Closing stock price on April 14, 2016: $33.72.
Market cap: $2.8 billion.
The company and the business model
From the company's 10-K - "Ubiquiti Networks (NASDAQ:UBNT) develops high performance networking technology for service providers and enterprises." The service providers are typically Wireless Internet Service Providers (WISPs). "Our technology platforms deliver highly-advanced and easily deployable solutions that appeal to a global customer base, particularly in under-networked markets." Manufacturing is outsourced, resulting in low capex. Sales costs are low as the company relies on an Internet forum/community to evangelize the products rather than a costly sales force, which allows disruptive pricing while the pricing encourages the evangelism. Headcount is low, and Ubiquiti is able to concentrate on R&D. Ubiquiti has a policy of focusing on the quality of R&D staff rather than quantity, and the CEO has blamed some recent glitches on straying a little from the policy. Results have been fairly volatile, probably because of the lack of recurring revenue, exposure to emerging markets and the variable impact of product launches. The CEO holds a majority of the stock, and only draws a nominal salary.
About this piece
This is about Ubiquiti's cash flows, with some comparison to two competitors. There are different visualizations of cash produced by the business versus cash put in, some of which are highly unconventional. I don't cover the company's products, markets or prospects, about which there is relevant material on Seeking Alpha in articles and comments.
The cash is held overseas
96% of Ubiquiti's cash is held outside of the United States ($476.9 million out of $496.7 million), and there'd be a tax bill if the cash was repatriated. The long-term debt of $115.5 million is the result of borrowing in the US to cover the gap between cash generated by operations in the US and the sum of stock buybacks, head office costs and investment in the US.
Cash flow and revenue
The chart below lets you compare Ubiquiti's cash flows to revenue. The red bars represent CFO (Cash From Operations), which is one of the three "bottom line" figures in the cash flow statement. The others are cash into investment, shown as blue bars, and the financing cash flow which is not shown. The small size of the blue bars shows how small the investment flow has been compared to the inflow from operations. Although CFO is a prominent item in the cash flow statement, it's affected by swings in non-cash working capital. The brown line represents CFO adjusted to remove the effect of the change in working capital, with the average change in working capital added back in. It represents the underlying CFO better than "raw" CFO. A positive change in working capital actually means less cash tied up in things like receivables and inventories, which means more CFO. I explain more about it later. I've also indicated some "bad news" items along the top. The BEC fraud was an email-based impersonation, and two employees were blamed for incompetence.
A chart further down shows CFO as a percent of revenue for Ubiquiti and two other companies (find "Ubiquiti turns more of its revenue into cash flow").
Volatile quarterly cash from operations
The next two charts show how volatile quarterly CFO has been, with no obvious seasonality.
The per-share view
The difference between the two charts above is the share count used in the "per share" version. This has come down recently due to buybacks. It's possible that the market sees the buybacks and the dividend as confirming the company is no longer in a growth phase. I believe that both are a reasonable use of the cash the company generates, and the fact that free cash flow has been generated in years of high growth and low growth is positive for the business.
For cash flows, I prefer "walk charts" to the more conventional time series charts. The next chart is just to illustrate the principle:
The next chart is the real thing, with an absolute and a per-share version. The small investment flow compared to CFO results in near vertical graphs. In both versions, the latest two quarters have each been multiplied by 4 to annualize them. Without the multiplication, the upturn in CFO would have looked like a big drop, but obviously the annualized CFO does not accurately represent the amount added to the cash stash.
An upturn in free cash flow can be bad in some cases, if it's the result of under-investing, perhaps to impress Wall Street with the free cash flow figure. That does not apply to Ubiquiti, because substantial growth in CFO has been achieved over several years with little investment, and with the CEO holding a majority of the stock, he would not squeeze out cash in the short term at the expense of long-term growth.
Adjusting for the change in working capital
One problem with looking at CFO is the effect of the change in working capital, and the terminology around the "change in WC" can be confusing. For example, if accounts receivable goes up, it pushes up non-cash working capital (at least if nothing else pushes it down, like accounts payable going up by the same amount). When non-cash working capital goes up, you might expect that "the change in working capital" will be positive, but actually it's negative (at least according to common usage). That's because the phrase "the change in working capital" is used in the context of the cash flow statement, and it's a kind of shorthand for "the effect of the change in non-cash working capital on cash flow." If non-cash working capital goes up, the effect is to decrease CFO (cash from operations). So, a positive "change in WC" means that non-cash working capital has gone down, with a positive effect on CFO.
The change in WC has two characteristics. First, there's the average working capital needs, which depends on revenue and the nature of the business. Most businesses need more working capital as their revenue grows, although a few (such as retailers that pay suppliers AFTER the goods have been sold) have the advantage of negative working capital needs, which means that someone else (like the suppliers) helps to finance the company's growth. The second characteristic is the variability of the change in WC - a company that sells consumer staples will have much less variability than a shipbuilder with cyclical revenue.
Ubiquiti does not have the advantage of negative working capital needs, but that doesn't matter much because the cash flow easily covers the needs (or, it would take a massive growth rate to tie up all the cash generated in non-cash working capital). Ubiquiti's working capital is quite variable, because inventory has to be built up ahead of product launches to minimize the chance of stock-outs, and sales of new products are not very predictable, so inventory might shift faster or slower than expected. The company has enough cash and cash flow to cover the variability in the change in WC, but investors need to be aware of how the variability has affected the CFO number.
In the latest two quarters, a positive change in WC was good for the CFO figure, and it's likely to swing back at some point in the future making CFO less than otherwise. Until the latest half year, looking at the annual figures, the change in WC has happened to smooth out CFO before the change in WC, making CFO less volatile than either net income or CFO before the change in WC. The next chart shows that the (possibly random) smoothing effect went into reverse in the latest half year. Investors should probably not get too excited about the big jump in CFO (for H1 2016, which jumps up when annualized), and should look instead at the panels on the right in the graphic after this one, where I replaced the change in WC with its average since 2010. In the chart, "Net cash provided by operating activities" is the same as CFO, it's just closer to the term used in the cash flow statement.
For the change in working capital, I included everything under "Changes in operating assets and liabilities" in the cash flow statement. That might be contentious and technically wrong, but to me what matters is the variable changes in value or quantity that affect the CFO number. "Variable changes" exclude amortization and depreciation where the reduction in value is scheduled in advance and included in the "add back" part of the cash flow statement.
In the next graphic, I show versions of CFO plotted against cash into investment (with absolute amounts on the top, and per-share amounts below). On the left, I show normal CFO in blue, and CFO before the change in working capital in red. Some of the detail isn't clear, but you should be able to see that for the first half of fiscal 2016, CFO has been significantly ahead of CFO before the change in WC. You could say that CFO happened to be flattered by the change in WC, so the figure for H1 2016 exaggerates the underlying CFO. In the middle, the blue line for CFO has been replaced with a version where CFO has been adjusted for the average change in working capital, and those figures are less than for unadjusted CFO because the average change in working capital is negative (because the company has required more non-cash working capital over the period). The average is just based on the average increase per year; in other words, I did not try to match working capital to revenue.
Because it wasn't easy to clearly show both the red line and the blue line in the middle panel, I show just the blue line in the panel on the right. It shows the CFO adjusted for the average change in WC; in other words, without any random swings from the change in WC, but using the average rather than just ignoring it (which would mean ignoring the non-cash working capital needed to support growth). I believe the panels on the right are the best representation so far of the history of the company's underlying CFO in relation to the investment that generated it.
The following table shows the data the chart above was based on. CFO hardly grew from 2013 to 2015 (in thousands, from $131,891 to $134,547, or 2.0%, or $1.46 per share to $1.50 per share, or 2.7%). After adjusting for the average change in working capital, the growth was 82.1% or 84.0% per share (34.9% and 35.6% CAGR). On that basis, the only two-year period with a drop was 2011 to 2013, from $86,700 to $73,438, or -15.3%, or $0.84 per share to $0.81 per share, or -3.6%. The 2013 results were affected by a serious counterfeiting problem from which the company recovered quickly, and in the same year, the company had its biggest ever positive change in working capital. While there was some comfort in seeing cash freed from being tied up in working capital at a time of crisis, the pleasing CFO figure was not as informative as the dip in net income, and if you don't adjust CFO to remove the effect of swings in working capital, you are probably better off just looking at net income, at least if you are looking at a year or two rather than the overall trend (To get the change in working capital, add the items under "Changes in operating assets and liabilities" in the cash flow statement, and see how it compares to the average of -$12,541 thousand per year).
I used the figures in the table to calculate that 34.7% of the latest half year's rise in CFO has come from a drop in non-cash working capital (relative to the average rate of increase). Here's the calculation:
The CFO for H1 2016 is 125,074 (this is all in $ thousands). That's 57,800.5 more than the full-year figure for 2015 divided by 2. The change in WC for the half year was 13,781, which is 20,051.5 more than the average (of -12,541 for a full year, which is -6,270.5 for a half year). The 20,051.5 "excess" change in WC is 34.7% of the rise in the half year's CFO of 57,800.5.
One way of viewing the working capital in relation to revenue is to look at the items expressed as days of sales, for example DSO (days sales outstanding, in receivables), or DSI (days of inventory). For a full year's revenue, the calculations are like DSO = 360 * receivables/revenue. The result is only a poor approximation when sales are lumpy or volatile, for example a big order just before the yearend would give no time to collect the cash, resulting in an artificially high number for DSO from the calculation while the actual DSO would be unusually low. Even though there's volatility in Ubiquiti's sales, the following chart shows a clear general decline in the total of the items charted (receivables + inventories + vendor deposits - payables - customer deposits) expressed as days of sales. That's surprising, as management has said that more inventory is held to avoid stockouts, and the use of larger distributors means higher receivables because they take longer to pay (whereas a small distributor with poor or less verifiable finances might be required to pay up front). The half year's revenue for H1 2016 has not been annualized in the chart.
An increase in the days of inventories can signal a problem in selling stock, although in Ubiquiti's case, it could be a planned increase ahead of a product launch or anticipated sales. An increase in the days of receivables can signal problems including the manipulation of earnings, but that's unlikely for Ubiquiti as the CEO is the majority shareholder, and the cash and free cash flow mean there's no pressing need to raise capital. The cash flow and cash held overseas are likely to be good enough to enable borrowing in the US on reasonable terms, and if for some reason the terms become onerous, then the company can stop the buybacks. Therefore, there's little pressure to flatter the accounts to make raising capital cheaper or easier. If days of receivables or inventories go up a lot, it's still worth checking earnings call transcripts and the prepared remarks, and the "Liquidity and Capital Resources" section of the 10-Q or 10-K.
Comparison to Ruckus and Cisco
Ruckus (NYSE:RKUS) and Cisco (NASDAQ:CSCO) both have growing free cash flow, but neither has the vertical graph that Ubiquiti has, which shows they needed to invest more, relatively, to get their CFO. Cisco is a big old mature company, with less growth in the period charted. There's noticeably more growth in Cisco's "per share" chart, which suggests that buying back stock has been a big factor in the "per share" growth of its CFO. Ruckus and Cisco were just the first two competitors I thought of. That could imply some kind of selection bias, but I can promise I did not systematically choose competitors that made Ubiquiti look better or worse in comparison. I did not adjust for the average change in WC (only because of the time it would take).
Ubiquiti's investment flow consists of capital expenditure and the purchase of intangible assets, with the purchase of intangibles actually consisting of the cost of trademark applications. For Ruckus and Cisco, the investment flow contains items which are not relevant to the operating business, such as parking cash in short-term investments. That's why the X axis is labeled "PPE plus acquisitions" for them while Ubiquiti simply has "Cash into investment." The purpose of acquisitions is ultimately to generate CFO, which is the same purpose as for PPE, so the sum of both is a relevant quantity to chart CFO against. Ruckus's PPE includes "internal use software." Purchase of intangibles is not a named item in Ruckus's cash flow statement while for Cisco it might be included in the small "Other" category. Ubiquiti could conceivably make an acquisition in future to acquire technology or an R&D team, but many targets would be ruled out because it would increase the headcount by a massive proportion compared to the acquired earnings or cash flow.
Plenty more competitors are listed in Ubiquiti's 10-K, and possibly none have a very similar product mix, similar customers and a similar breakdown of sales by geography. The comparison to Cisco and Ruckus won't be perfect, but I still think it's relevant to show Ubiquiti's near vertical graphs next to the less vertical graphs of the other two companies, because the steep slopes are the result of the business model rather than the products, customers or sales geography.
By comparing Ubiquiti and Ruckus to Cisco for various items, the next chart gives some idea of the relative sizes. Cisco is by far the biggest while Ubiquiti has rather more revenue than Ruckus. Ubiquiti beats Ruckus on net income and cash from operations. Ruckus spends more on R&D and PPE + acquisitions, and Ubiquiti needs to continue to get more from less to stay ahead.
The next chart shows that Ubiquiti has invested less as a percentage of revenue than the other two companies. It has turned more of its revenue into cash flow than Ruckus. Ubiquiti's conversion of revenue to cash flow has usually been behind Cisco, but it was well ahead in 2011, 2013 and H1 2016 (Adjusting for swings in working capital might show a small consistent outperformance, but I didn't have the time to do that for Cisco). Because the chart shows ratios, there was no need to annualize the quarters.
Since making the charts, it's been announced that Ruckus is being acquired by Brocade, see "Cisco Rivals Brocade And Ruckus Are Merging. Who's Next?" by Eric Jhonsa, SA Eye on Tech, Apr. 4, 2016 (seekingalpha.com).
A bad cash flow walk chart
Just to show what a bad chart looks like, here's one from the oil patch. Negative free cash flow is not necessarily bad, in fact it's good so long as the return on investment is sufficiently ahead of the cost of capital, and the balance sheet is not overstretched. It didn't work out like that for Chesapeake (NYSE:CHK) and many other resource stocks. From the chart, you didn't need to predict the oil price crash to see that capex in excess of CFO was not increasing CFO. A history of positive free cash flow reduces the risk, so long as the history stays relevant (e.g. vital patents aren't going to run out), although it doesn't eliminate risks, and there's always plenty of them listed in a 10-K.
Considering R&D as investment
The R&D spend has the same purpose as investment in property, plant and equipment - to maintain and increase the cash flow from operations. Spending on PPE tends to be lumpy whereas it's not a good idea to vary R&D a lot (which would mean alternately hiring and losing staff). However it's not a very clear distinction because a massive project like a gas to liquids plant can incur costs over many years, with possibly less certainty about future costs, operational success and markets than for R&D in some cases.
Because of the similarity of purpose, and because Ubiquiti's R&D spend is much bigger than its conventional investment flow, in the next chart I've included R&D with investment, and added R&D to CFO. That's not conventional, and is irregular because I've added an expense to cash flows, which technically mixes accrual accounting with cash accounting, but the R&D expense is likely to be fairly close to the cash cost because it's a regular item rather than a volatile one, although there are non-cash costs associated with R&D in the form of stock-based compensation. That was $2.9 million out of total stock-based compensation of $5.0 million in 2015, or 5.3% of the $54.6 million R&D expense, with the proportion falling to 4.2% in H1 2016. IMO the chart is probably a reasonable approximation to CFO before the cash cost of R&D, plotted against cash invested including the cash cost of R&D, providing a different and arguably more complete view of cash generated plotted against cash put in.
This shows just the "R&D included" green line without the other stuff:
Even with R&D included in investment, and without removing the non-cash stock-based compensation, the green line is more vertical than the lines for Ruckus and Cisco shown earlier (where R&D was not included).
Considering R&D and stock buybacks as investment
The main effect of Ubiquiti's stock buybacks is to increase the cash flow from operations per share (along with EPS), although it also reduces the total cash cost of paying the dividend. The effect is sufficiently "investment like" that I've included stock buybacks in the next chart. Buybacks are not exactly like other investments, because they depend on the success of the other investments, whereas an investment in PPE or an area of R&D has more scope for success or failure independently of the success or failure of other investments. However, it's still a use of capital which ought to be compared to alternatives when allocating capital.
So long as Ubiquiti generates positive free cash flow, then all previous buybacks increase the free cash flow per share. In that sense, buybacks might be seen as a relatively safe investment, which justifies flattening the graph. Because Ubiquiti's CEO is a majority shareholder, he can be relied on to make buybacks only when he believes it's a good use of capital, which is likely to be whenever the stock is cheap enough due to the good free cash flow and the difficulty in finding acquisitions that would make sense, although having to borrow in the US to finance buybacks could be a limiting factor. While a steeper graph in a walk chart is generally better, the steepness isn't the only consideration.
Up till now, the per-share charts have included the benefit of stock buybacks on CFO per share while ignoring the cost of the buybacks, so it's inevitable that the red "buybacks included" line in the next chart is not as nicely steep as the green line where they are not included. I've also switched to a cumulative view, which has the advantage of smoothing out noise and showing the long-term progress. Some caution is needed, because a horrible looking drop to zero in a normal chart would look like a less scary flat line in a cumulative chart.
The next chart is also cumulative and per share. Each panel shows three lines. The steepest (dark blue) is the relatively standard CFO vs. cash invested graph. The green line has the R&D expense included in investment and added back to the cash from operations, and the light blue line is the same except that stock buybacks have been included in investment, with the effect that points on the light blue line are like points on the green line shifted to the right. There are two panels because there are two different ways of accumulating per-share quantities. Rather than decide which is best, I prefer to conclude that however you look at Ubiquiti's figures, it's got a lot of cash out of its operations compared to what it's put in, although it takes longer for the effect of stock buybacks to pay back (in the per-share quantities).
The highlighted figures in the bottom two rows of the following table show that the per-share cash generated (as measured by variations on CFO adjusted for the average change in working capital) in the latest half year accounted for 16.9% to 18.8% of the total from 2010 to H1 2016 while the half year is only 7.7% of the period. I'd call that an excellent half year.
The cash stash
Q2 2016 (December 31, 2015)
Cash and cash equivalents $496,672
Total liabilities $209,188
Cash minus Total liabilities = $287,484
You can think of "Cash minus Total liabilities" as a highly conservative break-up value, which ignores the value of all non-cash assets.
2011 (June 30, 2011)
Cash and cash equivalents $76,361
Total liabilities $39,703
Cash minus Total liabilities = $36,658
Growth in Cash minus Total liabilities, 2011 to Q2 2016
= $287,484 - $36,658
Dividing the last figure by the Q2 2016 weighted average shares diluted of 86,091 (thousand) gets:
$250,826 / 86,091
= $2.91 extra cash minus total liabilities per share between 2011 and Q2 2016.
In this part, I give a very rough idea of where the accumulated CFO has gone.
Total stock buybacks + Total cash invested + Total dividends
= $199,226 + $29,558 + $30,672
Total CFO - (Total stock buybacks + Total cash invested + Total dividends)
= $631,484 - $259,456
I'll call that $372,028 "total free cash flow after buybacks and dividends." The figure includes dividends but not other financing flows, because the company borrows in the US while holding (much more) cash outside of the US. It's bigger than the $250,826 increase in cash minus total liabilities (over a shorter period, because I haven't seen a balance sheet for 2010). It's smaller than the increase in total stockholders' equity, which increased by $481,439 between 2011 (June 30) and Q2 2016 (December 31, 2015). The increase was from minus $53,872 to a positive $427,567.
While the breakdown is extremely rough, it's apparent that the biggest use of cash has been simply to keep it, with:
- Cash (and cash equivalents) increasing by $496,672 - $76,361 = $420,311.
- Cash minus total liabilities increasing by $250,826.
- Total stock buybacks = $199,226.
- Total dividends = $30,672.
- Total cash invested = $29,558.
(More recently, buybacks have been the biggest use of cash).
I expect many analysts would regard keeping the cash as having a lazy balance sheet. My view is that for a company with no recurring revenue and dependence on emerging markets and product launches, with various risks (including any trick that Cisco might pull), money is the best insurance that money can buy. It might also be handy if an acquisition opportunity pops up or buybacks become very attractive, but I suppose I shouldn't praise the insurance and opportunity aspects for the same dollars.
The analysis here is not deep because Ubiquiti's cash flows are relatively simple. A high proportion of revenue drops down to net income. Most of the net income drops down to cash from operations, with a small reduction on average due to the growing working capital needs, and quite a lot of variation due to the swings in working capital. I recently wrote about cash conversion at a big pharma company (which I'm long), and there was both the material (in various reconciliations) and the need, with a poor record of converting profit to free cash flow which cast doubt over the ability to maintain the dividend in coming years. After a complicated analysis, I concluded that its cash conversion was very likely to improve. I don't see the scope or need for such an analysis in Ubiquiti's case.
I've made a kind of waterfall chart which illustrates Ubiquiti's cash flow statements from 2013 to H1 2016, including a breakdown of the change in working capital. I don't think the detail is necessary or that most readers will want it, which is why the graphic is only linked to. There's also a "bad news" table and a few spreadsheet tables on the link which I decided weren't worth including in this piece.
For someone else's explanation of the change in working capital, see oldschoolvalue.com (when the author refers to a previous error, he hadn't grasped that a positive "change" meant working capital had gone down, but it's a rare slip from him).
The main source
All the figures for Ubiquiti were taken from the SEC filings on its site.
Disclosure: I'm long UBNT.
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