Follow the Money
Companies that generate lots of cash can be great investments, as long as they spend it wisely
(MONEY Magazine) – When times are uncertain, you feel more secure if you have money in the bank and lots more rolling in. But you also know that you won't get rich by letting cash sit in bank CDs. To make your savings grow, you need to put your money to work.
Companies aren't so different. Those that take in more cash than they need to run existing businesses don't have to worry about financial security. But sitting on that money won't help investors much.
Generally speaking, a company can use its cash to reward shareholders in one of three ways: by expanding, either through internal development or acquisition, to try to boost profits; by repurchasing stock to boost earnings per share even faster than total profits grow; or by raising dividends to return cash to shareholders.
When investors size up a stock, they usually focus on earnings, calculated by subtracting all expenses from sales. But a more meaningful measure is cash flow, sales minus only those expenses that require immediate outlays. The part of that cash flow that isn't earmarked for maintaining the business is known as free cash. Basically, that's the money the company has to play with.
Making the most of free cash is tough right now, in part because companies are bringing in so much of it. Earnings for the S&P 500 have increased at a double-digit annual rate for 12 straight quarters. At the same time, companies are hesitant to spend all that money amid concerns about rising interest rates and soaring oil prices. The result: Cash is piling up. But a full wallet doesn't automatically make a company a winner. The companies most likely to offer a superior return are those that have a lot of cash coming in--and great ideas for putting it to work.
I've gone through the 200 blue-chip growth stocks I look at when selecting the Sivy 70, and it seems to me that the following four companies have sound strategies for using the billions of dollars of cash they generate each year to benefit shareholders. All four rank among the 40 largest cash generators. And at least 9% of their revenue is free cash flow. Their shares are also moderately priced, trading at less than 17 times earnings projected for next year. Here's a look at how they're using their money.
» REINVESTING: INTEL Some companies have an easy time deciding how to put cash to work. To maintain its dominance and keep up with rapid changes in computer technology, Intel has to invest massively in the next generation of high-performance microprocessors. The company takes in nearly $13 billion in cash a year. Of that, research-and-development costs for 2005 are estimated at $5.2 billion and capital spending has been increased to $5.9 billion. Demand for chips is robust, but unless Intel increases manufacturing capacity, profitability could stall. To avoid that, the company plans to build a $3 billion plant in Arizona. In addition, Intel has unveiled a new energy-efficient microprocessor that should be in products next year.
» BUYING BACK STOCK: CISCO The world leader in networking systems and equipment, Cisco Systems throws off $7 billion in cash a year--and most of it is free cash. But growth investors don't buy stocks like Cisco for income, so the company still pays no dividend. Instead, Cisco uses its money for massive stock buybacks, which boost earnings growth. Such repurchases are also important because the company has issued millions of shares in recent years for acquisitions and employee stock options. The strategy also makes sense because Cisco's shares look undervalued. Cisco has spent more than $25 billion on share repurchases since 2001, shrinking the number of shares outstanding by 17%. The payoff: Total net income was up 11.6% for the recent quarter, but because of the smaller number of shares outstanding, earnings per share were up almost 20%.
» PAYING BIG DIVIDENDS: 3M There's only so much profit that can be wrung from a Post-It. As a mature technology company, 3M doesn't need to pour incredible amounts of money into research and development. So nearly a third of 3M's $4 billion in annual cash goes directly to shareholders as dividends. In fact, 3M has raised its payout for 47 straight years. As a result, the shares pay 2.4% compared with 1.8% for the S&P 500. Nonetheless, 3M still has more than enough money to fund R&D to the tune of over $1 billion a year. One current focus is nanotechnology, which involves components barely larger than a single molecule and has applications ranging from repairing teeth to making high-capacity electric-transmission lines.
» DOING ALL OF THE ABOVE: GE The second-greatest cash generator after ExxonMobil, General Electric brings in more than $26 billion a year. That's such an enormous amount that GE can afford to pursue all three cash strategies at the same time. Since 1994, GE has returned $75 billion to shareholders through stock buybacks and dividend increases. In fact, GE has repurchased nearly 10% of its outstanding stock over that period, and the latest buyback plan calls for spending another $15 billion. The dividend record is equally impressive. The company has raised its payout for 29 years in a row, and the stock yields a generous 2.6%. The rest of the cash goes to reinvestment that keeps GE's divisions leaders in their fields.
PUTTING THEIR MONEY TO WORK
These four companies bring in far more cash than they need, and they're using it in ways that should reward shareholders handsomely.
NOTE: As of Aug. 26. P/E ratios are based on projected earnings for calendar 2006. Earnings growth is the compound annual rate projected for the next five years. SOURCE: Thomson/Baseline.