Don't let it get away!
Help yourself with the Fool's FREE and easy new watchlist service today.
With liquidity concerns crashing down on firms like DryShips (Nasdaq: DRYS ) and General Growth Properties lately, I figured it's a fine time to find some firms able to remain above the fray.
We could simply look for cash-rich companies. Rick Munarriz recently told investors to beware of such firms, but he was mostly focused on giant tech firms like Apple (Nasdaq: AAPL ) and their imploding interest-rate-sensitive investment income. A search for cash-rich companies relative to market capitalization, meanwhile, often turns up a lot of mediocre, cigar butt-type businesses.
While I have demonstrated a bit of a Ben Graham streak now and again, I'm much more interested in routinely profitable firms that generate gobs of excess cash. So today, I'm searching instead for the Cadillacs of cash flow.
In that spirit, I start by screening for firms with at least 10 years of history as a public company with financial data available. Next, I weed out any business that has earned less than a 12% return on equity in any of the past 10 years. (So long, mediocrity. Ciao, cyclicals.) Finally, I use a custom data point I'll call the all-in cash coverage ratio.
You've probably run across the interest coverage ratio, which indicates whether a firm's interest expenses are well-supported by operating earnings. My metric is similar, but I want to make sure that cash flow comfortably covers cash interest payments, capital expenditures, and cash tax payments. In fact, I want to see this basket of cash demands met at least three times over, on average, for the past decade.
The result offers a selection of highly profitable, capital-light, tax-efficient firms. In fact, this is an elite group, with only five U.S.-listed companies meeting the criteria. Let's step through the three sectors that spawned these cash flow kings.
Technology leads the list, with Adobe Systems (Nasdaq: ADBE ) , Citrix Systems (Nasdaq: CTXS ) , and Dell (Nasdaq: DELL ) each entering the winner's circle. The software industry's high gross margins and recurring revenue are no doubt the envy of many bricks-and-mortar businesses. I'm not at all surprised to see a firm like Adobe on the list.
Hardware is a bit trickier, but Dell didn't make pole position in the PC industry by employing the usual business strategy. The firm's direct-sales model is extremely efficient, boasting fat margins and a negative cash conversion cycle. That latter bit is a positive thing, by the way. In plain English, Dell collects cash from customers before it pays suppliers -- a luxurious position to occupy.
An insurance business, like a software firm, requires minimal investment in fixed assets. It also generates float, which is kind of like Dell's negative cash conversion cycle, except on steroids. The similarities between insurance and tech break down pretty quickly after that, though.
With narrower margins and the potential for damaging price competition, consistent profitability in this business is tough, and it hinges on disciplined underwriting. I find that the best firms in this business tend to tackle a niche (or several), and really stick to their knitting. This helps to build a valuable brand, deter new entrants, and avoid mispricing risk.
Texas-based Torchmark (NYSE: TMK ) has a subsidiary called American Income Life that markets its protection insurance products primarily to labor-union members. The firm notes that affinity among union members is extremely high, that there are basically no competitors marketing to this niche, and that this particular subsidiary sports the highest profit margins out of the whole Torchmark group of companies. That's exactly the kind of hook you want to look for when kicking the tires of an insurer.
Sheer industrial might
The presence of industrial firm Danaher (NYSE: DHR ) is perhaps least intuitive, but I've long known that this is one extraordinarily well-run company. In some ways, it reminds me of another industrial ace I wrote about recently. Danaher embodies the Japanese culture of continuous improvement (kaizen) while avoiding Japan's penchant for capital destruction.
I haven't talked about what the other kings choose to do with their excess cash flow, but in Danaher's case, acquisitions are the predominant focus. Success on the serial acquisition trail is rare, but with such strong growth in per-share book value over the years, the approach appears to be working wonders here. I humbly offer Danaher as a large-cap, yet lesser-known, dynamo worthy of further research.