In an uncertain economic environment, it can pay for investors to focus on companies that can weather any storm. You can find such high-quality companies by looking beyond the usual revenue and earnings numbers on income statements and focusing instead on cash statements. This can shape a better understanding of companies’ financial might and stability.
In a nutshell, the more a company can generate cash—and manage that cash wisely—the greater its quality. Companies with strong cash flows include semiconductor manufacturer Broadcom AVGO, drugmaker Bristol-Myers Squibb BMY, and United Parcel Service UPS.
What Is Free Cash Flow?
While revenue and earnings are important metrics for getting a snapshot of a company’s profitability and growth potential, they are far from the whole story when determining the company’s financial stability and how well it will hold up in an economic downturn or recession.
Earnings and revenue can also be misleading, especially at turning points in market cycles. When interest rates jumped swiftly and steeply in the past year and pushed up the cost of capital, the high-flying, high-growth tech stocks and startups (which had long relied on cheap money to finance their businesses and were valued more on their prospects for future earnings) saw their share prices and business models take a hit. There are also opportunities to skew revenue and earnings through accounting maneuvers on the income statement.
With a cash flow statement, investors will learn how much cash a company is producing from operations and how much is left over after it accounts for day-to-day expenses such as payrolls, inventories, rents, and taxes—a measure known as free cash flow. That gives a more honest appraisal of how well a company is managing its operations and how equipped it is to handle debt payments, reinvest in its businesses, expand opportunistically, and return capital to shareholders in the form of dividends and share buybacks.
The more positive a company’s free cash flow, the greater its flexibility to manage its business. Negative free cash flow suggests a company could struggle to meet obligations, face constraints when innovating, and risk becoming less competitive.
Screening for Free Cash Flow
We’ve identified seven U.S. companies in a range of industries—including drugs, semiconductors, aerospace and defense, and railroads and freight—that can give investors comfort in uncertain times, based on their financial profiles and operating performance. While these companies could hit rough patches, their cash-rich status can help them through.
First we screened companies with market values of $50 billion or more for the ones that generate the highest operating cash flows and the highest free cash flow yields and margins, and that also deliver the highest return on invested capital.
To assure debt loads were manageable, we then screened for companies with debt/equity ratios (a measure of the level of debt to assets) below 2.0. We also looked for companies with low current debt/equity ratios—another gauge of liquidity that indicates how quickly a company could pay off its short-term, or “current,” debt.
While it varies from one industry to another, a rule of thumb is that a company’s current ratio should be 1.0 to 2.0, while an optimal debt/equity ratio should not exceed 2.0.
For this particular search, we excluded energy companies. Most of these companies are currently generating large amounts of cash thanks to the rise in oil prices in recent years, and would have been overrepresented on the list. We also excluded financials because unlike other companies their business models are all about cash and predicated on attracting cash deposits and using those deposits to finance activities.
Stocks With High Free Cash Flow
The top company on our screen was Merck MRK, but because it is trading at a nearly 20% premium to Morningstar’s fair value estimate of $97, we omitted it from our list. The remaining stocks are trading at or below Morningstar’s fair value estimates.
Here are seven high-cash-flow stocks, ranked according to their level of operating cash flow at year-end 2022:
Broadcom
A leader in networking and connectivity solutions, 3-star Broadcom, which has a fair value estimate of $640 a share, trades just above that level at a recent $644.71. Morningstar strategist Abhinav Davuluri notes that his fair value estimate could rise to $680 if the company’s pending deal to acquire VMware VMW is completed. Abhinav assigns Broadcom a Morningstar Economic Moat Rating of narrow to Broadcom and an Morningstar Uncertainty Rating of Medium. Broadcom pays an annual dividend of $18.40 a share, yielding 2.85%.
United Parcel Service
The 3-star-rated package delivery company trades at a 5% discount to Morningstar senior equity analyst Matthew Young’s fair value estimate of $177 a share, which he recently lowered from $179 following disappointing results in the first quarter as daily package volumes declined. UPS also lowered guidance for the full year. Additionally, the company is engaged in contract negotiations with the International Brotherhood of Teamsters, and there’s a risk the talks could result in “meaningfully higher” wage hikes, according to Young. He gives UPS an Uncertainty Rating of Medium, based on more competition from Amazon.com AMZN and the threat of a consumer spending slowdown.
Young assigns the stock a wide moat rating. “In our view, UPS’ flagship express and ground package delivery operations enjoy significant and maintainable competitive advantages rooted in cost advantage and efficient scale, which drive our wide moat rating. UPS is exceptionally capable of keeping would-be competitors at bay for a prolonged period. Its returns on invested capital have approximated an impressive 19.5% over the past decade, ahead of its cost of capital.”
UPS pays an annual dividend of $6.48 a share for a yield of 3.89%.
Bristol-Myers Squibb
At $68.17 a share, the 3-star drugmaker trades at a 3% premium to Morningstar’s fair value estimate of $66. Morningstar’s Damien Conover assigns the stock a wide moat rating based on a “wide lineup of patent-protected drugs, an entrenched salesforce, and economies of scale.”
New drug launches should offset generic pressures, he says, and “we believe the strong overall pipeline helps support its wide moat.”
Conover explains, “Bristol’s sheer size generates the strong and stable cash flows required to fund the approximately $800 million needed, on average, to bring each new drug to market.” He adds, “We believe Bristol is operating at an exceptional level.”
Bristol pays annual dividend of $2.28 a share, yielding 3.40%.
Gilead Sciences
A leader in HIV therapies that serves 80% of treated HIV patients in the United States, 4-star Gilead trades at a 19% discount to Morningstar’s $97 fair value estimate. Its dominance in the HIV market gives it a wide moat, and Morningstar’s Karen Andersen expects it will “translate its extensive understanding of the drug discovery and development process in HIV into new therapeutic areas.” Anderson calls Gilead a “powerhouse” in the broader infectious disease market, particularly in the hepatitis C market.
“Most of Gilead’s debt (to fund share repurchases in 2014-16 and large acquisitions such as Pharmasset in 2011 and Kite in 2017) is due beyond 2025, making the repayment schedule look manageable, particularly with annual cash flow from operations north of $9 billion,” says Andersen.
Gilead’s annual dividend is $3 a share, giving it a yield of 3.83%.
CSX
At a recent $31.76 a share, the 3-star-rated railroad operator trades slightly below Morningstar senior analyst Young’s fair value estimate of $32. He assigns the company a wide moat, citing its cost advantages and efficiencies. Its Uncertainty Rating is Medium, given its sensitivity to the health of the U.S. economy.
“Core pricing and margin resilience in past freight recessions and in the face of substantial coal volume losses over the past decade-plus are a testament to the rails’ robust competitive positioning,” says Young. “With near certainty, we expect the rails to continue to turn their two core moat sources into economic profit for the next 10 years, and more likely than not 20 years from now.”
CSX’s dividend payout is a skimpy $0.44 annually, for a yield of 1.39%. Yet the company’s share repurchase program is robust, and it bought back more than $1 billion of its stock in the first quarter.
3M
The giant material sciences conglomerate sports a 4-star rating, and Morningstar senior equity analyst Joshua Aguilar considers it a wide-moat “innovative powerhouse.” At a recent $98.25 a share, the company’s stock trades at a 23% discount to its fair value estimate of $127 a share.
“For at least the 27 years before 2019, 3M’s returns on capital (including goodwill) have more than doubled our estimated cost of capital, even during years when the company endured negative sales growth,” says Aguilar. “On average during the past 10 years, 3M still managed to earn returns on invested capital including goodwill that cleared its weighted average cost of capital hurdle easily by more than 2 times, and in some years more than 3 times. As a result, we have a high degree of confidence that 3M will continue to produce excess returns for at least the next 20 years.”
Still, 3M’s Uncertainty Rating is High, based on litigation risks surrounding its military standard-issue Combat Arms earplugs, which veterans have alleged to be defective. It also faces litigation risk related to its manufacturing of organic-fluoride-based chemicals in the 1940s that have contaminated sites and have been associated with health defects among exposed populations.
3M pays an annual dividend of $6 a share, yielding 6.09%.
General Dynamics
Global aerospace and defense company General Dynamics holds a 4-star rating, and at its recent price of $209.56, it trades at a 14% discount to Morningstar equity analyst Nicolas Owens’ fair value estimate of $240 a share.
“We think investors should welcome a potential buying opportunity for this wide-moat, topnotch steward of shareholder capital in a mostly acyclical sector,” notes Owens.
This content was originally published here.
