Why Free Cashflow is King
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Why free cashflow is King? Invast.com.au explains the importance of cashflow in this 'Insights' report. It is a common question when buying a company. Many analysts, when talking about stocks, often quote price to earnings ratio's or analysis of revenue and investment returns. We explained why we liked this method so much.
Transcript of Why Free Cashflow is King
- Invast Insights Week Commencing November 18, 2013
- www.invast.com.au | 1800 468 278 This week we look at the following topics: 1.0 Why Free Cashflow is king 2.0 Oil price revisited where to from here 3.0 Is the carry-trade alive and kicking? 4.0 Is Keep an eye on this small cap stock 5.0 Recap of our 2013 covered topics 6.0 Weekly economic calendar
- www.invast.com.au | 1800 468 278
- www.invast.com.au | 1800 468 278 1.0 Why Free Cashflow is king What is it worth? This is the most common question when buying a company. The question can also be applied to any other asset, like asking what a certain property, currency income annuity or commodity is worth. If you dont trade stocks this section might not seem important to you, but its worth noting that companies are the basis for all index and stock market measurements. Companies often dictate where central banks pitch their monetary policy, in return driving currencies. For this reason, we hope this analysis is of use to you regardless of what asset class you trade. When chatting about stocks, many analysts often quote the price to earnings ratio or go into detailed analysis on revenue, margins and investment returns. In most circumstances most of these numbers are useless and over the years we have grown to prefer one specific measure above all the rest Free Cashflow per share. We explain why we like this method so much below. But firstly, we need to put this discussion into context. The process of valuation is at best, a guess.There are no perfect methods or magic measurements.
- www.invast.com.au | 1800 468 278
- www.invast.com.au | 1800 468 278 When we launched this weekly publication back in late August, we explained that the process of valuation is guesswork right from the beginning. We made clear that our role here is to help improve your investment and trading returns. At times we get some of our thoughts right and we also get some wrong. But we dont take our estimates and numbers too emotionally, they are just a guide to help build our thoughts and ideas. Many other analysts fall into the habit of using a particular method as it becomes common practice. They get hooked, obsessed and talk about margins, ratios, earnings drivers and so on without really thinking about what the importance of cash in a business. We decided to write this section after reading a newspaper headline, explaining Australian electronics retailer Dick Smiths plans to list on the Australian stock market. We were surprised at the range of numbers being mentioned. The newspaper said Dick Smith was valued by a certain investment bank at between 11.5 to 14.5 times its earnings. This measure is called a price to earnings ratio. The actual numbers mentioned arent the problem but the valuation method is. We dont think it is appropriate for a business like Dick Smith.
- www.invast.com.au | 1800 468 278 Dick Smith is an Australian electronics retailer, previously under the ownership of Woolworths. After many years of stress with Dick Smith, Woolworths recently made the decision to sell and move on. Woolworths by the way is the largest retailer in Australia. You would have probably realised that by now. If the largest retailer in Australia cannot make money from a concept, we think others will also struggle. Retailing is very difficult but there can be opportunities to turnaround interesting businesses. We dont doubt this, but we just dont have confidence in Dick Smith as a concept. We think a price to earnings ratio as inappropriate since earnings as a measurement are not the best indicator of what Dick Smith owners will make. Measuring earnings alone is too simple. For example, costs could fall and revenue rise in a certain period of time, which will lift earnings. This was the same case with Myer prior to its sale in a few years ago at $4.10, before it fell below $2 two years later. Retailers like Dick Smith and Myer require ongoing spending in their stores to make sure customers keep coming back. If you survive without spending money, competitors will eventually copy and take away your profits. Barriers
- www.invast.com.au | 1800 468 278 to entry are low. To maintain power and discourage competition, retailers need to keep spending money. As a measurement, earnings do not always capture this investment requirement. The more stores you open, the largest the annual commitment becomes to refurbish and maintain your stores. Myers previous owners spent around half a billion dollars getting the business back to a respectable competitive level before selling shares to the market. The investment cycle for retailers is at most ten years. The best retailers like Woolworths pour billions of dollars each year to improve products and expand their stores, ensuring they dont lose the fight with arch rivals. Retailers can do well at certain points, mainly due to external factors. In a particular period of time, earnings might be growing because new stores and improved consumer sentiment is driving sales but that means nothing if in a few years time, stores need to be completely refurbished and new money spent on products, layout etc. when customers tune out. Myer is starting to realise this. Using a price to earnings ratio on a good earnings base is very misleading and the smart money doesnt buy the rational. It is a measure
- www.invast.com.au | 1800 468 278 at one point in time which can be manipulated by lowering costs or unsustainable revenue. So how do we measure this timing more appropriately? Fortunately a few days before reading the Dick Smith press report, we were reminded that Free Cashflow per share is an important measure of business performance by the very smart folks over at The Motley Fool. They run an independent research service. Free Cashflow per share measures cash generated by a business though its operations in one year. It then subtracts money put aside for capital spending, money used to fund working capital and the payment of taxes. Free Cashflow is essentially what is left over in the cash piggy bank after all commitments are made. This differs very much from earnings because the money set aside to invest is not capture on the profit and loss statement. The Motley Fool wrote their note in the Sydney Morning Herald; you can click here to read it. We think it is a great conversation around why the chief executive and founder of Amazon.com focuses only on Free Cashflow per
- www.invast.com.au | 1800 468 278 share as the key method of benchmark performance for his business. Amazon.com doesnt really care if it earns a low margin on its sales. What really matters to the business is increasing sales and cash on an absolute basis. Amazon.com would rather earn 1% return on large sales than 5% returns on average sales. Absolute returns are what matters. What matters is the amount of cash flowing through to its bank account and this cash ultimately helps Amazon.com decide on how it grows and how to reward its shareholders. Profit margins are a relative measure, cash is absolute. Amazon.com CEO Jeff Bezos knows a thing or two he started Amazon.com in the mid 1990s from humble beginnings after many years in the finance industry, his last role in a quantitative hedge fund. His sole focus on Free Cashflow per share has seen his operation grow to become one of the largest global retailers and the leanest in the industry, employing best of practice technology.We all know the story.
- www.invast.com.au | 1800 468 278 In Australia, Telstra shows why Free Cashflow is more important than actually earnings. Telstra spent large amounts of cash in technology under its previous boss, Sol Trujillo. This ensured service was superior to rivals. Cashflows started to improve after the investment was made. Because of the large investment, Telstra needs to book depreciation onto its numbers and so the earnings number understates the amount of cash the business actually generates. The infrastructure is built so as of the time of writing Telstra is investing very limited amounts of money to generate cash from its mobile operations. We all know how good the network is. Free Cashflow per share is a better measure of the ability to pay out dividends or make acquisitions than does the earnings base. Telstra generated $5bn of Free Cashflow in 2013 compared to earnings of $3.9bn a huge difference of $1.1b. Retailer JB Hi-Fi will be used as the perfect comparison against Dick Smith, even though their businesses are miles apart. The investment banks and IPO marketers will be using the solid rise in JB Hi-Fis shares to justify an earnings multiple for Dick Smith. Which one do we prefer? We wouldnt be buying any
- www.invast.com.au | 1800 468 278 any of them at the moment based on the Free Cashflow generation of the whole sector. Lets take JB Hi-Fis numbers as an example. On our estimates the business generated Free Cashflow of around $125m last year. As it rolls out more stores and as many of its existing stores hit their maturity profile, it will need to spend more money and so the Free Cashflow growth profile is probably not as good as what many expect. JB Hi-Fi is a leader in its segment, but that doesnt always make it a good investment. It is already admitting that its currently business model is struggling and has announced plans this year to roll out a new Home concept broadening its product offering. This probably wont be the golden goose it needs. The only option will be to continue spending either by rolling out more stores or by investing in new technology. Meanwhile as the base of stores grows, so too will be the annual commitment to maintain and refurbish the stores which are already bare bone in terms of fit out. Therefore we are fairly confident in saying that any earnings growth that JB Hi-Fi makes over the next three years assuming all goes well with the Australian economy
- www.invast.com.au | 1800 468 278 it will probably have to reinvest into its survival. So the $125m Free Cashflow booked last year is very limited in its absolute growth. JB Hi-Fis Free Cashflow return is roughly 5.6%, when comparing $125m against the $2.2bn valuation. We measure the business by taking total number of shares and multiplying them by recent prices. We form the conclusion that on a cash basis, taking into consideration the need for investment and change, JB Hi-Fis annualised return of 5.6% is poor compared to Australian 10 year bond yields of 4.69% as of the time of writing hardly a 1% margin of excess to compensate for all the things that could go wrong. We wouldnt touch it for that reason. Some will argue that JB Hi-Fi is a good business. They will say it can grow earnings, is well placed to benefit from the Australian economy turnaround. These are true but all these points fail to asses on merit the cash flow position of JB Hi-Fi. It might be a good business, but with returns less than 1% above bond yields, we dont think its a good investment. For this reason we would
- www.invast.com.au | 1800 468 278 be inclined to stay away from the Dick Smith sale or any other Initial Public Offering (IPO) which lacks the ability to generate superior Free Cashflow growth into the future. Online businesses have become the darlings of the investment community for very good reason they generate huge amounts of cash and once built into a market leadership position, their position is very difficult to diminish. These stocks remain our key focus.
- www.invast.com.au | 1800 468 278 2.0 Oil price revisited where to from here In our Invast Insights report published on 23 September 2013 we published our technical analysis on the Brent crude price in light of the Syrian situation moving from a military possibility to a negotiated settlement. At that time our technical analysis showed Brent crude trading within a target band range of US$107-117 per barrel which it did until briefly falling below the bottom end early this month. Based on that, we thought it prudent to revisit the charts and update our view. Our technical analysis indicates a potential end to the early November falls. The close on 8 November 2013 confirms a bullish engulfing candlestick pattern and a bounce off US$103.00 key levels which has acted as a support for the pair in Q2 this year. A Fibonacci extension of the recent drop from (A)- (B) suggests a potential gain to US$112.00 where the 127.2% Fibonacci extension is aligned with resistance level on the 10th October 2013. Vito Henjoto published these views in more detail in one of our daily technical
- www.invast.com.au | 1800 468 278 analysis videos which is worthwhile revisiting again calling the bounce of the bottom perfectly. Watch the video here: https://www.youtube.com/watch?v=H2GVBrAyG-4 Image: Brent crude analysis 13 November 2013 via Invast Website
- www.invast.com.au | 1800 468 278 3.0 Is the carry-trade alive and kicking? One of the more popular currency trading strategies is the Carry Trade. So popular that traders with minimum understanding of carry trade will have taken part in it. In fact, currency traders that have ever held a buy position in USD/JPY overnight are carry traders. The primary objective behind a carry trade is to carry a return by borrowing from a low yielding currency and invest in high yielding currency or asset. For example, if a trader held a buy position on the AUD/JPY overnight. He/she would receive an overnight swap from holding that position, because Australias interest rate is higher than Japans. The secondary objective is to profit from movements in the forex market. Should AUD/JPY appreciate, carry traders stand to gain from the overnight swap and currency gains by holding AUD/JPY overnight. A depreciation on
- www.invast.com.au | 1800 468 278 on the other hand, will result in the trader losing more than the overnight swap he/she earns. So even though carry trade is simple, the knowledge and timing of the currency market is important in a successful carry trade strategy. The ideal condition for a successful carry trade is an appreciation in the invested currency. Therefore, carry trade is associated with global risk sentiment, expanding when risk appetite is high and unwinding when risk is off the table. Carry Trade History Majority of currency carry traders are from Japan and the strategy itself gained popularity during Japan's lost decade starting in 1991. Japans lost decade occurs when the asset-price bubble burst and the country saw little to no growth despite the near zero interest rate policy. Due to the low interest
- www.invast.com.au | 1800 468 278 rate, Japanese turns to overseas investment for a better return. Since the mid-1990s, Japan is the only major economy with a near zero interest rate. The Japanese Yen essentially acts as the gatekeeper to access the carry trade and soon the term currency carry trade is better known as "Yen Carry Trade". Early 2000s saw a boom in global markets, with the CBOE Volatility Index (VIX) at a low level. There is a sense of stability in the market, leading to an increase in risk appetite. This entices hedge funds, investors and traders alike to borrow Japanese Yen at a low interest rate and invest it in riskier assets. Assets such as higher yielding currencies like AUD, EURO, GBP, US subprime mortgages, commodities, global indices and even emerging market debts. Due to the way carry trade work, the borrowed currency usually depreciates against the higher yielding investment. To maximise this, majority of carry traders leveraged their trade to increase the potential gains, often neglecting that the risk associated increases as well.
- www.invast.com.au | 1800 468 278 By the end of 2006, investments through Yen carry trade alone was estimated to be around USD$1 Trillion. Carry trades works as long as Yen continues to depreciate, and the investment provides significant return, all while the interest rate in Japan remains near zero. While carry trades work wonders under the right condition, the risk associated with it through leverage are often not hedged. Traders and Investors alike were so bullish between 2003 - 2007 they pay little attention to changes and the slowdown in the US market which eventually turn into the subprime mortgage crisis. Carry Trade and the Global Financial Crisis Another key important aspect of the Carry Trade is time. Carry trades are designed for gradual changes in global economy, allowing carry traders time to decide and manage their trades and ideally scaling out of their trades. When the subprime mortgage went out of control and confidence in the market was waning, traders scurry out of their carry trades.
- www.invast.com.au | 1800 468 278 As mentioned previously, yen carry trades amounts to USD$1 trillion just before the subprime mortgage crisis. The unwinding that took place when market spirals down, only adds to the momentum. High yielding assets and currencies rapidly loses their value as traders pull out their investment and the Japanese Yen surges to an all-time high against these currencies and the US dollar in particular. Not to forget that most of these carry traders leverages their position resulting in massive losses from the carry trade unwinding and crippling most hedge funds and financial institutions. While not widely reported in the media, there is no denying that carry trade unwinding has a huge impact in the global economic collapse. Japan's lost decade becomes bi-decade as the surge in Japanese yen rolled back what the Japanese government has set out to do to take the nation out of deflation. To stimulate growth in the economy during the global financial crisis most central banks adopts an aggressive monetary policy such as lowering interest rates, introducing quantitative easing and other stimulus packages.
- www.invast.com.au | 1800 468 278 At the peak of the global financial crisis, major economies such as United States, Eurozone and the United Kingdom have adopted near zero interest rate policy. Leaving carry traders with risky investments with no significant return. Currency market becames volatile as the VIX went to all time highs, there is no other way except to unwind their carry trade positions as soon as possible. Is carry trade alive and kicking? If so what has changed? 5 years following the global financial crisis, carry trade is now back in discussion. As major economies recovers thanks to their respective quantitative easing and stimulus packages. Wall Street at all-time high and increasing risk appetite in the market reminds us of 2003. In fact VIX is exactly around the same level before carry trades lift off in 2003.
- www.invast.com.au | 1800 468 278 Figure 1, CBOE Volatility index, 2013 = 2003 right before the boom source: tradingview.com
- www.invast.com.au | 1800 468 278 So is this a right time to get in and ride the carry trade? A hard question to answer but in 2009 as global economy is cleaning up the mess, carry trades are already up running although in a much smaller scale. Australian dollar was one of better performing currencies during the global financial crisis, thanks to Australias relatively high interest rate. Australias high interest rate attracts investors from US, Europe, UK and Japan. Not to mention that New Zealand's interest rate also remains high. Australia and New Zealand with their higher interest rates attracts old and new carry traders, most of which has done so without realising it. Both the AUD/JPY and NZD/JPY are now considered the benchmark in gauging carry trade appetite. Statistics gathered from the trading volume of exchange traded FX in Japan provided courtesy of our Japanese headquarters reflect an increasing net long position while net short position remains constant. Proof that carry trades are indeed alive and kicking.
- www.invast.com.au | 1800 468 278 Figure 2 AUD/JPY Trading Volume in Japan 2009 - 2013. Source: Invast Research
- www.invast.com.au | 1800 468 278 Figure 3 NZD/JPY Trading Volume in Japan 2009 - 2013. Source: Invast Research
- www.invast.com.au | 1800 468 278 Figure 4 GBP/JPY Trading Volume in Japan 2009 - 2013. Source: Invast Research
- www.invast.com.au | 1800 468 278 Figure 5 CHF/JPY Trading Volume in Japan 2009 - 2013. Source: Invast Research
- www.invast.com.au | 1800 468 278 The only hiccup and sudden unwinding of the carry trades are noted during the Tohoku earthquake and tsunami. Repatriation of the Japanese yen occurs not only from Japanese carry traders but also the global humanitarian aids adding to the rapid appreciation of the Japanese yen in early 2011. Debt crisis in the Eurozone and the US also seems like a small bump in the carry trade progress. While carry trade is still actively conducted, traders are now smart enough not to unload everything in one go. Looking at the chart patterns in currency movement and the stock market, technical trading is a huge part of modern day carry trading. Following most rallies in the market, there is consolidation or correction in the market. Ranging from 38.2% to 61.8% Fibonacci retracements per consolidation. Suggesting the current carry trades are done in a much more cool headed way to prevent sudden and massive unwinding in the market, as traders exit out of their currency carry trades regularly.
- www.invast.com.au | 1800 468 278 In the past three years, we noticed more traders and investors abandoning their search for holy grail in the market, instead they pursue a method to reign in their emotion and better manage their trades. Majority of traders are now realising the importance of banking their profits or limiting their losses instead of hoping for the best in the market. This changes the whole landscape of currency trading and in particular the carry trade strategies. The game is now played seasonally in stages, allowing a rally to consolidate properly without stressing key resistances to its limit. So if patterns are to repeat, the current condition is similar yet not the same as it was in 2003. With major nations adopting near zero interest rate, there are more currencies available to borrow with a low interest rate. Reducing the risk of a major unwinding of a single currency like the Yen did a few years back. Previous carry trades are similar to investing, where traders hold on to longer term position. The carry trades occurring in the market post global financial crisis are quick and shorter in time. We call it a "mini carry trade", most of
- www.invast.com.au | 1800 468 278 which lasts no longer than 3 months before it corrects itself. The United States and Japan, two nations previously associated with Yen carry trade have a low leverage limit, following strict government regulation to protect traders and investors from losing more than they have.
- www.invast.com.au | 1800 468 278 4.0 Keep an eye on this small cap stock In our Invast Insights reported published on 16 September 2013, we wrote about a business called Vision Eye Institute (VEI) as a long term holding to benefit from increased demand for eye surgeries otherwise known as ophthalmic procedures. The more time we spend looking at mobile devices and electronic display screens, the worse our eyes will become over a longer period of time. We dont have the exact medical study to confirm this view but as noted above, it is something we have written about previously. VEI shares havent done much since then, but we made clear the fact that our view was fairly long term so we arent breaking a sweat just yet. One of the stocks we also mentioned in our very first report under the 15 hidden gems section was Ellex Medical Lasers (ELX). The business specialises in lasers to the ophthalmic care industry eye doctors like those operating Vision Eye Institute centres. We arent sure if Vision actually use the technology but on a recent visit to the optometrist, your author undertook
- www.invast.com.au | 1800 468 278 a very quick and non evasive eye retina scan on what he believed to be an Ellex machine, confirmed upon later due diligence when returning to the office. We dont completely understand the technology or the product features but we like what we see in Ellex a market leading product coming out of Australia and attracting global customers in a huge market opportunity. We must declare an interest here the author did buy a modest parcel of shares but we believe in backing our own recommendations and so this should not come as a surprise. Ellex is a business which is expected to generate around $50m in global sales this financial year with a total market capitalisation of around $30m as of the time of writing. They recently raised equity through an oversubscribed share issue worth just over $3m which we think will be enough to see them through their plans in the medium term. Profitability has disappointed but there are expectations for Ellex to return to the black this year as sales in key markets like the United States improve. The fall in the A$ also makes life much easier.
- www.invast.com.au | 1800 468 278 In terms of growth markets, Ellex has only recently started to penetrate into Asia and the US market for its existing products. It has plans to undertake new studies for new lines of equipment which could be game changers for not only the stock but also the whole industry. The snapshot below shows the geographical diversity in sources of revenue with very obvious hurdles in 2013 but signs of improvement. The most important part below is the turnaround in the second half of 2013 and last weeks report that the 2014 financial year has so far commenced with very strong volumes.
- www.invast.com.au | 1800 468 278 Tables: Ellex Investor presentation reported to ASX on 12 September 2013
- www.invast.com.au | 1800 468 278 Our bottom line is that we like Ellex and think the turnaround strategy is progressing to plan. The market will start to pay attention when earnings grow and we think this will become more evident early in the new year. We want to get in before that and think at around 30 cents per share and a market capitlisation of $30m, the risk reward ratio is more than attractive to justify a holding in a well diversified portfolio. Liquidity is thin with the top 20 shareholders holding around 45% of the stock and directors holding 24% - but this also creates opportunities when the market decides its time to buy the stock. We plan to speak to CEO Tom Spurling sometime in the next few weeks if we can get a hold of time hell no doubt be busy showing off his companys products at the 2013 Annual Meeting of the American Academy of Ophthalmology in New Orleans on 16-19 November.
- www.invast.com.au | 1800 468 278 6.0 Weekly economic calendar
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- www.invast.com.au | 1800 468 278 7.0 Disclaimer Please note that you are receiving this report complimentary from Invast Financial Services Pty Ltd (AFSL 438 283). Invast staff members may from time to time purchase securities which are included in this or future reports. The authors of this report may or may not be holding a position in the securities mentioned. Please note that the information contained in this report and Invast's website is of a general nature only, and does not take into account your personal circumstances, financial situation or needs. You are strongly recommended to seek professional advice before opening an account with us. General Disclaimer: This newsletter contains confidential information and is intended only for the person who downloaded it. You should not disseminate, distribute or copy this newsletter. Invast does not accept liability for any errors or omissions in the contents of this newsletter which arise as a result of downloading this newsletter. This newsletter is provided for informational purposes and should not be construed as a solicitation or offer to buy or sell any financial product. Invast Financial Services Pty Ltd is regulated by ASIC (AFSL 438 283 | ABN 48 162 400 035).
- www.invast.com.au | 1800 468 278 Risk Warning: It's important for you to read and consider the relevant Product Disclosure Statement, and any other relevant Invast Financial Services Pty Ltd documents before you decide whether or not to acquire any financial products listed in this email. Our Financial Services Guide contains details of our fees and charges. All these documents are available here on our website, or you can call us on +612 8036 7555. CFDs and Foreign Exchange are leveraged products and carry a high level of risk and you can lose more than your initial deposit so you should ensure CFD and Foreign Exchange trading meets your personal circumstances. General Advice Warning: Being general advice, this newsletter does not take account of your objectives, financial situation or needs. Before acting on this general advice you should therefore consider the appropriateness of the advice having regard to your situation. We recommend you obtain financial, legal and taxation advice before making any financial investment decision. *Distributed with the permission of Invast.com.au