Cash In On Rising Cash Flow
There’s no free lunch on Wall Street. But there’s free cash flow, which can be almost as good.
Free cash flow is what’s left after companies cover operating expenses, capital investments, and dividends, taking into account any change in operating assets and liabilities. Trends in free cash flow reflect companies’ growth prospects and financial flexibility. Specifically, rising free cash flow is an indicator of financial health and suggests a greater likelihood of increased spending on:
• Stock buybacks.
• Capital projects.
• Debt retirement.
The Forecasts likes companies with high and rising free cash flow, as well as operating cash flow. Add spending on dividends and capital projects back to free cash flow, and you have operating cash flow, or cash from operations. Operating cash flow differs from net income in two important ways.
• First, operating cash flow does not consider noncash expenses such as depreciation and amortization, instead focusing on how much cash a company generates after operating expenses. Noncash expenses (or gains) can skew net income.
• Second, operating cash flow reflects changes in operating assets and liabilities, such as accounts receivable and inventory. These changes in working capital provide insights about company operations, although they have no direct effect on net income.
Operating cash flow is less susceptible to manipulation than net income. We see high levels of operating cash flow relative to net income as a sign of earnings quality, a factor we consider in our quest for new buys.
In the table below, we present 13 stocks with solid growth in operating and free cash flow, as well as net income. All 13 stocks also consistently generate operating cash flow higher than net income. Four of these stocks are reviewed below:
CA ($24; CA) grew free cash flow by 13% and operating cash flow by 9% over the last four quarters. After generating positive free cash flow in each of the last 10 quarters, CA has accumulated $2.62 billion, or $5.10 per share, in cash and equivalents. The company pays a modest dividend but directs most of its excess cash toward acquisitions.
CA continued its takeover binge this month, closing on a $350 million cash deal for Nimsoft, a developer of software that helps companies monitor computer networks. In 2009, Nimsoft reported revenue of $32 million and bookings of $54 million, both up from the prior year. Nimsoft has about 800 customers, mostly in the U.S. and Europe, with annual revenues between $300 million and $2 billion.
The deal fits into CA’s strategy to shift toward cloud computing, programs accessed via the Web rather than run from a personal computer. CA’s track record for integrating recent acquisitions is solid. The company’s return on assets reached 6.6% in 2009, up from 1.0% in 2006. CA is a Buy and a Long-Term Buy.
Hospira ($57; HSP) makes generic injectable drugs and the devices that dispense them. In 2009, operating cash flow jumped 62% on 26% growth in net income. After covering the cost of capital projects — Hospira does not pay a dividend — there’s plenty of excess cash. Free cash flow has risen at least 57% in each of the last five quarters, and the company’s cash assets have more than tripled during that period.
Hospira’s financial flexibility should support future profit growth. In the past year, Hospira made a series of deals to push into new markets and diversify its injectables portfolio. Moreover, legislation for health-care reform includes a framework for generic biological drugs, opening a new market for Hospira, the only U.S. company that already produces these treatments abroad.
The consensus calls for 7% higher per-share profits this year and 15% growth in 2011, and the 2010 target in particular looks conservative. Hospira is a Focus List Buy and a Long-Term Buy.
Weak corporate spending has meant sluggish sales for IBM ($129; IBM). But IBM is fattening operating profit margins by cutting costs and shifting to a richer product mix. Free cash flow rose 20% in 2009 and at an annualized rate of 17% over the last three years. Since 2006, IBM has lowered its share count by 13% and boosted its quarterly dividend 83% to $0.55 per share.
IBM holds $13.97 billion in cash, equal to $10.70 per share, and the company should continue to share that hoard with investors. IBM has spent nearly $26 billion on stock buybacks over the last three years and is currently authorized to repurchase at least $5 billion more. The company has also raised its dividend in each of the last 14 years.
Technology spending is beginning to pick up. IBM’s revenue should rise at least 4% this year, and Wall Street expects per-share profits to jump 11% to $11.11 per share. At 13 times trailing earnings, the stock trades 12% below its five-year average P/E ratio. IBM is a Focus List Buy and a Long-Term Buy.
Laboratory Corp. of America’s ($74; LH) free-cash-flow growth accelerated to 20% last year. But in typical fashion, LabCorp stored little of that cash on its balance sheet. Instead, the company reduced its long-term debt 39% and shaved 3% from the share count. In February, the company announced a fresh $250 million stock-buyback program, enough to reduce the share count by another 2.5% at current prices.
Acquisitions are strategically important for LabCorp, the country’s second-largest independent clinical laboratory. In the laboratory industry, fixed costs are high and regional labs abundant. LabCorp scoops up smaller companies that complement its existing portfolio — esoteric testing, for example — while also expanding into new geographic markets. LabCorp generally expects small acquisitions to account for an extra $20 million to $30 million of sales each year.
Last year, revenue rose 4% and per-share profits advanced 7%, the weakest results in nine years. Looking ahead, Wall Street sees 12% higher earnings in 2010. Yet the stock trades at just 13.5 times the year-ahead earnings estimate, a 12% discount to the five-year average forward P/E ratio. LabCorp is a Buy and a Long-Term Buy.