Here’s a question: What do you do as an investor when cash earnings are growing rapidly but top line growth isn’t? Here’s another: What do you do if the stocks that you own appear to be priced for a lot of top line growth that isn’t happening; even though the bottom line is improving? These are the central challenges facing investors in small-to-mid-sized Canadian technology and special situations stocks – and while the trade-off’s seem reasonable (we’ve heard “those are problems that I’ll take any day” from several investors) – the implications are significant for stock valuations going in to 2011.
As at the end of October the average P/CF (“price to operating cash flow before working capital changes”) for stocks in the 250 company Caseridge TechSys Index was 15x trailing cash flows versus 16x at the end of September – a reasonable multiple in an up market that highlights the fact that cash flows are increasing at a faster rate than valuations: a healthy indicator for stock prices. Growth on the gross profit line however has been anaemic all year with an annualized growth rate of just over 8% as at the end of October and a meagre 0.14% growth rate at the end of the last reported quarter. Now recall that these figures are year-over-year growth rates from a disastrous 2009 in which gross profits declined by as much as 20%. Clearly rounds of downsizing and cost reductions were implemented by those companies that have survived the recession and the modest growth in 2010 has resulted in a return to cash profitability for the companies in our index. This downsizing then explains the strong earnings growth and the resultant cash flow multiples.
Our Caseridge model uses gross profit as our primary valuation indicator however, and using this model the market is by our calculation presently pricing in a 30% increase in gross profits over the next 12-months. This growth should it materialize will still leave us below the top line pre-recession gross profit values. We’d be satisfied with this valuation if we could see evidence of top line growth in the stocks that we track. But we’re not. With present gross profit growth rates ranging from 8% to 13% (annualized) we just can’t square the circle between the strong growth priced in to the market and the meagre growth rates that we are actually seeing in what are, after all, growth stocks. We are also concerned that the leverage to earnings for many companies that comes with growth may be low – meaning that a return to even 20% growth would require higher spending on infrastructure and staffing ("sustaining capex") to bring back the resources that were eliminated as we fell into recession.
A 20% gross profit growth rate for 2011 would represent a wonderful recovery. Unfortunately we’re being asked to pay for 30% top line growth by a market that appears to be confused by the strong earnings that have come from cost cuts rather than from growth rates. You can’t be a growth stock if you’re not growing, and you don’t deserve a 15x cash flow multiple if you’re growing your top line at 10%.
We hope that you enjoy this month’s Caseridge TechSys DealBook.
Adam E. Adamouadamou@caseridge.com
Disclosure: No stocks are mentioned in this commentary