Zedi Part 6 – Cash Flow and Working CapitalOctober 9th, 2013 | Posted by in ZED
One conceivable criticism of Zedi is that there hasn’t been much in the way of cash generation in recent years. To wit:
Profit, as measured by EBITDA, has grown at a pleasing rate.
Free cash flow, as measured by cash flow from operations less investments in PP&E and intangibles, has failed to keep up. The important question is, why?
There are a number of reconciling items that stand between EBITDA and FCF. The most important ones, generally, are:
1) Capital expenditures
2) Cash interest expense
3) Cash tax expense
4) Change in working capital
As you can see below, #1 and #4 are clearly the culprits for Zedi’s recent free cash flow shortfalls:
I will start the discussion with total capital expenditures, which I derive by combining “purchases and property, and equipment”, “additions to internally-generated intangible assets”, and “purchases of intangible assets”. The first item in that list represents traditional plant capex, while the latter two represent investments in IT.
As you can see from the table above, prior to 2010 total capital expenditures were running at approximately $4 million annually. In 2011 and 2012 expenditures increased significantly. Why? The company built two headquarters locations: one in Calgary, where the company’s corporate offices are located, and one in Victoria, Texas, which is ground zero for the company’s expansion into the United States. Looking at the most recent annual report, the “Property and Equipment” section (Note 7) shows that over the past two years the company has made about $3 million worth of investments in these headquarters.
Headquarters investments are not recurring in nature, and Zedi won’t need to make similar investments any time soon. Based on this analysis as well as discussions with officers of the company, I think it is fair to expect going forward that capital expenditures should run below 2011 and 2012 levels, and likely below $5 million annually.
Excluding these expenditures, here is how the annual free cash flow would look:
This real estate FCF adjustment is noticeable (+$0.02 per share in 2011 and +$0.01 in 2012), but working capital is still the much bigger issue. Working capital swelled by $17 million total during 2011 and 2012, and continued to grow in the first quarter of 2013 before finally falling in the recently-reported Q2 2013. What is going on?
The table below shows the important working capital items and how they’ve changed relative to sales.
Accounts receivable has basically grown in line with sales (helped by a material decline in the most recent quarter). When netted against accounts payable, the net accounts figure has actually grown much less (41%) than has revenue (70%). I view the AR increase as the cost of doing business. For Zedi the cost is a bit inflated because DSOs are high-ish at ~90 days, but 90 days is the industry standard. I can live with that.
Inventory, on the other hand, has been more problematic. In the period depicted, inventories have grown ay 3x the rate of sales. The cash drain has been material: $14 million, or almost 1x EBITDA.
Silverjack shoulders most of the blame. The simplest reason Silverjack has been causing inventory growth is because the Silverjack pump is a capital good. As sales of Silverjack have grown from essentially zero a few years ago to ~$15 million in 2013, Zedi has had no choice but to grow its inventory of Silverjack proportionally.
But, I think the inventory increase has been further exacerbated by A) the nature of Silverjack orders, and B) the high rate of growth in Silverjack. Because the Silverjack pump needs to be installed on a well immediately after the well drilling is completed, Zedi needs to be able to fulfill Silverjack orders on a same-day or next-day basis. This requires more inventory than products with slower turnaround times.
As for the growth rate of Silverjack orders, growth has been so prolific that Zedi hasn’t had the time to optimize its Silverjack production schedules, warehousing schemes, and shipping processes. I’m guessing the Silverjack employees have had their hands full just simply meeting orders. The addition of a new dual-pump product line in Q2 didn’t help either.
This isn’t the worst problem to have though. Eventually the Silverjack growth rate will slow to more sane levels, at which point employees can focus on weeding out excess inventory and optimizing the entire chain. When I spoke to Zedi’s CFO, he told me that Silverjack employees are now under an “operational directive” to reduce inventory by year-end. I think it safe to assume that inventory will be flat, or decline, by the year-end.
Now I want to show an adjusted history of FCF/share that excludes working capital changes as well. Increases in working capital are absolutely a cost of growth and should be treated as such. But looking at what kind of cash flow a company generates before accounting for changes in working capital is instructive, because it indicates how much cash a company would generate in a steady-state, no/low-growth scenario. Here are the numbers for Zedi:
$0.07 to $0.08 per share of steady-state free cash flow in each of the last three years; not bad for a ~$0.70 stock. Also note the 1H’13 FCF per share figure of $0.04. For Zedi, the second half is almost always stronger than the first, so it is probably fair to estimate that the company is on pace for $0.09 or so FCF/share in 2013.
Let’s test that hypothesis…
I’ve discussed a normalized capital expenditure of below $5 million. I also think that the inflation of working capital is essentially done, and that working should grow in line with sales going forward. That means that if Zedi grows ~10% in the coming twelve months, the current $25 million working capital base will use up an additional $2.5 million of cash as it expands to meet sales.
As for interest expense, it is small and falling. It was $165k in the most recent quarter, and it should continue to decline in the absence of new debt for acquisitions. As for cash taxes, they have historically been minimal due to research credits, depreciation-based NOLs, and Canada’s low corporate tax rate. The NOLs should be exhausted in the next quarter or two, so I’ve modeled a 25% cash tax rate going forward. 25% is a bit higher than what I think the company will ultimately pay, but a little conservatism here is fine.
Based on all these estimates, here is what I expect for cash EPS and FCF, assuming a normalized working capital increase:
$0.09 of free cash flow per share, as predicted. Or $0.06 per share of cash flow after accounting for the increase in working capital that would be needed to support ~10% revenue growth.
You can look at these figures in one of two ways: either Zedi is a dependable but no/low-growth company with a 13% free cash flow yield ($0.09 of FCF divided into the $0.71 share price), or it is a dependable 10% grower with a 10% free cash flow yield ($0.07 into $0.71).
If you account for the ~$0.05 of free cash flow the company is likely to produce in the second half of 2013, the FCF yields are even higher because the FCF yield equation’s denominator becomes the stock price minus that $0.05 per share of retained cash.
The multiple you want to pay for Zedi is up to you. Different readers will have different opinions on the appropriate figure. I am comfortable arguing that even in the no-growth scenario (an unlikely outcome in my view), the $0.09 of steady-state cash flow Zedi is generating at the trough of a historical industry collapse is work 10-12x (an 8-10% yield), implying an intrinsic value of $0.90 to $1.10.
Looking at Zedi as a growth company, perhaps an investor would pay 15-20x for the $0.07 FCF/share figure that includes growth expenses. This would imply a slightly higher range of intrinsic value, approximately $1.00 to $1.35.
I am going to discuss valuation in more detail in a future post that looks at what some of the business segments might be worth individually. (I’ll spoil the conclusion now by saying now that the sum-of-the-parts value is supportive of the FCF-based valuation I’ve proposed here.) I will also look at what Zedi might be worth if the Canadian natural gas industry ever climbs out of the Grand Canyon-sized hole it is currently sitting at the bottom of. We must keep reminding ourselves that industry conditions could—and likely will—get better at some point in the next few years.
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