Posted by: donmihaihai | September 2, 2007

The power of dividends.

I was thinking of writing “the power of dividends” or “The power of free cashflow” or even high ROE and company riding on waves before started. Actually all are interrelated and depend on how I write it to make it as the main point. End of the day, the main point is still finding stock with excellent future, management and free cashflow.

Jaya is an excellent dividend payer. At the current price of $1.93, the dividend yield is pretty high at 5.44%. Looking at dividend yield at the current price misses the main point. The dividend payment history makes a better story. FY2007 : $0.105. FY2006 : $0.083 (after tax). FY2005 : $0.065. FY2004 : $0.04. FY2003 : $0.03. FY2002 : $0.02. FY2001 : $0.01. Jaya increases the dividend payment yearly since 2001 at a CAGR of 48%. From FY2001 to FY2007, NPAT increase at a CAGR of 43.6%.

Increase profit lead to increase dividends payment.

Another company that makes the cut is Micro Mech. FY2007 : $0.05. FY2006 : $0.035. FY2005 : $0.024. FY2004 : $0.012. FY2003 : $0.008. That was a CAGR of 58%. From FY2003 to FY2007, NPAT increase at a CAGR of 30.16%. So even NPAT grow at a slower rate than dividend payment, a CAGR of 30.16% is very fast.

At the current price of $0.675, dividend yield is 7.4%. So with such a past record of dividend and NPAT growth, how can both are still trading at a yield of 5.44% and 7.4%? Or is it that Jaya and Micro Mech are paying more than what they are earnings?  

Let look at Jaya 1st, in FY2007, Jaya cashflow from operation was $125,214,000, free cashflow was $75,673,000, and dividend payment was $72,684,000. From FY2000 to FY2007, Jaya cashflow from operation was $434,473,000 and Free cashflow was $245,812,197 and dividend payment was $232,593,000. By looking back into history, we know that Jaya was paying within its means, using free cashflow for dividend payment and at the same time reducing debt from free cashflow and cash from proceed thru exercising of options. Debt to equity ratio dropped from 0.25 in 2000 to 0.005 in 2007.

What about Micro Mech? In FY2007, Micro Mech cashflow from operation was $11,819,275, free cash flow was $6,310,573 and dividend payout was $5,539,435. From FY2000 to FY2007, Micro Mech Cashflow from operation was $54,794,524, free cashflow was $25,936,759 and dividend payout was $14,726,292( From 2000 to 2002, as a private company, Micro Mech dividend was $72,722). Better still, Micro Mech is debt free from the 1st day of their public listing and at 30 Jun 07, cash stand at $13,635,776, of which $4,870,543 come from IPO proceeds.  

From the numbers, it can be easily notice that the increase in dividend payments for Micro Mech and Jaya are supported by free cashflow. In Jaya case, debts are being repay while supporting higher dividends and at the same time reinvest to produce increasing profit. In Micro Mech case, cash keep pile up as free cashflow increase.  

So one of the 1st things to look for stock that produce increasing dividend with increasing profit is to look for free cashflow. In layman term it is very logic because will one want to start a business where the only cash return is the salary draw? Or why will he want to expand the business if the return pre and post expansion thru dividend are the same or even worst? Talk to anyone who owns a business, they will tell you cashflow is important, it is the blood of their business but free cashflow is something harder and more important, the real stuffs why they are working so hard. It is also like salary to most of us, Cashflow is the monthly salary, after taking care of monthly expenses and saving for long term needs, the extra cash in bank is what free cashflow all about. The sad part is just like businesses, not many people can say they have enough cashflow for both expenses and future needs which results in free cashflow. Of course we as an individual can adjust our expenses and future needs to ‘produce’ free cashflow. Can management of company do the same thing? Why not, it is up to them even thought some businesses are harder to generate free cashflow. But as an investor, we are free to choose and ignore other that unable to generate that magical thing. 

For company like Jaya and Micro Mech to increase profit and dividend yearly, something must be working for them. I can bet that any company cannot sustain that kind of grow rate with increasing free cashflow if ROE is low. In FY2007, Jaya ROE was 32% while Micro Mech ROE was 22%. Jaya average ROE from 1997 to 2007 was 20% and Micro Mech average ROE from 2000 to 2007 was 27%(for average ROE, cashflow was used instead of NPAT).  

So this is another interesting set of figure. Before anything else, one must know that any company that generates high ROE is always better than those which generate low ROE. So is a ROE of 32% and 22% considers good? Of course but that is just a year, but to generate ROE of 20% and 27% on average of 8 to 11 yrs is outstanding. So the trick here is find companies that generate high ROE and sustain it for a very long period. What more impressive is that Jaya achieve it with moderate level or debts in the early years and keep repaying with extra cash along the way. Micro Mech is even more impressive as it was sitting with a growing pile of cash since 2002. If cash was taken away while calculating ROE, the figure will be in the 30s to 40s depending whether using NPAT or cashflow from operation. 

From those figure, we are looking backward so unless one bought Micro Mech during it IPO at $0.184(adjusted) or Jaya at around $0.17 to $0.20 during 2001(prior share price is unknown) to enjoy raising dividends and share price. If we are standing at 2003(for Micro Mech) and 2001 (For Jaya), the prior years number are not going to be as good as what we seem right now. Micro Mech was just recovered from the biggest slump in semiconductor industry(semi con was it main customer) and Jaya was in deep slump as well as crude oil lump to low teen which pull the whole offshore industry down as well.  This again show that buying when thing are unfavourable is very profitable.  

So when things are unfavourable and without a good past history how to determine whether they are the one that able to generate outstanding return going forward? Well, it always go back to cashflow which also the indication of how well the management is responding to bad time. There may not be free cashflow at that time, but if the management is able to generate cashflow constantly, allocating them well with a good Balance Sheet(strong balance sheet is another indicator of strong management as well), they become a potential candidate for outstanding return if purchase at a reasonable price. 

The last thing is of course what is the future like? Is the company riding on waves? Yes, waves. Taking Jaya as an example, offshore shipping and shipbuilding is not an industry that produces outstanding return in the long run and in the 1990s and 1980s, it is such a lousy industry to be in. So what happen? Demand > supply. The longer the down cycle, the higher the up cycle can be. And that is what happen to Jaya, riding the biggest up cycle in history(yes the biggest and perhaps going to be the longest as well), ROE jump from 7.4% in 2000 to 32% in 2007. Now the most important point is to remember a ROE of 32% without debts don’t last in this industry and a ROE of 7.4% with debts don’t stay down for years as well. The most profitable way is to ride the waves at the beginning or somewhere along the way when Mr Market offers an attractive price. At the current price and stages of the bloom, one need to remind themselves whether we are catching the tail end of the waves, how long can it goes. Some waves are short and very profitable before it end but it will be very painful if one does not get out before it ended, it will be like crashing into hard rock.  

Other like Micro Mech is riding on a long term upward waves, even thought there are slumps along the way, the trend is upward. But while they are facing the pressure of price erosion, they are in a position of building up their competitive advantage, which will help them in the long run.  

Lastly there is always a perception that for dividend lover/collector/investor, he would go for company that are stable, mature and with a high yield. And for a growth investor, dividend can be secondary as long as the company grows very fast. There is a problem for dividend investor as time is the enemy of money especially if there is little or no growth. For growth investor, if the growth does not increase free cashflow which is where dividend comes from, then what is the point of growing? Cashflow, growth and dividend is always interlink, residual of a business.

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