Nowadays, more than ever, the management work performed by company directors is under the microscope of current and potential shareholders. All of us, as potential co-owners, are looking for companies that generate surplus funds from their operations. Subsequently, our gaze turns to how the directors use their available capital.
When analyzing a business, it is essential to consider how excess capital generated by a company is used by the management team.
Always ask yourself this question; is the capital being used in the best interest of the shareholder? If your answer is no, move on.
Now, below is a classic example of a company that generates excess funds. Let's look at and analyze the work of the company's managers Winpak ltd.
Company Profile :
Winpak Ltd manufactures and distributes high quality packaging materials and related packaging machinery. The Company's products are primarily used for the protection of perishable foods, beverages and in healthcare applications.
Financial analysis grid of the company Winpak ltd:
End of financial year: December 31
| Growth | 2010 | 2011 | 2012 | 2013 | TCA | 2014 9 months |
| Turnover (M$) | 579 | 652 | 670 | 715 | +7.3% | +10.2% |
| Earnings per share (M$) | 0.81 | 0.98 | 1.11 | 1.10 | +10.7% | +9.0% |
| Stock market price ($) | 11.79 | 12.00 | 14.75 | 22.90 | +24.8% | 27.50 |
| The assessment | 2010 | 2011 | 2012 | 2013 | AVG | 2014 |
| Price/earnings ratio | 14.6 | 12.2 | 13.3 | 20.8 | 15.2 | 23.5 |
| Profitability | 2010 | 2011 | 2012 | 2013 | AVG | 2014 |
| Net profit margin (%) | 9.1 | 9.8 | 10.8 | 10.0 | 9.9 | 9.6 |
| Return on equity (%) | 13.1 | 14.7 | 15.4 | 13.3 | 14.1 | 13.7 |
| Cash flow management | 2010 | 2011 | 2012 | 2013 | TOTAL | 2014 |
| Free surplus funds (M$) | 37.0 | 46.5 | 15.5 | 36.5 | 135.5 | 34.0 |
| Business Acquisition (M$) | 0 | 0 | 0 | 0 | 0 | 0 |
| Payment of a dividend (M$) | -7.8 | -7.8 | -7.8 | -7.8 | -31.2 | -63.9 |
| Share buyback/issue (M$) | 0 | 0 | 0 | 0 | 0 | 0 |
| Cash deposit/withdrawal (M$) | -29.3 | -36.4 | -6.4 | -27.8 | -99.9 | +30.7 |
| Payment / addition to debt (M$) | -7.5 | 0 | 0 | 0 | -7.5 | 0 |
| The financial situation of the company | 2010 | 2011 | 2012 | 2013 | 2014 | |
| Cash (M$) | 90.5 | 126.9 | 133.3 | 161.1 | 130.4 | |
| Long-term debt (M$) | 0 | 0 | 0 | 0 | 0 | |
| DLT/Equity Ratio | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | |
| Relative liquidity ratio | 3.21 | 3.21 | 3.40 | 3.95 | 3.07 |
Reading the table above, we see that Winpak ltd. has been generating free surplus funds consistently since 2010. Over the period, this is a sum of 135.5 Million$ which was generated.
Once this is established, we must turn our attention to the return on shareholders' equity, that is, to the ratio between the company's net profit and its shareholders' equity. Personally, I look for companies whose return on equity is higher than 15%, see 20%.
In the case of Winpak ltd. we can see that the average return on shareholders' equity over the period 2010-2013 is 14.1%, which is below the minimum threshold I am looking for.
With a return on equity like this, managers cannot rationally keep all the profits inside the company. They must seek to use this amount of available capital wisely.
But in this case, what are their options?
First, we could look at whether the company is the type to grow through acquisition. Looking at the table, we quickly realize that it is not. No acquisitions by the company since 2010.
Next, we take a look at the company's balance sheet. As can be seen from the table, Winpak ltd. has no long-term debt on its balance sheet. So it doesn't have to use that money to reduce its long-term debt.
Let's continue by looking at the dividend side. The company has been paying out a sum of 7.8 Millions$ dividend every year. Why hasn't it increased its dividend despite creating excess free cash? Reading the company's latest annual reports, we can see that the company's management says it is looking for an acquisition target in its business sector. This is surely the reason for not increasing the dividend for 4 years. The company is piling up its cash in the hope of making a major acquisition in its business sector and being able to pay for it in whole or in large part in cash.
It is also important to take a look at the changes in the number of shares outstanding over the period. Did it increase or decrease? In this case, the answer is no. There were no share issuances or buybacks over the period.
Finally, we take a look at the company's cash flow. In the case of Winpak ltd., It has been increasing steadily since 2010, going from 90.5 Million$ in 2010 to 161.1 Million$ in 2013. So, it is very clear that the company is stacking its excess free cash in cash.
Now your job is to determine whether this use of free excess funds is the right one.
Here are, in my opinion, the four options available to managers of companies whose return on shareholders' equity is less than 15% when it comes to determining the use of free excess funds:
1-Ignore the fact that the company's return on equity is insufficient and continue to reinvest excess free capital into the company's operations.
Verdict: Still a very bad decision that goes against the enrichment of shareholders.
2-Buying growth through business acquisitions.
Verdict: Excellent if the acquisition is made at a good price and the synergies with the company are good. Bad if the acquisition is overpaid and the synergies with the company are non-existent.
3-Carry out a share buyback of the company to reduce the number of shares in circulation.
Verdict: Excellent if the share buyback is done at an average price that is below the intrinsic value of the stock. Bad if the share buyback is done at an average price that overvalues the stock.
4-Increase the regular dividend payment or pay an extraordinary dividend.
Verdict: Excellent if the transaction does not jeopardize the sustainability of regular dividend payments or the post/financial situation of the company following the transaction.
Now let's look at the decision that the leaders of Winpak ltd., on March 20, and analyze whether it was the right decision in the circumstances.
In fact, on March 20, 2014, the leaders of Winpak ltd. have decided to pay an extraordinary dividend of 1.00$ /share (65,000 000$) to their shareholders.
Was this the right decision in the circumstances?
Personally, I think so, and here are the reasons:
-The average return on shareholders' equity of 14.1% that it generated at that time was insufficient to justify retaining the profits in the company.
-The fact that no potential acquisition target at a good price and offering interesting synergies was emerging in the short term eliminated the immediate need for capital to proceed with an acquisition.
-The stock's high valuation of more than 20x earnings at the time of the decision eliminated the appeal of a share buyback.
So the remaining option, that of an increase in the regular dividend or even the payment of an extraordinary dividend, was the one to be recommended, in my opinion, in the circumstances prevailing at that precise moment.
This is exactly the decision that the leaders of Winpak ltd. on March 20th. In taking this decision, they demonstrated rationality, in addition to demonstrating their dedication to working with a view to enriching their shareholders.
Martin Raymond
From the blog investi-a-la-bourse.com
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Very interesting. Thanks Martin for this article!
I quite agree with your conclusions, even if I don't really like exceptional dividends.
I would have preferred the company to have steadily increased the dividend in recent years rather than to make a flash in the pan this year. This gives more visibility on the long-term strategic management intentions.
Hi Jerome,
Of course, a long-term commitment to continually increasing the regular dividend would have been an excellent decision, especially since Winpak generates ample free cash flow to fund such a project.
On the other hand, the extraordinary dividend still satisfies me, at least they showed rationality in returning the cash to shareholders so that they can invest it at a better yield elsewhere.
Let's say it was the 2nd best option.
Martin
Thank you Martin for this very interesting article.
The economic rationality of a management in place is never easy to analyze, but by looking more closely at the choices made in the allocation of capital, the clues are easier to find.
In the list of points we could also add the choice to repay a debt more quickly. This is not always the best choice, since the interests are deductible from the taxable income, but sometimes it is justified.
I personally had a revelation on this subject of capital allocation while reading "The Outsiders". It is masterful! What a job done by Malone, Buffett and others. Extraordinary.
This is now in my Top 5 reading and I highly recommend it to anyone interested in investing in businesses.
Thanks Etienne for the recommendation, I'll definitely take a look.
Martin