I remember Computer Sciences (NYSE:CSC) back in the crazy days of the dotcom bubble. I think I probably lost money buying them in my early 20s, and that most likely right before the crash. I am not sure exactly, but the bitter taste in my mouth when I recall the stock makes we wonder how much I did lose back in the day.
That said, the blame back then rests entirely on my shoulders. When I was a wet behind-the-ears part-time day-trader (like everyone at the mortgage company where I worked), I was certain I was going to be a millionaire before I reached 30. Making money was so easy. Then, all of a sudden, business valuations started to matter.
CSC got hammered just like most Nasdaq stocks in the ensuing crash. The stock closed 1999 at a price of $94.63. At the end of 2010, the stock closed at a paltry $49.60, just a mere 48% dive in the past 11 years. Should I continue to be bitter and view this company as "dead money" as most who hate on cash flowing tech companies like to call these kinds of stocks?
As I have argued many times, price alone does not tell the whole story. Valuations do. You see, valuations in 1999 didn't matter, until they did.
When I was buying high flyers back in the day based on momentum alone, I didn't need to understand cash flow statements and balance sheets. That stuff was for old fuddy-duddy's like Warren Buffet. Stock picking had moved past that poor dinosaur, so I thought. Losing $130,000 of my $160,000 account that I built up by luck over the years in a matter of months made we swallow the humble pie and get to work learning what is that Warren Buffet looks for when buying a business.
That search obviously leads one to Graham And Dodd's classic: Security Analysis. In the 6th edition of that book, I fell deeply in love with the free cash flow that a business generates. There are many other metrics I look at before buying a stock, but the foundation of my analysis lies in the free cash flow analysis. As Fund Manager of the Decade Bruce Berkowitz said in the 6th Edition;
Graham and Dodd referred to that excess cash as 'earnings power' or 'owner earnings.' That's the amount of cash an owner can pocket after paying all expenses and making whatever investments are necessary to maintain the business. This free cash flow is the well from which all returns are drawn, whether they are dividends, stock buybacks, or investments capable of enhancing future returns.
That number, dear investor, is the return on money invested if you were to buy the entire business whole. If you spend $500,000 on the local sandwich franchise on your street corner, you will want to make sure you get a decent return. Otherwise, just put the money in the bank and don't take the risk.
With that as my new foundation, I can now look back on my owning CSC in 1999 (assuming I did) and realize what a greedy little momo-monkey I was. With the stock closing 1999 at $94.63, the free cash flow was only $2.34 per share. That is a paltry yield of only 2.47%. At the time, the 10 year bond yield sat at 6.5%. I could have received 4.03% more income (177% more) assuming CSC decided to pay all of their free cash flow out in the form of a dividend. Had I known what I was doing back then, I would have shorted CSC and bought the ten year bond. Obviously, that valuation metric would have made that a good trade.
Fast forward to Dec 31, 2010 when CSC closed at $49.60. After 11 frustrating years for anyone who bought and held, is the stock still a short candidate in favor of buying the 10 year? Hardly.
CSC last year made roughly $8.65 of free cash flow. Had they decided to pay out all of those owner earnings in the form of a dividend, the yield on this stock would stand at 17.4%! A nice little 600% increase. CSC delivered on the hype for massive growth over the past decade, but gamblers like me back in the day were paying prices that were 11 years ahead of where we should have. Makes you wonder what gamblers buying Chipotle Mexican (NYSE:CMG), with its current high growth rate, but lowly current 1.69% FCF yield, are thinking today. My guess is there will be an painful "aha" moment in their lives within the next decade as they realize they are paying a valuation today that might take CMG a decade to grow into.
For income nuts like me, CSC gets me excited again, but for the right reasons this time. The company is a cash cow, and has begun to pay out those business profits in the form of a dividend. Last year for the first time they initiated a .15 per quarter dividend. After two payments, they raised that amount by 33% to .20 per quarter. As of this writing, the projected yield on this stock is 1.7%. That is not great compared to other tech company payouts, but the potential for rapid growth in the dividend is there.
The company has plenty of cash flow to do it. It could, for example, pay out half of its free cash flow for a 8.7% yield, and leave the rest in the business, thus still having almost 100% more FCF per year than it did in 1999. The company has also launched a $1 billion share-repurchase program. I secretly hope they will continue to focus more on repurchasing shares at these undervalued prices as a way of returning cash to me, rather than the dividend. Since I plan to re-invest all dividends personally, I prefer to not have to pay the 15% dividend tax first before buying those shares. Just do it for me, CSC.
While that huge payout is fanciful thinking for us dividend lovers in the short-term, the real story is that with the company yielding this amount, it is a target for a potential take over. A private equity firm should probably do just what I speak of above and buy the entire company, letting that huge cash generation flow to their own pockets. CEO Michael Laphen is on record stating he is not interested in such a deal, noting that growth potential is huge for this corporate cost cutting, service-based tech company.
CSC, in my opinion, is dirt cheap here. For CSC to regain its bubble valuation of 1999, it would need to trade at $350.20 today to yield the same 2.47% FCF yield that it did back then. This just means that the cost to own a piece of CSC is about 87% lower today. CSC, the business, has more than caught up to it's bubbly stock price of $94.63 back in 1999.
Dividend growth investors would be wise to take a look at the numbers. If buying this company whole makes a ton of sense for a private equity firm, it probably makes a ton of sense for you to consider owning pieces of it while you still can.
Disclosure: I am long CSC. Most of our clients are long CSC with an initial 0.50% weighting.