Regular readers of this column will have become familiar with the frequent changes being made to the screens I run to keep them producing ideas despite the Covid hit. No such change needs to be made to the Free Cash Flow (FCF) Kings screen that I am rerunning this week, but I did make some significant changes last year. Whether by luck or by design, the revamped screen put in a strong performance over the past month and has highlighted 12 new stocks for the coming year.
While this screen may have already found its 'new normal' prior to lockdown, Covid-19 does still present some significant issues for it. The most noteworthy of these is that the screen is principally backward looking, and for many companies, the past may look very different from the post-Covid future – at the very least in the short term.
One of the reasons this is a rear-view-mirror screen is that brokers tend to pay far more attention to forecasting earnings than FCF. This makes it more dubious to screen based on predicted cash generation than would be the case with profits. What’s more, FCF in any one year can be misleading due to the impact of big one-off spending projects on the figure. Earnings attempt to provide a smoothed impression of progress, which is great on one hand, but is also the reason earnings are generally regarded as far more easy to manipulate than cash flow.
The changes I made to the FCF Kings screen last year involved: softening up the valuation criteria; switching focus to average FCF over several years rather than single years, which can be lumpy; and introducing a test to reduce the chance that companies highlighted were not value traps by looking for encouraging recent share price and broker forecast trends. The full criteria of the screen are:
■ Cumulative five-year FCF 10 per cent higher than it was three years ago.
NB of interest to accounts geeks, to compensate for a recent rule change on lease accounting, which shifts a significant portion of cash costs associated with rent out of the old FCF calculation, capital lease repayments are subtracted to arrive at the FCF figure.
■ Operating cash conversion (cash from operations/operating profit x 100) of over 100 per cent in at least two of the past three years.
■ Net debt less than three times cash profits (Ebitda).
■ Five-year cash return on invested capital (CROCI) better than average of all companies screened.
■ A pension-deficit-adjusted enterprise value (EV)/FCF ratio among the cheapest half of all stocks screened (below 18.6 times).
■ A dividend yield (DY) in the top half of all dividend-paying shares screened.
■ Top third three-month share price momentum or forecast EPS growth in each of the next two years and no forecast downgrades in the past three months.
Some of the most disappointing performances from the seven shares highlighted by the screen a year ago were from companies that face long-term uncertainties due to changing behaviours caused by the pandemic. This is particularly true of Go-Ahead. Still, overall the screen's results were strong even if the wide dispersion between winners and losers gives me pause for thought about how successful the revamped criteria really has been (see table).
12-month performance
| Name | TIDM | Total return (9 Sep 2019 - 18 Sep 2020) |
| Liontrust Asset Man. | LIO | 80% |
| Dunelm | DNLM | 70% |
| Centamin | CEY | 61% |
| Vodafone | VOD | -27% |
| Rank | RNK | -38% |
| Babcock International | BAB | -57% |
| Go-Ahead | GOG | -67% |
| FTSE All Share | - | -12% |
| FCF Kings | - | 3.0% |
Source: Thomson Datastream
The good performance during the last 12 months has started to repair a very uninspiring long-term record caused by four consecutive years of underperformance of the FTSE All-Share index. The screen’s seven-year total return now stands at 48.2 per cent compared with 23.6 per cent from the FTSE All-Share. While the screen results are intended as a source of ideas for further research rather than as off-the-shelf portfolios, if I try to inject a dose of reality into the performance figures with a 1.5 per cent notional annual dealing charge, the total return drops to 33.3 per cent.
Fundamental data relating to the shares passing this year’s screen can be found in the table below (extra data and a glossary of terms is available in the downloadable version of the table). I’ve also taken a closer look at the most expensive stock on the list based on EV/FCF.
12 free cash flow kings
| Name | TIDM | Mkt Cap | Net Cash / Debt(-)* | Price | Fwd PE (+12mths) | Fwd PE (+24mths) | Fwd DY (+12mths) | EV/FCF | EV/Sales | FCF Conv. | EBIT Margin | ROCE | Fwd EPS grth FY+1 | Fwd EPS grth FY+2 | Fwd EPS grth +24 mth | 3-mth Mom | 3-mth Fwd EPS change% | 12-mth Fwd EPS change% |
| BHP Group Plc | BHP | £37,341m | £10,995m | 1,768p | 13 | 13 | 5.6% | 14 | 3.1 | 101% | 37.2% | 21.6% | 5.4% | -7.3% | 6.2% | 9.0% | -2.9% | -17.0% |
| Tyman Plc | TYMN | £425m | £220m | 216p | 9 | 8 | 2.8% | 6 | 1.1 | 372% | 9.6% | 8.7% | -24.3% | 17.4% | 134.9% | 11.8% | 25.9% | -26.4% |
| IMI plc | IMI | £2,885m | £416m | 1,060p | 15 | 14 | 2.4% | 14 | 1.8 | 145% | 13.5% | 19.9% | -8.8% | 9.3% | 38.5% | 15.8% | 16.0% | -6.6% |
| Compass Group PLC | CPG | £22,530m | £5,093m | 1,263p | 28 | 19 | 1.3% | 18 | 1.0 | 148% | 6.3% | 23.1% | -72.9% | 95.0% | 1.8% | 10.4% | 4.5% | -72.6% |
| Rio Tinto plc | RIO | £62,422m | £6,352m | 5,007p | 11 | 13 | 5.9% | 13 | 2.8 | 136% | 31.9% | 25.8% | -2.5% | -6.3% | 10.1% | 11.1% | 15.8% | -9.8% |
| Ultra Electronics Holdings plc | ULE | £1,512m | £107m | 2,128p | 16 | 15 | 2.8% | 12 | 1.9 | 97% | 11.4% | 14.1% | 4.8% | 6.3% | 45.7% | 0.9% | 4.2% | 8.6% |
| Berkeley Group Holdings plc | BKG | £5,597m | -£1,136m | 4,455p | 14 | 13 | 4.7% | 10 | 2.4 | 116% | 24.5% | 13.7% | -2.5% | 9.5% | 7.2% | 1.7% | 4.8% | -9.7% |
| Drax Group plc | DRX | £1,105m | £825m | 278p | 10 | 8 | 6.4% | 7 | 0.4 | 49360% | 5.3% | 7.5% | -1.6% | -5.3% | -326.2% | 19.4% | -0.7% | 15.8% |
| NCC Group plc | NCC | £539m | £42m | 193p | 25 | 20 | 2.4% | 14 | 2.2 | 333% | 7.2% | 6.2% | -1.8% | 36.4% | 134.2% | 17.4% | 27.3% | -31.0% |
| CMC Markets Plc | CMCX | £1,054m | -£89m | 363p | 12 | 19 | 4.2% | 17 | 3.3 | 62% | - | 39.4% | 36.6% | -54.1% | -35.9% | 33.8% | 75.5% | 453.0% |
| Playtech plc | PTEC | £1,086m | £220m | 363p | 14 | 11 | 1.4% | 4 | 1.1 | 1465% | 8.1% | 5.9% | -50.0% | 59.7% | -471.4% | 17.2% | 7.7% | -61.3% |
| Plus500 Ltd. | PLUS | £1,604m | -£472m | 1,524p | 8 | 11 | 4.3% | 3 | 1.9 | 83% | - | 67.9% | 198.8% | -55.3% | -54.5% | 23.2% | 54.0% | 216.6% |
*FX converted to £
Source: Factset
Compass
International food-services outsourcing company Compass (CPG) has been badly hit by lockdown. It is contracted by businesses and organisations from a range of sectors to run their catering. This has meant many of the cafes and restaurants it operates closed as workers were sent home to try to contain the spread of Covid-19. The pie chart below shows a sector breakdown of the group’s end markets, along with the approximate percentage of its activities closed in each area at the peak of lockdown. Not nice.
The question is, what will the future of the business look like and how much pain will Compass have to endure to make it to the new normal?
Before the pandemic struck, Compass had amassed an enviable growth record, notching up a compound annual sales growth rate of 8 per cent over the past five years. It has grown through its investment in the existing business (especially bidding and setting up new contracts) and making bolt-on acquisitions to take it into new sectors and geographies.
As it tends to operate from its customers’ facilities, it requires relatively little capital to operate and grow. It has also used its increased scale to juice out efficiencies, increasing its underlying operating margin from 6.5 per cent to 7.4 per cent over its past 10 financial years. While the margin may not be much to write home about, combined with low capital requirements (it generates almost £3 of sales for every £1 invested in the business) it has been enough to make Compass an incredibly efficient profit machine, prior to Covid-19 at least.
In 2019 it achieved a 23 per cent return on capital employed (ROCE) – a measure of operating profit relative to the amount of money invested in operations. Meanwhile, strong cash generation and a focus on dividends and buybacks has meant £8bn has been returned to shareholders over the past decade.
But things have changed fast since the pandemic struck. In the three months to the end of June sales were down 44 per cent and the group reported a negative 6.3 per cent operating margin. Lockdown closed about half of Compass’s sites at its peak. The company reckons its recovery will only be gradual, although things are already showing signs of improvement with about 60 per cent of sites open at the end of June. Under its slow-recovery scenario, Compass hopes to get revenues back to 80 per cent of pre-lockdown levels during 2021.
Changes to behaviours, such as increased working from home, also means the shape of the business may have changed considerably when a “new normal” finally becomes established. The prospect of fewer workers in offices in particular looks an issue for the business & industrial division.
But in some respects Compass looks relatively well positioned to handle the exceptional situation. The absence of major property overheads gives it more options to resuscitate profits. In 2019, 30 per cent of its £23.3bn cost base related to raw materials and a further 49 per cent to staff.
In the US, where the company generated 60 per cent of last year’s sales, labour costs have proved more flexible than elsewhere (people are easier and cheaper to lay off). It has also proved easier to keep facilities open in the country. Group-wide, monthly costs have been cut by £500m and the previous annual investment plans of about £900m (approximately 3.5 per cent of sales) have had £200m shaved from them. All the same, higher health and safety costs and lower levels of demand stand to make some contracts uneconomic, although management says it is having “constructive” conversations about renegotiating contracts.
The financial position looks solid after the company raised £2bn by selling new shares at 1,025p in May. Bank terms linked to earnings have been waived and headroom stands at about £5bn. That compares with a £260m free cash outflow during the dire third-quarter trading period.
There could actually be some long-term benefits from the pandemic as it may accelerate the move to outsourcing, while flushing out smaller players; Compass estimates around half of its £200bn end market is still operated in-house, with another 20 per cent in the hands of small regional businesses. It is not hard to imagine the increased health and safety demands that have been placed on the food-services industry by the crisis, along with supply chain disruption for smaller operators, making Compass’s services seem more attractive. And while it’s still too early to peg too much hope on a step change, recent third-quarter results highlighted a marked pick-up in business from customers new to outsourcing.
As a clear Covid victim, Compass’s shares remain 42 per cent below their 52-week high of 2,104p. Part of this is justified by the dilution of the placing. Based on the historical enterprise value to sales (EV/Sales) multiple – see chart – there should be decent upside from any noteworthy recovery. EV/Sales is a very useful way to value companies when their ability to generate earnings has temporarily been hit, because sales give an impression of the raw potential should past levels of profitability and growth be recaptured. A good wedge of hope is required, but the company’s leading market position and past glories means hope will not necessarily prove misplaced.
