Friday, October 15, 2010

From Free Cash Flow to Willingness to Pay Shareholders

A while back, I wrote this post about stocks that have good record of free cash flow and naturally they also gave a lot of dividends. I thought I would just delve a bit deeper into how free cash flow affects dividend while also looking at 1 or 2 other factors.

Basically, to determine whether a company can consistently pay dividends and grow them, we need to know:

1. The firm's balance sheet, esp the size of its debt
2. The firm’s ability to generate good cashflow or even grow it
3. The top management’s willingness in actually paying dividends
4. If it actually gets paid out, what is the yield?

The first thing I usually look at would be the firm’s long term track record in generating free cash flow, which is operating cashflow minus capex, ie the cashflow that is left after deducting money invested in new equipment, new plants etc. The thinking is that the remaining cashflow can be used to pay down debt or pay out dividend. If the firm has no debt (that’s why Criteria 1 is there), then the money should logically flow into dividends.

On the same post, I only managed to screen out 30-40 companies that have consistently generated positive free cashflow. This is out of 700 listed companies in Singapore. This shows how difficult it is to actually produce enough cash to give out dividends.

However, even if the firm can generate cash, if the management is not willing to pay them out, then there is no point talking about it. To check this, we look at the dividend track record. If the firm consistently paid dividends or even increased dividends, then we are going somewhere.

An interesting case in point would be Yeo Hiap Seng (YHS). The free cash flow track record is stellar but it stopped paying dividends since 2006. It looked like they over-invested in the earlier part of this decade and is now using the free cashflow to pay down debt. But what is the management’s stance on dividends? Will they resume it after the debt issue is resolved? Or are they gonna invest into stupid ventures again?

Let’s look at the previous case study: Starhub. The operating cashflow on average is about S$600mn. The capex is about S$200mn. So FCF is close to S$400mn. The firm has been paying around S$300mn in dividend every year. So that’s very good! There is still S$100mn of buffer for it to grow its dividend.

However there is always the lingering debt issue. Starhub has roughly S$600mn of net debt, and equity in the latest quarter is a miserable S$60mn! This explanation on Drizzt’s blog explains that it’s due to some accounting after they merged SCV. The actual equity is S$1bn. So S$600mn of debt is no big deal. Not to mention, if the S$400mn of FCF is used to pay debt, it will take only 1.5 yrs to clear it.

But still it doesn’t make sense. Why does merging with SCV reduce accounting equity by 90%? Was SCV a negative equity entity? Even if there is no actual impact on every day operations, the book value is something that all investors look at. Can something be done to resolve this?

Well, perhaps it would be resolve in time. Meanwhile Starhub gives close to 8% dividend yield.

Which brings us to the last point: the dividend yield. Is it a reasonable yield? For every dollar buying the stock, are you getting enough back in dividends? But the yield is also a function of future growth expectations. A high yield usually means lower growth expectations.

Starhub’s yield of 8% can mean that there is very limited growth left. Or it can mean that investors expect the yield to fall in the future, ie dividend cut. Or it can really be a steal right now, and over time, the stock rises to $5 and makes the yield more reasonable at 4-5%. Which means you will double your money by buying now.

If you ask me, I think the former reasons look more likely. The market is not stupid, bargains like this don’t last long enough for an amateur blogger like me to blog about it. Not to mention that I am definitely not the first one blogging about it.

The best investment, obviously, is a high yield stock that can sustain or even grow its dividend over time. But high yield with growth is an oxymoron. If the firm can grow, it will keep the cash for growth instead of paying it out to shareholders. High dividend yield and growth cannot go hand-in-hand. But for some value investors, the goal might just be to find 1 or 2 of these high yield growth stocks, buy them and hold forever!

Friday, October 08, 2010

Payout Ratio

Payout ratio is simply Dividend Per Share (DPS) divided by Earnings Per Share (EPS), which tells you how much buffer does the company have for it to increase its dividends. E.g. EPS for Singtel is about 22c and DPS is 11c on average for the last few years, so the payout ratio is 50%.

But what is a good payout ratio?

If the payout ratio is 30-40%, which I would say is probably below the global average, then you know the company has some room to increase dividends.

If the payout ratio is close to 100%, ie the company is paying everything that it earned as dividends, then we cannot expect a lot of growth in dividends unless earnings is going to grow significantly.

In Singapore, sadly, a lot of high dividend stocks also have very high payout ratio, ie no further room for dividend to grow unless earnings can grow. But if earnings can grow, then the firm would want the money to invest in growth and not return them to shareholders. Hence high dividend plus strong growth is an oxymoron. These stocks don’t exist. Or they are very rare.

When dividend and payout ratio both gets too high, dividend cut becomes inevitable.

However, cutting dividend is a big deal for many companies in Singapore, bcos a lot of shareholders buy Sg stocks mainly for their dividend and if it is cut, it means disappointment and selling pressure. Of course it also shows that management is not capable of steering the business well enough to pay their shareholders.

In fact, it got so important to the extent that some companies actually issued debt to pay dividends!

The two prominent cases being Singpost and Starhub.

In the early years when Singpost was listed, it was obligated to pay a high dividend yield for some reason that I forgot. So while Singpost’s net profit was just over S$100mn, it has to pay S$300mn in dividends! So bo pian, raise debt to pay dividend. However, that only happened more than 6-7 years ago and the company hasn’t done anything stupid like that ever since.

Ok let’s talk about Starhub.

For the past few years, Starhub generates annual net income of roughly S$300mn and pays roughly $300mn in dividends as well! At the same time, the firm increases its debt holdings almost every alternate year, in 1 year by as much as S$600mn! So people asked questions like why do they raise so much debt when they could have cut the dividends to save money?

Well I guess there are no easy answers. But if we analyse the cashflow statement of Starhub, we can see that perhaps the situation is not as bad. So it might be worthwhile to look at free cash flow vs dividend paid instead. Which is what I would do in the next post!