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The Market's Smart Money Is Watching Free Cash Flow

The headlines may be about earnings, but the smart money always pays closer attention to free cash flow.

Right now that can be a tricky metric because the less companies spend, the better free cash flow looks. And over the past year, cost cutting has been a way of life in corporate America.

Considering that companies can only cut so much, especially as the second quarter winds down, the trick in the next round of earnings will be to figure out whether this robust free cash flow is sustainable.

Free cash flow, generally defined as operating cash flow minus cap spending, is the holy grail of any company because it is cash that comes with no strings attached.

It can be used for anything discretionary, including such things as acquisitions, dividends, stock buybacks and paying down debt.

The research firm Cash Flow Analytics, founded by Georgia Tech accounting professor Charles Mulford, ran some numbers and the results may surprise you.

Among the most notable moves in the first quarter came from sectors that had been the laggards:

  • Semiconductors and semi equipment, whose free cash flow margin (a metric devised by Cash Flow Analytics) not only reversed itself, but did so on a rise in median revenue and profitability.
  • Media, whose free cash flow margin rose in the first quarter from the fourth quarter but (not surprisingly) remains below a year earlier. Much of that increase appears to largely be the result of cost-cutting.
  • Telecommunications, whose cash flow margin was not only below the fourth quarter but a lower than a year earlier. Much of that decline, according to Mulford, is a result of lower profitability.

Here’s where it gets interesting, especially when trying to figure out which company is better managed:

AT&T’s free cash flow margin is tracking the industry fairly closely, with a free cash flow margin that continued a multi-quarter slide—down 3 percent from a year ago.

At the same time, Verizon’s free cash flow margin continues to rise, up 31 percent from a year earlier, on flat profitability and slightly higher revenue.

And that rise, according to Mulford, is the result of lower cap spending relative to revenue and lower inventories.

Intel’s free cash flow continues to rise, up 204 percent from a year ago. But after three years of being negative, so is AMD's , which popped higher in the first quarter and was 132 percent higher than a year earlier.

Finally—and we're saving the best for last—Sirius/XM barely bounced into the plus column for the first time in years; it's 113.9 percent higher than a year earlier. The improvement, Mulford said, is the result of improved revenue and profitability (as judged by Cash Flow Analytics: operating profits before depreciation.)

“They are actually growing capital spending,” he says, “so improvements here appear to be real and sustainable and not due to nonrecurring factors.”

Herb’s Hook: One quarter doesn’t make a trend—and we’re talking numbers from almost three months ago. But if smart money is watching the free cash flow in these companies, maybe you should be too.