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 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 Danaher Corp. (DHR), and CACI International Inc. (CACI).
Danaher designs, manufactures and markets professional, medical, industrial and commercial products and services that typically possess strong brand names, innovative technology, and major market positions. The company operates in over 50 countries through five reporting segments: Test & Measurement (22% of 2010 revenues); Environmental (21%); Life Sciences & Diagnostics (17%); Dental (14%); and Industrial Technologies (24%); The remaining 2% was derived from a joint venture with Apex. Sales in 2010 by geographic region were: North America, 49% (including 45% in the U.S.); Europe, 28%; Asia/Australia, 17%; and other regions, 6%.
The company reported healthy revenue gains in the September interim. Total sales advanced 46%, as core operations were up 7.5% (exposure to emerging markets was largely responsible), acquisitions contributed 35%, and currency drove the remaining 3.5%. Management revealed that an earlier-than-expected earnings contribution from the acquisition of biomedical laboratory instrument maker Beckman Coulter was reinvested into restructuring activities, used to pay down debt, and contributed to outsized cash flows. Acquisitions are built into the company’s business plan and we think future purchases will provide a meaningful source of cash over the long term.
The company continues to build up its exposure to non-industrial companies which we believe is helping to stabilize revenue streams. Further, Value Line analyst Erik M. Manning believes that potential setbacks in the U.S. industrial sector will be largely offset by fast-growing regions like China and Latin America. This feeling is not being shared by many market participants, which explains the stock’s relatively low price-to-earnings ratio. Thus, we think value investors may want to take a closer look here.
CACI International Inc.
CACI delivers professional services and information technology solutions to clients primarily in the U.S. federal government. Its services are primarily targeted to the areas of defense, intelligence, homeland security, and IT modernization. The company keeps its portfolio suite current by adapting emerging technologies and continually evolving legacy strengths. Demand is created by the increasingly complex network, systems, and information environments in which governments and businesses operate, and by the need to stay current with emerging technology while increasing productivity and, ultimately, improving performance.
The company posted solid results in the September interim, with revenues and earnings both up meaningfully. Meanwhile, contract funding orders rose to the highest amount in company history. Value Line analyst Kathryn Drew believes the company’s streamlining and automating processes will probably remain a favorite with clients considering recent concerns surrounding the federal budget. We are cautiously optimistic that the efficiency enhancing nature of CACI’s products will more than offset potential weakness in general government spending.
The company also appears focused on acquisitions, which augur well for its impressive free cash flow prospects. These future inflows should facilitate continued stock repurchases, which have proven to be a driver of recent earnings gains.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.