I love money. And early on when I was learning the ropes in value investing, I was taught to extend that love to companies who in turn generate a lot of money. Not necessarily by way of profits but in cash flow terms.
That’s when having a high CFO (Cash Flow from Operations) means more than a reference to a drunken Chief Financial Officer.
Over the last few couple of weeks, a few (82 to be precise) companies had shown up in my filter. 3 of these companies are the subject matter of this article.
One is Tata Communications (it showed up on my filter because it has had a negative 54% return on price in the last 12 months).
As mentioned earlier, in order to value a company, I look at its cash flows quite carefully. I have reproduced a simplified version of this company’s cash flow below:
Of the lot of numbers that are appearing in the table, I would like to bring the reader’s attention to the ones which are highlighted in yellow. Firstly, the company has shown a rising CFO – which is good news.
But as you would notice, the same is the trend on the capital expenditure, which has tripled from around Rs 1063cr (~USD 220m) in 2006 to Rs 3222cr (~650m) in 2009. At the same time, their profitability has come DOWN.
This in turn means that while the company can call this capital expenditure (capex) anything it wants, we should consider this capex as a necessary drain on the company’s financial resources and hence should take a substantial portion out of its cash flow from operations to arrive at the Free CFO.
As also apparent, having such negative cash flows have caused the company’s borrowings to go up, and consequently the interest cost.
Obviously, the hallmark of a competitive industry where one has to continue to invest to stay at the same level vis-à-vis the rest of the players.
Unfortunately, the stock market is littered with companies with similar problems and I find it is best to ignore them.
The other company that came up on my screen is a company called Smarlink Network Systems. This is a small market cap company (Rs 137cr), priced at around Rs 45 currently. There is no debt on books, and it has a low PE (~7X) and PB of (<1).
This company demerged from a company called D-link for which it now does the marketing of networking and communications equipment.
Due to the demerger, the past few years CFO is not relevant but if this year is any indication, then a free CFO of around 24-25cr should be reasonable (that works out to <6X of the market cap).
What’s more, there were liquid assets (Mutual Funds etc) on books, though since there has been a scheme of arrangement, I can’t be certain that these will continue to be on the books of the company. However since I can see some ‘other income’ in its quarterly results it is reasonable to assume that there are some other liquid assets. And to top it, there's been some insider buying in Feb and March.
All good signs in my view.
Yet another small cap company that came up on my horizon is Manugraph India. It has a market cap of Rs 155cr and a PB of 0.63. Below is how it’s price has moved in the last 3 years. From around Rs 200 in the ga-ga days of 2006/ 2007, (even till mid 2008, the price was Rs 100), the price is now at around Rs 51. I love researching such companies!!
Looking at this company’s cash flow (below), one can see why the company has been treated shabbily by the market. Its 2009 CFO was around half of its peak in 2006, as the economic slowdown hit its printing machinery business.
But what if the cash flows were to come back to earlier levels? How reasonable an assumption is that? Even if these come back to the AVERAGE levels of the last 6 years (Rs 56cr less say Rs 10cr as maintenance capex on a conservative basis), that would work out to < 5X the EV.
In order to find something more about the company, I requested a friend to call them at their India office but the company refused to provide any information about their operational prospects.
But I have learnt to live around shortcomings of this nature (heuristic thinking!). Please see the tenor of their announcements at the stock exchange since 2009:
Jan 6th, 09
Manugraph India Ltd. has informed the Exchange that the prevailing worldwide recessionary and sluggish market conditions have adversely impacted the orders of the Company. Some customers have either cancelled or postponed or requested for keeping in abeyance, the confirmed orders, which in turn has resulted in piling up of the inventory beyond reasonably high level, and thereby increasing the cost carrying inventory. This situation constrained the management to implement cost cutting measures meticulously, one of such being operation of plants for five days a week instead of six days at both the units at Kolhapur. The management is, however, hopeful that the situation will improve in the near future. The management will take periodic review of the situation and keep the exchange apprised of the important development.
June 3rd, 09
Manugraph India Ltd. had informed the Exchange that operations of plants of the company at Kolhapur have been reduced from 6 days a week to 5 days due to sluggish market conditions. The Company has now informed the Exchange that the Company does not foresee any improvement in business conditions. Also exports have slowed down significantly. Considering this local and global scenario, the company has been constrained to suspend the production at Unit No.II at Kolhapur and also has reduced its operations at Unit No.I substantially in consonance with the orders in hand and to reduce the piling of inventory. Until such time the situation does not improve, the Company will take cost cutting measures which are necessary to improve its working and reduce the financial burden.
Jan 12th, 10
Manugraph India Ltd. has informed the Exchange that: "With the improving economic scenario and order book position, both the manufacturing units at Kolhapur are currently operating at normal capacities".
Clearly, one can sense the change in underlying tone in the most recent announcement. I also like the fact that the company is making an effort to keep its shareholders abreast of the latest developments, good or bad and has taken sensible steps in cutting costs when necessary.
Hence even though I don’t have precise information, looking at the cash flows in relation to the market cap, the low current market price, which is around 10% off its lowest in the past 3 years (even when the economy was down), combined with the improving economic fundamentals, I am reasonably confident that there is limited downside but a good probability of a good return.
For me, both of the latter 2 companies are buys – examples of when the market is not recognizing a company’s cash flow generation capacity.
I have backed myself and these companies and have invested in them. Time now to wait. To see the money.
