Taxing stuff.

This discussion follows on from my previous post (EBIT +46%). From the comments that have been posted and private correspondence received, two facts have become clear to me.

1. I didn't do a very good job of making it really clear what I was talking about.
2. There is some value to be had from discussing tax a little more.

Let's quickly knock over number 1 first.

Cellestis is a young Company. You might not consider 10 years old to be young but "young" in this context means that it has only just begun it's growth and has a lot of growing to do. That alone means that any analysis of the Company performance probably puts emphasis on different characteristics than it would for a more "mature" Company.

As an aside to that it is my view that CST finds itself (from a shareholder analysis perspective) in a strange place. It is no longer a pure speculative play. A pure speculative Company usually has no income, no profits and certainly pays no dividends. All it has is potential to achieve those things. Cellestis is well and truly past that point. It has income, profits and pays dividends. On the other hand, Cellestis is not yet an "investment grade stock". Such a stock would have a number of characteristics but is probably most easily (lazily?) characterised by a PE of 15 or less. 

So, Cellestis finds itself stuck somewhere in between. At a quick glance somebody looking for a speculative play would probably not see CST as being sexy enough and somebody looking for an investment grade stock would probably see CST as having too high a PE.

Of course we know that those doing such a superficial analysis are doing themselves a disservice. That's their problem, not ours. 

Anyway, back to the theme. (did I say this would be quick?).

Because CST is "young", we who hold it as an investment are looking for something specific - growth. And we want spectacular growth. Furthermore, the growth we want is growth in earnings that come back to us, in one form or another. An effective measurement of this growth would tell us not only how fast the Company is growing but also how effectively the management of the Company is managing that growth.

During its building stage, Cellestis operated at a loss (as it should). These losses incurred tax credits. Now that the Company is making profits, they can net off those earlier tax credits against current tax payable on current profits. They have been doing this for the past few years as the profit stream has built. It seems that those tax credits have now been used up and the Company is now having to pay its full whack of tax on profits. (There may be a few tax credits remaining in overseas jurisdictions, I'm not sure). 

Okay. So, if, as I have expressed, my desire is to examine the Company growth it would make no sense to compare a figure (from last year) that has been artificially reduced by tax credits with another figure (from this year) that has not been artificially reduced. The easiest and correct way, therefore, to make that growth analysis is to drop the tax from the comparison. That is, compare EBIT (Earnings Before Interest & Tax). (It has been expressed to me that I should actually term it PBT - Profit Before Tax. That is actually correct. However it doesn't make any difference because CST has no borrowings :) and pays no Interest :) ).

Of course, as others have said, PAT (Profit After Tax) has its uses also. 

Which, conveniently segues us into a little discussion of Tax.

It is easy to say, "Well the Company sells stuff, pays for the stuff it buys and incurs some expenses along the way then pays tax to the Government - what ever is left over belongs to us and is what we should be looking at in assessing the investment that we make/hold".

Is that really true though?

As one of my friends points out - tax is not an outright (dead) expense. There is a little more to it than that.

In Australia, the Government has decided that we should not be charged twice for the earnings that we receive from the profits made by the Companies that we invest in. In the simple case (put aside overseas earnings for the moment), the Company tax rate in Australia is 30%. That means that for every $1 that our Company earns they pay the Government 30c. Leaving 70c that can be paid out to the Company owners (shareholders). Let's take the simple case of a Company that pays out 100% of post tax earnings as dividends. Dividends are counted as income for the shareholder. If we assume that the shareholder is on a tax rate of 30% then that 70c of income would attract 21c tax. That would mean that, of the $1 earned by the Company, 51c (30c + 21c) would go to the Government and the shareholder would net 49c.

Obviously that is not just and our Government agrees (not all Governments do). For that reason they have implemented a system of franking credits. 

In essence, what the Government has said is that the tax on Company earnings should be paid once and once only by the final recipient of the earnings at the tax rate of that recipient.

The mechanics of this are to firstly "gross up" your dividend to the amount of Company earnings that were made to enable them to pay that dividend (that is, add back the amount of tax that the Company paid on that dividend). In the example above that means add the 30c tax paid by the Company to the 70c dividend received to give a taxable income to the shareholder of $1. The taxpayer is then charged tax on the $1 of income and receives a tax credit of the amount of tax already paid on their behalf by the Company. If in the above example the taxpayers tax rate is 40% then the tax payable on the $1 income is 40c. 30c has already been paid by the Company so only a further 10c is payable.

You can check that this is correct. The profit was $1, the taxpayer received 70c and paid 10c in tax, leaving them with 60c which is the same as $1 less 40% tax.

Its actually harder to explain than do. Dividend certificates always show the franking credits in dollars and cents attached to any dividends. All the tax payer has to do is add that franking credit amount to their total income, calculate their tax and then subtract the franking credit amount.

When I am examining the dividend return for a Company I always gross them up. This enables me to make a fair comparison between alternate investments. Grossing up the dividends of all investments yields to a level playing field. In the end it tells me how much I will receive as income that I will need to include as taxable income on my tax return.

For a dividend that is 100% fully franked (as CST is) the simple way to gross up the dividend is to divide by 7 and multiply by 10. That grosses up the recent 2c dividend to 2.85c.

If you have money to invest and want to compare, for example, the interest rate on a Bank IBD and a dividend return, it is essential to remember to gross up the dividend. A 4.9% fully franked dividend gives the same return as a 7% IBD. 

There is another reason, aside from return comparisons, that we might be interested in franking credits and grossing up. 

Whilst the tax rate for Companies in Australia is 30%, our own tax rates may be higher or lower. If we hold our shares in a Self Managed Super Fund that is in pension mode then our tax rate on income is zero, zilch, nothing (I just like saying it). That means that if we receive 70c of fully franked dividend from the Company then at the end of the year, when we do our tax, the Government will send us another 30c (ie the tax that the Company paid on our behalf that the Government doesn't want).

So, in the end, when we are looking at the returns from a shareholding it can make sense to look at PBT (even in the absolute sense). 

EBIT +46%

I have to be honest, I hadn't really thought about the importance of EBIT (Earnings Before Interest & Tax) as a measure of the financial success of a growing business. It is only when I looked carefully at the Cellestis 2011 H1 results that I realized why this gives us a picture of what is happening (financially) with our company.


Tax is, to all intents and purposes, something that is totally outside the control of the Company. The tax rate and requirements can change from year to year. For that reason, if you want to measure how well the Company is being run in making profits it is sensible to exclude tax from the figures that you judge the Company by. After all, we shouldn't judge the Company by something that they can't control. As it happens, in Cellestis' particular case, at this particular time, there is a huge reason to exclude tax (ie use EBIT as a measure). In the past, Cellestis has not paid income tax at the full rate - most of the reason for this has been the consumption of tax credits that were accumulated during the early, development, years of the Company. It seems that we have now used all of those tax credits and are paying tax at close to the full rate.


If we look at the last four half years (2009 H2 -> 2011 H1) then our effective income tax rate has been 17%, 17.6%, 20% and 27%. So, in the last half year we have paid 27% income tax which is pretty much full Company tax rate. What this means is that if we used PAT (Profit After Tax) to compare successive period profit growth we would see a distorted figure that has been dampened by the increasing tax rate. (The impact of this will probably end now as we would expect the tax rate to flatten out. In other words, in the future, the growth rate of EBIT and PAT will probably converge.)


So, excuse me for getting excited, but I think that a 46% growth in earnings (cf pcp) is a spectacular result. Particularly on a 24% increase in Revenue. A 30% increase in Profit After Tax, even forgetting that tax dampening effect above, is something to shout about.


If they can do this when the Forex winds are working against them, just imagine how things might look when those winds die down (as they now have) or swing through 180 degrees (as they most certainly will at some point.)

CST Data Sheets.

Updated CST Data Sheets with 2011 H1 figures included.

Cash.

Again, if we are to accept the predictions from the Shaw Stockbroking Cellestis report, then it is hard to miss the progressive cash position of the Company. Because the report assumes a relatively low dividend payout ratio (54% to 61%) the cash holdings of the Company grow quite rapidly. By 2018 the cash pile has built to over $200m. By 2023 it would be approaching $400m. (All done using the Shaw numbers). If, as I believe (and Shaw intimate), the numbers are very conservative then the cash position could be even bigger.

Every well managed Company needs to have sufficient cash on hand to meet operational requirements, protect against untoward events and generally be prepared for whatever the future sends along. However, there is a limit to how much cash is sensible to hold - earning bank interest only. Previously, the Company have alluded to the necessity of holding $20m in cash. I suspect that view may well have changed as the Company has grown and they will want to hold more than $20m. $200m on the other hand is a lot of cash - I think it would be hard to justify so much "lazy money".

So, what might happen with that cash?

• Dividends. The Directors may decide to increase the dividend payout ratio. They have certainly not ruled that out. There may be a small problem in that they have expressed their desire to pay fully franked dividends. Depending upon how the overseas operations are structured, they may or may not earn enough franking credits to increase the amount of fully franked dividends. Of course there is nothing stopping them from paying some unfranked dividends, if they want.
• Capital Return. They could do a capital return to us. However, I think that would be quite limited as we have not actually contributed much capital in the first place.
• Share Buyback. They could start a share buyback program. In effect this is an acquisition - they would be investing (on our behalf) in a great little Company called Cellestis. Probably a lot of people like this option - the share price watchers are happy because it tends to drive the price up and I am happy because it means that I have to share the future profits  (and dividends) with less people.
• Acquisition. The Company have suggested that they would not be averse to making an acquisition if it made sense and would be earnings accretive. As far as we know, to date they have not found such a candidate. The problem for CST is that it is going to be hard to find anything that can match the returns that Cellestis will be making.
• Waste it on Company Ego. They could build themselves a chrome and glass edifice for Company headquarters. Fortunately our Directors have shown no inclination to do such a thing. 
• Sit on It. Bank Interest return? No thanks - I can do that (and better) myself.

The above is all just my musings. Really just stating the obvious. I have no idea whatsoever what the Directors are actually thinking about this issue. 

Finally, can I just point out the huge difference between Cellestis and most other biotechs listed on the ASX. If you are invested in most of those others you will be watching and worrying about their quarterly cash burn and where they are going to raise their next tranche of cash. What a pleasure it is, on the other hand, to have the luxury of wondering what Cellestis is going to do with its ever growing cash pile.

Admin.

As I have previously said, I really appreciate your comments. Some of you may have noticed that I have changed my comment policy slightly so that you need a google account to be able to comment. I have not done that to restrict the ability of people to comment. I have only done it because, despite numerous requests, multiple posters have insisted on posting under the name "Anonymous". It's just tedious trying to hold a conversation with somebody when multiple people are using the same name. The change that I have made means that you can comment while still retaining your anonymity to whatever extent you like. I apologize for the small inconvenience.

Luscious Dividends.

Browsing the Cellestis report from Shaw Stockbroking got me thinking again.


Now there's nothing to say that their numbers are correct but let's just for a moment presume that they are.


Perhaps I'm a bit different from other people in that I am totally interested in the return that I get from my investments, not what I might get if I sold them. That is, I don't care too much about the Share Price. My preferred position is to own an investment that returns me so much that there is no incentive for me to sell that investment to get a better return elsewhere. (it's just too much work pressing that sell button).


In other words, it's dividends that excite me.


Look at the predicted dividend flow as projected by Shaw:


2011 7c
2012 10.5c
2013 15c
2014 24c
2015 30c
2016 39c
2017 48c
2018 54c


If we consider a decision to hold as being the same as a decision to buy (do I need to explain that?) then we can see that based on the current price of $2.55 the dividend yield becomes


2011 2.7%
2012 4.1%
2013 5.8%
2014 9.4%
2015 11.7%
2016 15.2%
2017 18.8%
2018 21.1%



If, like me, you hold them in your superannuation fund in pension phase then it makes sense to "gross up" the dividends to account for the franking credits that the Government will so generously give back to us


Now, our returns are something like


2011 3.8%
2012 5.8%
2013 8.2%
2014 13.4%
2015 16.7%
2016 21.7%
2017 26.8%
2018 30.1%


To my way of thinking, 5.8% is an okay return (2012), 8.2% is a good return (2013) and 13.4% and up is a bloody fantastic return. It's not long till 2012 and not much longer (one year, actually!) till 2013. I reckon I can suffer another couple of years of cabbage soup and lard on stale crusts till these chickens come home to roost.


Seriously, it doesn't look too shabby to invest some money now (= hold), believing that you will get a 3.8% return for the next 8 months (that's an annual rate of 5.7%), 5.8% the next year, 8.2% the following year, etc etc.


Of course the dividends, in the harsh reality of the future may actually end up being bigger or smaller than projected but you have to believe in something, right?


I do understand that people look at it quite differently and will assess the yield on an ongoing basis as the share price changes. There's nothing wrong with that. It's just that I look at my investments more as I would look if I was buying an entire business. If somebody proposed a business venture to me (that I believed in) with those projected returns then I would be quite interested. If I owned such a business I wouldn't be asking potential buyers what they might be willing to pay me for it each and every day.


None of this is to say that if the rest of you go crazy and offer me a ridiculously high price for my shares that I wouldn't sell them to you (just as I would with the business venture). I'm not that crazy.


The question that anybody considering purchasing CST shares would have to consider is what is the best time to buy to achieve the maximum return with the minimum risk. As time moves forward the risk may diminish but, no doubt, the share price will increase. I guess each purchaser would need to make that assessment (guess) for themselves. Based on the figures above I'm quite happy to hold. (Actually, I'll let you in a little secret, I did buy a few more last week).


(coffee break)


My above thoughts got me thinking some more (on a roll today).


The other side of the story is about if you decided to sell your CST (or any) shares today, or at any time. In essence, you would be selling the future cash flow for a price today. In essence you would be "betting" that the money that you receive can earn you a better return elsewhere. This goes on all the time in the financial markets. It is why fixed interest bonds will be traded at prices quite different from their face value (and why they will often be quoted with an "effective interest rate") It is actually what share traders are doing (though they mostly don't actually realize it).


This is why an investor-centric discounted cash flow (DCF) is so useful. It enables us to turn our belief about the future into a financial metric that we can use to make our investing decisions. We can either use it to determine an effective rate of return or to determine what price we should pay to achieve a required rate of return.

A Shaw Thing*

Well, with Valentines day approaching I guess we all look forward to a little lovin'. Shaw Stockbroking have come to the party. 


As many of us would know, Shaw have been interested observers of CST for many years but have not published any official coverage. Finally, they have now initiated coverage of Cellestis.


With their kind permission I am able to pass on their Broker Report.


There is much to absorb and possibly discuss about this report but I will just make a couple of salient points here.


Firstly, this is an extremely well put together report and clearly reflects the long term interest of the broker in Cellestis. I am particularly impressed that they have been very conservative with their projections. On the other hand they also point out that it is quite likely that the Company will perform much better than these projections. 


Projections are just that - a projection based upon known facts and opinion. Personally, some of my opinions are at variance with theirs (but that does not detract from the value of this report).


I note that they have maintained the dividend payout ratio at around 60%. The problem with that is that by 2018 this means that the Company would have more than $200m cash on hand. I suspect that at some point the Company will increase the dividend payout ratio. Of course the alternative is that they use the $200m to make an acquisition. They have previously said that any such acquisition would be earnings accretive. 


I note that the Shaw DCF Valuation has been done without a terminal value in 2023. I understand why they have done this - the current patents expire then. Of course between now and then we would expect much to change about our Company anyway. It is also worth pointing out that, based on the Shaw figures, the Company would have something like $350m in the bank at that time - that alone is a terminal value. A quick and dirty calculation tells me that $350m in 2023 has a net present value of around $100m ($1 per share).


I am also a little curious as to why they have used a discount rate of 12.2%. I would normally use a lower figure (I have explained my reasoning in previous posts). That would result in an increase in the DCF valuation.


Anyway, don't read any of the above as a criticism, just a difference of opinion. 


Enjoy the read.




*Apologies for the title. It's Roger's bad influence.