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, we have chosen to highlight Teradata Corporation (TDC).
Teradata is a leader in analytic data solutions, including integrated data warehousing, “big data” analytics, and business applications. The company offers software, hardware, and related consulting and support services to help large organizations compile data about customers, financials, operations, etc. into a single data warehouse. Its analytic technologies then transform said data into information that helps customers manage, integrate, and analyze growing data volumes in order to gain business insight and competitive advantages. The company makes around half of its revenues from products and half from services, and the vast majority of the total comes from existing customers. North America was responsible for 59% of third quarter revenues; Europe, the Middle East, and Africa, 24%; Asia, 17%. In 2011, Teradata acquired Aprimo, a provider of cloud-based marketing software, and Aster Data Systems, a market leader in big data analytics.
Teradata's stock has experienced weakness of late, falling 16.6% in the past month, causing the price to test a six-month low. Similar to many global corporations with broad customer bases, investor interest in Teradata has been hampered by expectations for macroeconomic challenges ahead.
Evidence of that trend was visible in TDC’s results for the September quarter. The problem area was North America, where revenues only grew 2% year over year. There were three primary reasons for the slow growth. One was customers exercising caution with IT budgets due to the cloudy outlook for both domestic and global GDP expansion. This translated into generally smaller deals. Also, strong product growth over the past 18 months has given customers more flexibility to delay capacity additions, and there is risk that this will continue in the current quarter. Lastly, the strong 28% revenue growth experienced in 2011’s third quarter caused a difficult comparison.
Consequently, management now expects revenues to come in at the low end of its prior guidance range of 12% to 14%. It also sees earnings per share at the middle to high end of its guidance range, which is in line with our estimates.
News was not all bad out of the U.S., though, as the company won some new business. It sold a new data warehouse to Berkshire Hathaway's (BRK/B) apparel maker Fruit of the Loom to provide better visibility of its supply chain and financial metrics. Other wins include a predictive analysis solution for fast-growing insurer Aviva, digital forecasting for media firm 24/7, and better analytics for the Men’s Warehouse (MW).
Elsewhere EMEA has been surprisingly resilient, delivering 28% organic revenue growth in constant currency terms during the third quarter and 17% factoring in exchange rates. This would have been higher were it not for macroeconomic uncertainty. The company has been closing deals in China that were pushed back in the first part of the year. This, combined with Japan getting back on track drove revenues at the Asia unit up 14%.
Looking at free cash flow, year to date, Teradata has generated $342 million in free cash flow, a 12% increase over the same period in 2011. This was despite increased investment in property, equipment, and capitalized software in the third quarter.
Although it will probably be more difficult for IT capital expenditure to get approved at large institutions over the short term, we believe the company is well positioned for double digit revenue growth and strong free cash flow over the long haul. The company has leading technology in growing markets and provides customers with information that can save money and create opportunities for growth. Its products help simplify and automate database management, helping customers deal with the exploding amount of data being created. The company has 34 customers with petabyte data warehouses (a petabyte is roughly equivalent to the memory found in an average laptop times one million). Further, Teradata can provide analytics on data coming from social media, the Web, and mobile devices to gain insight into customers. Moreover, many of its solutions are available in the cloud and/or on corporate and government worksites.
We think the recent price decline has created a favorable entry point. Still, there is some risk that investor sentiment will fall further if global macro conditions deteriorate or there is more evidence of near-term restriction in IT spending. Thus, more conservative investors may want to look elsewhere.
At the time of this article's writing, the company did not have positions in any of the companies mentioned.