Is Hewlett-Packard a Cash King?

As an investor, it pays to follow the cash. If you figure out how a company moves its money, you might eventually find some of that cash flowing into your pockets.

In this series, we'll highlight four companies in an industry, and compare their "cash king margins" over time, trying to determine which has the greatest likelihood of putting cash back in your pocket. After all, a company can pay dividends and buy back stock only after it's actually received cash -- not just when it books those accounting figments known as "profits."

Today, let's look at Hewlett-Packard (NYSE: HPQ) and three of its peers.

The cash king margin
Looking at a company's cash flow statement can help you determine whether its free cash flow actually backs up its reported profit. Companies that can create 10% or more free cash flow from their revenue can be powerful compounding machines for your portfolio.

A sustained high cash king margin can be a good predictor of long-term stock returns. To find the cash king margin, divide the free cash flow from the cash flow statement by sales:

Cash king margin = Free cash flow / sales

Let's take McDonald’s (NYSE: MCD) as an example. For the four quarters ending in June, the restaurateur generated $6.87 billion in operating cash flow. It invested about $2.44 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald’s investment ($2.44 billion) from its operating cash flow ($6.87 billion). That leaves us with $4.43 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.

Taking McDonald’s sales of $25.5 billion over the same period, we can figure that the company has a cash king margin of about 17% -- a nice, high number. In other words, for every dollar of sales, McDonald’s produces $0.17 in free cash.

Ideally, we'd like to see the cash king margin top 10%. The best blue chips can notch numbers greater than 20%, making them true cash dynamos. But some businesses, including many types of retailing, just can't sustain such margins.

We're also looking for companies that can consistently increase their margins over time, which indicates that their competitive position is improving. Erratic swings in margins could signal a deteriorating business, or perhaps some financial skullduggery; you'll have to dig deeper to discover the reason.

Four companies

Here are the cash king margins for four industry peers over a few periods:

Source: Capital IQ, a division of Standard & Poor's.

Of these companies, only International Business Machines (NYSE: IBM) meets our 10% threshold for attractiveness, and it has increased its margins by more than 3% from five years ago. Unisys (NYSE: UIS) is within 3%  of meeting our threshold, and it shows the kind of steady growth in margins that we like to see. Hewlett-Packard’s margins are 6.4%, and they have declined by more than 3% from five years ago. Computer Sciences (NYSE: CSC) has the lowest margins of the listed companies, and while those margins have increased by nearly 2%, its current margins are the lowest they have been in the past three years. Compare these returns to the blue chips of software and biotech, to get some context.

Hewlett-Packard has faced a number of setbacks recently. The launch of its new TouchPad tablet got a disappoint reception among buyers, with rumors that Best Buy wants to return more than 200,000 unsold tablets. The company had to respond to disappointing sales by briefly marking its TouchPad down to $99 to turn over inventory.

HP has also suffered from a series of bad decisions from former CEO Leo Apotheker, including a recent attempt to spin off its PC business and its $10 billion purchase of Autonomy, a British software company. However, the company recently appointed Meg Whitman as its new CEO, a move that has brought hope for future improvement to many investors.

Future challenges for HP include pressure from competitors like Dell in the commodity-like aspects of its hardware business. In addition, it has to find a way to compete effectively with software companies like Oracle and IBM, which have focused more energy on the growth of their software businesses and also a head start on HP in that area.

The cash king margin can help you find highly profitable businesses, but it should only be the start of your search. The ratio does have its limits, especially for fast-growing small businesses. Many such companies reinvest all of their cash flow into growing the business, leaving them little or no free cash -- but that doesn't necessarily make them poor investments. Conversely, the formula works better for slower-growing blue chips. You'll need to look closer to determine exactly how a company is using its cash.

Still, if you can cut through the earnings headlines to follow the cash instead, you might be on the path toward seriously great investments.

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