An Important Metric is Flashing ‘Buy’ for These Stocks

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 (FCF) yields. This is the true honest-to-goodness measure of how just how much money a company can earn –and keep — when compared to its enterprise value. I was surprised to find at least nine stocks (excluding those that operate in the financial services industry) with a FCF yield 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 results at Martek Biosciences (Nasdaq: MATK). This maker of nutritional supplements is highly profitable on a GAAP basis. But thanks to large levels of depreciation associated with new factories, reported profits are muted. That may explain why shares took a pretty sharp hit this week.

If you move past that accounting 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, but shares 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 enterprise value.

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 AOL (NYSE: AOL), that may be hard to pull off, as key cash flow streams are starting to shrink.

In a similar vein, falling demand for newsprint could impact the FCF picture for International Paper (NYSE: IP)

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 annual earnings 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 long-term debt load.
So what is an appropriate price for a stock with such a high FCF yield? Well, few analysts think of price targets in these terms, although you could argue that shares should see buying interest that pushes the stock higher until the FCF yield drops to 15%. That implies +30% to +40% upside from current levels.
Micron Technology (NYSE: MU)
This memory chips maker has seen its shares 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, expecting EPS 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 months.

And all of that cash flow ties into the balance 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 boost book 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 (operating cash 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.