This article is part of ourRising Star Portfolios series.
Let's say you've found a company that, after years of negative free cash flow, has finally turned positive. Is it time to buy?
Perhaps. But it may also be a huge mistake.
It all depends on why the business is flipping from negative to positive free cash flow, and whether the market properly understands the situation.
Sometimes companies with negative free cash flow are great buys. My "Next Home Depot" screen is designed to find such businesses -- ones that exhibit the same traits as Home Depot in the mid '80s before it exploded for 1,500% gains over the next 15 years.
As I explain in this article, the market understood that Big Orange was exhibiting negative free cash flow only because it was reinvesting its free cash heavily into its high-growth business. By 2001, that high growth was done, Home Depot's capital expenditures subsided, and the business turned free-cash-flow positive. Not coincidentally, the stock price ceased its upward surge, and has been relatively flat since then.
If a company you own is transitioning to this stage in this same manner, you may want to consider that its high-return days are behind it. I recently constructed a screen to see if I can identify such businesses.
For this screen, I looked for the following:
Two years of positive free cash flow, after at least two years of negative FCF
Two years of capital expenditure growth slowing to less than 20% annually, after two years of 20% or greater growth
A similar slowdown in revenue growth
I isolated only the two years prior to the first FCF-positive year because even Home Depot snuck a positive year into its 15-year run. I just didn't want an occasional anomaly in any of these metrics to eliminate a company that otherwise fits what we're looking for.
Five to chew on
Only five companies passed this screen, and I can't really say any of them are reminiscent of the Home Depot situation. For instance, O'Reilly Automotive (NAS: ORLY) had plenty of FCF-positive years prior to the two negative ones caught by my screen. NetSuite (NYS: N) had some up years and some down years for capex growth. Air Methods (NAS: AIRM) and Hallador Energy Company (NAS: HNRG) were all over the place in each of these metrics.
MetroPCS Communications (NYS: PCS) is perhaps the best fit. Prior to 2009, it had only one year of positive FCF. Its capex growth has stalled somewhat, and revenue growth has decelerated over the past couple of years. However, one of management's strategies is to continue to expand "in and around" its existing markets, as well as in new areas if possible. So it's really hard to say if its big growth days are truly behind it. And, unlike Home Depot, MetroPCS' stock didn't exactly experience a huge run-up in the years before it turned FCF positive.
Not good enough
I had thoughts of this becoming an official screen for my Rising Star portfolio, the perfect complement to my Next Home Depot screen -- but I don't think it's ready for prime time. I don't feel I captured companies that are in the same position Home Depot was in the early 2000s. I'll continue my research and perhaps refine things a bit, and we'll see where the future takes us.
At the time thisarticle was published Fool analyst Rex Moore says if you're not failing, you're not trying. He owns no companies mentioned here.Motley Fool newsletter serviceshave recommended buying shares of Home Depot. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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