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 61% of 2012 revenues; Europe, the Middle East, and Africa, 24%; Asia, 15%.
Teradata’s stock has fallen out of favor with investors recently. On October 14, the company reduced its revenue and earnings forecast for the September interim (full results are due out October 31), largely due to weakness in Asia. Management is now looking for revenues and earnings of $665 million and $0.58-$0.59 a share for the September period, substantially below our prior estimates. As a result of the shortfall in the third quarter, Teradata has also reduced its revenue and earnings forecast for 2013. It is now looking for revenues of around $2.65 billion (flat with 2012) and earnings of between $2.25 and $2.35 a share (versus the $2.44 registered in 2012).
Overall, the International segment revenue in the third quarter declined approximately 2%, and was flat in constant currency terms, compared to the strong prior-year period when revenue grew 23%. Although business remained active in the Americas and in Europe in the third quarter, the Asia/Pacific region was down 21% (10% on a constant currency basis). The performance of the Asia/Pacific region had been weak in the last couple of quarters, but the sharp drop in activity in the September period caught investors by surprise. The shares have fallen 20% since the announcement and have not recovered much ground since. In fact, the shares are now trading only 8% above their 52-week low and 37% below their 52-Week high.
Details on the trouble in Asia will be released soon, but we believe Japan was a major source of weakness, as has been the case in recent history. It appears that customers in that country are being more cautious with their IT budgets in response to uncertain macroeconomic conditions. China also faces a difficult comparison after growth exploded in the prior year’s September quarter. Demand remains favorable in TDC's two largest markets, the U.S. and Europe. Indeed, revenue growth in the Americas segment was approximately 7% in the quarter.
We view the recent Asian weakness as largely outside the company’s control. Eventually, we expect demand to bounce back and Teradata looks well positioned for solid 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. 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.