Follow the cash trail

4/7/2008


The economy may be in a recession, but outside of the financial sector, the cash crunch is not exactly an epidemic.

Most U.S. companies have seen strong growth in operating cash flow in recent years, and have put that cash to work in a variety of ways. As the table below shows, U.S. firms have meaningfully increased their spending on capital projects, acquisitions, dividends, and share buybacks. In addition, the companies held more than $680 billion in cash and short-term investments in the most recent quarter, up more than 50% from five years ago.

The statistics pictured below reflect 318 nonfinancial companies in the S&P 500 for which five years of data is available. Because of difficulties interpreting their balance sheets and cash-flow statements, financial firms are normally excluded from calculations involving cash flows.

Before you start panicking because capital spending has jumped, consider that the overall spending trends make sense. Some companies hoard excess cash, but most either invest it in their business (capital spending), make acquisitions, or give it back to shareholders (dividends and buybacks).

Within that cash-flow data are three points relevant to today’s investors:

Debt is not always bad. Over the last year, companies issued more long-term debt than they repaid, just as was the case five years ago. Given the low interest rates seen in recent years, that makes some sense. Over the last year, the S&P 500’s nonfinancial companies issued $155 billion more in debt than they repaid, up from $86 billion five years ago. That $155 billion is equal to nearly 20% of the cash flow generated by operations and represents a key source of funds.

More debt, but less leverage: Overall leverage has declined over the last five years despite the increase in debt, as shown in the chart below. Last year, the S&P 500’s nonfinancial companies combined for a debt/equity ratio of roughly 58%, down from about 78% five years ago. During that five-year period, profit growth fueled a 60% increase in equity.

Buybacks are big: While dividend payments have increased steadily in recent years, share buybacks now dwarf cash payouts. Five years ago, the S&P 500’s nonfinancial companies paid out about 13% more in dividends than they spent repurchasing shares, net of newly issued shares. But over the last year, share repurchases topped $329 billion, versus $141 billion in cash dividends.

Given that the S&P 500’s nonfinancial companies grew net profits more than 145% over the last five years (19.7% annualized) while the net profit margin rose to 6.3% from 4.1% and the average stock returned an annualized 16%, we can deduce that marketwide, corporate investments have paid off. Analyzing the wisdom of spending policies at individual companies is a complex business.

Three companies that have delivered profit and cash-flow growth while increasing their spending on dividends and stock buybacks are profiled below.

One reason Harris ($50; NYSE: HRS) has topped consensus earnings estimates in each of the last eight quarters is the surprising growth of its radio-frequency (RF) division. The unit sells a variety of radio products to the U.S. Department of Defense, as well as other U.S. agencies and foreign governments. High-margin radio products account for about a quarter of Harris’ revenue but more than half of operating income. RF has grown revenue by at least 20% in each of the last four years.

That performance seems likely to continue. In the December quarter, RF revenue increased 25% from year-earlier levels and 13% from the September quarter. New orders, including contracts with the U.S. Army, National Guard, Air Force, and Marines, also rose. In an effort to lessen its exposure to the U.S. defense-spending cycles, Harris is increasingly marketing RF products to foreign governments. In the year ended December, the RF unit generated 25% of sales overseas, a percentage likely to increase over the next few years. To maintain RF growth, Harris is expanding its product lineup to include such products as land mobile radios, personal radios, and communications terminals.

Harris’ other divisions are also contributing to the company’s strong cash flow. Harris should generate at least $400 million in free cash flow in fiscal 2008 ending June, giving the company the ability to continue its share repurchases. Harris is a Focus List Buy and a Long-Term Buy.


Questar ($58; NYSE: STR) generates only modest growth from its regulated businesses. Regulated operations earned about $82 million (16% of profits) last year, not quite enough to cover the $84 million in dividend payments. Profits at the regulated natural-gas utility and pipeline were flat in 2007.

Unregulated activities provide more than 80% of earnings and almost all of Questar’s growth potential. Strong results from energy-related businesses helped Questar’s cash flow from operations rise at an annualized rate of 20% over the last five years.

In the second half of this year, Questar may be able to boost production if the U.S. Bureau of Land Management decides to allow year-round production. Regulators currently allow the production of natural gas at the Pinedale field, Questar’s most promising property, only from May through November. The bureau is expected to rule on the environmental impact of year-round drilling by June — and an unfavorable decision could hamper production growth.

In March, Questar bought 22,000 acres in Louisiana for $659 million. After the purchase, the company projected production growth of 14% to 16% this year, up from prior guidance of a 6% to 9% increase. Questar cited both higher expected production and a rise in natural-gas prices in raising its earnings guidance to a range of $3.05 to $3.20, up $0.15 from previous estimates and 6% to 12% above year-earlier levels. Questar is a Long-Term Buy.


UnitedHealth Group ($36; NYSE: UNH) increased its revenue at an annualized rate of 20% over the last 10 years, but that growth has not come at the expense of profitability — net income rose at a 26% clip during the 10-year period. The managed-care giant produces strong cash flows. Cash from operations has topped net income in each of the last 10 years, and the company shares much of that cash with shareholders.

In 2007, UnitedHealth generated $5.88 billion in cash from operations and repurchased $5.89 billion more in shares than it issued. Since 1998, the company has repurchased $22 billion in shares, in the process reducing its shares outstanding by nearly 15%. UnitedHealth plans to spend another $4.8 billion on buybacks this year.

In addition to aggressive stock buybacks, UnitedHealth also spends heavily on capital projects and acquisitions. In 2007, UnitedHealth spent $817 million on new technology and products, more than twice as much as any of its largest competitors. That strong capital spending has allowed the company to expand into new markets and grow subsidiaries that provide health-care data and analysis and pharmacy-management services. UnitedHealth is likely to continue investing heavily in its business and making acquisitions, both key to sales and profit growth. UnitedHealth is a Long-Term Buy.


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