2 Stocks to Avoid Based on Poor Growth in Operating Cash Flow

by: Bret Jensen

It was quite the day in the market Wednesday as it reacted to the continued inability to get a debt ceiling agreement done and European sovereign debt issues that will not be put to bed. I have been taking some long positions in some defensive sectors recently including Walgreens (WAG), Teva Pharmaceuticals (NYSE:TEVA) and NextEra Energy (NYSE:NEE). To counter that, I continue to take positions in companies and sectors (e.g., social media) on the short side including LinkedIn (NYSE:LNKD), Netflix (NASDAQ:NFLX) and Lululemon (NASDAQ:LULU), all of which I have out of the money I put bear market call spreads on. One of the areas where I am looking to find further short candidates are stocks with high valuations and unimpressive growth in operating cash flow. Here are two that meet these criteria:

Public Storage (NYSE:PSA) - Public Storage operates as a real estate investment trust (REIT). It engages in the acquisition, development, ownership and operation of self-storage facilities in the United States and Europe. The company's self-storage facilities offer storage spaces for lease on a month-to-month basis for personal and business use. Public Storage also has interests in commercial properties containing commercial and industrial rental space; facilities that lease storage containers; and ancillary operations, which include reinsurance of policies against losses to goods stored by its self-storage tenants, retail operations comprising merchandise sales and truck rental operations. As of December 31, 2008, the company had interests in 2,012 self-storage facilities with approximately 127 million net rentable square feet in 38 states; and 181 self-storage facilities with approximately 10 million net rentable square feet in 7 western European nations.

Overview – Even though PSA’s stock price is up approximately 75% in the last two years, its operating cash flow from FY2008 to FY2010 was about the same. Operating cash flow for the first two quarters of 2011 implies about the same annual cash flow as well. PSA is now selling at the very top of its five year valuation range based on price to cash flow. In addition, it has missed earnings badly twice in the last four quarters. It has only grown earnings by an average of 6% annually over the past five years. Consensus earnings estimates for 2011 to 2012 project approximately the same growth rate in EPS. For a company selling at over 20 times this year’s projected earnings and poor operating cash flow growth over the past three years; this company’s valuation seems rich even with a 3% dividend yield.

FMC Technologies (NYSE:FTI) - FMC Technologies, Inc. provides technology solutions for the energy industry and other industrial markets. It designs, manufactures and services technologically sophisticated systems and products, such as subsea production and processing systems, surface wellhead systems, high pressure fluid control equipment, measurement solutions and marine loading systems for the oil and gas industry. The company operates in 15 countries worldwide.

Overview – This equity has more than doubled in the past two years. Despite this, operating cash flow actually decreased from FY2008 to FY2010 by approximately 20%. FTI sells at the very top of its five year valuation range based on price to cash flow as well as P/E and P/S. It has also missed earnings estimates two of the past four quarters. It has a trailing P/E of over 30 and a five year projected PEG of just under 2. FTI reported a decent earnings report after hours on Wednesday, beating earnings estimates by a penny and seeing an increased in backlog of 9%. Looking back over the last 10 years of valuation ranges, FTI typically trades in a range of 15 to 25 times trailing earnings. S&P has a price target of $40 on the stock which is around 10% under its current price. This stock is one to avoid at current price levels.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in PSA over the next 72 hours.