Is Frontline a Cash King?

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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 Frontline (NYS: FRO) 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 December, the restaurateur generated $7.15 billion in operating cash flow. It invested about $2.73 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment ($2.73 billion) from its operating cash flow ($7.15 billion). That leaves us with $4.42 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.

Taking McDonald's sales of $27.0 billion over the same period, we can figure that the company has a cash king margin of about 16.4% -- a nice high number. In other words, for every dollar of sales, McDonald's produces more than $0.16 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.

A closer look
Here are the cash king margins for four industry peers over a few periods.

Frontline(3.1%)(19.8%)8.0%16.8%
Nordic American Tankers(129.8%)(108.1%)54.9%(120.3%)
Ship Finance International(48.9%)(13.6%)37.2%(18.5%)
Teekay Tankers48.1%38.9%55.3%N/A

Source: Capital IQ, a division of Standard & Poor's.

Of these companies, only Teekay Tankers (NYS: TNK) meets our 10% threshold for attractiveness, with cash king margins above 40%.  Nordic American Tankers (NYS: NAT) and Ship Finance International (NYS: SFL) both have cash king margins in the low negative numbers. Frontline's margins are also negative, but they are in the low single digits and its margins have seen some improvement since their dip last year. Compare these returns to the blue chips of software and biotech, to get some context.

Frontline, along with many other companies in shipping, has suffered from an oversupply of cargo shippers, shrinking demand, and an inability to gain access to credit. As an oil tanker business, Frontline is also affected by civil conflict in Northern Africa and the Middle East, which has caused a reduction in oil production in those areas. In addition, there have been recent increases in oil exploration and new oil discoveries in the U.S. which has led to a reduced demand in oil that has been shipped from other places. This affects Frontline, along with Ship Finance International and Nordic American Tankers.

Some shipping companies are more insulated from these challenges than others. Teekay offers a large dividend (currently at a 10% yield). This gives it a nice cushion, because it can decrease the dividend to conserve money in the short term if necessary. This may help it weather the storm of these challenges and emerge with a competitive advantage over other companies in the industry. DryShips (NAS: DRYS) has also managed to insulate itself from some industry challenges by setting up advance contracts that take up 54% of its dry bulk capacity at an average rate of about $35,000 per day for 2012. However, unless the industry improves before these contracts expire, DryShips may suffer from some of the same challenges of the rest of the industry.

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 Frontline? 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.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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