News Analysis date published New: 
Wednesday, April 10, 2013 - 13:00
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Wednesday, April 10, 2013 - 13:00
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Wednesday, April 10, 2013 - 13:00

This Underused Metric Points To Big-Name Bargains

Wednesday, April 10, 2013 1:00 PM

Perhaps the most powerful investing angle for our times has been the ever-rising tide of cash parked on corporate balance sheets.

And the only way to build that cash (besides selling stock or key assets) is to generate free cash flow (which is defined as operating cash flow minus capital spending).

I recently took note of the impressive free cash flow being generated by small-cap firms. In this column, I look at mid-cap stocks in the S&P 400 and bigger companies in the S&P 500. Not only are these firms prodigious producers of free cash flow, but they look like solid values as their free cash flow (FCF) yields (which is free cash flow divided by market value) exceed 10%. Anytime you spot such robust FCF yields, it's time to step up your research: High yields only last while a stock remains unnoticed.

The double-digit yielders
Less than 3% of all stocks (11 of them to be exact) in the S&P 400 are able to boast of a double-digit FCF yield. As I did in my look at small caps, I eliminated any companies that failed to generate positive free cash flow in each of the past three years. The remaining four, though, are worth further research, though in my mind, one stands out as providing especially compelling value.

Strong Mid-Cap Free Cash Flow Yields

Protective Life (NYSE: PL)
This financial services firm, which focuses on insurance products, has developed a steadily profitable business for all economic climates. Going back six years, through economic upturns and downturns, its free cash flow has always exceeded $550 million annually.

More impressive, that robust cash flow has managed to boost tangible book value per share from $9 in 2008 to a recent $58. That means shares trade for just 60% of tangible book. (The stock currently trades at $35, so $35/$58 = 60%.) And with such a valuation disconnect, Protective Life has wisely been an active buyer of its own stock, acquiring roughly 5 million shares (representing 6% of the share count) in the past two years, with plans to buy back more shares in 2013.

"Management estimates it has the capacity to engage in $500 million in (mergers and acquisitions) without sacrificing the current $100 million annual pace of share repurchase," according to analysts at Merrill Lynch.

Indeed, the company is said to be in talks to acquire the U.S. assets of French insurer AXA for $1 billion. That may help boost the company's long-term growth trajectory, but with shares trading at such a sharp discount to book value, shareholders would be better rewarded with more aggressive buybacks.

Analysts at UBS disagree, noting that "a potential acquisition is the main catalyst for further material upside in the stock ... as Protective Life has considerable expertise in acquisitions."

If the AXA acquisition comes to pass, then management may choose to hold off on further share buybacks this year. By 2014, however, look for more aggressive efforts to reward shareholders -- especially if this stock remains so far below tangible book value.

For that matter, the dividend deserves greater attention. Though it has steadily risen from 48 cents a share in 2009 to a recent 70 cents, the payout ratio remains below 20%. Looking out several years, this business is likely to generate more than $1 billion in annual free cash flow, as was the case in 2008 and 2009, once interest rates move back up to historically typical levels.

With $1 billion in free cash flow and a 35% payout ratio, the dividend would rise to around $4.20 a share, equating to a 12% dividend yield. It may be several years before that scenario plays out, but patient investors may be handsomely rewarded at current entry points -- not only from that eventual juicy yield, but the share price appreciation that would ensue from this stock's rising appeal for income investors.

Sticking with insurance
There are four companies in the S&P 500 that sport impressive double-digit FCF yields, and it's no coincidence that three of the companies are insurers.

Strong Large-Cap Free Cash Flow Yields

The hard-to-fathom question is why these stocks remain out of favor in light of their solid financial performance. To be sure, insurance stocks are not timely -- low interest rates tend to depress insurers' earnings -- but the fact that free cash flow is solid implies that the numbers will be far higher when rates rise.

Look at Prudential Financial (NYSE: PRU), whose free cash flow has been so robust that book value per share has risen from $32 in 2008 to a recent $83. Trading at a recent $55, this stock sports a price/book ratio of just 66%. Due to some regulatory issues, Prudential isn't buying back any stock at the moment, but is expected to resume share buybacks later this year, and analysts assume that Prudential will have up to $1.2 billion to work with to buy back shares.

It's notable that Xerox (NYSE: XRX) investors are finally responding to the company's remarkable generation of free cash flow.

But Xerox's recent rebound has room to continue. The company has generated an average of $1.7 billion in free cash flow in recent years, yet the company is valued at less than $11 billion. Analysts at Citigroup expect free cash flow to move above $2 billion in 2013, 2014 and 2015, which should set the stage for both share buybacks and a dividend boost.

Risks to Consider: The companies on the tables above have generated meager or even negative revenue growth in recent years, and a downturn in the U.S. economy would make it hard for them to generate a revenue rebound.

Action to Take --> This is an exercise that should apply to many companies in your portfolio. If a company is largely mature, then it should be expected to generate solid free cash flow to offset the mature top-line characteristics.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.