Cash Flows Don’t Lie (Or Do They?): Part II

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While cash flows have been used as a guide to indicate the health of a company, just looking at cash flows is not enough. Multi-Act experts conduct an analysis of 3 companies,in the auto parts retailing industry, a highly favoured segment amongst investors and analysts. You’ll see why investing in auto part retailers may not be wise under certain circumstances. As we analyze 3 companies in the following areas, discover fundamental traits that should make investors skeptical:

  • Profitability: Margin Cycle
  • Cash Flow Generation: Working Capital
  • Cash Flow Utilization: Capital Allocation

Operating cash flows and free cash flows can sometimes include non-operating cash flows despite being compliant with accounting rules. This is due to the inclusion of pseudo-borrowing dubbed as working capital changes. The first part in our series “Cash Flows Don’t Lie (Or Do They?)” discussed how cash flows may not be purely organic, but rather driven by accounts receivable sale.

Among specialty retailers, the auto parts segment is one that is still growing (same-store-sales) and meeting the investor’s quest for continuous Q-O-Q or Y-O-Y numbers. There has been a growing number of stores as well as square footage by near 4-5% p.a. for nearly a decade. And thus, is a favorite among analysts and investors.

We will see some of the main fundamental traits of these companies that which should trigger skepticism despite continued analyst upgrades or price momentum – Profitability cycle, Cash flow generation and Capital allocation (mainly use of those cash flows).

1. Profitability: Margin cycle

Miles driven cycle pick up has also driven profit margins towards historically high levels. Age of vehicles is somewhat of a debatable indicator because of better engineering over time. The same would apply to LIFO inventory-based liquidations helping profit margins to some extent.

Company 1

company-1Source: Factset

This company shows the most rapid growth in margins as well as in gross profit margin level. In their financial filings they mention that lower costing due to supplier negotiations coupled with LIFO accounting has been helping, among other things.

Company 2

company-2Source: Factset

Company 3

company-3Source: Factset

Here Company 3 is however an odd man out facing sputtering growth since 2015 but offers more stable margins, which remain depressed. The possible reasons being non-autopart segments. However in 2016 the autopart segment organically de-grew here.

2. Cash Flow Generation: Working Capital

Auto part retailers are considered as strong cash flow generators. But the question is how? Are these organic and pure economic cash flows or do they have any mixture of easy credit?

The biggies are busy aggressively financing the working capital with suppliers. Relative concentration against vendors has helped retailers to lean the terms in their favor quite rapidly with vendor based financing.

financial-reportsSource: Company Financial reports, Numbers in USD mn, Fiscal year end Dec

financial-reports-company-2Source: Company Financial reports, Numbers in USD mn, Fiscal year end Aug

financial-reports-company-3Source: Company Financial reports, Numbers in USD mn, Fiscal year end Dec

While the receivables and other short term accrued payables form a minor amount of the working cap (except to some extent for Company 3 which is also in industrial parts distribution), these relaxed terms by the vendors financing inventories certainly have helped to improve the Cash Flows and repurchase own shares at increasingly higher prices.

3. Capital Allocation: Cash Flow Utilization

As to capital allocation involving distribution, Company 3 is taking a different position again with most of its distribution in the form of Dividends than through share buy backs. It  also has a conservative balance sheet. But Companies 1 &2 have gobbled up 30%-35% of their own shares in the last five years.

Summary

Such squeezing of vendors as a trend may subject vendors to varied risks such as higher debt loads, consolidation among vendor parties & off shoring.

We think this credit based cash flows improvement may not be that sturdy and thus investors should value these cash flows with conservatism. The same goes with EPS and EPS growth. Heavy dose of aggressive share repurchases (not only well over free cash flow, but also operating cash flows- which themselves are buttressed by vendor funding) at historical high valuation of shares tends to form a dangerous loop. EPS growth funded through such repurchases justifies high value multiples. Share repurchases are touted as effective capital allocation, being wealth generation for shareholders (Total return) and return of wealth to shareholders. However, such rapid EPS growth as extrapolated by analysts may not be sustainable. This steroid generated energy may not last in the long run.


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