Building a Core China Portfolio – Part 6, Cash is King; How To Spend It!

13 Sep

The table below (Click to enlarge) highlights VTech’s historical free cash flow (FCF), outlines how the cash is allocated, and contains just a couple of basic ratios that stress test the balance sheet.

I’ve calculated FCF by taking the company’s cash flow from operations, and deducting the CAPEX, investments and other investments. Some might argue not to use the ‘other’ line item, as it generally connotes non-recurring items. When analyzing a single year or a few years I would agree that it makes sense to exclude non-recurring items, and check whether such items are indeed included in this line.

Benjamin Graham discusses non-recurring items in his famous Security Analysis. His example of a refund for over paid taxes illustrates the difference between the treatment of non-recurring items by an analyst in a single or a multi year analysis:

“Most of the non-recurrent items play a double and contradictory role in security analysis. They should be excluded in arriving at the results for a single year, but they should be included in the overall results for a period of years. A substantial refund of overpaid taxes for example has nothing to do with the year’s operating profit, and it is a misuse of language to call it part of the “earnings” of the year in which it was received… Yet, in a seven or ten year analysis of average earnings, a tax refund pertaining to the period belongs in the picture jus as much as the profits or losses against which it was accrued.” (Graham and Dodd, 1956)

Either way, apart from 2000-1 the company has been cash generative every single year.  We already flagged those years in a previous blog entry, and assumed they were the result of the tech bubble bursting – we will still have to find out what actually happened. Yet I am satisfied with the level of cash generation. I also note that apart from outlier years, the FCF as a percentage of net income has been around 75-80% on average for over 15 years. In other words, the earnings on the P&L have a high level of cash conversion – they are quality earnings.

Looking below at the allocations, this data is also mostly positive. There are essentially three types of allocation:

1.      Dividends and buybacks (to the equity holders)

2.      Payment of debt and interest / coupons (to the providers of debt)

3.      CAPEX and acquisitions (potential company growth – or value destruction if it goes wrong!)

As potential equity holders we should be interested to see that the lion’s share of the FCF has been allocated as dividends and share buybacks to shareholder. Firstly, this should come as no surprise, as we’ve seen previously that VTech has no debt on its books. In fact, if one looks at the bottom line of the table, we see that on average 75% of FCF has been allocated in dividends and buybacks since 1992. On the one hand this is good, as the company is not making use of funds for acquisitions. Acquisitions are often a risk and can be value destructive. Unless a company already has a record of successful value creating acquisitions I would not a priori look favorably on the use of cash for such endeavors. However, with a sustainable ROE of high 30%’s (see – I would like to find out whether there are any other organic growth opportunities VTech could be spending its cash on. Think about it – where else am I going to get a 35%+ return in the market so easily?!  There might not be such an opportunity out there, but I’d ask the question when we get to that stage.

Finally, there are the ratios at the bottom of the table. These basic ratios are a basic and initial stress test on the balance sheet. Though we know these guys have basically no debt on the books, so I’m not too worried.

So in conclusion, I am still positive about VTech, and will continue dedicate time to my investigation. This analysis has highlighted VTech as a company with high quality earnings historically, a history of strong capital allocation to equity holders, a seeming avoidance of risky acquisitions, and as we already knew no debt burden. The only question that arises is whether I would prefer them to plough cash into growth opportunities, but we will ask more about such opportunities in a later blog entry.

Until now we’ve been looking in the rear view mirror. Next time I will begin looking at the business itself, and then we will use that information to look forward and derive a fair value range.


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