Over the last couple of years, there has been a lot of talk about the importance of free cash flow (FCF). And for good reason.
A business that generates consistently positive FCF has more cash coming in than going out — which matters in a rising interest rate environment where borrowing costs are higher.
FCF isn’t perfect. But it can be a more useful metric to follow than a company’s net income for a number of reasons. For example, a large expense may be depreciated over several periods using net income. But for FCF, it would show up at once as a large charge. In this vein, FCF does a good job of showing if a company’s operational costs, dividend, share buyback program, and other costs are being funded with cash from the business or using other means.
Devon Energy stock is dirt cheap
Daniel Foelber (Devon Energy): Exploration and production company Devon Energy reported its fourth-quarter and full-year 2022 results on Tuesday. Last year, the company notched its highest FCF in company history and paid $5.17 in dividends per share. Devon also announced an 11% increase to its fixed quarterly dividend and a share repurchase program aimed at decreasing the outstanding share count by 5%. The company forecasts 2023 production of 643,000 to 663,000 barrels per day and a $3.6 billion to $3.8 billion capital investment plan, which it said can be funded even if West Texas Intermediate crude oil prices fall to $40 a barrel.
Yet despite all of this positive news, Devon stock fell by over 10% on Wednesday, around 16% last week alone, and is now down over 31% from its 52-week high. The stock is under pressure because Q4 production numbers came in lower than expected due to a fire at a Texas gas compression station. And as impressive as earnings and FCF were, they were lower than expected, while spending was higher than expected.
What’s more, the company announced a fixed-plus-variable dividend of just $0.89 per share for Q1 2023, which is lower than any quarterly dividend from 2022.
Even after the sell-off, Devon Energy stock is still up 133% in the past three years. The sell-off illustrates the dangers of forecasts and expectations that are so optimistic that even excellent results can’t live up to them.
Yet if we zoom out, there’s every reason to believe that Devon Energy stock looks like a great value. Its price-to-earnings ratio is just 5.8. And while the company may not pay as many dividends in 2023 as it did in 2022, a $0.89 quarterly dividend will still be a forward yield of 6.7%.
Devon Energy’s dividend yield was so high — and its growth was so fast — that a cooldown looks relatively disappointing. Yet, in actual numbers, Devon Energy remains a highly profitable and inexpensive stock with an attractive yield.
Flowserve is about to start generating some serious cash flow
Lee Samaha (Flowserve): The company is a manufacturer and provider of flow control solutions (pumps, valves, and seals) to the process automation industries. As such, its main end markets are heavy industries like oil and gas, chemicals, power, water, and everything else lumped together as “general industries.”
As ever with such end markets, they won’t be firing on all cylinders at all times. Indeed, Flowserve’s chemicals end market faces some headwinds due to a slowing economy. However, its oil and gas, power, and water end markets (more than 60% of revenue in its last reported quarter) are in excellent shape and set the company up for substantial cash-flow growth in the coming years.
Management pre-announced its fourth-quarter 2022 earnings recently and outlined that its full-year bookings were $4.4 billion compared to revenue of approximately $3.6 billion, leaving a backlog of $2.7 billion at the end of the year. The strength of its bookings and backlog gave management confidence to forecast 9%-11% revenue growth for 2023, and Wall Street analysts are expecting the company’s free cash flow to double from around $100 million in 2022 to slightly more than $200 million in 2023.
With energy prices remaining relatively high and the need for the energy industry to catch up on years of underinvestment following the slump in energy prices in 2014, Flowserve is set for significant earnings and cash-flow growth in the coming years. Consequently, it’s reasonable to expect the company to hike its current $0.80 dividend (yielding 2.2%) accordingly. Flowserve is another dividend investing option in an industry full of strong dividend stock candidates.
Big free cash flow helps UPS deliver big dividends to shareholders
Scott Levine (UPS): Dividends are great, but they mean little if the company distributing them is doing so while imperiling its financial health. That’s why income investors will oftentimes favor companies that generate strong cash flow, like UPS. The stock’s forward dividend yield of 3.5% will likely attract investors, but it’s the company’s robust cash flow that should provide reassurance that the dividend is sustainable.
In 2022, UPS generated free cash flow of $9 billion, easily covering the $5.1 billion in dividends that it paid out to shareholders. With regards to the year ahead, UPS, like so many companies, foresees a challenging 2023. Between the geopolitical tensions surrounding the war in Ukraine, rising interest rates, and a possible recession, UPS expects headwinds to hinder growth this year, and management forecasts free cash flow to ebb from 2022 to $8 billion. As undesirable as this may be, if UPS achieves this guidance it will sufficiently cover the approximate $5.4 billion that the company expects to return in the form of dividends.
One of the factors contributing to the lower projected free cash flow in 2023 is the approximate $5.3 billion in capital expenditures that the company has planned. Of the several projects planned, one that management highlighted on the recent Q4 2022 conference call is a $2.4 billion investment “in buildings and facilities to add automated sort capabilities and increase efficiency across the network.”
While this and other projects may affect the company’s free cash flow in 2023, investors can be confident that management is adept at identifying capital expenditures to ensure future growth. For example, UPS reported an increase in return on invested capital from 30.8% in 2021 to 31.3% in 2022.