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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 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. Some items that affect GAAP earnings but do not reflect economic results include mark-to market adjustments of assets and liabilities and unusual tax rates; the latter often concern prior years and should usually be ignored when assessing a company’s present profitability. Depreciation represents money that has already been spent, and many companies do not have to invest anything near the amount of depreciation expense to maintain output.

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 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 two noteworthy companies we have chosen to highlight, PTC, Inc. (PTC) and MEDNAX (MD).

PTC, Inc.

PTC develops software and services that help customers improve engineering, supply chain, manufacturing, and other aspect of their businesses. The company address five types of issues: computer aided design (CAD); product lifecycle management (PLM); application life cycle management (ALM), supply chain management (SCM) and service life cycle management (SLM). PTC groups the middle three offerings, PLM, ALM, and SCM, into what it calls extended PLM.

Computer aided design products enable users to create designs, perform engineering calculations, and do advanced surfacing, virtual prototyping, and other design functions. The extended PLM suite helps customers address product and software lifecycle challenges, automate development, and select the best parts and materials suppliers. The SCM line helps manufacturers and their service providers streamline maintenance, improve field service ticketing and scheduling, manage contracts and warranties, and distribute technical and parts information.   

PTC’s results were mixed in its second fiscal quarter (fiscal years end September 30th). Revenues rose 5% on a constant currency basis, but would have slipped a few percent before acquisitions. The Americas was strong, with a 14% gain, but that was partially offset by declines of 10% and 5% in Japan, and the Pacific Rim, respectively; a stronger dollar further depressed revenues from Asia. Earnings per share, though jumped 50%, thanks to better margins on some products, and the results of a restructuring program that cost about $77 million over the past two years. In fiscal 2014, PTC forecasts a roughly 16% gain in non-GAAP EPS, to around $2.10 a share, before about $0.65 a share in non-cash stock-based compensation and amortization of intangibles.

With minimal cash needs for capital expenditures, PTC should be able to lift earnings per share at around a 10%, thanks to a large, steady book of recurring business, annual acquisitions, and some share repurchases.

MEDNAX, Inc.
      
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. Managing these units and settings, however, 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 the management expertise required to effectively and efficiently operate these units and settings in the current healthcare environment. The company offers services through hospitals and out-patient facilities in 85 metropolitan areas located in 34 states. It is the leading provider of outsourced pediatric care, serving about 25% of the patients in neonatal intensive care units.

After advancing at an annual rate of about 10%, for years, earnings per share grew 15% in the March period. As usual, results benefited from several acquisitions of physician groups over the last year, but organic revenues also rose 3%. With a 3%-5% increase in same-unit revenues, and what the company calls a robust acquisition pipeline, we think earnings per share will advance around 13% this year, to about $3.15.

MEDNAX ranks 15th out of the top 100 free cash flow generators in the Investment Survey. Moreover, with growing healthcare needs of the Baby Boom generation and more patients likely to be delivered by the Affordable Care Act, earnings-per-share ought to advance at a better than 10% clip for the foreseeable future. The company’s very low debt-to-total capital ratio and high free cash flow generation make rapid growth through acquisition quite likely. We suggest that investors seeking exposure to the healthcare sector take a look.  


At the time of its writing, this article’s author did not hold positions in any of the stocks mentioned.