Below is an analysis from Motley Fool on divy sustainability. This was done BEFORE the earnings announcement. With the positive surprise in free cash last qtr, these figures are likely conservative.
Dividend Sustainability
While the gross margin improvement in Pivot’s business is noteworthy, Pivot’s financial flexibility does come with some nuance. As a middleman in the IT space, profit margins are still razor thin. For instance, over the past two years, Pivot’s average adjusted EBITDA margin has come in at around 1.5%.
From a profitability perspective, that leaves little wiggle room for the company and speaks to the importance of the company’s managed services strategy, which we outlined in our recommendation. As an IT product reseller and service provider, its thin margins can disappear quickly if product revenue continues to trend downward and its higher-margin services strategy fails to take hold.
The good news is that Pivot-branded services revenue was up 22% last quarter, and the company’s update last week indicates more strength in the third quarter. Looking ahead, Pivot will need to get back on track in the fourth quarter since it’s the company’s strongest from a seasonality perspective.
Against that backdrop, let’s now look at the company’s dividend sustainability. We’ll begin with Pivot’s core free cash flow (FCF) from operations. We calculate Pivot’s core FCF after capital expenditures, but prior to accounting for fluctuations in working capital. As you’ll see in the table below, Pivot typically earns around $10 million in core FCF on an annual basis, while paying out $5 million in dividends. This results in a dividend-payout ratio of around 50%.
Source: Company filings.
Looking forward, given the struggles in the third quarter, core FCF may very well come in at around $7-8 million this year, resulting in a payout ratio closer to 70-80%. Pivot’s seasonally strong fourth-quarter results will go a long way toward determining full-year results. We’ll provide an update on management’s comments regarding the fourth quarter in a couple weeks when Pivot releases its third-quarter results.
Now, let’s look at Pivot’s dividend-payout ratio using the traditional method of calculating FCF. This includes subtracting or adding back cash flow related to the company’s changes in working capital. Working capital includes all of the company’s non-cash- and non-interest-bearing current assets and liabilities. This includes changes in the company’s inventory, accounts receivables, accounts payables line items from its balance sheet.
From this perspective, there appears to be a cash crunch at Pivot Technology due to fluctuations in working capital items during the first half of this year.
Source: Company filings.
The challenge with using the traditional method of calculating FCF is that it can be misleading from time to time. Fluctuations in working capital items can lead one to believe that a company’s business operations have improved dramatically from one year to the next, or declined considerably depending on the period in which you’re measuring FCF.
It can be misleading because fluctuations in working capital items tend to net out over time, especially for a distribution-oriented business like Pivot’s. For instance, during the good times inventories tend to rise as a distributor anticipates strong orders. This rise in inventory will actually reduce the company’s traditional FCF. Alternatively, during the bad times, a distributor will typically halt new inventory and focus on collections typically resulting in a decline in accounts receivable (AR). This decline in AR will actually boost a company’s traditional FCF. For this reason, simply glancing at traditional FCF when analyzing a business like Pivot’s can be misleading. It’s important to look at core FCF and traditional FCF along with how the company’s working capital items historically fluctuate.
In Pivot’s case, changes in working capital have cost the company roughly $1 million on an annual basis over the past two years. Looking further back, changes in working capital have resulted in a cash outflow of just $1.8 million since the beginning of fiscal 2015.
This is why you’ll notice some analysts will calculate a company’s payout ratio based on its FCF prior to changes in working capital. We pointed this out during our Dividend Examiner piece last month on Crius Energy Trust (TSX:KWH.UN). The trouble with Crius is that the company’s fluctuations in working capital items have not historically netted out over time. In fact, they have consistently created a cash flow drag for the company. In cases like this, we prefer to calculate a company’s payout ratio by using an average annual working capital charge in order to properly account for its true cash flow generation.
When it comes to accounting for changes in working capital, it’s best to take it on a case-by-case basis. In Pivot’s case, as a middleman, fluctuations in working capital should even out over time, unless something is wrong. Fortunately, Pivot’s working capital fluctuations appear to be quite normal; in other words, business as usual for an IT reseller. For instance, the cash flow impact from inventory and accounts receivables net out over the trailing 12 months. The cash flow drag you see in the second table above is actually from a reduction in accounts payable. This is a much better than an unusual build in inventory or receivables, which can indicate trouble moving inventory or collecting cash from its customers.