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 URS Corporation (URS) and Autodesk, Inc. (ADSK)
URS is a leading provider of program management, infrastructure planning and design, engineering, construction, maintenance, and decommissioning services to public agencies and private sector clients worldwide. The majority of URS’ services are technical in nature, not managerial. The company operates through three reporting segments: Infrastructure & Environment, Federal Services, and Energy & Construction. The 2010 revenue breakdown by market sector was as follows: Federal, 49%; Infrastructure, 21%; Industrial and Commercial, 18%; Power 12%. Major federal clients include the Dept. of Defense, NASA, the Dept. of Energy and the Dept. of Homeland Security.
Shares of URS Corporation have yet to fully recover from the steep market decline experienced in the summer of 2011. The company’s relatively high exposure to the U.S. Government has contributed to its near 20% underperformance of the broader market averages over the past six months. Although potential austerity measures and budget constraints from the public sector are somewhat concerning, Value Line analyst Eric Antonson believes federal demand for URS’ highly specialized engineering and technical services ought to remain healthy (federal revenues were up 7% in the September quarter). The company’s federal client base is highly diversified, which ought to insulate it from pockets of weakness. Further, it continues to win new work in high growth areas such as unmanned aerial systems, electronic warfare support, cyber security, and cloud computing. Lastly, many of the projects URS is working on are of high importance and ought to find support from bond sales and private financing if federal grant programs and dedicated tax revenue streams fall short.
Looking at private sector demand, URS’ Power unit stands to benefit from new emission regulations by the EPA. Indeed this contributed to the division’s backlog rising 30% sequentially in the September interim (its highest level since Q1 2009). Increased front-end engineering and design work (FEED) also drove this result, and should lead to larger engineering and construction opportunities in the future.
Over the years, URS has proven capable of producing fairly consistent cash flows despite fluctuating demand conditions. We attribute this to an organizational structure that is skewed toward variable costs. This affords URS the ability to redirect resources away from underperforming sectors toward areas with more favorable prospects. An attractive long term project pipeline should also support strong cash flow. Expected future business includes decommissioning Cold War era nuclear sites, the elimination of chemical weapons, a highway-funding bill currently making its way through congress, and utility companies building combustion turbine natural gas plants to replace older, less efficient facilities. Still, conservative investors may be dissuaded by the company’s exposure to potentially lower U.S. Government budgets.
Autodesk is a leading design software and services company. The company’s 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%).
The company has done well at expanding margins recently. Indeed, in the soon-to-be concluded fiscal year 2011, we expect over 250 basis points of improvement following 2010’s very strong recovery. Much of this is attributable to revenue expansion creating operating leverage, as well as effective cost control in sales, marketing, and R&D.
We expect revenue momentum to continue in the current year, driven partly by the manufacturing sector. Sales to that particular industry reached an all time high in the October quarter. Further, the company’s balanced product portfolio, diversified global footprint, and assorted mix of both large and small customers ought to ensure top-line gains continue. Although Europe will likely experience the slowest growth rate in the year ahead, that region is still expected to generate a double-digit advance. Also, Value Line analyst Colleen Reynolds expects strong growth in Asia Pacific to continue for the foreseeable future. The company plans on transitioning many of its newer functionality to the cloud which should benefit profitability. Further, Autodesk’s relatively low level of capital expenditures and aspirations to conduct more streamlined R&D activities ought to help keep free cash flow strong in 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.