Free Cash Flow Standouts

Free Cash Flow Standouts

Posted: Nov 30, 2009 10:40 AM by Sham Gad

In a business, cash matters a lot. In fact, cash matters more than profits for the simple reason that the cash cannot be massaged like profits. That's why many of the best value investors ascribe more weight to cash flow than net income.

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By Way Of Example
A simple example can illustrate both the problems with net income and the need to focus on cash flow. Suppose a retailer notices that earnings are set to come in lower than internal projections. This company can boost sales - and hence net income - by suddenly extending credit to its customers with generous terms. Think about furniture companies that extend offers like "no payments for 24 months". These customers make purchases using that credit. The income statement will reflect increased sales, which will lead to greater net income. At the same time, accounts receivable will rise to reflect the credit extension. The cash flow statement, however, will show that cash flow from operations has decreased by the net increase in accounts receivable.

To be fair, if all these credit customers pay their credit card bills, the cash will ultimately be collected. But as we've seen, today credit card bills are some of the first things that cash-strapped consumers abandon when times get tough or one loses a job. As a result, the company that ultimately showed a sales and profit increase will be forced to write down those receivables. (For more on this topic, check out Cash Flow: The Best Fundamental Indicator.)

Cash Gushers
So, sticking to businesses where you can count the cash year in and year out is not a bad way to invest. Consider drug company Forest Labs (NYSE: FRX), which has a market cap of $9.3 billion and an EV of $6 billion. This company continues to produce gobs of cash. In 2007, net income was $454 million, yet free cash flow (FCF) was over $850 million. In 2009, net income was $767 million; FCF was over $1 billion. Even if this figure declines over the next year, the FCF yield is still very impressive. (For more, check out Free Cash Flow: Free, But Not Always Easy.)

Another way cash flow is valuable is when you have businesses currently experiencing net losses but with positive free cash flow. This could be an excellent sign of great, conservative management at a company. This is the case at construction equipment manufacturer Terex (NYSE: TEX), which is experiencing the most difficult period in the company's history. In the last quarter, the company lost $103 million but generated $15 million in free cash flow. That's an incredible accomplishment in this environment.

Investors looking for safer havens than a drug company or construction company in this economy don't have to look far. Microsoft (Nasdaq: MSFT) continues to generate cash with over $15 billion over the last three years. Ensco International (NYSE: ESV), which provides oil drilling rigs, commands a $5.7 billion enterprise value and gushes out gobs of free cash flow. Demand for oil rigs can experience short-term volatility with the price of oil, but over the long run, demand for deep-water drilling rigs continues to remain strong. (For more, see Spotting Cash Cows.)

Count What Can Be Counted
In a business, cash matters a lot - count the cash before you invest. (For more, see Analyze Cash Flow The Easy Way.)


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