The Dividend Trap

A dividend trap is where a stat is published stating the dividend return of a company, where that stat is incorrectly used to derive value in a stock.

For example, if a company pays out 50% of it’s earnings as a dividend each year, which equates to 5% of the current share price, one might assume that they get 5% Return On their Investment (ROI). However, if the company has a bad outlook for coming years, resulting in a drop in future earnings, the future dividend may only be 1% of the current share price, giving a 1% ROI.

Tip: A downward trending share price might give a clue that there is a dividend trap!

Lewis Hurst

Similarly a dividend trap can occur if an investor assumes that dividends are being paid from earnings, but actually the dividend is coming from the sale of subsidiaries, large assets (such as stock, in the case of an ETF), or debt – which makes future dividend payments of that size unsustainable.

Moral of the story: Don’t buy stocks based on the dividend without looking into the finances and company outlook.


Kathmandu (NZX:KMD) Quick Overview

The aim of this overview is to try to work out if there’s any value to be gleaned in the current Kathmandu Holdings Limited (KMD) share price. To be clear I’m only doing a quick overview – I don’t expect to be diving very deeply into KMD to determine what’s the most appropriate type of valuation for this company or the nuances of it’s operations, which an investor should probably be interested in. I’m simply skimming over this to see if there’s any value to be had, and on what terms.

So, as an investor rather than a trader, I’ll be looking at a longer term investment. I’m not looking to gamble on the short term prospects of state of the economy, market sentiment or the development of COVID19.

Therefore my approach will be to try to see if there’s any value in the current share price, based on the premise that in 2-3 years time KMD will be trading as it did in 2019. And in determining value in the current share price, I will be considering the opportunity cost of 2-3 years of investing lost to get back to the state of play in 2019, and whether there is likely to be another capital raise.

Working Out If KMD Will Do Another Capital Raise (CR)

KMD recently did a $207m CR and made ~$15m cost reduction initiatives, including rental costs and employer subsidies in NZ, AU and EU. I see that they managed to get just under $4m from NZ wage subsidies.

2018/19 Operating Expenses were $225.7m and $234.0m, respectively.

2019 Net Debt was $19.3m (down from 2018 by about $10m).

Gross Product Margin is about 60%.

The average NPAT over the last decade was $37m, not accounting for inflation. The past 2 years results were abnormally high compared to former years – probably should research why that it if I was going to dive deeper, but I won’t.

It looks like prior to the $207m capital raise, they didn’t have much in the bank to get them through (about $25m + $4m wage subsidy that’s not listed on the balance sheet) – out of which there are a bunch of current liabilities ($81m), which seem to rely on inventory being sold, as I understand the balance sheet.

A crude calculation suggests that they might have about $151m in cash + $123m in inventories ($65m of which need to be sold) to cover $219m worth of costs in the coming year.

The more I delve into this, the more I feel that it’s difficult to have any idea if they will likely need to raise capital (CR) again next year because there are too many variables to work out if they’ll be covered for the following year.

Nevertheless, they seem like they’re probably covered for this year, and the security of the following year will entirely depend on how well they do this year, or they’ll need another CR.

Finding Value In The Current Market Capitalization

Lets increase the current MC by 8% to account for the required rate of return to cover opportunity cost, then lets pessimistically assume that they do another CR next year, which dilutes shares, effectively increasing the price of them today by 30%. Then lets increase the MC by 8% again to account for the opportunity cost / required rate of return for investing for that year. This gives an effective current MC of $1,060m at todays price.

A MC of $1,060 against a future NPAT of $37m (which is the average across the past decade – a little low, I know, but coming out of a recession, profit won’t be amazing, so this value might be prudent), gives a ratio of 28 (3.5% dividend after tax, at best). Assuming that the year after, things return to recent year’s NPAT of ~$50m, this would be a ratio of about 21, which equates to a less than 5% dividend (after tax) in a couple of years time.

The prospect of a future 3.5 – 5% dividend (after tax) is not enticing enough to risk my money for, and get no 8% return for a couple of years prior.

Of course, this is the pessimistic view. Without a CR and with a small profit this year and a return to $37m NPAT the following year would give a ratio of just over 20 (5% dividend next year after tax, at best), or a ratio of ~15 if NPAT returns to $50m next year – giving a dividend of up to ~6.5% (after tax).

So, is there any value in the current share price? For me, not really, but it’s not that bad in a portfolio that wants a reliable OK (but not too exciting) dividend in a few years time. Addendum: Looking back, I originally said that there wasn’t value for me, but that was based on the belief that there wasn’t much growth in KMD. I now believe that this is wrong, making my projected PE a bargain (and still a good option for someone looking for a reliable dividend).

There’s a bit of a dividend trap there on the NZX website, which suggests that you could get a 15% dividend (before tax) based on previous dividends and today’s share price.

For me to be interested, I would want to be investing in KMD at about $0.50. Of course, it entirely depends on what your exit strategy is – someone buying as a trader may well find value here. Or someone looking at the numbers in their own way might find value – after all, this was a quick overview and I didn’t delve very deeply into any of the numbers, history or other factors that may effect my perception of value in KMD. Moral of the story, you may wish to do your own investigation to see if there’s value in KMD’s share price today.

Addendum: If KMD return to recent years NPAT, based on a Comparables Market valuation, one would expect that in a few years time, KMD would return to pre COVID19 share prices. If we assume no dilution during this period, an investor could see themselves doubling their money based on an exit strategy of a sale. If there’s a dilution of 30%, this could return only +40% (100% – 30% = 70% x 2 = 140%, or a 40% increase) during this period (Of course a 40% increase over 2 years is only 18% increase pa, compounding).

The downside risk would be two consecutive years of dilution, or no return to recent years performance. Alternatively the downside might be performance returning to recent years results, but not market sentiment. In which case, the above dividend return would be the exit strategy. Clearly any investment in KMD would be a sale with the view of a trade (depending on market sentiment) or an investment of 1-2 years, the fail scenario being if there were multiple consecutive years of capital raises before return to normal (100% – 30% = 70%, 70% – 30% = 49%, 49% x 2 = 98%; aka -2% change in value to portfolio).