Value Investing

Most investors prefer (and are happy) to see their company they invest paying them high dividend without realizing that sometimes high dividend paid does not do any good to the company. Dividend can be paid from the after-tax profit and in certain circumstances from the retained earnings accumulated through years of operations. It means the company can pay dividends to its shareholders even if it loses money in that particular year, provided that it has adequate retained earnings meeting the minimum requirement set forth by the regulator. The level of dividend paid out could have impact on the future expansion too, where fresh capital is required.

To pay or not to pay?

Dividend, alone, does not tell us whether or not the company is doing well, i.e. profitable and generating cash. As you can see, the company can dig into the retained earnings to pay its shareholders dividend. Investors should look into other more meaningful indicators, such as Cash Flow Return On Invested Capital (CFROIC). CFROIC is talking in length in Joe Ponzio’s web blog at www.fwallstreets.com and won’t be discussed in details here. In brief, the ratio determines how good the company generates free cash flow from the capital invested. Outstanding companies not only are able to generate high free cash flow compared with invested capital but also re-invest its excess cash for a high return. It’s irrational, in my point of view, for this type of company to pay dividend to its shareholders who are unlikely to churn out the money given for a high return.

Case Study: Thai Rayon

Once a year after Thai Rayon (TR) announces the dividend, minor shareholders always grumble on the low dividend paid-out. For year 2007, it pays the shareholders 1.60 Baht from an EPS of 12.35 Baht. Although this year dividend is substantially increased from last year level at 1.10 Baht, the paid-out ratio is considered minuscule compared to its huge earnings. To determine if it is rational for the company to retain most of its earnings, one needs to look into its future expansion plan as well as the efficiency in churning out profit from its capital employed (CFROIC).

TR announced in August to replace its production line 1 with new production capacity of 100 TPD. The capital expenditure for this expansion is set at 450 MB and will be spent from Oct 2007 to Jun 2008. At the beginning of the year, TR starts building production line 5 with estimated budget of 865 MB. This line will be completed in Mar 2008. TR also sets aside additional 656 MB to build new carbondisulfide plant which is expected to complete in Mar 2008. This newly-built plant will decrease the company’s dependence on charcoal, one of its key raw materials. Apart from these, TR also increased its stake in two pulp and paper plants in Canada, in order to increase its captive of such essential raw material as pulp and paper grade for producing rayon.

Let’s scrutinize closely on the benefit from building production line 5. This line is capable of producing normal VSF at 85 TPD. With realization price at 80,000 Baht per MT, annual revenue is 2,482 MB. Profit margin before interest and tax is estimated to be 30%, therefore, operating profit before interest and tax is 744 MB. With less than 2 years, the production line 5 is breakeven. The margin is affordable to drop down to 17% and this production line still breakeven in 2 years.

Conclusion

So far, I have not seen such a lucrative business listed on the Stock Exchange of Thailand. And I can see why the company decides to re-invest its excessive cash instead of paying it out to shareholders. I believe this will benefit the shareholders most in the long range.

About the author
The author is the founder and fund manager of Diamond Fund established in May 2002. Value investing is the crux of his investment philosophy. As of November 30, 2007, the return of Diamond Fund for YTD (not annualized), 1-year, 3-year and since inception is 49.58%, 47.10%, 119.06% and 307.84% respectively.

Disclaimer
The author has a stake in TR. His opinion given in this article might be prejudiced although he has tried his best to maintain the neutral position. The data presented in this article is carefully verified by the author to ensure that it is as accurate as possible. However, he can’t ensure that there will not be any mistake. To use the information in the article for one’s own investing, the liability shall not be born to the author.