Look To Cash Flow For Confirmation


Net income is designed to be the ultimate measure of corporate performance, the one metric that shows whether a company became richer or poorer in a period. But the calculation of net income allows a range of choices to account for transactions, so management’s choice of accounting assumptions can result in overstated earnings and exaggerated growth rates.

As a check against such machinations, cash provided by operations (CPO) provides a useful complement to net income. CPO, from the statement of cash flows, approximates the cash a company generates from running its business. To calculate CPO, net income is adjusted for noncash expenses (like depreciation), noncash revenue (like undistributed earnings in minority-owned subsidiaries), and changes in working capital that consume or free up cash (like an increase or decrease in inventories).

Because CPO depends on fewer accounting assumptions than net income, using the two measures together can help reveal bona fide growers. For example, consider a retailer that ramps up inventories in a bid to boost sales. The jump in inventories won’t immediately impact net income, but the increase in working capital will hurt CPO in the period the inventories are built. Adding to inventories may be the right move, but that is tough to know as an investor.

CPO tends to be much more volatile than net income, and an investor should not expect the two measures to move in lockstep. But if net income is growing and CPO is flat or worse, the lack of confirmation represents a yellow flag. Ultimately, cash is needed to pay the bills, so a company that does not generate cash from its operations over the long haul faces long odds for survival.

By subtracting capital spending and dividends from CPO, you get free cash flow — a key measure of a company’s financial flexibility. Free cash flow represents money that management can deploy to benefit shareholders through debt repayment, acquisitions, internal expansion, share repurchases, and dividend increases.

For example, Comcast’s ($18; CMCSa) capital spending and depreciation were roughly equal for most of the past four years. But depreciation, which hurts net income but does not impact CPO, has continued to climb while capital spending has dropped over the past year, resulting in a surge in free cash flow. To the extent one believes Comcast’s capital spending will remain stable at today’s lower levels, the surge in free cash flow deserves as much consideration as the company’s slow-growing net income.

Encouragingly, aggregated CPO and free cash flow for U.S. companies rebounded with net income in the December and March quarters. Among the companies contributing to this resurgence are the five recommendations reviewed in the following paragraphs, all of which have delivered impressive growth in CPO in recent quarters. For the 12 months ended March, all five reported their highest free cash flow per share since at least 2007.

AmerisourceBergen ($31; ABC), a distributor of pharmaceuticals and other medical products, has reported year-to-year growth of more than 15% in CPO in four of the past five quarters. Free cash flow has shown similar growth, reaching $2.94 per share for the 12 months ended March.

Management says its first priority for cash is growing the business. Amerisource has spent more than $1 billion on acquisitions in the last eight years. The company plans to spend $350 million on stock buybacks in fiscal 2010, enough to lower the share count by 4% at current prices.

Buoyed by big earnings surprises, the stock is up 20% this year. Yet the stock trades at a discount to five- and 10-year historical norms based on earnings and sales. Amerisource, expected to deliver 24% profit growth and 8% sales growth for 2010, is a Focus List Buy and a Long-Term Buy.

Comcast ($18; CMCSa) is a steady producer of free cash flow, up 15% to $4.94 billion over the last 12 months. In that time, the share count declined 2% and cash holdings jumped 82% to $3.52 billion.

The company added 427,000 digital customers in the March quarter and lost 82,000 basic cable subscriptions. As a sign that more consumers are willing to pay for advanced services, average monthly total revenue per video customer increased 6% to $123. This boost in cable spending has come despite the lack of a housing recovery, which Comcast sees as a potential growth catalyst in the next year.

After rallying on its earnings report, Comcast shares have slumped on news that the Federal Communications Commission plans to reclassify broadband Internet as a communication service. FCC Chairman Julius Genachowski says the intent of the move is to ensure that cable and other broadband providers treat all types of information equally on their networks. But some are worried that the FCC’s move opens the door to broader price regulation.

Regulatory uncertainty could weigh on the shares in the near term. But the stock’s current price appears to discount such concerns, and the solid March-quarter results suggest consensus expectations of flat profits for 2010 may be conservative. The stock trades at just 14 times trailing earnings, 28% below its three-year median P/E ratio, a deeper discount than its largest U.S. pay-TV peers. Comcast, yielding 2.1%, is a Focus List Buy and a Long-Term Buy.

Microsoft’s ($29; MSFT) CPO reached $7.39 billion in the March quarter, an all-time high. The company also generated $5.85 billion in free cash flow during the quarter. Microsoft holds cash of $39.67 billion, or $4.53 per share, versus just $3.75 billion in long-term debt. Microsoft returned $3.1 billion to shareholders through dividends and stock buybacks in the March quarter. The stock yields 1.8%, and stock repurchases have trimmed the share count by 8% over the last 12 quarters.

While Microsoft is best known for its Windows operating system and Office suite of business software for personal computers, future growth depends on the company’s ability to exploit other markets. Microsoft has had mixed success in carving out a niche in mobile technology. At the end of February, 15% of U.S. smart-phones were loaded with Microsoft’s operating system, down from 19% three months earlier. Hewlett-Packard ($48; HPQ), which uses Microsoft’s operating system for tablet computers, has offered $1.2 billion for Palm ($6; PALM). Palm has its own operating system for mobile devices, and H-P plans to make the Palm program the basis for a new generation of computers and smart phones.

Microsoft is trying its hand at building its own devices, including the Kin, a social-networking gadget aimed at youths. Shares appear to reflect plenty of uncertainty, trading at 15 times trailing earnings, 18% below the five-year average P/E ratio. Microsoft is rated a Long-Term Buy.

In each of the last three quarters, Rogers Communications ($35; RCI) managed year-to-year growth of at least 52% for CPO and 109% for free cash flow. CPO has exceeded net income in every quarter since March 2003. Over the last year, sales jumped 33%, while returns on assets, equity, and investment more than doubled.

Rogers and two rivals control a combined 96% of Canada’s wireless-telecom market. Ratings agency DBRS predicts that share will shrink by 7% to 10% over the next five years as Canada encourages more competition. But by then, Rogers and its rivals will likely be slicing up a larger pie. Canada’s wireless penetration rate, currently 67%, is expected to grow steadily and could reach 80% in 2015.

Rogers trades at 13 times trailing earnings, a 30% discount to the three-year median P/E ratio. Rogers, with an Overall Quadrix score of 99, is a Focus List Buy and a Long-Term Buy.

Sigma-Aldrich’s ($57; SIAL) CPO rose 29% over the last four quarters, while free cash flow jumped 40% on improved sales and wider profit margins. The company attributes its margin expansion to a favorable product mix and productivity improvements. Long-term debt, cut in half last year, now equates to less than one-fourth of cash assets.

In March, Sigma bought Ace Animals, a commercial rodent breeder in Pennsylvania, for an undisclosed sum. Wall Street projects 13% higher per-share profits this year, followed by another 10% jump in 2011. The company forecasts 7% to 8% organic sales growth over the next five years. Sigma-Aldrich is a Long-Term Buy.

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