Opt For Rising Cash Flow

5/30/2016


It pays to have options. Just ask the high school senior who receives multiple college-acceptance letters, or the recent college grad weighing competing job offers.

In the corporate world, many of a company's most important options hinge on cash flow. It lets executives determine the proper balance between pursuing acquisitions, bolstering the balance sheet, returning capital to shareholders through dividends and stock buybacks, and reinvesting in the business with new plants, machinery, or product development.

Over the past 12 months, S&P 500 Index companies' combined cash provided by operations slipped 2%. To derive operating cash flow, we start with net income, then add back noncash costs (such as depreciation and amortization) and changes in working capital (such as inventory and accounts receivable). Our analysis focuses on the 427 stocks in the index with historical cash-flow data. Most utilities and many financial stocks don't report cash flow.

The four sectors to grow cash flow in the past year — consumer discretionary, consumer staples, health care, and telecom services — are also the only sectors to increase capital expenditures during that period, as shown in the table below. Additionally, they have delivered some of the strongest dividend growth.

DISSECTING FREE CASH FLOW FOR S&P 500 STOCKS
Free cash flow represents operating cash flow minus capital expenditures and dividends.
--------- Trailing 12 Months, In Billions (% Change) ---------
Sector (Number Of Companies
With Cash-Flow Data)
Cash From
Operations
Capital
Expenditures
Dividends
Free
Cash Flow
Consumer discretionary (77)
186
(8)
93
(17)
39
(9)
55
(-5)
Consumer staples (37)
142
(2)
44
(2)
57
(12)
41
(-10)
Energy (32)
115
(-34)
128
(-36)
38
(-1)
(51)
(-21)
Financials (69)
222
(-2)
32
(0)
46
(26)
144
(-9)
Health care (53)
170
(12)
26
(8)
45
(16)
99
(12)
Industrials (65)
163
(-3)
70
(-5)
44
(6)
49
(-7)
Materials (27)
51
(-8)
30
(-6)
13
(-3)
8
(-20)
Technology (62)
298
(-2)
67
(-2)
62
(8)
169
(-5)
Telecom services (5)
82
(15)
43
(5)
21
(8)
17
(72)
S&P 500 stocks (427)
1,429
(-2)
533
(-10)
365
(10)
532
(-1)

The average S&P 500 stock currently trades at 15.0 times operating cash flow, a 9% premium to the five-year average of 13.7. This average reflects 414 companies, excluding not only the 73 stocks that lack cash-flow data, but also 13 more with ratios below zero or above 75.

Taking cash flow one step further leads us to free cash flow, or cash from operations minus capital spending and dividends. It represents what's left after a company covers all of its obligations. S&P 500 stocks average price/free cash flow ratios of 28.8, about 8% above the five-year average of 26.6 — excluding 114 companies with ratios below zero or above 75.

Investors tend to bid up anything scarce, and S&P 500 stocks with the strongest quarterly growth in cash flow have outperformed the average stock over the last year. The price/free-cash-flow ratio has been among the most effective Quadrix factors over the past five, 10, and 25 years. But neither it nor other cash-flow metrics such as price/operating cash flow have been effective over the last several 12-month periods.

Four stocks with strong cash flow are profiled below.

Alphabet's ($738; GOOGL) rich balance sheet — net cash totals $70.06 billion, or $93.50 per share — reflects its prodigious cash flow. Alphabet is one of just four S&P 500 companies to increase cash from operations in 12 consecutive quarters. For the 12 months ended March, cash from operations reached a record $27.07 billion, sixth-highest among nonfinancial stocks in the index.

Alphabet launched its first stock-buyback plan in October but has kept quiet on whether a dividend may be coming. Under its $5.1 billion plan, Alphabet had already repurchased $3.9 billion in Class C shares, which trade under the ticker GOOG, through the end of March. See Portfolio Review for more on Alphabet's new products. Alphabet is a Focus List Buy and a Long-Term Buy.


The business model of C. H. Robinson Worldwide ($75; CHRW), a third-party logistics provider, requires minimal investment because the company outsources clients' transportation needs to railroad and motor carriers. Annual capital expenditures rarely exceed $40 million or 10% of operating cash flow. The company spent about $1.1 billion on four acquisitions in the past five years, primarily to expand its overseas and e-commerce operations. Most of its growth comes organically via adding new customers, expanding relationships with current clients, and introducing new services.

Over the past five years, C.H. Robinson has lowered its share count 13% and increased its per-share dividend at an annualized rate of 9%. Although free cash flow fell 31% in the March quarter, it had increased in each of the previous nine quarters. Operating cash flow has grown in seven straight quarters. C.H. Robinson is a Focus List Buy and a Long-Term Buy.


Over the past five years, CVS Health ($98; CVS) has grown its cash from operations at a 12% annualized rate and free cash flow at 14%. Its last 11 dividend hikes have exceeded 10%, and dividend growth topped 20% in each of the past six years. CVS has used stock buybacks to lower its share count by 22% over the last six years. Management plans to repurchase $4 billion in stock this year, roughly 4% of outstanding shares.

Since the start of 2014, CVS has completed deals worth about $17 billion to expand its reach in pharmacy retail, specialty-drug distribution, and home-infusion services. It has also spent more than $2 billion in each of the past two years to build new stores, improve distribution centers, and update technology. Its store count jumped about 25% in the past two years, including pharmacies in Target ($69; TGT) stores. Annual capital expenditures typically account for more than 25% of operating cash flow. CVS, yielding 1.7%, is a Buy and a Long-Term Buy.


In the March quarter, staffing agency Robert Half International ($41; RHI) reported 7% lower operating cash flow and 29% lower free cash flow. The quarterly decline — largely due to lower deferred income taxes, lower accounts payable, and higher accounts receivable — appears to be an aberration. Annual operating cash flow and free cash flow have risen more than 6% in five consecutive years, as well as eight of the past 10 years. Annual capital spending has ranged from 16% to 22% of operating cash flow over the past decade.

The balance sheet contains $214 million in cash, versus just $1 million in total debt, giving Robert Half flexibility to pursue a deal or return more excess cash to shareholders. In the past three years, its dividend has grown at annualized rate of 10%, while stock buybacks have shaved 6% from the share count. Robert Half, yielding 2.2%, is a Focus List Buy and a Long-Term Buy.

11 FREE-CASH-FLOW GROWERS
Trailing 12-Month
--- Last Quarter ---
Last 20 Quarters
Price/Free
---- Cash Flow ----
------- Quadrix Scores -------
Company (Price; Ticker)
Free
Cash Flow
($Millions)
Change
(%)
Free
Cash Flow
($Millions)
Change
(%)
Number
With
Positive
FCF
Number
Of Year-
Over-Year
Increases
Recent
Sector
Median
Value
Quality
Overall
Alphabet
($738; GOOGL)
17,649
35
5,230
42
20
12
29
21
33
96
57
Biogen ($280; BIIB)
3,274
1
836
32
20
14
19
28
75
98
92
C.H. Robinson
($75; CHRW)
443
21
27
(31)
16
14
24
24
52
84
69
Citrix Systems
($83; CTXS)
924
38
298
20
20
12
15
21
57
90
97
CVS Health ($98; CVS)
4,647
5
1,344
15
19
9
23
36
54
86
75
F5 Networks
($110; FFIV)
623
3
117
(12)
20
18
12
21
71
95
96
Kroger ($35; KR)
1,099
11
148
194
12
11
32
36
68
92
83
Lam Research
($81; LRCX)
860
81
89
(31)
20
9
16
21
86
84
93
Lear ($117; LEA)
1,069
156
175
193
16
13
8
26
94
94
99
Owens Corning
($52; OC)
432
492
-75
69
14
12
14
24
84
84
97
Robert Half Int'l
($41; RHI)
243
20
31
(29)
18
16
22
24
87
97
84
Note: Quadrix scores are percentile ranks, with 100 the best.

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