Ann: Change in substantial holding-SDI.AX, page-17

"All SDI need to do is raise the dividend payout ratio to 50% and the share price should pick up. They don't need that much cash anymore"

@asrw,

Yes, at face value, the company looks to be in the best financial health that it has been for years. Which, speaking as a shareholder, is a great thing.

The conventional measure of this, namely Net Debt-to-EBITDA, clearly shows this:

SDI's NIBD-to-EBITDA
(Half-Year Period Ending, annualised EBITDA)

DH03: 0.8
JH04: 0.6
DH04: 3.9
JH05: 1.5
DH05: 3.4
JH06: 1.0
DH06: 2.3
JH07: 0.8
DH07: 6.6
JH08: 1.9
DH08: 1.4
JH09: 1.3
DH09: 1.0
JH10: 0.8
DH10: 2.0
JH11: 2.4
DH11: 2.4
JH12: 1.2
DH12: 1.0
JH13: 0.7
DH13: 0.8
JH14: 0.4
DH14: 0.5
JH15: 0.2
DH15: 0.3
JH16 (forecast): zero
DH16 (forecast): 0.1

(Note the seasonality, with working capital at 31 December balance dates typically a full 500 basis points higher than 30 June balance dates, meaning that June half operating cash flows are usually several multiples higher than those in the December half-years.

As a result, I expect the company's net debt for 30 June 2016 due to be reported as having been almost zero, down from $2.1m @ 30 June 2015 and $3.8m @ 31 December 2015.)

So, yes, one might rightfully think that the dividend payout ratio can afforded to be lifted meaningfully.


However, there are a few things that warrant considering when it comes to the ability of SDI to convert its reported profits into distributions to shareholders, notably:

1. Working Capital Demands
2. Capitalisation of R&D Expenses


Dealing with the working capital of the business: because it has a long supply chain, SDI's working capital requirements are very high; an incremental investment in working capital equivalent to 40% of every additional dollar of revenue is required to support sales growth.

For context, over the past 13 years (which is only how far back my model goes), SDI's working capital has grown from $16m, to $27m (this 65% increase being commensurate with the 70% increase in Revenue over that period).

For context, this $11m increased investment in working capital compares to cumulative Operating Cash Flow over that period of some $65m. Which means that around one dollar out of every seven dollars of Operating Cash Flow doesn't reach the Free Cash Flow line.

Clearly, this "leakage" of capital, when viewed through a pure potential return-to-shareholders lens, is quite material.


And then there's the issue of R&D expenditure, of which around 75% is capitalised. This means that this is capital that is not accounted for in the P&L, but which hits the company's cash flows.

Again, for context, over the period under review, SDI cumulatively capitalised more that $27m of R&D expenditure, according to my analysis. This, too, is a very meaningful quantum in the context of $65m of cumulative Operating Cash Flows.

In simple terms it means that actual Free Cash Flow coming out of the business is actually only half of what it would have been were it not for these two capital-consuming aspects of the business.

Put another way, over time, "cash" earnings for this business are roughly only half the level of reported earnings. [*]

And this is the reason that the payout ratio has been quite low historically (20% average).

So you are right, there is probably some headroom for the payout ratio to be increased, but not much above 50% of reported profits, because that would mean that all cash earnings are being distributed, leaving nothing left for investment in growth.


[*] This is one of the reasons SDI always appears to be a lot cheaper on an earnings yield basis (i.e., on a P/E multiple) than it does on a Free Cash Flow yield basis.