There is a whole range of ways to value a company, from its
price-to-earnings (P/E ) ratio to its
Return on Equity (ROE)
. Yet investors should really be focused on
free cash flow
) yields. This is the true honest-to-goodness measure of how just
how much money a company can earn --and keep -- when compared to
. I was surprised to find at least nine stocks (excluding those
that operate in the financial services industry) with a FCFyield of
at least 20%. With powerful levels of FCF, these companies have all
kinds of financial flexibility, from paying off debt to buying back
stock, boosting dividends or making growth-inducing acquisitions.
Unloved and misunderstood.
I was thinking about FCF this week when reviewing the quarterly
Martek Biosciences (Nasdaq: MATK)
. This maker of nutritional supplements is highly profitable on a
basis. But thanks to large levels ofdepreciation associated with
new factories, reported profits are muted. That may explain
whyshares took a pretty sharp hit this week.
If you move past thataccounting issue, though, you'll discover that
Martek's FCF is much more impressive than its profits. The stock
may seem attractive at 13 times projected profits on a market cap
basis, butshares are really stunning at just five times FCF on an
enterprise value basis (which, when inverted, implies a 20% FCF
yield ). That means if the company can maintain this robust level
of FCF, it will have more cash in five years than its entire
And Martek's not alone. The companies on this list also sport FCF
yields of 20% or higher. The key question is whether that FCF can
be maintained or even boosted. In some cases, such as
, that may be hard to pull off, as keycash flow streams
are starting to shrink
In a similar vein, falling demand for newsprint could impact the
FCF picture for
International Paper (
In addition to Martek, which I talked about above, here are two FCF
plays that look quite appealing…
Smurfit-Stone Container (Nasdaq: SSCC)
Thanks to a robust amount of cost-cutting, this maker of
paper-based packaging has suddenly become a free cash flow machine.
Smurfit Stone had been generating negative free cash flow for a
number of years but managed to post a whopping $922 million in free
cash flow last year. Although 2010 will represent a pullback in
FCF, thanks to heavy capital spending, FCF could top $1 billion in
2011, thanks to modest price increases for the company's products.
Goldman Sachs estimates that every $10 per ton increase in
paperboard products boosts the company's annualearnings by around
$400 million. Goldman anticipates that pricing will indeed trend
higher in both 2011 and 2012, as industry producers have done a
very good job of restraining output. That rising level of FCF could
enable Smurfit Stone to make a major dent in its $1.2 billion
So what is an appropriate price for a stock with such a high
FCFyield ? Well, few analysts think of price targets in these
terms, although you could argue thatshares should see buying
interest that pushes the stock higher until the FCFyield drops to
15%. That implies +30% to +40% upside from current levels.
Micron Technology (
This memory chips maker has seen itsshares drift slightly lower
during the past 12 months thanks to never-ending concerns that
memory chip prices will slump and kill profits. Indeed, you could
argue that analysts are now well prepared for a pricing pullback,
expectingEPS to fall -40% in the current fiscal year to around
$1.10. Much more relevant to our analysis today is Micron's FCF,
which surged to $2.4 billion in fiscal (August) 2010 and could
still exceed $1 billion in both fiscal 2011 and 2012 -- even as
industry pricing is pretty weak. Analysts at Auriga, which believe
that consensus and pricing forecasts for Micron are too high, still
think the company will generate $2.5 billion in FCF in the next 24
And all of that cash flow ties into thebalance sheet . Both Micron
and memory chip rival Samsung have ample net cash balances
(slightly north of $2 billion for Micron). Yet rivals such as
Hynix, Elpida, Promos and Powerchip are choking under massive debt
loads. So if this industry does see any deep price weakness, some
of those players might be forced to exit the business, according to
analysts. And that would be a strong long-term positive for Micron.
All that FCF is helping to boostbook value , which now stands at
about $7 a share and could approach $9 a share by the end of
calendar 2012.Shares trade for around $8. As Micron has become such
a strong FCF generator, management may start to look to buy back
stock if they are comfortable with expectations of at least $1
billion in FCF per annum. Micron could extinguish -10% to -15% of
its share count every year, if it chose to do so.
Assuming FCF falls to $1 billion in the current fiscal year and
rebounds to $1.5 billion in subsequent years, then this business
should be worth at least eight times free cash flow on an
enterprise value basis of $12 billion. By that math,shares have
+50% upside -- or more.
Action to Take -->
FCF is surging at many companies, thanks to recent massive cost
cuts. The companies in the list above sport notably high FCF
yields, but many other firms still have FCF yields in excess of
10%. You can calculate these yields by dividing annual FCF
(operatingcash flow minus capital expenditures) by the company's
enterprise value (market value plus debt minus cash).
Micron, Martek Biosciences, and Smurfit-Stone should stand out as
especially appealing names to investors on a FCF basis.
-- David Sterman
David Sterman started his career in equity research at Smith
Barney, culminating in a position as Senior Analyst covering
European banks. David has also served as Director of Research at
Individual Investor and a Managing Editor at TheStreet.com. Read
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.
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