Mathematically speaking, free cash flow is net income plus depreciation minus the total of dividends, capital expenditures, required debt repayments, and any other scheduled cash outlays. It’s basically a measure of how much hard cash a company generated in a given period after paying for its regular business expenses and growth initiatives. It is a good gauge of how well management is performing for its shareholders.
Some investors prefer free cash flow over earnings, in fact, because they believe that earnings, which are largely an accounting figure, can be manipulated more easily than hard cash. Also, in some cases, earnings get distorted unintentionally by accounting principles. Depreciation is an excellent example of the latter situation, as depreciation inherently represents money that has already been spent and has little to no impact on a company’s cash flow, but often has a major impact on earnings.
Of course, free cash flow isn’t the only metric one should consider when evaluating an investment opportunity, but it can quickly weed out companies that simply don’t measure up. To help investors find companies that have a solid history of generating healthy amounts of free cash flow, Value Line produces a weekly screen that appears in the Index section of every issue of The Value Line Investment Survey that highlights this metric.
Labeled “Biggest ‘Free Flow’ Cash Generators”, the screen lists the top 100 companies of the 1,700 The Value Line Investment Survey follows based on free cash flow generation over a trailing five-year period. The long time frame is used to ensure that companies with solid histories of creating cash flow are brought to the fore, weeding out companies that have temporary boosts to their cash flow generation because of short-term or one-time events.
A recent review of the screen brought out a few interesting companies, including Iconix Brand Group (ICON), Celgene Corp. (CELG), and F5 Networks, Inc. (FFIV).
Iconix Brand Group
Iconix Brand Group Inc. changed its business model from manufacturing shoes to the licensing of various trademarks in 2003. In mid-2005, it changed its name from Candies. It now owns and manages a portfolio of consumer brands, including Candie’s, Badgley Mischka, Joe Boxer, Danskin, Rampage, Ocean Pacific, Mossimo, London Fog, Rocawear, Bongo, Starter, and Mudd. In deciding which brands to purchase, the company evaluates the strength of the targets as well as the viability and sustainability of their future royalty streams. The company licenses its brands to retailers worldwide that have the responsibility for designing, manufacturing and distributing the licensed products. Iconix supports its brands through advertising, product development, and “coordinated trend direction” to enhance product appeal and help maintain and build brand integrity.
Iconix is ranked second on our current list of “Biggest Free Cash Flow Generators”, as it has created 31 times more cash than it has paid out for capital equipment and dividends over the past five years.
Acquisitions are responsible for its high position, and have become a big piece of the puzzle for Iconix since management decided to change the business format. Indeed, contributions from stakes in the likes of the Peanuts brand and Madonna’s Material Girl line drove most of the gains enjoyed in the first half of the year. The more recent purchase of the worldwide rights to license the Ed Hardy brand ought to help maintain this momentum over the next six months, but analyst David Cohen does not think the company is even close to being finished expanding its brand-license portfolio. Cohen believes that strong free cash flow will continue funding management’s buying spree, while allowing the company to also expand overseas.
Celgene Corp. engages in the development and commercialization of therapies to treat cancer and immune-inflammatory diseases. It offers a plethora of therapies, with current sales being dominated by Revlimid (68% of 2010 sales, treats cancer of white blood cells responsible for the production of antibodies), Vidaza (15%), and Thalomid (11%). It also has an extensive pipeline, which includes immunomodulators, oral anti-inflammatory agents, kinase inhibitors, small cell lung cancer treatments, ABI compounds, and cellular therapies.
The company has seen serious earnings momentum so far this year. A better-than-expected second-quarter net gain of more than 25% was largely the result of ongoing traction from its flagship product and increased penetration overseas. Being a drug developer, it has limited cash earmarked for capital spending, and the board of directors has upped the parameters on the current share-repurchase program. Looking forward, the healthy cash flow has recently prompted us to consider bolstering already strong earnings growth estimates.
The shares have been trading at a discount due to concerns that Revlimid is causing greater risk of developing second primary malignancies. However, a favorable resolution is expected to be reached by a European regulatory board in the immediate near term, and sentiment for the stock has improved.
F5 Networks, Inc.
F5 Networks, Inc. engages in development, selling, and servicing of products that optimize the delivery of network-based applications, and the performance and availability of servers, data storage devices, and other network resources worldwide. It offers a wide range of services including consulting, training, installation, maintenance, and other technical support.
Cash flow generation has really ramped up of late, on the back of expanded product and services platforms. The mobile applications market is booming and we see no slowing of recent demand trends. F5’s dominant market position, coupled with its reputation for technological superiority, augurs well for free cash flow generation, despite expectations of a slight increase in capital deployment to help stave off growing competition.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.