Amid a series of unsettling developments, including the collapse of Silicon Valley Bank and the ongoing Russia-Ukraine war, the equity markets have been wracked by volatility. With a recession looming large on the horizon, prudent investors are focusing their attention on companies that demonstrate superior profitability, robust growth prospects, a leading position in their product categories, and a growing market share.
Of particular interest to investors is the soundness of companies' free cash flow and their management's approach to capital allocation.
The following companies generate robust free cash flow, put it to good use by way of dividends, acquisitions and buybacks, and represent long-term value for investors. These businesses are well placed to weather any economic turbulence down the road with relative ease given their plump cash cushion.
Palo Alto Networks (PANW) provides network security solutions. The platform-based cybersecurity vendor offers network security, cloud security, and security operations to 85,000 customers across the world.
The firm’s customers include more than three-fourths of companies ranked in the Global 2000, an annual ranking of the top 2000 public companies in the world.
Palo Alto has a healthy balance sheet. “We assign Palo Alto an Exemplary capital allocation rating based on its sound balance sheet, exceptional investments, and appropriate shareholder distributions,” says a Morningstar equity report.
The firm’s strong cash and liquid investments reserve and positive cash flow margins prompted Morningstar analyst Malik Ahmed Khan to add, “We are not overly concerned by the firm's use of debt.”
Further, the stickiness of the firm's product portfolio reduces downside risk in the event of an economic downturn, adds Khan who puts the stock’s fair value at US$200.
Palo Alto Networks is a leader in multiple cybersecurity sub-segments, including network security, cloud security, and security operations. “The firm stands to materially benefit from secular tailwinds across its three key verticals as cloud migrations shift to zero-trust security, and increased automation in cybersecurity increases Palo Alto’s value proposition to its clients,” asserts Khan.
Palo Alto’s wide economic moat, or sustainable competitive advantage, is underpinned by its sticky platforms, combined with a broad range of cybersecurity applications.
Altria Group (MO) is a holding company that consists of Philip Morris USA, U.S. Smokeless Tobacco, John Middleton, and Helix Innovations. It holds a 10% interest in the world's largest brewer, Anheuser-Busch InBev and a 42% stake in cannabis manufacturer Cronos.
Altria sells cigarettes and other tobacco products, including machine-made cigars and pipe tobacco. The company's Marlboro brand is the leading cigarette brand in the U.S. with a 43% annual share in 2022.
“We applaud the company's focus on maximizing cash flow from the declining cigarette business while maintaining market share and leveraging pricing power,” says a Morningstar equity report.
While Altria has bought back over US$1 billion in shares on average every year since 2012, “dividends are the company's top capital-allocation priority,” says Morningstar director Philip Gorham.
The stated payout ratio target of 80% on an adjusted basis is probably appropriate, given the very few M&A alternatives in the tobacco space, he adds.
The U.S. cigarette market, while in secular decline, remains relatively attractive. Morningstar forecasts a 5% annual volume contraction rate of the U.S. cigarette, a slightly faster rate than most markets. “However, the ability to consistently price above the rate of volume declines should ensure that Altria can continue to increase its revenue, earnings, and dividend,” assures Gorham, who puts the stock’s fair value at US$52.
Paychex (PAYX) provides payroll, human capital management, and insurance solutions servicing small and midsize clients primarily in the U.S. Apart from its traditional payroll services, Paychex offers human capital management (HCM) solutions such as benefits administration and time and attendance software, as well as human resources outsourcing and insurance agency services.
Paychex has a strong balance sheet as it operates a capital-light business model with strong free cash flow generation. “We assign Paychex an Exemplary capital allocation rating based on our assessment of a sound balance sheet risk, fair investment efficacy, and appropriate shareholder distributions,” says a Morningstar equity report.
The company is making strategic acquisitions to expand its suite of human capital management solutions. Paychex’s US$1.2 billion acquisition of Oasis in 2019 propelled it to become the second-largest PEO [professional employer organization] provider in the U.S.
“In the absence of attractive acquisition targets or internal investment opportunities, we would expect Paychex to return excess cash to shareholders through increasing the payout ratio beyond 80% of net income or increasing share repurchases,” says Morningstar equity analyst Emma Williams.
Paychex has returned over US$7 billion to shareholders over the past eight years, primarily through dividends and to a lesser extent share repurchases. “Paychex can comfortably continue to pay out 80% of net income over our [five-year] forecast period,” says Williams who appraises the stock’s fair value to be US$120.
