Ann: Preliminary Final Report, page-39

@vic_wattle,

I have been out of circulation for a few weeks, so I'm sorry I am responding to you now.

The notion of Free Cash Flow and growth in Free Cash Flow is, I think, is a very important aspect of investing (well, to me it is, at any rate), so I thought I'd add my tuppence-ha'penny worth of opinion to the debate, albeit belatedly.

The best way to understand, and appreciate, Free Cash Flow investing is to adopt a business owner mindset, i.e., to say to yourself, "If I owned TME outright, what would I "see" as the Free Cash Flow coming out of my business?"

And the way to answer that would be that it would be the capital the business generates organically (i.e., Operating Cash Flow), less the capital that needs to be reinvested in order to keep the business going (i.e., Sustaining Capital Investment).

Now, the first bit is easy... the company gives us that figure (or, at a minimum, it gives us the information we need to calculate it).

Take the FY2018 year: Cash Flows From Operating Activities were recorded as $139.7m (But be careful: they were a bit naughty in stating $5.4m of interest payments under the Financing Activity category. This interest expense is clearly incurred as part of the normal operating activities of the business. So, I think Operating Cash Flow for the year is really $134m).

Determining the second part, namely Sustaining (or Stay-in-Business) Capital Investment is a little bit more difficult, because it is not explicitly stated in the accounts. Often, if you contacted the company's management, someone might provide you with an appropriate figure to use.

Alternatively, if Purchase of Property, Plant and Equipment is at a relatively consistent level over time, you could simply make an approximation based on history, and use that figure as a proxy for Sustaining Capital Investment.

[The important thing is to be able to separate stay-in-business capital spending from capital spending to drive growth (eg., building a new factory, purchasing extra assets such as warehouses, acquiring other companies) because as a business owner, what you are interested in is how much free cash flow comes your way each year with the business being at steady state conditions.
And then, how that free cash flow gets allocated by you (or by your company's managers), for example, towards expanding (organically or by acquiring), paying you dividends or paying down any debt the company might have, becomes a separate consideration that needs to be considered on its own merit.]

In TME's case, being a capital-light business, Purchase of PP&E is a relatively small number (~$3m pa compared to >$130m in Operating Cash Flow) so you could simply use $3m as Stay-in-Business Capex.


Now, while TME is not a capital-intensive business, it is definitively an "Intellectual Property" business, meaning it does have significant product "development" type of calls on capital, in the form of Purchase/Capitalisation of Intangibles.

Unfortunately, unlike the PP&E figure, the Intangibles figure is both a large number (~$25m in FY2018) and is also a highly variable number (having grown almost every year, from $14m three years ago and $6m five years ago). Knowing how much of that $25m figure is stay-in-business related, and how much is for expanding the company's suite of service offerings, is hard to know. While the company might be able to offer you some guidance in that regard, an alternative would be to adopt a conservative stance and to deem all of it to have been incurred purely to keep the business going (and that any growth that occurs is purely a bonus; in reality we fully expect TME to continue growing its Revenues, Profits and Cash Flows, so accounting for 100% of spending on development (i.e, Intangibles) is clearly a conservative approach.

Still, applying the above, we can derive FY2018 Free Cash Flow as follows:

FCF:
= OCF Less Stay-in-Business Capital Spending
= $134m - ($3m + $25m)
= $106m


And, now, based on current TME's current EV of $2.15bn (based on current A$ share price, AUD:NZD exchange rate and projecting Net Debt @ 31 December 2018 to account for the current half cash flows... particularly the impact of the special dividend recently paid), that yields a FCF Yield on EV of 4.9%, by my reckoning.


Note: I have excluded the cost of any acquisitions from my Free Cash Flow determinations, because - all things being equal - acquisition expenditure is considered to be more of a "growth" nature, and therefore, fall outside of the ambit of steady-state, stay-in-business valuation. (Of course, there are a great many companies that undertake acquisitions in order to plug earnings holes in the core business and, in this case, this sort of investment should be treated as stay-in-business, but that's a long discussion for another time.)


As for TME's CAGR in FCF, based on the above approach, I get the following:

Last 7 years: 4.0% (FY2011 FCF = $80.8m)
Last 6 years: 5.8% (FY2012 FCF = $76.1m)
Last 5 years: 6.3% (FY2013 FCF = $78.7m)
Last 4 years: 5.2% (FY2014 FCF = $87.1m)
Last 3 years: 6.4% (FY2015 FCF = $88.6m)
Last 2 years: 8.8% (FY2016 FCF = $90.0m)


But remember, because this Free Cash Flow stuff is not a precise science, and involves the making of a few assumptions, any conclusions that are drawn can only be indicative, rather than prescriptive.