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 compelling companies, including MEDNAX, Inc. (MD) and CBRE Group, Inc. (CBG).
CBRE Group, Inc.
CBRE Group (formerly CB Richard Ellis Group) is the world’s largest commercial real estate services firm, based on revenue. Approximately 38% of its 2010 top line (2011 figures have yet to be released) was derived from facilities & property management, mortgage loan servicing, and asset management. The balance stemmed from tenant representation, property/agency leasing, property sales, valuation, capital markets (equity and debt) solutions, development services, and proprietary research. Clients include occupiers, owners, lenders and investors in office, retail, industrial, multi-family and other types of commercial real estate. The customer base is well balanced, and boasts 80% of the Fortune 100 companies. Corporations accounted for 44% of revenues; insurance companies and banks, 19%; pension funds and advisors, 10%; individuals and partnerships, 7%; government agencies, 5%; REITs, 4%; other, 11%.
The company recently reported December-quarter earnings that were a penny below our forecast. Total revenues were up 7% driven by strong investment sales and property management fees. The recent acquisition of ING’s real estate investment management arm has significantly increased assets under management (and thus, fees) helping to send the investment management unit’s revenues up 31%. Value Line analyst Sharif Abdou thinks this new addition will continue to bolster results in the coming quarters and prove accretive to the operating margin. The company grew this metric an impressive 250 basis points thanks to cost reductions taken during and preceding the fourth quarter, and we expect operating leverage to continue ahead.
Not all developments were positive, however. A 4% year over year revenue decline from the largest segment, Leasing, was caused by a weak showing in North America. This was slightly worse than its nearest public competitor, Jones Lang La Salle (JLL) which suggests CBG may have lost a bit of market share. We are not overly concerned, and think CBG’s greater exposure to the United States will help it outperform the competition this year, assuming moderate improvement in the domestic commercial real estate market and underperformance in Europe. We believe concerns regarding the latter may be causing management’s guidance to be overly conservative.
Patient investors looking for a way to play a budding rebound in the commercial real estate market may want to consider these shares. Indeed, recent expansion of its footprint in South America and Asia/Pacific — two of the world’s fastest growing markets — should keep cash flows rolling over the next several years.
MEDNAX is a leading provider of physician services including newborn, maternal-fetal, pediatric subspecialty, and anesthesia care. In an effort to improve outcomes and manage costs, hospitals typically employ or contract with physician specialists to provide specialized care in many hospital-based units or settings. Hospitals traditionally staff these units or settings through affiliations with local physician groups or independent practitioners. However, management of these units and settings presents significant operational challenges, including variable admissions rates, increased operating costs, complex reimbursement systems and other administrative burdens. As a result, some hospitals choose to contract with MEDNAX for its quality initiatives, information and reimbursement systems and management expertise required to effectively and efficiently operate these units and settings in the current healthcare environment.
At the end of 2010, its network comprised 1,700 affiliated physicians, 989 of which worked within hospital-based neonatal intensive care units (“NICUs”), for babies born prematurely or with medical complications. Around 175 doctors provided maternal-fetal care for expectant mothers experiencing complicated pregnancies. Other pediatric subspecialists include 104 physicians providing pediatric cardiology care, 84 physicians providing pediatric intensive care, and 39 physicians providing hospital-based pediatric care. In addition, it has more than 310 physicians who provide anesthesia care to patients in connection with surgical and other procedures as well as pain management.
On February 2, 2012 the company released earnings and revenues that were in line with our estimates. While same unit revenues were up 2.7%, organic volumes were only up 0.4% on fewer neonatal care babies, caused by weak economic conditions slowing the birth rate modestly. The top line advance can be explained by better pricing. The payment mix showed signs of stabilizing, but investors remain concerned that a shift toward lower-margined Medicaid business will crimp profitability in the coming years. We think continued signs of an improving employment landscape will help ease investors’ concerns. Overall, we believe core operations will remain fundamentally sound in the coming quarters based partly on the essential nature of MEDNAX’s services.
The primary means of growth appears to be the rapidly expanding anesthesia business. The company spent $161 million to acquire several localized anesthesiology teams in Texas, New Jersey, and elsewhere in 2011. Management revealed that it is feeling more comfortable with its expertise in the space, and thinks this allotment may very well rise to $200 million in 2012 saying, “now is the time to take the foot of the brake” in regards to M&A activity. The company said its deal pipeline is full, and although timing is not certain, we think this new business may lead to upward revisions in earnings per share estimates, as well as possible multiple expansion in the coming year. In addition to its strong core business of taking care of sick infants and mothers, this should keep free cash flow at relatively high levels for the foreseeable future.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.