Corn Field of Dreams

Free cash flow is essentially the money a company has left over each quarter after paying various operating costs and shelling out for large investments like plants and equipment. The simplicity of the measure is what makes it so useful. All companies produce at least some revenue, and more than half of the names in our 8,000-strong database generated positive earnings over the past year. But less than a quarter of them ended up with positive free cash flow.

That's because, for purposes of calculating their earnings, companies are permitted to treat large investments in plants and equipment as quarterly expenses called depreciation rather than lump-sum charges. Free cash flow doesn't allow for any such treatment. So young companies that are making such large purchases will probably turn "profitable" long before they generate reliable quantities of cash for shareholders.

Since free cash flow is most useful for value-stock searches, it's best to use it as part of a valuation measure, like the price/free-cash-flow ratio and its reciprocal, the free-cash-flow yield (FCF/price). Our screen looks for companies whose P/FCF ratios are below their industry medians, and whose free-cash-flow yields top 5%. And since half the point of generating free cash is returning it to shareholders, we look for dividend yields of 1% or more. Four more criteria: Trailing 12-month sales for each company have to top $500 million, both sales and earnings must've each grown by 12% a year over the past three years and debt/capital ratios must be below 0.5.

The seven companies on our list met these demands. Please research them carefully before investing.

Let's look at one our screen survivors. We last wrote about agricultural processor Archer-Daniels-Midland (ADM) in a February 2003 value screen ("Inner Beauty"). Therein we pointed out that earnings could get a boost from increased demand for ethanol, a type of fuel made from corn, and from a shift in soybean operations to low-cost South American plants. Both have happened, and shares since our story have climbed 125%. The stock also carries an annual dividend yield of 1.4%, paid for with the company's hefty free-cash-flow yield of about 8%.

For years Archer-Daniels was known as something of a disappointing stock, except to those who were familiar enough with its trading pattern to buy near $8 and sell near $13, and grab a few dividends along the way. Today it fetches $24. The breakout, say analysts, is attributable to the company's improved management team and increased focus on making sure each of its operations is sufficiently profitable.

This latter item might sound like something of a no-duh, but Archer-Daniels' corn-processing division, which contributes more than a third of profits, operated with questionable fundamentals for years. Ethanol was viewed as a government-subsidized waste bin for excess corn, not to mention an unnecessary one given the low gas prices at the time. And the business of producing high fructose corn syrup, a food ingredient and soft-drink sweetener, was mired in oversupply.

The economics of ethanol have obviously changed. Demand has picked up sharply, and Archer-Daniels, which controls 25% of the market, is now adding capacity. That's something it seemed set against until recently. And corn syrup prices are expected to rise 5% to 10% next year on a reduction in excess supply combined with a sugar-for-corn-syrup deal with Mexico that should boost demand.

That's not to say that profits are on a tear. Earnings per share for the company in fiscal 2006 are expected to increase by just four cents to $1.46, according to Reuters Research's eight-analyst consensus. But fiscal 2007 earnings are forecasted to climb a respectable 18% to $1.72. With free cash totaling between $500 million and $1 billion a year recently, analysts say much of the company's focus will be on dividends, share repurchases and debt reduction. Debt currently makes up about a third of the company's capital.

Further investments in energy products might be another use for cash. President and Chief Executive Allen Andreas announced last month that he would retire within a few years, after 20 years with the company. The board says it'll seek a replacement with some experience in the energy sector. "The board is signaling a change for the long term towards making ADM perhaps more of an 'Energy Market To The World' rather than just a 'Supermarket To The World,'" wrote Deutsche Bank analyst Eric Katzman in an Oct. 4 research note. (Katzman doesn't own shares of Archer-Daniels-Midland; Deutsche Bank doesn't have an investment-banking relationship with the company.)

Gone are the days of grabbing shares of Archer-Daniels at 10 or 12 times earnings. Shares now trade at 16.7 times the fiscal-2006 forecast, just a smidge below the average for agricultural processors of 17.4. But forecasts have been on the rise; that $1.72 a share in earnings projected for fiscal 2007 was just $1.42 three months ago. Investors who missed out in recent years on skyrocketing profits flowing out of the oil fields may want to look to the corn fields while the getting's still good.