Cash generation is often regarded as the ultimate yardstick against which a company’s performance should be judged. After all, companies need cash to survive, invest and prosper. By contrast, profits can prove a lot less nutritious over the long term, especially if they’ve been overstated by a creative finance director.
The problem investors face when focusing on cash flow, though, is that it is often lumpy, which can make it hard to interpret. Should a company decide to invest heavily in new capacity, for example, it will report poor cash generation while spending that money no matter how attractive future returns from the investment are destined to be. Profits could be a far better pointer to the business’s potential under these circumstances.
These difficulties in analysing cash flow means, despite the importance of cash, that the market often seems to pay relatively little attention to it, which can leave rich pickings for those investors that are prepared to take a cash-focused approach. So the idea behind my free-cash-flow (FCF) kings screen is to find shares with attractive cash credentials that may have been overlooked.
The screen looks for companies that look cheap compared with their FCF and offer an attractive dividend yield. The idea of marrying the hunt for dividends and cash flow is that a company that is confident of its cash flows may well express this by making generous payouts to shareholders. Furthermore, since dividends are paid from cash, income-hunting investors can be more confident of the sustainability of dividend payments from a company that is generating good amounts of cash.
As well as looking for shares that are attractively priced, the screen looks at a few indicators of quality. Given the lumpy nature of cash flow, the screen does not insist on smooth rises in cash flow or strong generation in all years assessed, but rather it looks for companies that give a decent general impression of having solid cash credentials. The screen also looks at a measure of the efficiency with which a company produces cash from its asset base. The full screening criteria are as follows:
■ FCF higher than it was five years ago and rising in at least three of the past five years.
■ Operating cash conversion (cash from operations/operating profit x 100) of over 100 per cent in at least two of the past three years.
■ Cash profits of at least two times net debt.
■ FCF return on total assets (FCF/TA) greater or equal to the median average.
■ An enterprise value (EV)/FCF ratio among the cheapest quarter of all stocks screened (below 16.9 times).
■ A dividend yield (DY) in the top third of all dividend-paying shares screened.
Following two fairly disappointing years of performance from the screen, the criteria I’ve used this year has been tightened up slightly (a tougher EV/FCF test) and a slightly different calculation of FCF has been used. However, the screen’s objective remains the same and its methods are largely unchanged. Indeed, given the lumpy nature of cash flows, perhaps it's fair that the performance of my FCF kings stock screen has itself been lumpy.
Over the last 12 months the six stocks picked last year produced a 6.7 per cent total return compared with 11.4 per cent from the All-Share index.
2016 PERFORMANCE
| Name | TIDM | Total return (28 Aug 2016 - 25 Sep 2017) |
| Communisis | CMS | 52% |
| Sprue Aegis | SPRP | 34% |
| Telecom Plus | TEP | 8.6% |
| NWF | NWF | -0.1% |
| Netcall | NET | -3.6% |
| Interquest | ITQ | -50% |
| FTSE All-Share | - | 11% |
| FCF Kings | - | 6.7% |
Source: Thompson Datastream
The cumulative return from the screen over the four years I’ve run it now stands at 49.2 per cent, or 40.4 per cent if I factor in an annual 1.5 per cent charge to reflect the notional costs of switching between portfolios each time the screen is updated. Over the same period the FTSE All-Share has delivered a 30.6 per cent total return.
FCF Kings versus FTSE All-Share index
Fifteen stocks passed the screen’s tests this year. As well as listing all of these stocks in the table below, which is ordered from lowest to highest EV/FCF, I’ve taken a look at three stocks from around the top, middle and bottom of the table.
| Name | TIDM | Mkt cap | Price | Fwd NTM PE | CapIQ DY | EV/FCF | FY EPS gr+1 | FY EPS gr+2 | 3-month momentum | Net cash/debt (-) |
| Centamin | CEY | £1.6bn | 141p | 16 | 8.2% | 5.6 | -38% | 8.2% | -12% | $297m |
| Bloomsbury Publishing | BMY | £119m | 159p | 13 | 4.2% | 6.5 | -3.5% | 7.2% | -7.0% | £15m |
| DFS Furniture | DFS | £455m | 215p | 11 | 5.1% | 10 | -18% | 1.7% | 4.6% | -£133m |
| Severfield | SFR | £192m | 64p | 11 | 3.6% | 10 | 11% | 8.3% | -17% | £32m |
| Headlam | HEAD | £491m | 581p | 14 | 5.4% | 11 | 5.9% | 3.1% | 9.5% | £50m |
| Royal Mail | RMG | £3.8bn | 384p | 10 | 6.0% | 11 | -11% | 2.5% | -10% | -£358m |
| Marks and Spencer | MKS | £5.7bn | 351p | 13 | 5.3% | 12 | -7.4% | 1.5% | 2.4% | -£1.8bn |
| Moss Bros | MOSB | £101m | 100p | 17 | 5.9% | 13 | 6.3% | 4.9% | -5.9% | £21m |
| Brewin Dolphin | BRW | £936m | 341p | 17 | 3.9% | 13 | 14% | 13% | 0.7% | £154m |
| Restaurant Group | RTN | £609m | 304p | 14 | 5.7% | 13 | -26% | 0.5% | -11% | -£23m |
| Norcros | NXR | £105m | 171p | 6 | 4.2% | 13 | -0.4% | 5.2% | -5.5% | -£23m |
| Hostelworld | HSW | £344m | 360p | 43 | 3.7% | 14 | 816% | -42% | 5.0% | €18m |
| Kier | KIE | £1.1bn | 1,170p | 10 | 5.8% | 15 | 11% | 12% | -8.5% | -£147m |
| Communisis | CMS | £123m | 59p | 9 | 4.1% | 16 | 3.4% | 4.0% | 21% | -£28m |
| BT | BT.A | £28bn | 285p | 10 | 5.4% | 17 | -3.5% | 2.9% | -4.4% | -£10bn |
Source: S&P Capital IQ
Bloomsbury Publishing
The 20th anniversary of the first Harry Potter book is providing Bloomsbury (BMY), the publisher of the series, with yet another chance to cash in on the enduring popularity of the boy wizard. Two new Harry Potter books will be published this month to accompany a British Library exhibition celebrating two decades of the Hogwarts hero. Meanwhile, Bloomsbury is continuing to publish new illustrated versions of the original books.
And outside its children’s division, Bloomsbury has other tricks up its sleeve. Strong cookery titles helped the group achieve excellent first-quarter sales, and digital revenues also rose strongly. Indeed, overall sales in the first three months of the year were 19 per cent ahead or 13 per cent measured in constant currencies. The start of the year is traditionally quiet for Bloomsbury and more news of how things are panning out will come on 24 October when the company is due to release half-year figures.
The company’s cash flows are of particular interest for income-focused investors at the moment because Bloomsbury’s investment in its 2020 digital strategy means earnings cover has dropped below the target level of two times. Management has taken comfort from cash flows to continue pursuing the aim of ongoing dividend growth (the annual compound average dividend growth rate over the past five years has been 7 per cent). While the digital 2020 investment programme resulted in £1.5m capital expenditure last year, tightening stock controls have helped boost cash generation and the balance sheet looks very healthy.
Last IC View: Buy, 166p, 22 Jun 2017
Restaurant Group
A key attraction for investors in Restaurant Group (RTN) is its fat dividend, which it maintained at the time of its first-half results as a show of confidence in its recovery strategy. It is still early days in the company’s attempts to stem falling like-for-like sales at its restaurants and cope with rising costs. That said, a new team has reformulated menus to tempt customers back who may have been deterred by a historic upwards creep in prices. The company is also attempting to cut costs and believes savings of £10m will be made this year. This will support investment in efficiency improvements, including improving IT systems and online presence. The company also hasn’t given up on expansion despite its difficulties. Its modest growth plans focused on its more promising pubs and concessions business.
While there are some signs that trading volumes may be picking up, it’s far too early to be confident of a revival in the fortunes of this former sector darling. Indeed, several years of industry expansion means competition is tough and new concepts focused on freshness and counter service are presenting challenges. The potential impact of Brexit on consumer confidence is also a concern. What’s more, costs are on the rise on many fronts, from staff, to ingredients, to business rates.
The dividend is therefore central to Restaurant Group’s investment case and, therefore, so too is the cash flow that supports the payout. Encouragingly, cash flow has held up well, with first-half net debt falling from £35.6m to £19.3m and “underlying” first-half FCF dropping by only £700,000 to £35.1m despite an £11.1m fall in underlying pre-tax profit to £25.5m.
That said, both the underlying FCF reported by the company and the figures used by the FCF kings screen ignore a number of significant nasties. The group is spending cash on property charges it previously made provisions against and restructuring activities. The way these cash costs are recorded (a total of £12.5m in the first half) means they fall outside the FCF calculation. One could well argue that it’s wrong to ignore these cash expenses, and if that is the case the FCF valuation in the accompanying table is too flattering. Still, the cash flow and balance sheet look healthy enough to mean the dividend looks as though it could continue to be maintained if the recovery pans out as hoped.
Last IC View: Buy, 339p, 31 Aug 2017
BT
Following a recent spell of share price weakness, BT has just managed to squeeze into the screen’s picks based on the key EV/FCF valuation metric. The telecoms giant could actually look much more attractive on an EV/FCF basis were the screen still ignoring pension deficits (one of the tinkerings made this year is to calculate EV by adding pension deficits as well as net debt to market cap). That’s because the company’s pension deficit is almost equal to its substantial net debt. The pension is currently one of the issues that’s at the forefront of BT investors’ minds as the company is undergoing a triennial pension review. The strength of the bond market over recent years provides grounds to worry that the company will be required to make large top-up payments that would drag down cash flows and put pressure on future dividends. Alternatively, though, a lenient settlement could produce a positive surprise.
It’s not only the pension that is keeping cash-focused BT investors awake at night. There is political pressure on the income stalwart to increase spending on broadband infrastructure to speed up internet connections and improve national coverage. The company also needs to spend on infrastructure to keep competition at bay and entice new customers with faster data connections. Meanwhile, the company’s TV business is also likely to see costs rise for the rights to sports events, especially given the threat of streaming services entering the market. There is also uncertainty about the level of future 'spectrum' payments to the government for use by its mobile operation.
As well as these headwinds, earlier this year the company’s global services division revealed that accounting irregularities would result in a £245m hit. This was enough for the company to abandon a pledge to grow the dividend by 10 per cent, although the official line is that the dividend policy will remain “progressive”. Given the uncertainty, coupled with recent disappointments, it’s perhaps not too surprising the shares have floundered. However, this gives scope for a recovery over the coming 12 months should investors start to get favourable news on some of the significant points that need clarifying.
Last IC View: Hold, 288p, 14 Jul 2017
