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How to Find Safe FCF Yields: Go Where the Competition Isn't

- By Geoff Gannon

Someone emailed me this question:

Why do you focus so much on FCF yield?

Take a look at these stocks (note: he provides a link to a list of 40 stocks with a free cash flow yield of 10% or higher).


What would stop them from returning 10 %+ every year, as opposed to NACCO, OMC etc., stocks that have very high FCF yields, and that you openly like a lot?

In other words, how do you look at different FCF Yields and decide: This is a real yield, and this is not?"

The number that really matters isn't free cash flow. It's the amount of cash flow available to buy back stock, pay dividends, acquire other businesses, etc. divided by the stock price (so that's your "free cash flow yield") plus the annual rate of growth in that cash flow while still making such payments.

To simplify, if a stock could have a 5% dividend yield and a 5% growth rate (while still having a 5% dividend yield), it would interest me as much as a stock that just had a 10% dividend yield or just had a 10% growth rate. It's today's payout plus the growth in that payout that matters to me.

Doing that kind of math on any of the stocks I buy (at the time I buy them) will get you closer to seeing what I saw in them. So, if I buy a bank with a 4% dividend yield, I think that it could grow 6% a year while paying that 4% yield out. It's usually something like that. I see a clear path to 10%+ type returns even if you end up having to hold the stock for a while.

So, how does that relate to your list of stocks with 10% plus free cash flow yields?

Well, one issue is that some of the stocks on that list are leveraged. So, you have a supermarket stock like SuperValu (SVU) which has a lot of debt. I wouldn't view that the same way as Village Supermarket (VLGEA) which has an overcapitalized balance sheet (for a supermarket) or Kroger (KR) which actually owns about half of its properties and then has a very nice debt structure of long-term, fixed rate bonds that should lock in a very low real interest rate for a very long time.

SuperValu equity might be cheap. But it's risky. The common stock is junior to debt. The company has a lot of debt. That means a lot of financial leverage is being piled on top of a business (supermarkets) with a ton of operational leverage. If same-store sales decline just 2% a year for a few years in a row - you will suddenly become very concerned about whether debt payments will be made and your stock will be safe. Supermarkets do end up in bankruptcy. Like railroads, the reason for this is usually that someone put too much debt on them. Owning a supermarket outright that you bought with 100% cash and where you own the land and the building and so on - that's a really quite safe business. But, then if you are leasing the building and you are making acquisitions using debt - or if you went public having been an LBO in the past....

Situations like that are risky. SuperValu is a situation like that. I'd skip it.

You mentioned Omnicom and NACCO as being two stocks I spoke about having good enough free cash flow yields. Omnicom is financed largely through "float" produced by getting paid by customers before having to make payments on behalf of those customers. Like almost all ad agencies, the traditional Z-Score (which is meant for manufacturing firms) would tell you Omnicom is in financial distress. However, Moody's and companies like that would rate Omnicom bonds as an investment grade type risk. So would I. What you are talking about with Omnicom is that I said previously (in 2017) that if you could buy the stock at about $65 a share - I thought it was cheap and would suggest buying it. I meant that the free cash flow yield - when coupled with the growth rate I'd expect - was adequate. And then, on top of that, I didn't think Omnicom was overleveraged at this point. I wouldn't be so sure about SuperValu. So, I'd cross SuperValu off my list of stocks to analyze based on high free cash flow. But, I'd keep Omnicom on the list.

In the case of NACCO (which I own), I knew the stock would have about $5 of net cash per share after the spin-off was completed. The company was basically laying off debt on its spin-off (Hamilton Beach Brands) by having Hamilton Beach pay NACCO a cash dividend right before the spin-off. NACCO is also structured in a way that liabilities are mostly at the unconsolidated subsidiary level and non-recourse to NACoal (the parent of those subsidiaries) and then the liabilities at that level (NACoal) are in turn non-recourse to NACCO. Now, NACCO does have liabilities related to its history as an underground coal mine operator that it will never get rid of. It has environmental and pension type liabilities. That's at the parent company level. And it's a risk. But, overall, I looked at the company and decided it had much better financial strength than something like SuperValu. So, I would consider buying NACCO but wouldn't consider buying SuperValu. This is a judgment call. Other people would say coal is a dying business but supermarkets will be around forever. Investors who think that way would cross NACCO off their list and keep SuperValu on it. That's what makes it a judgment call. From my perspective, NACCO's a lot safer stock than SuperValu. This is because I want to see an unleveraged free cash flow yield plus growth that gets you to 10%+ a year. SuperValu might get you a 10%+ yield and outperform any and all the stocks I'd consider. But, it's going to do that by using leverage. And that's not what I'm looking for.

Other stocks on your list of high free cash flow stocks include some industries that are tricky for me to calculate a "normal" free cash flow yield. For example, I didn't look at NACCO's last twelve months of free cash flow when considering whether to buy it. What I actually did was take the average of all years from 1991 to the present (so about 25+ years) in terms of real profit per ton of coal mined and then I used the current level of coal production in tons. I then made some other assumptions I considered conservative. For example, I used an estimate for losses from corporate overhead that are probably excessive now that the company has shrunk in size.

My point is that I'm looking for "normal" free cash flow - not last year's free cash flow. There is an oil refiner on the list of 40 stocks with a free cash flow yield over 10%. The economics of oil refining are such that I can't estimate free cash flow for them. NACCO was easy because they operate under long-term cost plus contracts on behalf of customers where a mine is sited next to a power plant. The economics of what kind of "spread" in terms of profit per ton you are going to get is really clear. I've looked at oil refiners and I just can't get comfortable with estimating a normal spread the way I can with a long-term cost plus contract. This is similar to why I might own something like BWX Technologies (BWXT) and not another kind of defense contractor. BWXT is a cost plus monopoly provider of a key system (shipboard nuclear reactors and the associated equipment) for the U.S. Navy. The Navy buys submarines from more than one provider. However, those subs use reactors from only one supplier (BWX Technologies). So, I'd be more comfortable with the lack of competition in the case of BWX Technologies than I would with other defense related businesses.

This is a big one. I tend to focus on companies where I believe competition is limited. For example, on my member website, I recently wrote about both Cars.com (CARS) and NIC (EGOV). Honestly, I'd be more likely to spend time researching NIC than Cars.com, because NIC faces limited competition for operating dot gov portals on behalf of U.S. states (it already operates 27 portals and there are only 50 U.S. states). Meanwhile, Cars.com faces publicly traded competitors who are spending 50% to 75% of their annual revenue (you read that right) on advertising. I don't feel comfortable investing in an industry where everyone is desperately trying to achieve scale. Those companies obviously feel the car buying information website market is a winner take all kind of business. Otherwise, they wouldn't spend more on advertising than they actually make in profit. They are spending their way to a loss right now, because they believe they can achieve phenomenal annual growth rates in numbers of visitors to their sites. That's too unsettled an industry for me to invest in.

So, I've mentioned SuperValu as an example of one disqualifying trait (high leverage). I've mentioned Western Refining (WNR) as having a business model (operating oil refineries) I find too difficult to predict cyclically normal free cash flow for. And then I just mentioned Cars.com as an example of an industry that is growing too fast, is too competitive, etc. for me to feel comfortable investing in.

The easiest way to test whether I'd buy into a high free cash flow yield stock or not is to imagine I'm not buying a stock. Instead, I'm buying a business. Imagine I'm in Warren Buffett (Trades, Portfolio)'s shoes. Or, rather Warren Buffett (Trades, Portfolio)'s shoes when Berkshire was much smaller. If I controlled a holding company and had the chance to put 20% of the net worth of the conglomerate into buying all of Omnicom (at $65 a share, like I said) - would I do it?

Yes.

I would definitely buy all of Omnicom and keep it forever.

Would I buy all of NIC?

Probably. At the right price, I think I would.

What about Cars.com?

I just don't understand the competitive landscape well enough.

Western Refining?

I wouldn't want to be in the business of owning oil refineries. It's just not a business model I can reliably quantify over a full cycle. So, no. I would want to be in the advertising business but not in the refining business.

Some of the other stocks mentioned on that high free cash flow yield list are stocks I've looked at. I researched NeuStar extensively. This is now a private company. They had one very good business. They administered the "North American Numbering Plan" which is mostly the assigning of telephone numbers in the U.S. (but also Canada and some other smaller countries). They had the contract for about 20 years but lost a re-bid process in 2015. I don't remember exactly when they finally lost the contract (rather than the stock market just knowing they were going to lose it), but that's probably why you saw the free cash flow yield being so high. The market knew they had lost the contract and hammered the stock price accordingly, but the free cash flow associated with the contract was still appearing in the last 12 months of results. They had a very high free cash flow, monopoly type business that was going to disappear. They had taken the proceeds from that and bought or expanded into other things. So, there was still a lot of value left in the company and it went private. But, I analyzed it as a possible investment only on the basis of the North American Numbering Plan. I came to the conclusion there was a real chance they'd lose the contract. They did. So, that's why I never invested in it. The stock was trading at a cheap price if you were sure they'd win the contract again.

I wasn't sure. So, I didn't buy the stock.

Note the difference here between NeuStar and either NACCO or BWX Technologies. A lot of people think I bought into NACCO or BWX because of the contracts. But, that's not true. Yes, they have contracts. But, I bought in because of the competitive economics that underpin the contracts. The reason a customer of BWX Technologies signs a contract is because BWX Technologies is either the only producer at scale of something like nuclear reactors (in the U.S.) or it is a member of a more oligopolistic type market (like in the case of administering nuclear related sites). The companies doing nuclear-related work for the U.S. government generally have to be both American and historically rooted in Cold War programs (the Manhattan Project in the 1940s, nuclear weapons in the 1950s, nuclear submarines in the 1960s, etc.). This is because interest in nuclear technology among companies peaked from about 1950 to about 1980. Since 1980, this has not been a growth field that others are interested in. And then for national security reasons, countries with nuclear weapons, nuclear powered ships, etc. rely on a provider in their own country. It's true that both the U.S. and Russia have nuclear powered navies and it's also true someplace like China might want to build a lot of ships much like those in the U.S. Navy - but, U.S. companies aren't going to build the reactors for the Chinese government and Chinese companies aren't going to build the reactors for the U.S. Navy. There's a local, historical reason for why the contract would be granted to BWX Technologies. Generally, whoever had the U.S. Navy as a customer in the past is going to be the only company ready to meet its needs in the future.

The same sort of thing is true with NACCO. The power plants were built where they were built for a reason. They were designed to be fueled with coal and they were built on top of coal deposits. This is very different from siting a power plant near a railroad and shipping in coal at commodity prices. The mine and the power plant are interdependent. It's true there's a contract. But, the economics would be good even if there wasn't a contract. Ultimately, you are always going to fuel your power plant using the coal from the mine you are sitting next to. The two options are: 1) Close the power plant or 2) Use the locally available coal.

The risk with NACCO is that coal power plants close. The risk is not that the coal power plants they are now fueling consider a lower bid from someone else. The economics of the business preclude that. That's why it's not a competitive business they're in. Competition wouldn't make any sense there.

Most of the companies on that list of 40 high free cash flow yield stocks don't have that kind of easily understandable moat. There are some dominant companies on the list. For example, GameStop (GME). GameStop dominates the market for video game retailing, especially used video games. There are network effects in that business. And this is not a market others want to enter anymore because they think it's all going digital. That, of course, is the danger. GameStop might become obsolete after everyone has an Xbox or PlayStation hooked up to very fast broadband and is buying a digital copy for direct delivery over that broadband.

I've thought about GameStop as a stock. I buy video games myself. And for many years now, I haven't gone to any place like a GameStop to get a game. All my purchases have been either digital or done on Amazon. Now, I tend to be a little faster to adopt some of these technology changes. So, that doesn't mean GameStop will be out of business by this time next year. I had a Kindle as soon as it was released. It took years and years from the time I switched to only reading digitally for half of all author royalties to start coming from e-sales instead of print sales.

For example, "cord cutting" is something being talked a lot about now. I got rid of cable 6 years ago. So, for the last 6 years I've certainly been cautious about investing in any TV content related business.

But, I still research these stocks. I have visited several GameStops and tried to do a little scuttlebutt in regards to that company. I doubt I'll ever own the stock. But, it's something I've spent time researching.

And I did some research on MSG Networks (MSGN) as well. The issue with MSG Networks is a combination of whether subscribers are durable in the truly long-term and whether the company has too much in liabilities. They have a long-term contract that depends on subscriber numbers for them to service safely. The issue is that liabilities are fixed while subscribers are variable. If they keep their subscribers, this will be a great stock for the next 15 years. But, if they lose subscribers, this stock could face real financial risks. If they had signed the kind of contract they have now in 1990, I wouldn't be worried. But, cable channels are just changing too much for me to get comfortable with MSG Networks. I don't know what subscriber figures will look like from 2018-2032. And if you don't know that, you don't know the company will always be solvent. The stock might do great. But, I'm not sure the future will be anything like the past. It's too unpredictable.

Generally, I'm looking for a company that has what Warren Buffett (Trades, Portfolio) would call a "moat" or what GuruFocus would call "predictability" or what I would call a lack of competitive pressure - especially in regards to price competition. Yes, I want a high free cash flow yield. But, I want that free cash flow yield to not be at risk from price competition from rivals and I want the company to be able to pass along inflation.

On any list of 40 stocks, I'd probably throw out 36 of the 40 names pretty quickly. They just aren't "predictable" enough or "moaty" enough. What I mean is: they are in industries that are simply too competitive.

I always want to invest where I see a lack of competition. That's probably my No.! rule. Go where the competition isn't.

Disclosure: Geoff owns NC, CFR, and BWXT

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This article first appeared on GuruFocus.