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 noteworthy companies, including Synaptics, Inc. (SYNA) and Autodesk, Inc. (ADSK)
Synaptics is a leading developer and supplier of custom-designed human interface solutions that enable people to interact with a wide variety of mobile computing, communications, entertainment, and other electronic devices. The company’s PC application unit (50% of revenues) dominates the notebook PC touchpad market with a near 70% market share. Thus, its performance generally mirrors that of the broader laptop market. The Digital Lifestyle unit provides touchscreen controllers to most major tablet and smartphone OEMs including Huawei, Nokia (NOK), LG, ZTE, Sony Mobile (SNE) and Samsung.
Synaptics reported in-line results for the March quarter as PC revenue was better than expected, but the opposite was true for the Mobile unit. Rapid share growth at manufacturers of lower-cost Chinese smartphones appears to be hurting the average selling price. We think fewer sales to Nokia is also to blame. We expect these trends to continue in the June period. Difficult compares in that quarter are also a cause for concern.
Meanwhile, SYNA boasts the first implementation of in-cell technology for a smartphone with the Sony Xperia P. In-cell technology eliminates the discrete touch sensor by integrating the touch element within the LCD display itself, resulting in thinner smartphones with improved display and lower power consumption. We believe Synaptics has a strong lead versus competitors in getting these products to market. Apple (AAPL) is rumored to be including in-cell in the upcoming iPhone 5. This would be significant for Synaptics as it would essentially make in-cell the industry standard. However, it will likely take some time to ramp up, since it involves changing how phones are designed and constructed, as well as the overall level of collaboration with LCD makers. A recent design win in the critically acclaimed HTC One X and a rumored deal for the Amazon (AMZN) Kindle Fire is also encouraging for SYNA’s future market share growth. Overall, we expect the smartphone market to continue growing at a 30% pace in the year ahead.
On the PC side, Synaptics should see some benefit from new notebooks using Microsoft’s (MSFT – Free Microsoft Stock Report) Windows 8 operating system. And, Intel’s (INTC – Free Intel Stock Report) big push into Ultrabooks or very thin laptops should also spur gains.
Despite near-term headwinds in the mobile space, we think Synaptics is generally well positioned for strong free cash flow generation over the long-term. The complexity of designing custom solutions makes us doubt the theory that touch controllers will become commoditized. Also, SYNA’s lead with in-cell technology reinforces our positive long-term outlook.
Autodesk is a leading design software and services company. Its software enables customers to experience their ideas before they are real by allowing them to create and document their designs and to visualize, simulate, and analyze real-world performance early in the design process by creating digital prototypes. This allows customers to optimize and improve designs, save time and money, improve quality, and foster innovation. The four reportable operating segments and their contribution to fiscal 2011 revenues were as follows: Platform Solutions and Emerging Business (37% of 2011 revenue), Architecture, Engineering, and Construction (29%), Manufacturing (24%), and Media and Entertainment (10%).
A large part of Autodesk’s investment case is in its Suite strategy. Customers have been taking advantage of the synergies gained by purchasing a basket of products that are typically sold at lower prices compared to stand-alone products. The Suites have higher maintenance costs which ought to support long-term cash flow. Still, it seems as though Autodesk is becoming more promotional on Suites, which may hurt near term profitability somewhat.
The company has a long track record of making small bolt-on acquisitions. With ample cash reserves, we think this will be a continued source of cash flow growth for the foreseeable future.
Customer demand for Autodesk’s products appears to be holding up nicely, even in Europe where visibility is currently very low. Too, the company has exposure to the economically sensitive commercial construction and manufacturing markets, but demand from these sectors has remained healthy. We think the company has been able to gain market share of late even though competition remains intense. Overall, we think these shares will continue generating ample free cash flow over the coming three to five year period.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.