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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 do not 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.

After a recent review of the screen, we have chosen to highlight VeriFone Systems, Inc. (PAY).


VeriFone Systems, Inc.

VeriFone designs, markets, and services merchant-operated and self-service point-of-sale (POS) electronic payment terminals for the financial, retail, petroleum, government, transportation, and healthcare vertical markets. VeriFone’s brand name, large footprint, and contributions to technological innovation have made it one of the largest providers of electronic payment systems worldwide. The company had the following geographic revenue breakdown in the April quarter: The United States and Canada, 27%; Europe, Middle East and Africa, 42%; Latin America, 20%; Asia, 11%.

Since VeriFone bought rival Hypercom in August 2011 (sans its U.S. operations), the payment terminal market has been dominated by only one other player, French-based Ingenico. We believe the global market share breakdown is roughly equivalent to 40% each, with VeriFone having a slightly higher share.

In general, most of VeriFone’s customers will replace their existing terminals every five years or so. This noncyclical turnover, combined with its geographically diverse footprint, and lucrative software, maintenance, and taxi advertising revenues makes for consistently high free cash flows.

Through the first half of 2012, VeriFone shares have had a very uneven performance. The stock rose 49% for the first four months of the year; however, on April 30th, the company released a statement that it was merely keeping its 15% organic revenue growth estimate intact, instead of raising guidance like it had done numerous times in the past. Investors likely saw this as a signal that European operations were coming in softer than originally anticipated due to the region’s challenging economic conditions. Further, the euro has become weaker over the past two months, and investors seemingly got spooked, forcing the stock down 43% from its 2012 high in late April to a 2012 low in mid-June.

While the still-weak euro may well hinder results a bit, we point out that only 25% of PAY’s revenues are denominated in the ailing currency. Also, VeriFone’s European exposure is mostly limited to northern countries with healthier economies than their southern counterparts.

The stock has rebounded a bit of late, climbing 16% from its 6-month low in June following the recent award of an exclusive five-year, $35 million contract by the District of Columbia Taxicab Commission. Under the terms of the agreement, VeriFone will develop, install, and support payment systems capable of electronic trip reporting, credit card processing, and news/entertainment content delivery (PAYMEDIA) for the Capital's 6,500 taxis. There is also potential for around $2 million in additional ad revenues per year. The deal will boost VeriFone's taxi footprint in the U.S. by 23%, to over 35,000 units. This is on top of the impressive London taxi build out leading up to the 2012 Olymipic Games.

Although exposure to Europe is a bit concerning, we think the company’s long term prospects are favorable. In addition to emerging markets in Latin America and Asia where middle class populations are growing, we think new technologies such as near field communications will force more retailers in developed markets to upgrade their hardware and software before it becomes absolutely necessary. These growth vehicles ought to provide ample free cash flow in the coming years.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.