By The Valuentum Team
Thomson Reuters (NYSE:TRI) may not have an elevated Dividend Cushion ratio like that of many of its peers, but it's more a function of the size of its dividend obligations than anything else. It's dividend yield is fantastic! We're big fans of the company's track record of returning cash to shareholders, with more than $14 billion dished out in share buybacks and dividends since 2004. More recently, buybacks have taken a larger share of the capital returned, but a steadily-increasing dividend has become the norm at Thomson Reuters. Improving EBITDA and operating margins will help fuel free cash flow expansion, and with nearly 90% of its business recurring, there's so much to like. Thomson Reuters boasts 20+ consecutive years of dividend increases.
Image Source: Thomson Reuters
We're big fans of one of the world's leading sources of information for businesses and professionals, but we have to acknowledge the firm's Dividend Cushion ratio, which is near parity. The company does have a nice, balanced revenue stream, however, and its predominantly subscription-based business offers significant visibility. Proprietary databases act as considerable barriers to entry for smaller rivals, and management's commitment to maintaining a strong and stable capital structure is quite encouraging. The company will look to build on its consistent free cash flow generation in 2016 and beyond, and we'd like to see more capital go to deleveraging initiatives than buybacks at the moment.
Let's dig deeper.
Thomson Reuters Corp's Investment Considerations
• Thomson Reuters Corp is a source of information (human intelligence, industry expertise and innovative technology) for businesses and professionals. It delivers insight to the financial and risk, legal, tax and accounting, IP and science and media markets. The company has a nice, balanced revenue stream.
• The firm continues to sustain profitability in its core US legal business and capture global growth opportunities in its tax & accounting segment, while its IP & science group drives subscription expansion. Proprietary databases act as considerable barriers to entry for smaller rivals.
• Thomson Reuters Corp has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 19.7% in coming years. Total debt-to-EBITDA was 2.5 last year, while debt-to-book capitalization stood at 39.9%. Roughly 90% of revenue is recurring.
• The company is organized in four business units: 1) financial and risk -- news and analytics, 2) legal -- information to support legal and investigative purposes, 3) tax & accounting -- tax compliance and accounting information, and 4) intellectual property & science -- IP and science information.
• We're big fans of the company's track record of returning cash to shareholders, with more than $14 billion dished out in share buybacks and dividends since 2004. Thomson Reuters boasts 20+ consecutive years of dividend increases.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Thomson Reuters Corp's 3-year historical return on invested capital (without goodwill) is 11.4%, which is above the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation™ rating of GOOD. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Thomson Reuters Corp's free cash flow margin has averaged about 11.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Thomson Reuters Corp, cash flow from operations increased about 36% from levels registered two years ago, while capital expenditures fell about 0% over the same time period.
We think Thomson Reuters Corp is worth $38 per share with a fair value range of $29.00 - $47.00.
The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our nearterm operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 1% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -2.8%. Our model reflects a 5- year projected average operating margin of 23.4%, which is above Thomson Reuters Corp's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Thomson Reuters Corp, we use a 9.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $38 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Thomson Reuters Corp. We think the firm is attractive below $29 per share (the green line), but quite expensive above $47 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Thomson Reuters Corp's fair value at this point in time to be about $38 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Thomson Reuters Corp's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $47 per share in Year 3 represents our existing fair value per share of $38 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.