Ann: Appendix 4D December 31 2017, page-9

"Do you or others have a preference for dividend increase, special dividend or buy back? Would the lack of liquidity prevent a buy back being useful?"

@Just_a_guy

I had the fortunate occasion to meet with SDI management recently and a discussion along these very lines took place during that meeting.

For the past 20-odd years, which is as far back as I have gone back to check, SDI's balance sheet has never been in the healthy kind of condition that it is today. The company is sitting on net cash, which has been rising in recent financial periods despite the company significantly increasing its dividends.



On just about every measure of financial health, SDI's balance sheet is in a condition that has not been seen before. ([*] See further brief discussion on this in the charts near the end of this post.)

Of course, when the world becomes awash with cash, there is always the risk that it burns a hole in people's pockets, and then those people feel compelled do deploy the cash in one way or another.

I have seen a great many cases of boardrooms capitulating to the "Have Cash - Must Spend" syndrome, the result of which is poor capital allocation discipline.

This is (or, "was", more like it) my single biggest concern with SDI: there are not too many corporate executives - when faced with growth challenges, as SDI currently is - who are able to resist the temptation to go out and buy something in an attempt to plug the earnings hole.

Which is why my very first question to the CEO and CFO was,

"What are you going to do with our cash?"

I am pleased to say that, while they may spend a few hundred thousand or a million or so, on something like new technology, what they are not going to do is make some or other Big Splash, Hallelujah! - $10m type of acquisition, which would completely re-gear the balance sheet.

They acknowledged that some things have been passing through their in-trays, but it was clear to me that they did not give any of them serious consideration.

With the founder, and family patriarch, still very involved in the business strategy, the Cheetham family is certainly not of the collective mind to do anything cavalier. These are cautious, conservative people. SDI is their baby. They are protective of the culture and the ethos of the business (to a fault, possibly) and manage the capital of the business for the long-term, rather than being too concerned about placating the market's requirement for instant earnings gratification.

So, having established that the surplus capital that exists today is not going to be used for a big-ticket purchase of anything, gets to your question of a choice between:

1.) Continued increase in dividend,
2.) Special dividend, or
3.) Share buyback

The have already been doing Number 1.) over the past few years with the dividend rising more than seven-fold to an all-time high; however as we all know, even this has not been enough to stall the cash build (quality problem to have, to be sure).

So I think they will continue to increase the dividend: I expect the final dividend for this year will be declared at around 1.4c or 1.5c, which would result in a payout ratio close to 70%.

Of course, they could continue increasing the payout ratio, as they have in excess of $50m in retained earnings, but the problem is that as the payout ratio get closer to parity they will start to chew into the franking credit balance, which is not that deep, being a mere $5m or $6m (~4.5cps).

So, I am happy for them to continue to increase the dividend, but they are running out of headroom to be able to continue doing so. Besides, even at a 100% payout ratio, the cash balance will still largely remain intact.

That brings us to a special dividend.

While I am normally a fan of special dividends being declared when a company has surplus capital, and when it really has nothing better to do with the money, but in SDI's case this is complicated by the company's relatively limited franking credit balance.

So that then leaves a share buyback.

While this would be my preferred choice by far given the current market value of the business, which I believe undervalues the company, the problem is that it would have the impact of compounding the relatively lack of liquidity in SDI's stock. If I was an SDI director, I would argue that liquidity in the trade of the stock should be subordinated as an issue compared to allocating capital that is value-accretive (which a buyback would be), but I suspect I would be voted down.

I think that one potential solution would be for the stock being vended into an off-market buyback involving some of the 55m shares that belong to the founder; in such an event it would be immaterial to the liquidity of the stock.

The trouble with an off-market buyback is it would have to be offered to all shareholders and, if the company's chairman wanted to vend a significant part of his shareholding into such an arrangement would probably require all sorts of legal machinery to be kicked into action, as well as independent experts to be commissioned, and for an EGM to be convened. And all of that stuff costs money.


So, it is a tough one, with no real obvious solution.
But, as I said, it is a quality problem to have.

And, in the context of the discussion above, I guess that "Do Nothing" is not that bad an option.



[*]

The Current Ratio is at all-time highs, close to 4x:



Net Current Assets (i.e., Current Assets Less Current Liabilities as well as Non-Current Liabilities) is also at record levels, at almost $25m.


And, as an interesting aside, Net Current Assets (recall: Current Assets Less Total Liabilities) is currently equivalent to one-third of the company's market value, a record level that it did not even reach when the share price fell to as low as 10c to 15c in 2011/2012: