Cash Rules Everything Around Me!

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What You’ll Learn Today

• Ideal levels of FCF Margin and FCF Yield for a company to be considered a “cash cow.”

• Why FCF is to be considered the best indicator of a company’s financial health.

• 3 best Big Tech “cash cows” that are reasonably valued right now and hold promising future outlooks.

Cash Rules Everything Around Me!

3 Best Cash Cows to Buy Right Now - September 2024

INTRO

The U.S. stock market has largely been driven by a few stocks, collectively referred to as The Magnificent Seven, in the past couple of years.

• Alphabet (GOOG; GOOGL)

• Amazon (AMZN)

• Apple (AAPL)

• Meta Platforms (META)

• Microsoft (MSFT)

• Nvidia (NVDA)

• Netflix (NFLX)

At least a couple of The Magnificent Seven have shares that exist as “cash cow” stocks that every investor would like to have in their portfolio. The reason is that such companies generate consistently high levels of free cash flow (FCF).

In accounting terms, FCF means the money left behind from business operations after deducting major investments called capital investments, or CapEx, and working capital requirements.

With extra money in the bank from generating cash flows so well, these companies can make major financial decisions on how to allocate that free cash flow, including share repurchases, dividend payments, acquisitions, paying down debt, or reinvesting into the company.

And as investors, it’s prudent to evaluate companies on their ability to consistently produce strong cash flows. This forms the very basis of a company’s intrinsic value - it’s ability to consistently generate high-levels of cash flow over the long-term. It lends to a strong financial standing and an ability to perform well uninterrupted even during uncertain economic situations. 

Now, let’s touch on FCF Margin. FCF Margin is simply the level of free cash flow expressed as a percentage of revenue. Generally, we tend to view any company with a 20% or greater FCF margin as a cash cow. And obviously, the higher, the better.

A FCF yield also aids with investment analysis, providing understanding of how much free cash flow a company generates per dollar invested in its shares, as well as what potential returns they might expect from purchasing the company's shares. A FCF yield of >2% is very attractive in our view. Of course, in all respects, additional research and investment analysis is always necessary before making any investment decisions.

In this write-up, we'll explore two cash generating machines from The Magnificent Seven: Microsoft (NASDAQ: MSFT), and Alphabet (NASDAQ: GOOG, NASDAQ: GOOGL). We’ll also look at Palo Alto Networks (NASDAQ: PANW), with these 3 collectively presenting themselves as the best cash cows for investors to potentially include as apart of their investment portfolios right now.

Palo Alto Networks (NASDAQ: PANW)

• FCF Yield: 2.9% 

• FCF Margin: 38.7%

• Market Cap: $101.7 Billion

Palo Alto Networks (NASDAQ: PANW) is a leading American multinational cybersecurity firm. Cybersecurity is one of the best niches within today’s market with tremendous potential for growth and prosperity. The cybersecurity market stood at around $190 billion in 2023 and is expected to grow at a 9.4% CAGR to reach $298 billion in 2028. 

If we look at the company's latest financial report, the numbers reflect its growing position within the industry. In Q4, Palo Alto Networks achieved 12.1% growth in revenue and 8.2% growth in net income. Both levels are very good! The company also grew their revenue by 16% for the full year FY24, maintaining its double-digit growth trajectory.

With respect to next quarter, it is also providing revenue guidance in the range of $2.10 billion to $2.13 billion, a 12% to 13% increase (YoY) versus consensus at $2.10 billion, and net income guidance with a 7% to 8% YoY increase. So, growth persists at both the top-line and bottom-line levels of the P&L (profit & loss statement).

Now, for the most relevant metrics. Over the past year, Palo Alto Networks also generated around $2.9 billion in FCF. Revenue for the same period was $7.5 billion, while its FCF margin stood at 38.7% relative to its revenue and a FCF yield of 2.9% relative to market cap valuation. These numbers show that PANW stock is a very attractive cash cow with a relatively low valuation right now. 

What does the company do with all that free cash flow? Well, first of all, it’s reinvesting in the growth of its business. Since 2019, its sales have doubled, meaning the company is constantly attracting new buyers and delivering value. And as detailed above, both revenue and earnings are consistently growing at double-digit rates.

Additionally, while PANW doesn't offer dividends, it has indeed been actively buying back shares as a means of delivering value back to its investors, even outside of any appreciation in the stock price. After the share repurchases on record, the company is still left with a sizeable $2.6 billion from its FCF.

Palo Alto Networks is also stockpiling cash to maintain a healthy balance sheet, with a total debt-to-equity ratio of only 26%, while also investing its cash in long-term investments, which increased last year by nearly $2 billion. As a whole, all of this is pointing to PANW as having strong financial position, with a stock that could be worth much more in the well into the future. 

Microsoft (NASDAQ: MSFT)

• FCF Yield: 2.2%

• FCF Margin: 29.6%

• Market Cap: $3.03 Trillion

Microsoft’s products are largely related to operating systems, gaming, cloud, and application software. But more recently, the company is making heavy investments in artificial intelligence (AI). Growth in capital expenditures (CapEx) has been significant, with a focus on expanding cloud and AI capacity. This has led to questions about the impact on profit margins and cash flows. Let’s dive in.

Despite heavy capital investments in the cloud and AI, the company's FCFs in the past 12 months were $67.4 billion, which was enough to effectively allocate toward share repurchases, dividends, debt payments, and acquisitions. This amount also equates to 29.6% of its $227.6 billion in revenue, so it’s managing very attractive “cash cow” levels of FCF. Its current market cap is around $3.03 trillion, and the $67.4 billion LTM (last 12 months) FCF (free cash flow) reflects an FCF yield of 2.2%. Pretty darn good!

There’s also healthy growth being incurred with its dividend payouts, which have seen a YoY increase +10% versus the dividend paid out in the prior year. The chart below reflects how the dividend paid has steadily grown year after year, highlighting a favorable trend in using FCF to provide shareholders with value.

Results for FY Q4’24 further demonstrated the company's strong financial performance. The company earned nearly $65 billion in revenue with a 70% gross margin and 43% operating margin. It continues to generate tremendously strong profits as software remains a high margin business for the company. Net income came in at $22 billion, supported by double-digit growth. Its bet on OpenAI is also clearly paying dividends, with over 65% of Fortune 500 companies using Azure OpenAI Service.  

Strong earnings reports and growth prospects indicate Microsoft's growth story is far from over. Cash flow growth, combined with strong present cash flow, should enable substantial long-term shareholder returns. Microsoft's shares have recently suffered a decline but are gradually recovering, presenting an attractive investment opportunity.

Alphabet (NASDAQ:GOOG, NASDAQ: GOOGL)

• FCF Yield: 4.0%

• FCF Margin: 22.6%

• Market Cap: $1.73 Trillion

Alphabet (NASDAQ: GOOG, NASDAQ: GOOGL) is another big tech stock that owns Google and YouTube, with these two subsidiaries making up the company's true cash cows and Google services generating over 90% of revenue. 

In Q1 2024, the company reported revenue of $80.5 billion, increasing +15.4% YoY, and EPS of $1.89, well-exceeding the estimates of 39 cents. Management expects that in FY2024, YouTube and cloud services will generate a combined $100 billion-plus annual run rate. 

Growth from the company's ad revenue based on Search increased by +11% in the previous quarter. Google maintained almost a 91% market share in global Search, though this is down from nearly 93% from a year ago. Nevertheless, it continues to generate nearly $200 billion in annual sales from the advertising business attached to Search.

Google Cloud is also contributing significantly to revenue growth, increasing +26% and helping the company register a total increase of +13% in revenue. 

Over the last year, Alphabet generated $69.5 billion in free cash flows, reflecting a FCF margin of 22.6% relative to revenue of $307.4 billion. Also, with a market cap of around $1.73 trillion, the FCF yield stood at a very attractive 4.01%, indicating the real possibility of potentially being undervalued relative to the very high levels of FCF the company is generating.

Similar to Palo Alto Networks, Alphabet doesn't pay dividends but has instead used its FCF to deliver to its shareholders in the form of stock buybacks. In 2023, the company spent $61.5 billion, the majority of its FCF, on share buybacks. For more context and insight on the benefit of stock buybacks, dive into a previous write-up: Share Repurchases.

So, Alphabet is another cash cow which investors should potentially consider for inclusion in their portfolios. Both Google's Search and Cloud segments are reporting accelerating growth, indicating that investment in AI is boosting revenue or at least not having an adverse impact. But AI will be a key long-term growth driver for Google, and the company is integrating generative AI into most parts of its business.

Conclusion

Cash Cows are generally well-established companies that do not need as much capital to grow. Instead, such companies bring in loads of free cash flow that help them sustain dividends and buybacks – and generate long-term value for investors.

It’s rare to find such attractive cash cow investment opportunities within Big Tech, especially at reasonable valuations. In the case of the 3 companies detailed above, it truly helps that they are all market leaders that exist as largely low-capital intensive companies with strong and durable competitive advantages. And Alphabet, Palo Alto Networks, and Microsoft are presenting themselves as just that right now - rare opportunities!

Cash cows tend to do very well over the long-term. In terms of value and financial health, Free Cash Flow (FCF) is the best indicator. Both Return on Invested Capital (ROIC) and growth drive a firm's future available Free Cash Flow, which ultimately drives market valuation. So, look to invest in companies with high FCF.

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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP.

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