Collectors Universe (NASDAQ:CLCT) is a perennial watchlist stock for me. The yield is usually enticing, and the company generates very high return on equity, or ROE.
It's clear from the above chart that ROE has spiked materially higher post-financial crisis. It also seems that it's becoming more stable than in the past, too. I'd like to start off by examining this recent phenomenon in more detail.
Breaking ROE into pieces
I created the below DuPont with data from the firm's financial statements to gain insight into what's driving Collectors Universe's recent surge in return on equity.
Note: 2015 in the above DuPont refers to results as of June 30th, 2015. This was the end of CLCT's fiscal 2014. It's currently about 3/4th through fiscal 2015, but due to the cyclicality of the business, I decided to use annual reported results for analysis only.
It looks like a mixture of increasing asset turnover (revenue/assets) and higher financial leverage (assets/equity) have contributed the most to the material gains in ROE over the last few years. This gives us a starting point for further examination.
CLCT shares currently pay a dividend that yields roughly 6.87%, which, on the surface, looks great. One glance at the firm's EPS, however, and we can quickly conclude that its payout ratio is also higher than normal at well over 100%. Before jumping to any conclusions about a dividend cut (the payout over 100% has been the story for many years now, and CLCT has a strong balance sheet with a fat cash pile to cover the dividend), I'd like to look at how the dividend impacts ROE.
How does the dividend effect return on equity?
So how is the dividend paid if the payout ratio is over 100%? Simple - out of the company's cash flow, or if that's not enough, out of its existing cash pile. This likely explains (at least, in part) the higher asset turnover ratio over the years. Let me explain.
Starting with the asset turnover ratio, revenues (the numerator in the equation) have inched up over the last few fiscal years, growing by only a little under 2% for fiscal 2014. The higher asset turnover, therefore, is largely due to this growth, as well as the company's ability to eke out this slow growth from a shrinking asset base. This is where the dividend comes into play.
The year ended June 30, 2015 (aka the end of CLCT's fiscal 2014) shows a cash balance of a little over $17 million, or about a $2.7 million decrease from the year before. Cash from operations dipped in fiscal 2014, coming in at about $10.6 million. This was lower than the $11.36 paid in dividends for the same year.
After subtracting the cash used for investing activities ($1.34 million) and financing activities (at a total of $11.92 million, with dividend payments accounting for $11.36 million of this figure), it appears Collectors Universe had to dip into its cash pile to the tune of about $2.66 million. This drain in cash from roughly $19.91 million at the beginning of the year to just $17.25 million at the end of the year was largely because of the dividend payment, which in turn contributed to the declining overall asset base - helping improve the asset turnover ratio in the process.
Other current assets that shrank year over year include inventories, prepaid expenses, and deferred income taxes. The only current asset that increased from June 30, 2014 to June 30, 2015 was accounts receivable, but overall, current assets decreased by about 11.59%, and they comprised about 74% of total assets. Cash accounted for a little over 72% of these current assets, so it has the ability to move the total asset base quite a bit.
Non-current assets account for roughly 26% of total assets, and these only shrank by around 3%. Now that we have the assets analyzed, we can look at equity and examine why the leverage ratio has continued to increase.
More leverage, more magnification
The more leverage, the more magnified ROE is. We already analyzed that a decline in total assets was mostly driven by a decrease in current assets (which consists mostly of cash). This explains the numerator of the leverage ratio. Equity, the denominator, decreased even more. But why?
Source: Collectors Universe 2014 annual report. Fiscal 2014 (year ended June 30, 2015) is on the left, fiscal 2013 (year ended June 30, 2014) is on the right.
We can see that the consistent payout above 100% contributes to an accumulated deficit. The company is paying out all of its earnings - and then some - which means there aren't any earnings left to retain. The increases in additional paid-in capital haven't helped offset the decline in overall equity, either, which helps explain the higher leverage ratio.
It also leads to a situation where overall shares outstanding increase, but overall equity declines on the balance sheet.
So, what's the effect on ROE?
I wanted to see what would happen if Collectors Universe decided to scrap the dividend, considering it looks unsustainable. The company's cash pile is currently at a decade low as of its most recent quarter, and now rests at only about $12.7 million.
Management stated in the Q3 conference call that this was still in the "safe zone," and that it was committed to retaining the dividend, and in management's defense, the business definitely does spit out a lot of cash flow. The company's CFO said that it would revisit the dividend if cash fell to $10 million or less during this year's first quarter conference call, though. It also requires only minimal capex to run the business, but I'd still like to see what ROE would be without the dividend.
Below I created a hypothetically adjusted DuPont analysis. I assumed no dividend payments were made during fiscal 2013 or 2014, and held everything else constant.
It appears ROE would probably be significantly lower if the company held onto its cash and retained all of its earnings. So maybe paying out more than it earns is a good thing? More on that later.
Collectors Universe is hard to value from a minority shareholder perspective, because many traditional models don't work very well. It's hard to value it using the dividend discount model, because the firm doesn't grow its dividend consistently. We could use the sustainable growth rate (retention ratio * ROE) as the input for g in the DDM model, but the firm doesn't retain any earnings, so that's out of the question as well. The free cash flow-to-equity valuation model might be appropriate, but I'm not looking to purchase the entire company.
So this leaves us with relative valuation methods, and I think the P/E ratio and relative dividend yield would be the most beneficial for calculating intrinsic value. According to Morningstar, the 5-year average P/E and 5-year average dividend yield for CLCT shares are 19.6 and 8.9%, respectively, leaving me with a feeling that the company is currently overvalued.
Shares now trade at about 23.6 times earnings, and despite the above-average yield in absolute terms, it's actually relatively lower than average. If we valued the company based on its historical valuations over the last five years, I think fair value is around the $15.75-17.25 range.
Conclusion: Should the dividend stay or go?
Collectors Universe is an unique firm operating within the context of a franchise. I think it would be nearly impossible for a new competitor to replicate the business expertise, knowledge, and reputation for quality grading and authentication that it's acquired over the years.
The company's only real competition is privately held NGC, but operating as a duopolistic franchise usually pans out in the form of higher profits over the long haul. Still, I'd argue that its return on equity is probably overstated when taken at face value. The improving asset turnover and larger leverage ratios that are driving ROE higher are mostly fiction - largely as a result of its abnormal cash draining habits and the lack of retained earnings.
As far as the burning question of "Should it cut the dividend?", I'd say that if Collectors Universe really wants to keep the dividend, then it should issue debt while rates are still low. This is assuming the company really can grow into its dividend payment as suggested by its management.
Analysts and investors frequently ask the company on conference calls about the sustainability of the dividend, and during the most recent call, CEO Robert Deuster said once again that, "we're very confident we'll be able to retain the dividend, at least with the business model and the activity we have...," but ended his response by saying that,
So, you can never say absolutely, positively forever on dividends, but I'll tell you our strategy up to this point in time has been to build the business model such that we have healthy cash flow with expansion of our reach around the world, serving the markets with good financial results that we should be able to continue this, and that's our goal.
Debt would allow Collectors Universe to manufacture some "breathing room" while waiting for future growth if it's really that insistent on paying out such a high dividend. That way the company doesn't have to tap its cash pile when there's a kink in its cash flow hose, either - at least in the short term.
Not only that, there's a good chance it would help lower the company's overall cost of capital in the process, because debt is a cheaper source of financing than equity is. Because Collectors Universe is still primarily a domestic outfit for the most part, it can turn its currently high tax rate curse into more of an advantage by creating a "tax shield" with the tax deductible interest payments that would result from debt issuance. As of now, the capital structure is all equity.
To sum things up, if Collectors Universe could afford to pay out the current dividend (and maintain the cash cushion to sustain it in rare cases when cash flow doesn't provide enough wiggle room), then it would make sense from a shareholder value ,perspective I guess. Unfortunately, this isn't true at the moment, because the cash pile is getting too low to justify the dividend without the cash flow growth to back it up. It doesn't look like the dividend will be covered in fiscal 2015, either.
Debt could pretty much solve the company's problems immediately to fund the dividend in the short term, but only temporarily. Growth needs to come, but what if it doesn't? Then management should eliminate the dividend, re-adjust the capital structure, and wait until the business is established enough to pay out a sustainable dividend that it can increase over time.
I think a clean cut might be better than a decrease, assuming management would then focus on rebuilding the cash pile, figuring out an optimal capital structure to settle on, and then reinstating a more realistic dividend payment. There would then be more certainty for investors, who would likely appreciate a more sustainable starting yield and an annual dividend increase to look forward to.
Even if Collectors Universe eliminated the dividend, it would be very tempting to pick up some shares if they fell back down to $17 or lower. I'd personally like to own this wide-moat company eventually - dividend or not.
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