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 MasterCard Inc. (MA), Viacom (VIA/B), and Express Scripts (ESRX).
MasterCard is a leading global payments company linking financial institutions, businesses, merchants, cardholders and governments worldwide by enabling them to use electronic forms of payment instead of cash and checks. The company processes credit, debit, prepaid and related payment transactions over the MasterCard Worldwide Network. It manages a number of widely accepted payment card brands, including MasterCard, Maestro, and Cirrus. MasterCard generates revenues by charging fees to its customers for providing transaction processing and other payment-related services and by assessing clients based on the dollar volume of activity (gross dollar volume, GDV) on the cards that carry its brands.
The company has been delivering the goods in 2011. Indeed, net income rose 33% in the second quarter on an 18% revenue increase (constant currency). It appears that MasterCard users are swiping more (transactions up 17%) and spending more per swipe (GDV up 16%). International volumes have been particularly strong. Not only have payment volumes risen, but MA is also seeing new business from SunTrust and Sovereign Banks and new processing relationships in the Netherlands and Brazil.
We expect the company to continue producing strong free cash flow due to consumers’ increasing preference for credit and debit transactions, especially in less-developed markets. The recent acquisition of DataCash and Travelex ought to begin contributing to the bottom line in 2012. Further, the company is partnering with Google (GOOG) to offer mobile payments via its new smartphone application,
Express Scripts, Inc.
Express Scripts, Inc. is one of the largest pharmacy benefit managers in North America. The company helps clients manage the cost of prescription drugs by evaluating drug prices to help clients in selecting a cost-effective formulary (list of prescription drugs covered by a particular drug benefit plan). It also leverages purchasing volume to deliver discounts to health benefits providers, promotes the use of generics and low-cost brands, negotiates discounts from drug manufacturers, and offers cost-effective home delivery services which result in drug cost savings for plan sponsors and co-payment savings for members. Express Scripts clients include HMOs, health insurers, third-party administrators, employers, union-sponsored benefit plans, worker’s compensation plans and government health programs. In 2010, ESRX processed 754 million prescriptions through Home Delivery and at retail pharmacies. Note, Value Line has given Express Scripts an above average Safety Rank.
The company’s strong free cash flow over the past several years is being put to good use as it is set to buy smaller pharmacy benefits manager Medco Health Solutions (MHS) for $29.1 billion. The combined entity would be the largest in its industry, and should reinforce the probability of future cash flow growth. Express Scripts CEO George Paz said the merger will “accelerate efforts to create greater efficiencies in the healthcare system and better protect American families from the rising costs of prescription medicine while improving health outcomes.” Note: The merger is still awaiting regulatory and shareholder approval, but ought to close sometime next year.
Viacom is a leading global television and motion picture content company. The Media Networks segment creates and acquires programming and other content for distribution to audiences via their television, the Internet, and mobile devices. MTV Networks reaches approximately 635 million households in more than 160 countries and territories through multiplatform properties, which include MTV, VH1, CMT, Logo, Nickelodeon, COMEDY CENTRAL, Spike TV, BET, and TV Land, among others. The segment generates 65% of revenues principally from advertising sales, affiliate fees, and ancillary revenues. The Filmed Entertainment segment produces, finances, and distributes motion pictures and other entertainment content under the Paramount Pictures, Paramount Vantage, Paramount Classics, MTV Films and Nickelodeon Movies brands. The unit’s revenues are generated primarily from the theatrical release and/or distribution of motion pictures, sale of home entertainment products such as DVDs, and licensing of motion pictures and other content to pay and basic cable television, broadcast television, syndicated television and digital media outlets.
Viacom’s solid second-quarter results went largely unrewarded amidst increasingly negative sentiment towards the stock market of late. Operating income rose an impressive 22%, thanks largely to profit growth in the Media Networks segment. Management attributed strong advertising growth, brought about by an influx of hit television programs and impressive ratings. Further, Paramount Pictures recently became the first studio to ever deliver six consecutive $100 million-plus domestic box office movies, and was the first studio to cross the $1 billion domestic box office threshold for the fifth year in a row. Plans to create a new animation division ought to ensure motion picture revenue growth stays healthy for the foreseeable future.
This success is allowing the company to produce meaningful free cash flow. It is putting those monies to good use as it recently decided to raise the quarterly dividend from $0.15 to $0.25 a share. Too, management has reinforced its commitment to return cash to shareholders through its stock buyback program.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.