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 noteworthy companies, we have chosen to highlight F5 Networks (FFIV) and Danaher Corp. (DHR).
F5 Networks is the world’s largest provider of application delivery products and software, which help customers ensure that applications delivered over the Internet are secure, fast, and available. The foundation of most of F5’s products is its Traffic Management Operating System (TMOS), and its main products are application delivery controllers (ADC). These include hardware and software for global and local traffic, network and application security, access, and web acceleration. Products are available as modules or as software only “virtual editions” designed to run on standard and high-volume servers.
F5’s stock price soared from 2009 to the end of 2010 as earnings per share more than doubled, thanks to burgeoning use of the Internet and with it, demand for ADCs. Since 2012, though, the going has been tougher, and share net climbed just 1% in fiscal 2013, ended last September. To quote the F5’s CEO, last year was a “tale of two halves”, in which product sales fell during the first two quarters and were up 1% and 7% in the last two. The company attributed some of the shortfall to weakness in Asia and to clients’ postponing purchases to await new product. And indeed, in fiscal 2013, F5 “refreshed” virtually its entire product line, which ought to generate sales growth this year.
The company recently released strong fiscal first quarter 2014 results, and provided encouraging guidance. It also said it will be increasing its share repurchase activity, which makes a dividend seems unlikely in the future. We expect future acquisitions to consume cash as well. Sales ought to pick up as customers upgrade to the refreshed products. F5 is also seeing good business replacing Cisco’s (CSCO - Free Cisco Stock Report) out of date ACE system with its own line; to date, it has done over 1,000 such replacements.
Demand for F5’s products and services is still in its high-growth period, with Internet and mobile traffic likely to rise at a double-digit pace. Among other areas, cloud applications, increasing security needs, and the coming “Internet of things” offer substantial opportunities. And with no debt and over $500 million in cash, F5 is well positioned to grow through acquisitions. Still, the stock is up around 48% from its 2013 low, which has trimmed our estimated capital appreciation potential, though it remains above-average.
Danaher designs, manufactures, and markets professional, medical, industrial, and commercial products and services used in a broad variety of industries, from healthcare to water quality and fuel distribution. It has five segments: Test & Measurement (about 18% of 2013 sales); Environmental (17%); Life Sciences & Diagnostic (36%); Dental (11%); and Industrial Technologies (18%). Foreign sales account for around 57% of revenues. With operations largely in businesses that do not grow much faster than the broader economy, Danaher has grown substantially through acquisition; it has bought over 60 companies in just the last five years. The largest purchase was Beckman Coulter, acquired in 2011 for $5.5 billion. That deal lifted Life Sciences & Diagnostics to the leading position.
After three years of solid share-net growth from 2009 to 2012, growth slowed last year to around 6%, partly due to the relatively low amount of acquisition activity: newly acquired operations added only around 3% to total sales. Slower growth in emerging markets, such as China, also contributed to the small gains. Still, the company has seen higher market share in some lines, and some restructuring outlays penalized 2013 results. Without factoring in substantial new deals, we expect earnings per share to advance at a mid- to high single-digit pace in 2014. But the company is planning around $8 billion of acquisitions over the next two years, a sum that, while large, is easily affordable, given DHR’s high cash balance and low debt-to-capital ratio. Longer-term, we think earnings per share will rise at a low double-digit rate. As such, the stock should appeal to investors seeking long-term appreciation and international exposure, though its recent price, nearly double its 2011 low, discounts some of the growth we foresee.
At the time of its writing, the author did not hold positions in any of the stocks mentioned.