This article is part of our Rising Star Portfolios series.
At the end of each earnings season, I run a screen against more than 2,200 companies, as I look for a few to add to my Messed-Up Expectations portfolio. The screen looks for companies whose stock price might be messed up by determining how much free cash flow (FCF) growth is currently priced in. I'm looking for situations where that growth is very low, but where the company is likely to be able to produce much more FCF growth than is currently expected. This time, the screen returned 98 companies.
The first candidate
General Electric (NYSE: GE ) is the conglomerate that has its hands in just about everything from light bulbs to medicine. It's a big player in energy (nuclear, wind, oil), makes engines for airplanes, and has medical equipment in hospitals all over the world. Lots and lots of parts to this company.
- Price-to-tangible book value (P/TBV) is near the lowest it's been since the early 1990s, trading at 3.5 times.
- It generates about 2.5 times as much cash flow from operations (CFFO) as net income.
- Its interest coverage ratio is a healthy 11 times.
- Its return on equity (ROE) seems to be recovering from dipping into the single digits back in 2009.
- It carries a lot of debt. Currently, the debt-to-equity ratio (D/E) is 3.6, down from 4.6 a few years ago. Of the $471 billion in debt, the vast majority of it is from the primary business, not the finance arm.
- It has not grown revenue on a year-over-year basis for the past two-and-a-half years.
- It has gamed its financial statements in the past (and been punished by the SEC for accounting fraud) to please Wall Street in the past.
I'm going to keep this one on my radar, though reluctantly. There are several reasons to think it's undervalued right now (P/TBV being one), and I believe the market is probably wrong on its current FCF growth expectations of less than zero for the next 10 years (at my usual 15% hurdle rate to discount). I don't like that debt level, but the company has gone for years (at least the past decade) at a similar D/E without blowing up. The one part I truly dislike is how consistently GE meets or slightly exceeds analyst expectations. The last time GE missed by more than a penny was the first quarter of 2008, and the time before that it was Q1 2005. It's only missed expectations once going back to the beginning of 2006, right through both a bull market and a brutal recession. Really?
The second stock to watch
General Dynamics (NYSE: GD ) is into business aviation (Gulfstream), military hardware (it builds ships and subs, tanks, rockets, and so on), and information technology. It's heavily dependent on the departments of Defense and Homeland Security, as well as the various intelligence agencies.
- It has maintained ROE right around 20% for the past several years, as well as steady margins of 12% (operating) and 8% (net).
- CFFO is consistently greater than net income, and FCF tracks net income fairly consistently (sometimes really close, sometimes greater than).
- D/E is a very reasonable 23% and is down from 40% at the end of 2008.
- The cash conversion cycle has increased from 80 days in 2006 to more than 95 days now.
- This is from a slowdown in how often it's been turning its inventory -- from 15.4 times in 2006 to 12.1 times over the past year (TTM) -- and its accounts receivable -- from 4.2 times in 2006 to 3.7 times TTM. This appears to be a long-term trend.
- Revenue growth over one-, three-, and five-year periods has dramatically slowed down (though up slightly from a year ago) and is now just 2.6% over the past year. If the military cuts back on its spending, this will worsen.
This is a company that's mostly dependent on military and intelligence spending, with some contribution from private aviation. That's been fairly steady or increasing over the past several years, though the amount of military spending going forward is a big unknown. I'll add this to my watchlist, even though I already have military-spending exposure through both Oshkosh (NYSE: OSK ) -- which is a direct competitor to GD -- and Textron (NYSE: TXT ) . Plus, buying GD would increase the portfolio's exposure to private aviation (Textron's Cessna division).
1 stock to pass
Dell (Nasdaq: DELL ) is a company that revolutionized how computers got built and sold. It's still selling desktops and laptops to lots of people.
- Year-over-year revenue growth has turned positive after a couple of years of pretty big declines.
- ROE has recovered back up to about 50% after bottoming out in the recession.
- Interest coverage ratio is over 17.
- Except for the year ended 1/30/09, CFFO has been healthily above net income.
- D/E has ramped up from 15% for the year ended 2/1/08 to more than 93% TTM.
- That's because the company has been issuing debt -- a lot -- over the past several years, going from total debt of $587 million on 2/1/08 to more than $7.7 billion on 7/29/11.
- Over the past five fiscal years, it's spent $10.7 billion to reduce its shares outstanding by just 308 million. That's an effective average price of well over $34. The shares of the company actually haven't seen that price since September 2005, showing everyone the power of stock-based compensation to transfer wealth from shareholders to option holders.
Pass. I don't like the big ramp-up in debt over the past several years, and I certainly don't like the amount spent on share repurchases just to hold the share count down. If I want to increase the portfolio's exposure to computers and consumer electronics, Apple (Nasdaq: AAPL ) -- which is already a holding -- seems to be a much better way to do that.
With all the volatility in the market recently, you might think it's time to get out while the gettin's good. But I'm in this for the long haul, looking for good companies that are cheap today thanks to the volatility. Using a screen is just the first step in finding these good companies to invest in. Looking at recent financial information lets you quickly choose to keep on researching or to pass. And writing down your reasons to proceed or p ass lets you revisit the decision in the future in order to improve your investing process.
Come and discuss these and other investments on my Messed-Up Expectations discussion board, or follow me on Twitter.
Apple is a great company, but here's another tech company that's set to profit from the latest technology revolution. The report is free of charge for Fool readers -- and here's your chance to get instant access.
This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).