Sunday, May 3, 2015

Is Free Cash Flow King?

     I read this excellent article last weekend from Barron's profiling two Chief Investment Officers, Bill Priest and David Pearl, who focus on "shareholder yield" in evaluating potential investment opportunities. Shareholder yield is simply a fancy term to describe how companies allocate their capital. The five uses of capital are reinvesting internally, making acquisitions, buying back stock, paying dividends, and paying down debt. The companies that attract attention from the two CIOs do the best job of balancing the needs of the company (reinvesting internally and making acquisitions) with the needs of shareholders (buying back stock and paying dividends) and debt holders (paying down debt).
     Microsoft, a top pick outlined in the article, is an example of a company that meets the competing demands of internal managers, shareholders and debt holders. For the twelve months ending March 31, 2015, by my calculations, Microsoft had free cash flow ("FCF") of around $26B ($32B cash from operations less $6B capital expenditures). The company spent $9B on acquisitions, bought back $11B of shares, and paid $10B in dividends. Given the low interest rates, they financed some of these expenditures by issuing net new debt of around $10B. Looking at their balance sheet on March 31, 2015, Microsoft was in the enviable position of having about $95B in cash and short-term investments, compared to total funded debt of approximately $32B. One of the risks a cash generator like Microsoft faces, not covered in the article, is repatriating cash from overseas into the US. However, with interest rates at their current low levels, it probably makes more sense for Microsoft to keep issuing debt in order to meet any short-term US cash needs (i.e. funding dividends and buybacks).

     The article also makes light of the price to FCF ratio as a way to screen potential investments. For fun, I ran some screens to identify cheap price/FCF companies on the US and Canadian exchanges. In Canada, the cheapest companies based on the price/FCF ratio were Power Corporation (POW), Manulife Financial (MFC), and Power Financial Corporation. Interestingly, their dividend yields are 3.5%, 2.8%, and 4.0% respectively. In the US, the cheapest companies based on FCF were Ares Management (ARES), Annaly Capital Management (NLY) and Prudential Financial (PRU). Their respective dividend yields were 5.3%, 11.9% and 2.8%. Microsoft was the 108th cheapest company based on FCF, appearing after familiar names such as Ford (#30), Apple (#58), and Cisco Systems (#87).  The lists contain many financial companies, some private equity funds, and a fair amount of technology companies.

     Is there value in identifying cheap price/FCF companies? Based on my initial screens run for North American companies, I think the jury is still out.

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