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 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 Check Point Software Tech. (CHKP) and WESCO International Inc. (WCC)
Check Point Software Tech.
Check Point Software Tech. engages in the development, marketing, and support of Internet security solutions. The company provides firewall, and virtual private networking solutions. Through its NGX platform, it delivers unified security architecture for various perimeter, internal, Web, and endpoint security solutions that protect business communications and resources for corporate networks and applications, remote employees, branch offices, and partner extranets. Its ZoneAlarm products offer endpoint security solutions that protect personal computers from hackers, spyware, and data theft.
The company continued to enjoy success in the second quarter, posting an 18% share-net advance. Revenues increased roughly 9%, while lower operating costs aided margins. Check Point has been consistently growing share earnings by double-digits each quarter over the past few years, and it does not appear like much will change. Although analyst Randy Shrikishun expects the competition to remain hot, management’s recent announcement that the share repurchase authorization was increased to $1 billion augurs well for results going forward.
The balance sheet is extremely healthy. Check Point has no debt on hand and north of $1.37 billion in cash in the coffers. Free cash flow, meanwhile, is expected to remain solid, despite any increased competitive headwind. Indeed, the company has no significant obligations on the docket and, as a software maker and provider, it requires little capital investment. Although it has the flexibility to continue pursuing acquisitions, share repurchases are likely to take center stage, thereby fueling shareholder gains.
WESCO International Inc.
WESCO International, Inc. distributes electrical, industrial and communications products for maintenance, repair and operations, as well as original equipment manufacturers. It also offers construction materials and supply chain management/logistics services. As of December 2011, WESCO operated eight automated distribution centers and about 400 branches in North America. It does have a foreign presence, too, with international business accounting for about 20% of sales.
Although higher-than-expected costs recently caused the company to come up a bit short of expectations, it notched its seventh consecutive quarter of double-digit earnings growth (15% to be exact in the June quarter). Cost controls lifted margins nonetheless, while the top line increased 10% thanks partially to acquisitions. Also, the bottom line grew nicely thanks to lower interest expense, a direct result of reduced debt obligations.
Analyst Marek Mscichowski thinks that double-digit earnings growth is sustainable. While Mscichowski expects stabilization in construction markets to be a boon, he also believes that management will continue to put cash flow to work. Indeed, the company has been aggressively deleveraging the balance sheet, all the while maintaining an active disposition on the acquisition front. The latter will undoubtedly help boost revenue and earnings growth even if global demand remains soft. Free cash flow is expected to remain strong, and Mscichowski would not be surprised to see the company institute a dividend payout. Either way, shareholders should benefit.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.