As an investor, it pays to follow the cash. If you figure out how a company moves its money, you might eventually find some of that cash flowing into your pockets.
In this series, we'll highlight four companies in an industry, and compare their "cash king margins" over time, trying to determine which has the greatest likelihood of putting cash back in your pocket. After all, a company can pay dividends and buy back stock only after it's actually received cash -- not just when it books those accounting figments known as "profits."
Today, let's look at Honeywell International (NYSE: HON ) and three of its peers.
The cash king margin
Looking at a company's cash flow statement can help you determine whether its free cash flow actually backs up its reported profit. Companies that can create 10% or more free cash flow from their revenue can be powerful compounding machines for your portfolio. A sustained high cash king margin can be a good predictor of long-term stock returns.
To find the cash king margin, divide the free cash flow from the cash flow statement by sales: cash king margin = free cash flow / sales
Let's take McDonald's as an example. In the four quarters ending in December, the restaurateur generated $6.97 billion in operating cash flow. It invested about $3.05 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment from its operating cash flow. That leaves us with $3.92 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.
Taking McDonald's sales of $25.5 billion over the same period, we can figure that the company has a cash king margin of about 14% -- a nice high number. In other words, for every dollar of sales, McDonald's produces $0.14 in free cash.
Ideally, we'd like to see the cash king margin top 10%. The best blue chips can notch numbers greater than 20%, making them true cash dynamos. But some businesses, including many types of retailing, just can't sustain such margins.
We're also looking for companies that can consistently increase their margins over time, which indicates that their competitive position is improving. Erratic swings in margins could signal a deteriorating business, or perhaps some financial skullduggery; you'll have to dig deeper to discover the reason.
Four companies
Here are the cash king margins for four industry peers over a few periods:
Company | Cash King Margin (TTM) | 1 Year Ago | 3 Years Ago | 5 Years Ago |
|---|---|---|---|---|
Honeywell International | 7% | 5.6% | 11.1% | 9.1% |
BorgWarner (NYSE: BWA ) | 6.6% | 4.4% | 4.5% | 5.8% |
Johnson Controls (NYSE: JCI ) | 0.7% | (1.7%) | 5% | 3.2% |
Exide Technologies (NASDAQ: XIDE ) | (1.9%) | (3.1%) | (1%) | (3.5%) |
Source: S&P Capital IQ
None of these companies meets our 10% threshold for attractiveness. Honeywell comes the closest, but its current cash king margins are more than two percentage points lower than they were five years ago. BorgWarner has the next highest margins at 6.6%, and its current margins are the highest they have been in the years shown. Johnson Controls' margins are less than 1%, and while they are up from last year, they are lower than they were five years ago. Exide consistently put up cash king margins in the negative numbers over these past few periods.
Components manufacturer Honeywell performed well in 2012 due to its involvement in strong areas of an overall weak economy. Some of its worries for the upcoming year relate to problems one of its major clients, Boeing, is facing. Between its labor dispute with its engineers and problems with its 787 Dreamliner, some worry that it may not be able to meet its commitments, which would spell trouble for Honeywell and other suppliers like General Electric and Spirit Aerosystems. However, Honeywell's position as a supplier to Textron helps create a safety net in case things go south with Boeing.
Auto components manufacturer BorgWarner is the leading producer of automotive engine solutions. Its existing supplier relationship with large automakers like Ford put it in a strong position. However, to remain competitive the company has to keep up with the technological innovations put up by Honeywell and other component manufacturers working in the same space in addition to keeping costs down.
Johnson Controls�manufactures building control and HVAC systems in addition to automotive components. In the auto components space, Johnson Controls serves huge auto companies like Ford and General Motors. While Johnson Controls benefits from these relationships, it also has to look forward to new opportunities as these businesses lose market share. The company has also faced some setbacks in its struggle to acquire A123 Systems' assets after bankruptcy, as Chinese company Wanxiang America won the auction for those assets and gained approval of the deal from the Committee on Foreign Investment. However, Johnson Controls' failure here is competitor Exide Technologies' gain, since it denies Johnson Controls assets that would improve its competitive position.
The cash king margin can help you find highly profitable businesses, but it should only be the start of your search. The ratio does have its limits, especially for fast-growing small businesses. Many such companies reinvest all of their cash flow into growing the business, leaving them little or no free cash -- but that doesn't necessarily make them poor investments. Conversely, the formula works better for slower-growing blue chips. You'll need to look closer to determine exactly how a company is using its cash.
Still, if you can cut through the earnings headlines to follow the cash instead, you might be on the path toward seriously great investments.
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