Two Brilliant Tech Stocks a Cut Above the Rest

On Monday, I cautioned that two prominent telecommunications giants were levering up and growing larger at the wrong time.

Unfortunately, they’re not alone. According to Dealogic, there have been 19 agreed-upon deals or public takeover offers of $ 10 billion or more so far this year. This is the highest ever mega-deal volume over the same time period.

M&A booms go hand in hand with robust credit market conditions.

According to Standard & Poor’s, for every $ 1 of growth in corporate cash, debt has risen by $ 3.67 over the past three years in aggregate.

And only 186 companies within the S&P 500 have actually decreasedtheir combined short- and long-term debt levels in the past year.

Indeed, in this environment, deleveraging may be uncommon – but it sends a powerful signal.

Companies that are currently reducing their debt levels either have tremendous excess free cash flow, or astute managements (or both).

As it turns out, there are two such companies in the technology sector…

Tech Gem #1: No Longer a Copy Machine Dinosaur

Most investors think of Xerox (XRX) as a dinosaur stuck in the increasingly obsolete copier industry.

Well, Xerox should no longer be considered just a copier company.

Granted, copying and printing still account for around 40% of its sales. But the company is now transforming itself into a provider of business process and information technology outsourcing services.

And since over 70% of Xerox’s revenue currently comes from the United States, it has plenty of opportunities to grow overseas, especially in emerging markets.

With $ 2.4 billion in free cash flow over the past 12 months, the company has had the flexibility to reduce leverage after allocating for capital expenditures.

Over the past year, Xerox decreased its total debt level (slightly different measure than total liabilities) from $ 8.5 billion to $ 8.0 billion.

Tech Gem #2: Big Data Solutions

NetApp (NTAP) is a provider of business services, as well. NetApp helps organizations store, manage, protect and retain their data.

The company just announced fourth-quarter 2014 results and has now beaten consensus quarterly earnings estimates for nine consecutive quarters.

NetApp has also reduced its debt levels from $ 2.3 billion to just under $ 1 billion in the past year.

This isn’t all that surprising, considering the company has a war chest of $ 5 billion in cash and cash equivalents on its balance sheet. That’s a huge cash balance, considering that its total market cap is $ 11.4 billion.

But reducing debt is just one indication of management’s confidence in sustainably high free cash flow.

An Airtight Investment Case

NetApp and Xerox may not have noteworthy dividend yields, butdividend growth is more desirable than high yields, all else equal. And both of these companies have increased their dividends by a healthy amount in the past year.

Better yet, both companies were able to buy back meaningful amounts of stock in the past year – without issuing debt to do so.

These sizable buybacks translate into fabulous total yield figures, which is the dividend yield plus the net percentage of shares outstanding that the company has repurchased in the past year.

Xerox and NetApp also trade at stellar valuation levels, with forward price-to-earnings (P/E) ratios of 10.8x and 12.0x, respectively.

It gets even better when you consider a more appropriate valuation metric, though…

Enterprise value (EV) relative to earnings before interest, taxes, depreciation and amortization (EBITDA) is superior to the popular P/E ratio because it allows us to better compare companies with disparate cash and debt levels.

The median EV/EBITDA for the entire S&P 500 is 11.2x. But Xerox and NetApp have EV/EBITDA multiples of 6.9x and 6.4x, respectively. In other words, Xerox and NetApp have very cheap valuations.

Bottom line: Xerox and NetApp boast dividend growth, high total yields and dirt-cheap valuations. They’re also going against the grain and reducing their debt levels at a time when most companies are dialing up the leverage.

All of these factors indicate that both companies are producing significant free cash flow and their managements are making smart capital allocation decisions – and these diamonds in the rough are poised to outperform.

Safe (and high-yield) investing,

Alan Gula, CFA