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 Rovi Corp. (ROVI), Avis Budget Group (CAR), Hologic Inc. (HOLX)
Rovi provides solutions that allow consumers to simplify and guide their interaction with digital entertainment. Its primary offerings include interactive program guides (IPG, an interactive listing of television or video program information that enables viewers to navigate through, sort, select, and schedule video programming for viewing and recording), IPG advertising, licensing technologies (such as recommendations and search capability), media recognition technologies and licensing of its extensive database of descriptive information about television (3.5 million shows), movie (450,000 movies), music, books, and game content; as well as content protection technologies and services.
Worldwide subscribers receiving a licensed or Rovi-provided set-top-box based IPG rose to 133 million at the end of Q2 2011, up from 124 million in Q2 2010. Excluding prepaid licensees, primarily Comcast (CMCSK) and DISH Network (DISH), total Rovi licensed subscribers are approximately 91 million vs. 85 million in the year ago period. Rovi’s June quarter earnings per share clocked in slightly above the high end of management’s guidance range. The business is benefiting from new international license agreements, increases in device shipments incorporating its hardware and software (mid- to high-end plasma, DLP and LCD televisions and Blu-ray or DVD hard drive recorder based products), the continued conversion of analog TV subscribers to digital, as well as advertising growth. Management also mentioned that it secured a number of new device wins. Indeed, Samsung’s Smart TV platform, Sony’s (SNE) Bravia TVs and new Toshiba sets will incorporate Rovi’s cloud storage solutions. In response, management raised the midpoint of its 2012 earnings guidance by 3%.
We expect a number of new technologies to keep impressive free cash flow rolling in for Rovi over the next several years. Its new TotalGuide application for set-top boxes enables subscribers to quickly see what’s on their favorite channels; search; and browse by program, celebrities, cast, across linear, on demand, and DVR programming. Too the RoxioNow platform enables consumers to instantly rent, purchase, and playback media on consumer electronic devices and, through the RoxioNow online entertainment locker. The service has been selected to power digital entertainment delivery for a range of companies including Best Buy (BBY), Blockbuster (DISH), Dell (DELL), Hewlett-Packard (HPQ – Free Hewlett Packard Stock Report), Lionsgate (LGF), and Sears/Kmart (SHLD). Management said that Rovi is also the “technical implementation” of UltraViolet a digital rights authentication and cloud-based licensing system that allows consumers “buy once, play anywhere”. This means you can buy a physical DVD or BluRay disk to play in a conventional player and also have it available for streaming to a tablet, smartphone or laptop. UltraViolet does not store files, it only coordinates and manages the rights for each account, not the content itself. By creating a “digital-rights locker” rather than a digital media storage locker, Rovi bypasses the cost of storage and bandwidth used when the media is accessed, giving it a cost advantage over competing solutions from Amazon (AMZN) and Disney (DIS - Free Disney Stock Report).
Avis Budget Group
Avis operates two of the most recognized brands in the global vehicle rental industry through Avis and Budget. Avis caters to the premium commercial and leisure segments of the travel industry, whereas Budget focuses on the value-conscious demographic. The company has branded rental locations in over 150 countries throughout the world and it generally maintains a leading share of airport car rental revenue. Avis believes it enjoys “complimentary demand patterns” i.e. when times are good more people rent from Avis and when the economy is faltering, more people rent form Budget.
The company recently completed the $1 billion purchase of Avis Europe PLC. Following the acquisition, Avis became the largest publicly traded rental car business in the world. The combined entity is expected to generate annual revenues of $7 billion and generate cost synergies in excess of $30 million. Too, management noted that the combination will give the company increased presence in the rapidly growing Chinese and Indian markets. This should ensure free cash flow remains strong for the foreseeable future.
Meanwhile, the stock price has fallen 34% over the past six months despite solid volume growth. The reason appears to be investors’ concerns over global economic conditions. Value Line analyst Michael Ratty thinks momentum is sustainable. If volumes do continue their upward trajectory, we expect operating leverage to ensue. Overall, we view the recent weakness in the share price as a buying opportunity. Still, this equity’s very low scores for Stock Price Stability, Earnings Predictability and Safety will likely dissuade conservative investors.
Hologic is a developer, manufacturer and supplier of premium diagnostics, medical imaging systems and surgical products dedicated to the healthcare needs of women. Its breast health products include a portfolio of breast imaging and related products and accessories including digital and film-based mammography systems, and magnetic resonance imaging (“MRI”) breast coils.
Hologic has developed a new breast imaging platform, Dimensions, which uses tomosynthesis to produce three dimensional (3D) images. Value Line analyst Steven Shnayder notes that customer interest for the device appears to be high, and he expects orders to accelerate in the coming months.
Meanwhile, international sales have been strong and the company’s Diagnostics revenue came in better than expected during the June interim, finally returning to year over year growth. This prompted management to raise its top-line forecast marginally. We note that the company has a solid track record of accurately forecasting results, and we think strength from the new 3D technology, Diagnostics, and international expansion will lead to healthy earnings gains and free cash flow in the years ahead.
Still, these shares are not without risk. Although the healthcare sector has long been viewed as more defensive than most industies, if the U.S. economy does slip into another recession, hospital budgets may come under pressure as people avoid the costs of going to the doctor and unemployment causes decreased healthcare coverage.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.