The story across the border at Canada's premier publisher, Thomson (NYSE:TOC), just keeps getting better and better. Three months ago, the company reported a 9% growth in revenues and an 11% increase in profits for its third quarter. Last week, the company did that one better, reporting that for all of 2004 it increased revenues by the same 9%, but boosted profits by 15%. Not bad, eh?
The flip side of those numbers appears when you look at the company's generation of free cash flow. In Q3, Thomson posted a 25% year-on-year increase. For full-year 2004, however, free cash flow increased "only" 14%. Now, you can interpret that result in either of two ways. You can be disappointed that 14% is not as good as 25%, and that because free cash flow growth underperformed GAAP earnings growth, the company is not quite as profitable as it first appears.
Or you can acknowledge that it's not easy for a mature, large-cap company like Thomson to increase its profits at a double-digit clip. And admit that, whether you focus on the 15% profits growth or the 14% growth in free cash flow, either way, the company achieved admirable results last year. (That's how I look at it.)
But a Fool should beware of just saying "great results" and buying based on that. As shareholders of eBay (NASDAQ:EBAY) and Amazon.com (NASDAQ:AMZN) learned over the past few weeks, valuation matters, too. Whenever a company's price gets too far ahead of its fair value, even a hint of a slowdown in growth rates can bring the unsupported price crashing back down to earth.
And this is where the Thomson investment thesis breaks down. At its current market capitalization, Thomson sports an enterprise value (EV) of $26.8 billion. Generating $1.1 billion in annual free cash flow free (FCF), as it did in 2004, the company has an EV/FCF ratio of 24, for an EV/FCF/growth ratio of about 1.7. At best, that's a slight discount to the valuation of the market at large.
If that doesn't convince you, try comparing Thomson's valuation with its return on equity (ROE) -- a double-check I use myself when searching for potential hidden gems. As with EV/FCF/growth, I look for companies that score 1.0 or less on an EV/FCF/ROE basis. But with its ROE of 9%, Thomson does even worse under this equation, scoring a pricy 2.7.
So here's what Thomson's numbers are telling this Fool: As a business, Thomson is doing a bang-up job. Investors who got into this one at an attractive price should be patting themselves on the back. But for the rest of us, it may be more prudent to await a better price.
For more Foolish news and commentary on this legal and financial publishing powerhouse, read:
- Thomson Prints Profits
- Thomson Closes the Books
- Publishers Dueling for No. 1
- Thomson's Patently Good Buy
- Thomson's Book Fair
Fool contributor Rich Smith holds no position in any of the companies mentioned in this article.
