Are These Medical Companies Cash Kings?

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As an investor, it pays to follow the cash. If you figure out how a company moves its money, you might eventually find some of that cash flowing into your pockets.

In this series, we'll highlight four companies in an industry, and compare their "cash king margins" over time, trying to determine which has the greatest likelihood of putting cash back in your pocket. After all, a company can pay dividends and buy back stock only after it's actually received cash -- not just when it books those accounting figments known as "profits."

Today, let's look at ResMed (NYS: RMD) and three of its peers.

The cash king margin
Looking at a company's cash flow statement can help you determine whether its free cash flow actually backs up its reported profit. Companies that can create 10% or more free cash flow from their revenue can be powerful compounding machines for your portfolio. A sustained high cash king margin can be a good predictor of long-term stock returns.

To find the cash king margin, divide the free cash flow from the cash flow statement by sales:

Cash king margin = Free cash flow / sales

Let's take McDonald's as an example. In the four quarters ending in June, the restaurateur generated $6.87 billion in operating cash flow. It invested about $2.44 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment ($2.44 billion) from its operating cash flow ($6.87 billion). That leaves us with $4.43 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.

Taking McDonald's sales of $25.5 billion over the same period, we can figure that the company has a cash king margin of about 17% -- a nice high number. In other words, for every dollar of sales, McDonald's produces $0.17 in free cash.

Ideally, we'd like to see the cash king margin top 10%. The best blue chips can notch numbers greater than 20%, making them true cash dynamos. But some businesses, including many types of retailing, just can't sustain such margins.

We're also looking for companies that can consistently increase their margins over time, which indicates that their competitive position is improving. Erratic swings in margins could signal a deteriorating business, or perhaps some financial skullduggery; you'll have to dig deeper to discover the reason.

Four companies
Here are the cash king margins for four industry peers over a few periods.

Company

ResMed22.8%15.4%13.1%3.9%
Accuray(9.2%)(1.7%)(8.1%)(1.0%)
CONMED11.5%(0.1%)7.9%3.8%
Varian Medical Systems12.6%16.1%11.9%13.7%

Source: S&P Capital IQ. TTM = trailing 12 months.

Aside from Accuray (NAS: ARAY) , all of these companies meet our 10% threshold for attractiveness. ResMed has the highest cash king margins, at more than 20%, and it has steadily grown those margins over the past five years. Varian Medical (NYS: VAR) has the second highest margins, but its margin is about in line with where it was three and five years ago. Aside from a sharp dip in its margins last year, CONMED (NAS: CNMD) has consistently increased its cash king margins from five years ago. Accuray, on the other hand, has seen declines in its margins over the past five years.

ResMed benefits from being one of the dominant players a growing market for selling CPAP machines to treat sleep apnea. It is a medical condition in which individuals suffer from a brief collapse in their airway, which causes them to stop breathing, waking them up. Some of the growth in this market may be explained by the growing problem of obesity, which is one of the leading causes of sleep apnea.

Accuray offers innovative radiological treatments (through a product called CyberKnife) that help patients avoid invasive surgeries. However, it is not without competition. Varian Medical Systems and Siemens (NYS: SI) also offer products to assist with radiation therapy that compete with CyberKnife. In response, Accuray bought out TomoTherapy, which eliminated a competitor with a great deal of potential.

CONMED provides surgical devices and equipment used for patient monitoring and minimally invasive surgeries. The company recently entered into a distribution and marketing agreement with the Musculoskeletal Transplant Foundation to be the exclusive worldwide marketing representative for its sports medicine allograft tissues and to serve as the worldwide distributor for its platelet-rich plasma, which works to heal patients by using their own blood components. CONMED will receive $63 million in upfront payments and has the potential to make $84 million over the next four years if MTF can meet supply targets.

The cash king margin can help you find highly profitable businesses, but it should only be the start of your search. The ratio does have its limits, especially for fast-growing small businesses. Many such companies reinvest all of their cash flow into growing the business, leaving them little or no free cash -- but that doesn't necessarily make them poor investments. Conversely, the formula works better for slower-growing blue chips. You'll need to look closer to determine exactly how a company is using its cash.

Still, if you can cut through the earnings headlines to follow the cash instead, you might be on the path toward seriously great investments.

Want to read more about ResMed? Add it to My Watchlist, which will find all of our Foolish analysis on this stock.

At the time this article was published Jim Royal owns shares of McDonald's. Motley Fool newsletter services have recommended buying shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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