Monday, October 19, 2015

Excess Cash Flow is essential for successful dividend investments

As I keep learning more about investments, and expand my horizons through continuous reading about companies and by reading books about investing, I get to see recurring themes or certain aspects in a new light. Sometimes, I might read about an aspect about investing and brush it aside, although a small dot is kept within my brain waiting for the right moment to be connected to my overall investment strategy. My “eureka” moment of using tax-deferred accounts for income investing in retirement occurred in 2013. A few years ago, I had another “eureka” moment, which was related to using cash flow for analyzing investments. I started analyzing cash flow along with the income statement and balance sheets as I started reviewing pass through entities such as REITs and MLPs.

As many of you know, I am a big fan of Warren Buffett and his writings. One of the recurring themes in his annual letters to shareholders and interviews is that he look for companies that generate excess cash flow, without requiring much in terms of capital investment to grow or maintain the business. In other words, he looks at businesses from the aspect of a business owner, in order to determine how much cash he can safely extract from them, without jeopardizing the investment success of the enterprise. The maximum amount of cash that could be distributed from a business to its owners is referred to as owner’s earnings. This is roughly equal to cash flow from operations, minus cash flows for investment such as Capex. The fact that Buffett likes to extract cash from businesses he owns through Berkshire Hathaway is one of the reasons why I believe he is in fact a closet dividend investor.

There are generally two types of businesses that generate a lot of free cash flow. While I focus mostly on earnings, I do look at cash flow from operations, and then take out the expenditures needed for investing activities. That way I come out with the cash flow that is available to be distributed. This of course is a very high level view of the situation, and I do encourage everyone to review each situation one company at a time and delver into specifics.

The first type are those that manage to deploy a large portion of this cash back into the business at attractive rates of return for the enterprise. Those are very rare to find however, because rates of return on new projects are never guaranteed, and are also subject to the laws of diminishing returns. Very few companies can also expand operations by branching out into new industries, and maintaining the high rate of return on invested capital.

For example, if you have an enterprise with 1000 stores that each earn $1 million/year in profits. Let's assume that the invested capital is $10 billion, and that your total profits are going to be $1 billion/year. Your return on capital is 10%. However, if you deploy that whole $1 billion/year to build 100 additional stores each year, there is no guarantee that the new locations will generate the same profits as the old locations. In addition, there might be the incentive for managers to open more stores that could be generating marginal profitability merely to build their empire and earn bigger bonuses for themselves, despite the fact that this might be a poor capital allocation decision. For example, if each additional store ends up earning only $200,000/year due to competitive pressures and cannibalizing of sales from existing locations, then the return on invested capital would have been a terrible 2%/year.

If you think about it, building new stores takes time: to select locations, obtain permits, build the location, set-up the supply chain, hire qualified staff, and market the business. All of this is required in order to attract enough satisfied clientele to generate enough revenues so that sufficient profits on the invested capital could be earned.

The only company I know of, which has successfully reinvested all excess cash flows at high rates of return for decades has been Berkshire Hathaway (BRK.B). Another could be Markel (MKL). There could be others that are just starting out, but after a few years they start generating more cash than they know what to do with. While I could only point out to a handful of companies that have managed to reinvest all excess cash back at high rates of return, I could easily list a hundred dividend growth stocks that generate a lot of excess cash flow, pay excess cashflows to shareholders, and still grow. Those are the second types of companies.

The second types of businesses are those that only need a portion of their free cash flow in order to grow operations, while sending the remaining cash to shareholders. The best businesses are those that can grow without investing all of their free cash flow in order to grow operations. For example, a consulting company like Accenture (ACN) does not need a lot of infrastructure in order to satisfy clients’ needs and earn billable revenue. You can see that the business generated almost $4.1 billion in operating cash flow, and only spent approximately $400 million on capital expenditures. The other $775 million were for acquisitions of other businesses. This means that Accenture doesn't have high capital requirements, and can essentially print money for its shareholders, to the tune of $1.35 billion in dividends and $1.9 billion in share buybacks.

Other companies like Coca-Cola (KO) only invest their cash flow into projects that have a high certainty of generating high returns on invested capital. Otherwise, smart managements realize that mere accumulating of cash in the bank might lead to a bad culture of capital squandering through ill-conceived projects with bad business prospects. Therefore, this cash is better used by distributing to shareholders through dividends and share buybacks. Plus, Coca-Cola does not need to invest all of of its own cash to grow and reach consumers, because it can sell high-margin syrup to independent bottlers, who (the bottlers) are the ones to pay for the expensive bottling and distributions systems that tie up a lot of capital. Only in the event where a certain market is not living up to expectations does Coca-Cola decide to buy those bottlers outright.

A company I discovered in 2013 was Dr Pepper Snapple (DPS), when it was selling at an attractive valuation relative to PepsiCo (PEP) and Coca-Cola (KO). If you look at the statement of cash flows, you can see that the company is a cash machine. It generated $1.022 billion in operating cash flows in 2014, which was up from $866 million in the earlier year.  The business only needed $185 - $195 million/year in new capex/investments. The rest of the cash was spent on dividends - $317 million in 2014, and buybacks - $359 million in 2014.

Incidentally, for a high quality business such as Dr Pepper Snapple ( and Accenture), it usually makes no difference whether you are looking at net income or free cash flow when evaluating trends in the business and sustainability of the dividend.  I have found that I can get sufficient information in analyzing a business mostly by focusing on net income and earnings per share. I find net income to be more helpful in estimating true economic earnings power of a business. This is because net income includes adjustments that demonstrate the true earnings power by allocating income and expense items over to a specific period of time. This is helpful in evaluating the performance within a given period using net income ( and also performance between different periods). Using the cash flow statement, you may have too much noise in the data, because cash could be going in or out of the door for income/expenses that actually are for another year. For example, if my employer accrues bonuses for all active employees at the end of the year, but pays those bonuses in the second quarter of the next calendar year, they will have this expense reflected in net income, but not on the statement of cash flows at year-end. This will be reflected in the next year's statement of cash flows.

In another example directly reflecting Dr Pepper Snapple, the company might defer taxes in the amount of $43 million in 2014, but it still has that liability to pay sometime in the future despite saving the cash on hand today. In other words, the free cash flow will be higher than net income in 2014. However, once this estimated tax payment is indeed paid in the future, those items will be reconciled. This is a real expense that affects the bottom line - despite the fact that cash has not left the door to pay the government.

In addition, the company might have spent $48 million in Employee Stock Compensation Expense in 2014, which is added the operating cash flow since it is a non-cash expense. However, by providing stock to employees, the company is diluting existing owners and therefore this has an actual economic impact to the bottom line.

My favorite example is that in 2010, the company made 20 year licensing deals with PepsiCo and Coca-Cola that paid Dr Pepper Snapple $900 and $715 million dollars in cash respectively. As a result, Dr Pepper Snapple is recognizing $64.60 million in annual revenue over a period of a couple of decades. While the cash was paid in 2010, and was reflected in the cash flow statement, the company has to earn it over a period of 20 years.

In a more crude example, if a business decides to buy advertising for two years at once, the statement of cash flows will have an outflow in year one, and nothing in year two. The net income would correctly allocate the expense between the two years, and it would more accurately reflect the economic reality.

Of course, there is a third type of companies, which unfortunately have to reinvest all of their cash in order to survive. Advanced Micro Devices (AMD) is one such company which has not created much shareholder wealth for decades. Due to rapid technological obsolescence, it has had to reinvest all of its money to remain competitive against rival Intel. As a result, owners of AMD have never received any dividends ( nor have they received much in terms of capital gains, unless they had a great track record of timing their purchases and sales)

For most of the companies I own in my portfolio, they generate so much in free cash flow that they end up drowning shareholders with cash through dividends and share buybacks. In addition, they are characterized by strong competitive advantages, strong brand names, good pricing power and managements who keep an eye on rational capital deployment in the best interest of shareholders. In addition, most of these companies operate in industries with low risk of changes that will impact their status quo in the industry, and also have recurring revenue streams that ensure money coming in during all phases of the economic cycle.

Full Disclosure: Long KO, DPS, ACN, BRK.B.

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