Individual investors and private equity firms often target companies with great yields. But they are talking about two different numbers.
While the first crowd focuses on divided yields, the big-game hunters focus on free cash flow yield. In fact, if you draw a connection between the two, you can find the path to stocks that are capable of robust dividend growth -- and just may get acquired at a nice premium.
To understand why free cash flow yields are so important, you just need to look at the frenzied pursuit of Dell Inc. (Nasdaq: DELL) by Southeastern Asset Management, Silver Lake Partners, Carl Icahn and Michael Dell. All of these big-money players knew that Dell Inc. was quite undervalued in the context of its prodigious free cash flow.
Over the past four fiscal years, Dell has generated a cumulative $14.5 billion in free cash flow. That's just $2 billion less than all of Dell's enterprise value. Assuming that Dell is able to maintain that level of free cash flow, then the current proposed buyout will pay for itself in less than five years. After that, it's pure profit.
Many private equity firms can do even better by using their target's balance sheet to borrow money to pay for the deal. In this era of rock-bottom interest rates, low borrowing costs can create some pretty compelling deal economics. In just the technology sector, there are a host of other companies that have limited growth prospects but generate huge amounts of free cash flow.
Here's a quick peek at tech firms with free cash-flow yields (free cash flow dividend by market value) in excess of 10%.
Note that these companies sport free cash-flow yields that are far higher than their dividend yields. Why should you care? Because even if these firms are never acquired by a rival or a buyout firm, their high free cash-flow yields means they can afford to hike their dividends by a significant amount. Of course, these firms may choose to divert some of their financial firepower toward share buybacks, but either way, shareholders benefit.
I took a look at all of the companies in the S&P 400, S&P 500 and S&P 600, and found a few dozen companies that sport free cash-flow yields in excess of 8%.
Insurers dominate the list. Many of them have spectacular free cash-flow yields. As I noted this month, profits -- and free cash flow -- are poised to rise even higher for these firms as interest rates start to move up. Strong free cash-flow yields, the interest rate catalyst, and low valuations in relation to tangible book are all good reasons why insurers remain among my favorite investments for 2013.
Beyond the low-growth tech firms and insurers, you can find other examples of companies with high free cash-flow yields that are more than three times as high as their current dividend yield. They all hold great appeal for two reasons. First, their high free cash-flow yields mean their stock prices will be more resilient if the broader market stumbles badly. Second, they are in a position to double or even triple their dividends.
Frankly, it's a bit surprising to see Oracle (Nasdaq: ORCL), Broadcom (Nasdaq: BRCM) and Expedia (Nasdaq: EXPE) on this list. These three tech firms are experiencing near-term growth pressures but still have decent long-term growth prospects. Broadcom, in particular, is shaping up to be one of my favorite value/growth plays, which I'll be focusing on in a separate article.
You'll also note a pair of oil refiners, Valero Energy (NYSE: VLO) and Marathon Petroleum (NYSE: MPC) in this table. Back in August, I noted that refiners are trading well off their 52-week highs but are clear long-term beneficiaries of rising U.S. oil output.
Controversial Stock, Impressive Financials
In looking at the other companies on the table above, I took note of a great deal of controversy regarding insurance claims software provider Ebix (Nasdaq: EBIX). The company has been under investigation by the Securities and Exchange Commission, prompted by allegations from short sellers that the company misled investors by issuing false financial statements.
Goldman Sachs (NYSE: GS) announced plans to acquire Ebix earlier this summer for $20 a share but walked away from the deal in the face of the controversy. Shares have now fallen by more than half from their three-year high.
Yet Ebix also has its share of supporters that contend that short sellers' claims are off the mark. If they're right, this is a remarkably inexpensive value play.
Consider that shares trade for around 8 times projected 2013 profits and sport a free cash-flow yield approaching 14%, and that Ebix is in the midst of a $100 million share buyback that could eliminate up to 20% of the share count.
It's not clear whether the claims against the company have merit, but if the SEC closes its investigation without finding any wrongdoing, then shares would immediately surge in value. More than half of the trading float is held by short sellers, equating to 16 days' worth of trading volume.
The timing of the SEC investigation is unclear, but interested investors should tune into Ebix's conference call, which is slated for Nov. 5. Management is likely to discuss the key issues in contention and may also cover the current status of the SEC investigation.
Risks to Consider: These companies have been posting robust free cash flow in a firming economy, though it's useful to take a look at their free cash-flow levels in 2009 and 2010 to see how they would fare in a weaker economic environment.
Action to Take --> In an ever-rising market, high free cash-flow yields remain as one of my favorite investment metrics. These stocks are likely to be quite stable, offer the possibility of a buyout and, most importantly, have room to sharply hike their dividends.