By David Sterman
Investors are feeling a bit whip-sawed these days. An improving U.S. economy and troubling events abroad make it hard to know where the market will head next.
In times like these, it may pay to de-emphasize growth stocks, as these types of investments need a really strong economy to flourish. Instead, you may want to add some exposure to companies with long track records and largely mature business models that are throwing off ample free cash flow (FCF). I've recently been looking at three companies that are rock-solid and poised to do well in a surging or a flat economy.
1. DirecTV (NYSE: DTV)
For many years, cable and satellite firms were unprofitable because they poured every spare dime back into the business in a bid to grow large. Those days are over and the industry is now mature. Now these companies can just sit back and reap all the cash flow those heavy investments were intended to produce. DirecTV is a fine example. The company is minting money, with FCF hitting a record $2.8 billion in 2010, up from less than $1 billion just three years ago.
What does that kind of money buy you? Large stock buybacks. The company bought back $5.1 billion in stock last year, and shares outstanding have now fallen from 1.4 billion in 2005 to a recent 886 million. DirecTV has just announced plans to buy back another $6 billion in stock, which could take the share count down to 750 million by next year. Management is also likely to issue the company's first-ever dividend next year as well.
The recent economic crisis proved one thing: People will cut off other discretionary items before they mess with their TV access. Sales grew 10% in a very difficult 2009 and another 12% in 2010. So any fresh economic slowdown is unlikely to hurt this business model. Shares recently traded hands at $45, but I see them moving up to $55 this year as investors start to focus on more share buybacks and higher FCF in 2012 and 2013.
In addition, despite the rise of the Internet and mobile phones as entertainment options, DirecTV actually continues to gain subscribers (even as cable competitors flattened out or shrank a bit). Long-standing agreements for carriage of channels will make it impossible for people to get access to most programs without going through the cable and satellite guys. Time Warner (NYSE: TWC) has developed an iPad app that allows for TV usage on a tablet. But that highlights the fact that, for the time being, you'll need to go through the big boys even if you want TV on mobile/Internet. I think the day will come when DTV stops adding subscribers, but as of now, it's still in growth mode, even more so in Latin America.
The biggest risk to the business model is the potential delay or cancellation of the upcoming American football season, which typically generates a big chunk of business for DirecTV. You may want to hold off buying shares until the current player/owner labor impasse is resolved.
2. Rent-A-Center (Nasdaq: RCII)
In tough times, cash-strapped low-income consumers tend to rent furniture and appliances, as the purchase price for these goods is often too high. In better economic times, a different dynamic is in play: College grads finally leave the nest and start to buy or rent homes of their own and they need to furnish their houses and apartments in a hurry, often turning to rental centers. That's what makes Rent-A-Center a "rain-or-shine" business model. The company always sees steady demand, and FCF ranges from $100 million in bad economic years to $300 million in good years.
To be sure, the housing sector remains weak, so the company isn't benefitting from an uptick in new household formations just yet. To goose growth, Rent-A-Center is rolling out mini-stores inside other retailers' stores (a win-win, since some retailers are now operating stores that are too large for the low levels of traffic they're experiencing). There are currently 200 of these store-in-a-store branches, and management hopes to ramp that to 800 by 2013.
In addition, Rent-A-Center is starting to expand into Mexico and Canada, which could expand its total retail footprint by 25% in the next four years. The Mexican opportunity is quite large, with a potential for 400 stores, according to management. Analysts expect sales to rise 6% this year and next, which assumes same-store sales will remain flat. Profit growth will be about twice as fast. Those may not be sexy metrics, but rain-or-shine business models are rarely sexy.
Rent-A-Center's impressive cash flow characteristics have enabled the company to start paying a dividend while also buying back stock (3.6 million shares were purchased in the fourth quarter). In fact, shares outstanding have fallen for eight straight years. That's one sure-fire way to boost earnings per share (EPS). I view this stock as a moderate gainer in a still-weak economy -- though with minimal downside -- perhaps moving up 30% or 40% in 18 to 24 months if the economy continues to strengthen.
3. Mylan (NYSE: MYL)
The steady stream of blockbuster drugs losing patent protection has been a real boon for generic drugs makers. [See my recent take on how to profit from this trend here.]
Mylan is the second-largest generic drug maker (behind Teva Pharmaceuticals (Nasdaq: TEVA), with more than $5 billion in annual sales. More importantly, the company has recently streamlined its business to bulk up cash flow. FCF rose from $82 million in 2008, to $311 million in 2009 to $600 million last year. I'm not expecting that level of FCF growth in coming years, but this is now a large, stable ship that should generate at least that much FCF in coming years.
As part of my "rain-or-shine" thesis, demand for generic drugs is not impacted by the vagaries of the U.S. economy. Moreover, further cost pressures in health care will keep industry dynamics moving in the favor of drug makers.
Mylan's business model is quite simple. Seek out drugs large and small that represent new generic opportunities. Every month or so, the company announces plans for the manufacture of a new off-patent drug. Each deal adds a few pennies to EPS. Eventually, those pennies add up. Analysts think per share profits will grow more than 20% this year and about 15% in 2012 to about $2.30 per share. Shares trade for less than 10 times that view. This stock looks to have up to 30% upside with virtually zero downside. I like that risk/reward set-up.
Action to take: Playing it safe means giving up some upside. If the market rallies higher from current levels, these three stocks may only post comparatively moderate gains. But if the market slumps, companies with steady revenue streams like the three I mention here will likely fare far better than some of the racier names out there.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.