timing of tax payments. However, the overall trend is unmistakable, with free cash flow of $2.56 billion over the last 12 months, up 39% from a year ago. The hospital operator pays no dividend but aggressively deploys its cash flow to buy back shares. Over the last year, HCA spent $1.94 billion on repurchases, lowering the share count by 23.6 million, or 5%.
In the June quarter, same-facility equivalent admissions rose 4.9%, while revenue per admission rose 1.2%. The combination of strong demand for hospital services, pricing power, and aggressive buybacks boosts our confidence that HCA can top consensus per-share-profit-growth targets of 13% this year and 10% next year. HCA is a Focus List Buy and a Long-Term Buy.
Shire's ($223; SHPG) free cash flow more than doubled to $3.93 billion in the 12 months ended June, punctuating a five-year uptrend. A $1.65 billion break-up fee paid by U.S. drug giant AbbVie ($60; ABBV) accounted for much of that growth. However, free cash flow would have risen at least 20% and operating cash flow at least 18% without that payment.
The consensus projects profit growth of 8% this year, 16% next year, and 13% annually over the next five years. Shire's six biggest-selling drugs delivered revenue growth excluding currency translation in the June quarter, averaging growth of 12% and offering reason for optimism about growth in the year ahead. At the end of June, Shire was conducting 19 clinical tests on rare-disease drugs, including four in the last stage of testing — not to mention about 30 compounds or research programs in the preclinical stage. Shire is a Focus List Buy and a Long-Term Buy.