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Professional Investor - Netherlands
23 May 2023

Mind the gap

Cash flows are the cornerstone of investing because cash ultimately drives the intrinsic value of a company. When discussing valuations however, especially when talking about multiples, investors often refer to earnings. A company’s earnings are smoother than its cash flows, which makes them more predictable and a good measure for long-term profitability. Cash flows can at times tell a different story though, and it is important for investors to take note. Especially when earnings and cash flows deviate over a period of time. This will help to avoid value traps, but more importantly, to spot future opportunities. 

In a normal, well-run company, over the long term there should be little to no difference between earnings and cash flows. The difference tends to be mostly in timing, when earnings and costs are recorded and when cash is spent or received. Lumpy items such as investments, M&A activity and restructuring charges can be expensed over longer periods in the income statement. A company’s cash flow statement does immediately take these items into account however, as it records cash coming in and going out of the company. This tends to make them more volatile and harder to predict, but they are important to investors as they can tell a different story. 

Cash flows and earnings can deviate from one another significantly, for example when a company is investing for the future. Capital expenditures push down cash flows but are not reflected in earnings until the investments are depreciated over time. It can thus be that a company can look attractive on earnings, but faces significant pressure on its near term cash flows. The other way around, cash flows can significantly outperform earnings when a company has completed investing and starts to monetize an asset. This often provides interesting investment opportunities.

Once-in-a-generation investments paying off
A good example of this can be found in the telecom industry. Telecom companies (telcos) faced a once-in-a-generation investment to upgrade their copper cable networks to glass fiber, which allows for much higher internet speeds. Because of the high upfront investment to build a fiber network, once it is in place the competitive advantage is huge. And once in place, the asset will generate revenue for decades. Given that internet is a vital part of today’s infrastructure, risk of obsolescence is low. 

During the investment years however, cash flows are depressed by heavy capital expenditures. This made telcos look cheap on earnings multiples. But when they still face years of heavy investments, this can be a value trap for investors. As these companies approach the end of their investment cycle, they can see big improvements in their cash flows and potential to return cash to shareholders. 

Some of the telcos in the Kempen dividend portfolios are now approaching this tipping point. The bulk of investments are in the past, which means capital expenditures will be gradually scaled back. At the same time, the investments in upgrading the network is starting to pay off by upselling to customers. As a result, cash flows improve significantly. In other instances, the future value is realized all at once, by selling the infrastructure at a much higher valuation multiple than what the company is trading at. Either way, it opens up the opportunity for increased shareholder returns in the form of dividends or buybacks. European telcos Telefonica and Hellenic Telecom Org. (OTE) for instance pay an estimated 7.6% and 4.9% dividend yield respectively, with OTE offering a 3% buyback yield on top. Both companies have potential room for growth as they see their cash flows improve.(1) 

Investing at the right time
Another example is Taylor Wimpey, a British housing developer. We hold this company in our dividend and value strategies as it is a company with solid strategic capital allocation, which we believe is underappreciated by the market. One of the main input costs for housing development is the acquisition of land. Developers tend to hold an inventory, or ‘landbank’, on which they can develop homes for several years. During the COVID19 pandemic, Taylor Wimpey invested heavily in the expansion of its land bank. At that time it was very contrarian, as construction sites were closed and it was difficult to see how big the impact of the pandemic would be on housing demand. Because of that, the company was able to buy years’ worth of land supply at very attractive prices. 

Now, several years later, the company has ample supply of land and can develop housing without the need to replenish its land bank in the near term. They can continue to generate strong cash flows by reducing land spend, even when home prices might take a turn lower and sales volumes decline. This results in Taylor Wimpey’s very attractive dividend yield of 7.6% (2) remaining well covered, while earnings may come under pressure in a cyclical environment. 

Long-term investments
Both examples above show how cash flows can tell a different story than earnings. Companies that have invested for the long-term the right way, can deliver attractive returns and shareholder payouts even when their earnings are under cyclical pressure. For investors it is therefore important to understand the cash flow generating power of companies.
 
1,2 According to Bloomberg analyst consensus data, May 22th 2023 

DISCLAIMER 

Van Lanschot Kempen Investment Management N.V. (VLK IM) is licensed as a manager of various UCITS and AIFs and authorised to provide investment services and as such is subject to supervision by the Netherlands Authority for the Financial Markets.

This document is prepared by the fund managers of Kempen Global High Dividend strategy (‘the Strategy’), managed by Van Lanschot Kempen Investment Management N.V. (VLK IM). The Strategy might currently hold shares in the subject company. The views expressed in this document may be subject to change at any given time, without prior notice. KCM has no obligation to update the contents of this document. As asset manager VLK IM may have investments, generally for the benefit of third parties, in financial instruments mentioned in this document and it may at any time decide to execute buy or sell transactions in these financial instruments. 

This document is for information purposes only and provides insufficient information for an investment decision. This document does not contain investment advice, no investment recommendation, no research, or an invitation to buy or sell any financial instruments, and should not be interpreted as such. 

This document is based on information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. 

The views expressed herein are our current views as of the date appearing on this document. This document has been produced independently of the company and the views contained herein are entirely those of VLK IM.

The authors

Marius Bakker Van Lanschot Kempen

Marius Bakker

Portfolio Manager

Roderick van Zuylen Van lanschot Kempen

Roderick van Zuylen

Portfolio Manager

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