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Six high-yielding free-cash-flow kings

The nine high-yielding stocks selected by our free-cash-flow kings screen significantly underperformed the market this year. But will this year's picks wrest back the crown from the FTSE All-Share?
August 25, 2016

Picking stocks that are not only high-yielding, but have a good chance of re-rating is no easy task. But based on past performance we would have expected our free-cash-flow kings screen to do a little better than its 2 per cent negative return since last September. That's because on a total return basis the FTSE All-Share delivered an impressive 18 per cent return over the same period, cemented by a very strong rally since the end of June. This also marks the first time that our screen has failed to beat the main benchmark since we revamped it in 2013.

 

Free-cash-flow kings 2015-16 performance

NameTIDMTotal return (22 Sep 2015 - 18 Aug 2016)
ZytronicZYT20%
Aberdeen Asset ManagementADN14%
MitieMTO1%
HendersonHGG-4%
NetPlay TVNPT-4%
MS InternationalMSI-5%
Volga GasVGAS-8%
William HillWMH-9%
Go-AheadGOG-18%
Average--2%
FTSE All-Share-18%

Source: Thomson Datastream

 

The thinking behind this screen is that companies that are not only profitable, but have a very good track record of converting profits into free cash flow (FCF), should be very attractive for investors. Because of their discipline or market position, highly cash-generative companies can offer pleasant surprises such as maintaining dividends when times are tough, making extra returns to shareholders like special dividends or buybacks, and funding investment in growth. While our screen returned 17 per cent in 2013 and 23 per cent in 2014, last year's picks were hampered by weak operational performance and broad market sell-offs. And although the free-cash-flow kings screen has returned a total of 36 per cent on a cumulative basis since its inception (or 30 per cent if we factor in a 1.5 per cent annual reinvestment charge), that's significantly down on the 51 per cent investors would have netted had they held on to the picks from the 2013 screen.

 

Buy-and-hold strategy

YearFTSE All-ShareFree-cash-flow kings
201317.6%50.7%
201411.0%20.4%
201518.3%-1.5%

Source: Thomson Datastream

 

The screen looks for companies with a good track record of rising free cash flows, operational cash flows that exceed operating profits in most years, and a solid return on equity or assets. With the screen 6 per cent up at the end of the 2015 calendar year, the discipline again looked to be paying off. However, the screen failed to rebound as strongly as the benchmark following market-wide sell-offs in January, when concerns around a slowdown in China rippled through global equity prices, and again in June, when shares in MS International (MSI), Mitie (MTO) and Go-Ahead (GDG) all dropped as a result of the EU referendum. Overall, there were no spectacular disasters, but even with their chunky dividends reinvested, only three of our picks - Zytronic (ZYT), Aberdeen Asset Management (ADN) and Mitie - made a profit.

 

Free-cash-flow kings cumulative total return

Source: Thomson Datastream

 

To compound matters, in between those sell-offs the companies that proved to be the two worst performers - William Hill (WMH) and Go-Ahead - were hit by profit warnings. In March, the betting firm warned that soft margins had been compounded by an increasing number of its customers "self-excluding" in an effort to control their impulse to gamble. Two months later, Go Ahead acknowledged that additional investment in the Govia Thameslink Rail franchise would lead to margins halving for the current financial year and next.

In an effort to capture a spread of larger and smaller companies, the FTSE All-Share and Aim indices produced six shares that met each of the following criteria, (and which like last year includes an extended quality test):

■ FCF higher than it was five years ago and rising in at least three of the past five years.

■ Cash generation (cash from operations/operating profit) of over 100 per cent in at least two of the past three years.

■ Cash profits of at least two times net debt.

■ A return on equity of greater or equal to 10 per cent, OR free cash flow return on assets (FCF/TA) greater or equal to the median average, OR operating margins greater or equal to the median average.

■ Enterprise value (EV)/FCF ratio below the median average.

■ A dividend yield (DY) in the top third of all dividend-paying shares.

 

Six high-yield shares

Communisis

Multichannel marketing group Communisis (CMS) has had a tricky year of restructuring its client-facing operations, although recent results for the six-month period to June showed that cost savings are already starting to feed through to adjusted operating profits. With two major contracts secured in the period, the outlook is good too. The UK-headquartered group, which helps companies with data intelligence and "brand experience", has also invested in overseas expansion, with international sales now accounting for around 24 per cent of overall revenue at the last count.

House broker Liberum expects adjusted EPS for the 2016 financial year of 6p, putting the shares on a very low earnings multiple. What's more, Communisis also has the lowest price-to-earnings growth (PEG), genuine value (GV) and price to book value (P/BV) ratios of any of the shares that passed all of the screen's tests (last IC view: Hold, 37.5p, 5 August 2016).

 

Interquest

Since 2012 recruitment group Interquest (ITQ) has proved adept at translating its niche focus on specialist technology jobs into earnings growth. That progress was checked by a profit warning immediately following the EU referendum result, which the company said had caused clients to delay hiring decisions and would result in net fee income and net profits for the current financial year "materially below market expectations". Broker Panmure Gordon had previously been expecting pre-tax profits of £5.6m and EPS of 11.8p.

But while that announcement, which sparked a 44 per cent fall in Interquest's shares, warned of challenging conditions across the recruitment sector, management is optimistic that the company's concentration on niche candidates in the rapidly growing digital economy will soon return it to free-cash-flow growth (last IC view: Buy, 82p, 9 March 2016).

 

Netcall

Of the six picks in the 2016 screen, customer engagement software provider Netcall (NET) boasts the highest cash conversion rate, and by some distance. Over the past three years, operating cash flows have been 94 per cent higher than operating profits on average. Very high cash conversion can sometimes be a sign that a company is pursuing an aggressive policy of depreciation and amortisation, but in Netcall's case a considerable chunk of the operating cash is being paid out as share-based payments to certain employees.

However, with a large proportion of recurring revenues, Netcall last year saw fit to increase cash returns to shareholders by proposing an "enhanced dividend programme", although the company is keen to retain enough cash to fund opportunistic acquisitions (last IC view: Take profits, 72p, 25 February 2015).

 

NWF

For a company exposed to two much-frayed markets - milk and fuels - agricultural supplier NWF (NWF) has been remarkably adept at protecting its margins. In the 12 months to May, a period in which milk prices reached a level below the average cost of production and Brent crude hit a 13-year low, the company actually increased underlying pre-tax profits by 2.5 per cent to £8.3m thanks to a focus on efficiency and inventory management over volume sales.

This should give investors some confidence that NWF can manage the impact of weaker sterling on the dollar-priced commodities, such as soy and oil, which it buys wholesale. Taking this headwind into account, the shares trade at 14 times Panmure Gordon's full-year adjusted EPS forecast, and come with a track record of steady dividend increases dating back to 2012 (last IC view: Buy, 162p, 8 August 2016).

 

Sprue Aegis

A potential defect - or perhaps contrarian aspect - of this screen is its inclusion of companies with good multiyear track records, but whose high dividend yields might mask a sharp recent share price drop. This could be the case with home products supplier Sprue Aegis (SPRP), which saw its share price half after an April profit warning. Not only had the company overstocked in France and witnessed falling sales in Germany, but a problem with the batteries in one of its smoke alarm models resulted in a £5.5m warranty provision. And although operating losses are expected to be "significantly lower" than first thought, the company has already said that sales for the six months to June are likely to be around half of those in 2015.

However, Sprue's loan-free, cash-rich balance sheet has left enough room to maintain the interim dividend at 2.5p a share, providing investors with some encouragement that the full-year payout can be maintained (last IC view: Hold, 130p, 18 April 2016).

 

Telecom Plus

Utility supplier Telecom Plus (TEP), the only one of this year's shares with a market capitalisation above £100m, is another example of a company whose cash conversion rate would be thinner were it not for a significant share incentive scheme. In the year to March 2016, share payment charges amounted to £2.5m, and came on top of a £5.8m hike in administrative expenses, putting pressure on statutory profits and margins.

However, there's no doubting that Telecom Plus's strong customer feedback and growing membership base has resulted in robust and sticky cash generation. So while earnings per share have stalled in recent years, the company is able to return increasing amounts of free cash to shareholders by way of dividends (last IC view: Buy, 969p, 14 June 2016).

 

NameTIDMMkt CapPriceFwd NTM PEDYPEGP/BVEV/SalesEV/FCFFY EPS gr+1FY EPS gr+23-mth MomentumNet Cash/Debt(-)
Communisis CMS£85m41p75.6%0.590.680.316.1613.7%5.5%2.8%-£26m
InterquestITQ£20m54p65.6%6.680.830.166.10-14.0%18.5%-42.1%-£6m
Netcall NET£78m57p263.5%-3.713.7915.09-15.1%-0.7%13.7%£15m
NWFNWF£82m170p143.4%8.662.240.2010.68-8.1%13.3%14.1%-£10m
Sprue Aegis SPRP£76m165p384.8%-2.430.608.35--3.2%£22m
Telecom Plus TEP£838m1,047p184.4%4.264.221.1713.484.9%7.2%8.2%-£35m

Source: S&P Capital IQ