Positive Signs for These Negative Cash Flow Stocks

Most of us at The Motley Fool, including me, love free cash flow. But, if we take that obsession too far, we'll buy into companies we shouldn't, and miss out on some truly great stocks.

Today, I'll show you how to avoid that mistake -- I'll give you my monthly list of stocks with negative free cash flow that might be poised for greatness.

Good FCF, bad FCF
We love free cash flow for a number of reasons, mainly because it gives us a more realistic view of a company's earning power. Yet as you've probably learned if you've been investing for more than a few days, nothing is ever simple in the world of stock picking.

Joel Litman, managing director at Equity Analysis & Strategy, is one of the top experts around when it comes to evaluating cash flows. At a recent presentation at Fool HQ, he pointed out that there are times to buy heavily into a company with negative free cash flow. Determining "good negative free cash flow" and "bad negative free cash flow" begins with a look at a company's rate of return alongside its rate of growth.

Big Orange
The perfect example is Home Depot. The home improvement retailer absolutely plastered the market from 1985 to 2001, yet showed negative free cash flow in all but one of those 16 years.

Home Depot's negative free cash flow during that period was the result of management pouring all its cash back into its high-return business -- and not because of any deficiency in the business itself. "As long as that growth in capital will realize returns above the cost of that capital," Litman says, "negative free cash flows can be a great sign for the business."

In 2001, Home Depot finally hammered out positive free cash flow and has maintained that positivity every year since. Its stock price, however, has been relatively flat.

Litman says the market has understood the issue very well, namely that the positive free cash flow was the result of management slowing its rate of reinvestment back into the business. This is sometimes accompanied by share buybacks, dividend boosts, and other "good things for investors." However, he says, "None of these can be as good for shareholders as massive growth into an incrementally high return business."

If a company you own is transitioning to this stage, you may want to consider that its high-return days are behind it.

The next Home Depot
The natural question, then, is which companies today are exhibiting characteristics similar to Home Depot in the early part of its high-growth, negative-cash-flow phase?

I set up a screen for all companies on U.S. exchanges with a market cap greater than $200 million that have:

• Grown their revenues an average of 25% or more over the past two years.
• Grown their capital expenditures an average of 25% or more over the past two years.
• Generated negative free cash flow each of the past two years.

Because we're looking for younger businesses early in their growth cycles, I also limited the results to companies that were founded since 2000. A total of 36 pass the screen this month:

Data provided by S&P Capital IQ. TTM = trailing 12 months.

We're left with a list of young, mostly small companies that are investing heavily back into their high-growth businesses -- just as Home Depot was doing in 1985.

There are interesting names to research here. Clean Energy Fuels has not had an easy time of it since hitting our screen in April, dropping about 20% in that time. At this price, I view it as a great play if you believe in the long-term viability of natural gas as fuel for trucks and autos.

Triangle Petroleum is a tiny oil and gas exploration driller in the Bakken Shale and Three Forks region of the Williston Basin. It has no debt, $34 million in cash, and outstanding revenue growth. It has yet to turn a profit, however, and by the very nature of this screen is free-cash-flow negative. Still this screen forces us to look ahead, and Triangle could be a big winner depending on how the drilling goes. Still, it's too high risk for the purposes of my real-money portfolio.

I view Molycorp as having a similar risk profile. The industry intrigues me, but I have low confidence in my ability to read the rare-earth tea leaves. Falling prices for rare-earth products have hurt Molycorp, and I feel it has little control over things in the near term because of uncertainty over China.

Fusion-io -- which allows companies to more effectively and quickly handle data (and saves them money in the process) -- recently announced a major new deal with Cisco. Analysts expect 82% revenue growth for Fusion-io over the next couple of years, and fellow Fool Evan Niu considers it a buyout candidate.

Velti is an interesting story whose shares have tumbled 50% in the past few months. The Dublin-based firm helps other companies with mobile advertising, and announced outstanding quarterly results in May. The market must have been expecting more, however, and sent shares downward again. There is some concern about exposure to Europe, but perhaps what has really spooked investors is a cash position that has dropped from $160 million to $41 million in just three quarters. CEO Alex Moukas noted on the conference call that "we are highly confident in our ability to achieve breakeven operating cash flow by the first quarter and positive free cash flow by Q4." If that happens, pressure on the shares may ease up.

Winners and losers
As is the case with all of my screens, this one is now being tracked and scored so we can measure exactly how it's performing. Check my "Next Home Depot" CAPS page here, and mark it as one of your favorites.

While Clean Energy Fuels is a risky play in the energy sector, there's a far more stable stock out there that should benefit no matter which way the energy winds blow. Find out more in our special report, "The Only Energy Stock You'll Ever Need." It's free for the taking.