where to from here, page-35

MM,

With respect, I think your assessment reflects a failure to understand the capital cycle of the enterprise.

In isolation, a dividend payout ratio means nothing whatsoever when it comes to assessing the capital adequacy of the organisation (or, as you euphemistically put it, “saving for a rainy day”).

So let’s undertake a bit of a tutorial:

When it comes to assessing capital adequacy we need to go to that bit of the Annual Report that focuses on capital flows.

It’s my favourite financial statement: THE STATEMENT OF CASH FLOWS

The Enterprise, as you know, has cash coming in the door every year, from the sale of its products and services.

It then has to pay the for the provision of services it receives (employees, suppliers, contractors, consultants etc), and for the procurement of for the products it uses (raw materials, stock-in-trade etc).

The difference between these two sets of payments is called: NET RECEIVABLES

Now from Net Receivables a few very important people have to be paid: the lenders to the Enterprise (the banks) and the Tax Office.

Once Interest and Tax been paid, what is left is OPERATING CASH FLOW (OCF)

This is where is gets interesting because it is at this stage (aside from active working capital management that has a bearing on NET RECEIVABLES, but we’ll ignore that for the sake of simplicity’s sake) that the Enterprise’s management gets its paws on the capital and can start to allocate it as it sees fit.

To that end, other than do nothing, management can deploy the capital either by:

1) Investing in the operations of the Enterprise,
2) Investing in other enterprises, or
3) Servicing capital providers.

Items 1) and 2) fall under the part of the Cash Flow Statement headed “CASH FLOWS FROM INVESTING ACTIVITIES” (intuitively!) and items 3) falls under the section headed “CASH FLOWS FORM FINANCIING ACTIVITIES [because it is here that the providers of capital (i.e., the providers of both debt capital – the banks, and equity capital – the owners of the business) get their share of the capital flows]

That might sound simple, but it’s somewhat nuanced.

For instance, Investing in the Operations of the Enterprise has two sub-components:

a) Investing to remain productive and competitive (also known as “Stay-in-Business” or “Maintenance” capex), and

b) Investing to grow the business organically (“Growth” or “Expansion” capex)


And Servicing the providers of capital can take several forms. It can involve:

a) Paying the banks back any borrowings (note: this involves the Capital component of borrowings. Recall that the Interest component is captured in the OPERATING CASH FLOW SECTION)

b) Paying dividends to shareholders
c) Returning capital to shareholders by other mechanisms, e.g., Share Buybacks


So the managers of the capital of the Enterprise have discretion to essentially spend the Operating Cash Flow on six broad activity elements:

1. Stay-in-Business Capex (although in reality this can only be flexed down over very short periods of time; is somewhat non-discretionary over the medium- and longer-term, as neglecting it will cause the Enterprise to become unproductive and uncompetitive)
2. Growth/Expansion Capex
3. Acquisitions
4. Debt Reduction
5. Dividends
6. Share Buybacks


The trouble with your fallacious assertion is that it only considers one of these in isolation, viz. Number 5: Dividends


So for completeness I’ll analyse all aspects of the capital flows of WES for you, to alleviate the misapprehension under which you are labouring.

Taking your chosen 10-year time horizon, and following the capital cycle template I described above; in the 10 years between 2003 and 2012:

WES generated a total of $19.3bn of OCF

Of this, $11.3bn was spent on TOTAL CAPEX.

Now we need to pause here for a minute because the CASH FLOW STATEMENT reflects only TOTAL CAPEX. We need to figure out how much of it was STAY-IN-BUSINESS/MAINTENANCE CAPEX and how much of it was EXPANSION/GROWTH CAPEX.

There are two ways to do this. We can ask the company directly because we know their management accountants do account for cash flows in this manner.

I do indeed ask the company for this figure every and they have told me that for FY12 STAY-IN-BUSINESS CAPEX came to $800m, for FY11 it was $770m, for FY10 it was $720m, and for FY09 it was $680m.

As a sanity check, I have compared these figures with Total Group Sales in each of those years, and the ratio is remarkably consistent, varying between 1.35% of Sales and 1.39% of Sales, so they make sense from a consistency point of view.

Then as yet a further check, I have compared these to the depreciation expense in each of those years because, according to the laws of finance theory, if your depreciation policies are sound, then that correlates very well with the level of Stay-in-Business Capital that is needed to “maintain” the depreciating asset base.

Again, the results are remarkably consistent, with depreciation varying against assessed Stay-in-Business Capex over time by no more than 2%.

So, I am quite happy and satisfied that for WES, Stay-in-Business can be approximated over time by the depreciation expense.

That means the STAY-IN-BUSINESS/MAINTENANCE CAPEX for WES over the past 10 years has come to $4.0bn


Now it gets to the really interesting part for me: DISCRETIONARY FREE CASH FLOW

Deducting cumulative STAY-IN-BUSINESS/MAINTENANCE CAPEX of $4.0bn from cumulative OPERATING CASH FLOW of $19.3bn, leaves us with cumulative FREE CASH FLOW of $15.3bn.

Of that, $9.3bn was paid to shareholders as DIVIDENDS.

Leaving $6.0bn available to either paid down borrowings or to grow the company by expansion capex or by acquisition.
Or to – using the euphemism - that’s $6.0bn “Saved for a Rainy Day”.

$6bn out of Total Operating Cash Flow of $19bn...nearly a third...is Surplus.

At the risk of sounding churlish, that'll buy a lot of umbrellas!

But let’s not stop there.

Let’s do the exercise comprehensively and look at what’s happening to the rest of the Capital Flows


It can be seen that cumulative GROWTH/EXPANSION CAPEX has totalled a whopping $7bn (TOTAL CAPEX of $11.3bn less STAY-IN-BUSINESS CAPEX of $4.4bn) and NET ACQUISITIONS totalled $4.1bn.

In other words, $11bn was spent on growing the company over the past 10 years, either organically or through acquisition.


So, let's recap: they had $6.0bn of SURPLUS CAPIAL, and then spent $11.1bn on growth, meaning they had a deficit of $5.1bn which needed to be financed by external sources (notably via borrowings and a capital raising).


Well, what does this mean for the financial health of the company?

Is the balance sheet deteriorating under this “heavy-handed” deployment of capital?

Are there any early warning signs of solvency stress?


To answer this, let’s look at the sorts of solvency metrics for WES that capital market practitioners – both debt and equity – scrutinise when assessing trends in the financial health of an organisation, namely EBITDA-to-Net Interest, and Net Interest Bearing Debt-to-EBITDA. (Note: I have included metrics for the period of time only post- the acquisition of Coles because that is obviously the period of interest to current investors.)

As can been seen in the following list, the balance sheet is not only in fine fettle, but the solvency metrics are actually IMPROVING, despite the aggressive capital investment programmes in recent years.

EBITDA-to-Net Interest:
FY08: 3.9x
FY09: 5.2x
FY10: 7.0x
FY11: 9.0x
FY12: 10.7x

NIBD-to-EBITDA:
FY08: 3.24x
FY09: 1.11x
FY10: 1.07x
FY11: 1.05x
FY12: 0.99x

[Note that some analysts (wrongly) I believe include in the cash calculation the $1.7bn near-cash in the form of current investments that back insurance contracts. This reflects premium income paid for by policyholders and while it is technically “earned” by WES, I still exclude it as a matter of conservativeness.]

But for illustrative purposes, if it was included, the rate improvement in the balance sheet would be even more pronounced:

NIBD-to-EBITDA (including premium income cash):
FY08: 2.92x
FY09: 0.89x
FY10: 0.76x
FY11: 0.64x
FY12: 0.61x


So, at stark odds with your bizarre theory that “A-Full-Dividend-Payout-Ratio-Means-An-Inabilty-to-Generate-Surplus-Capital” in which you failed to incorporate the full suite of WES’s capital flows, WES is not only not distributing a high proportion of its accounting profits to shareholders, but it is doing so while at the same time investing aggressively to grow the business.

And yet – and this is the most crucial observation to make – the balance sheet solvency metrics are still IMPROVING.

In other words, WES’s problem is not that they don’t have enough capital because they have a relatively high payout ratio, which is what you were implying; but they in fact generate EXCESS capital DESPITE the payout ratio.

So, contrary to your somewhat glib assertion that WES are NOT Saving for a Rainy Day, now that you have been able to study the cold, hard capital capital flows first hand, I am sure you will have a better appreciation of the financial pedigree of the company being a lot more than the single metric of the dividend payout ratio...that’s just one piece in a large jigsaw puzzle of capital flows into – and out of – the organisation.


FINAL SUMMARY AND CONCLUSION:

WES’ PROBLEM – AND ITS A QUALITY PROBLEM TO HAVE – IS THAT THEY ARE, IN FACT, SAVING TOO MUCH FOR A RAINY DAY.

MENNELL – “Not enough capital BECAUSE of high payout ratio”
CAMDEN – “Excess capital DESPITE the high payout ratio”


Don’t feel bad; this type of mistake the sort that many investors routinely make – both institutional and individual, simply because they spend too much time looking at the PROFIT AND LOSS STATEMENT in isolation, without comprehending the full suite of financial statements in totality.

My wish is that more individual investors look at cash flows, and not accounting profits, when assessing companies for investment.

For you can torture a PROFIT AND LOSS STATEMENT and a BALANCE SHEET and they will confess to whatever crime you want them to, but a CASH FLOW STATEMENT cannot tell a lie.
(In case you couldn’t tell, this is a favourite soapbox topic of mine!)


Good luck with your short position(s)...I’m sure that at some stage the share price chart will have a few squiggles that you can be smart enough to jag up or down as the case may be.

Me: I’m too slow and Neanderthal-like to be able to pick those points...I am resigned to being a boring old, long-only dinosaur.


Camden, the Cranky Cash Flow Creep