Some problems are better to have than others. Not knowing how to spend your cash is a conundrum many people can only dream of having. This is an issue many companies are facing and their investors could benefit. Data from Capita Asset Services - released in October 2014 - showed FTSE 100 companies were sitting on net cash of £53.3 billion, up £15.6 billion from a year earlier.

Companies have become leaner and meaner since the financial crisis. Concerns over high debts and low organic growth prospects have fueled a raft of preservation strategies characterised by cost-cutting and a focus on the core business. Asset sales, falling costs and higher earnings now that the economy is improving have left many companies with substantial cash piles.

Directors have several options on how to use their excess capital to make their companies more competitive. Acquisitions, reducing debt and fueling organic growth could be on the agenda.

Companies expecting limited gains from these options are faced with pitiful returns from keeping their cash in the bank for a rainy day or through buying government bonds. Many are expected to return their excess capital to shareholders instead.

The companies Shares expects will hand more of their cash back to investors include retailer Card Factory (CARD), non-life insurer Lancashire (LRE) and courtesy car provider Redde (REDD:AIM). We also look closely at what defence specialist QinetiQ (QQ.) and internet domain services company Minds + Machines (MMX:AIM) will be doing with their spare cash.

Special payments

The main channel of returning cash to shareholders is through paying a dividend. The board recommends the size of such a payment for shareholder approval when the interim or full-year results are reported, or following a quarterly update at some larger companies. A dividend that grows in line with the company’s earnings per share (EPS) is the sign of a progressive business and warrants a closer look to ensure it could afford to continue growing its payments.

This route to handing capital back to shareholders may not be in the company’s best interests. Excess cash will typically be the result of a one-off event, such as a period of strong earnings growth or an asset sale. If management cannot increase the dividend by at least the same rate each year the market could take it as a sign that the company is in trouble or at best under-performing.

One way a company will return millions of pounds of its cash to investors without effecting its yield projections or valuation is to pay a special dividend. This payment is made alongside the normal, recurring dividend and is usually larger. Non-life insurer Beazley (BEZ), for example, recommended a 5.6% rise in dividend to 9.3p a share for 2014, alongside a 16.1p a share special dividend. This additional payment was made after profits fell
on the back of premium declines and management felt they could not generate a high enough return from investing the cash in writing new business.

This is a trend that has engulfed the non-life market in recent years and both private and professional investors are taking note. Athelney Trust’s (ATY) fund manager Robin Boyle says his investment trust last year bought stakes in numerous Lloyd’s insurance market underwriters because of their cash appeal. ‘I felt they were over-capitalised and would throw off wonderful dividends, and that’s what they’ve done,’ he comments, saying that other industries are following the same trend. ‘I feel the fund management industry is also over-capitalised and will soon have to pay hefty dividends. The problem is finding a stock that’s cheap. So far I’ve bought Jupiter Fund Management (JUP) and River & Mercantile (RIV), but can’t find anything else at present.’

A piece of the action

A special dividend is a bonus for existing investors and can grab the attention of those not holding the shares.

Investors lucky enough to receive word that they are in line for such a payment should use the windfall to buy more shares in the company to benefit from further growth. This will push the value of the shares up as more investors place orders, so move quickly and buy on the day the cash arrives before momentum builds in the stock.

It is not a good idea for investors to buy a stock simply to collect the special payment. Buying the shares before they go ex-dividend and then selling them may not generate any gains as the price automatically adjusts by the dividend’s amount as soon as the ex-dividend date passes.

Investors should only buy a special dividend-paying company if they believe the business is a sound investment, capable of generating sufficient future cash flows. So the rule is, back a company you would want to own and not just for the special dividend. High street retailer Next (NXT) is a one such stock that could draw investor attention for its investment case rather than its special dividend programme.

Silicon wafer recycler Pure Wafer (PUR:AIM) is an example of a company whose special dividend should be left to its existing shareholders. The company is to receive a huge insurance payment following a fire at one of its plants. The board plan to return the cash to shareholders instead of rebuilding the site, which is expected to be between 60p and 125p a share. Pure Wafer is unlikely to make similar future payments with it only making one year of positive underlying earnings in the past five years. At the time of the announcement Shares described the company as a ‘failed business and has been for years’.

Buying it back

There are alternatives to putting more cash in a shareholder’s pocket. A company can buy its own shares in what is known as a buyback. This is usually preferred to a special dividend when management believe its shares are undervalued. The acquired shares are then cancelled or held in treasury to re-issue at a later date or use as part-payment for an acquisition. Fewer shares in issue lead to improved earnings per share.

Valuation is not the only consideration when deciding on such a move. Companies typically consider buybacks when visibility of cash flows mean they can cope with debt and do not need to invest the cash in the business to remain competitive.

A perfect example of the role valuation can play when a board decide how best to return cash to shareholders is high street bakery Greggs (GRG). The company scrapped a planned £10 million buyback programme on April 29, replacing it with a £20 million special dividend. This works out at 20p a share.

Greggs reported record pre-tax profits for 2014, increasing 41% to £58.3 million, despite sales only rising 5.5% (4 Mar). Predicting another strong year of growth for 2015 it recommended a 12.8% dividend hike to 22p a share.

The company did not mention the rise in its share price when scrapping the buyback. Management citied a ‘review of its capital structure’ as a factor, despite its shares costing 32.6% more since the buyback was announced.

Next has a track record of regularly amassing more cash than could be deployed by investing in the business to deepen its competitive advantage and bolster earnings quality. Its first option was to continue its long-standing buyback programme, but it has since cancelled this strategy. The retailer targets running an efficient balance sheet, but if the shares are too expensive it will not buy. With the stock trading above the £58.00 maximum price the board set as a ceiling for buybacks it paid a 150p a share normal dividend and 150p a share special dividend in the year to the end of January.

Counting the cash

For investors wishing to spot an undiscovered income champion a closer look at a company’s profits and cash flow are crucial. Huge profits make good headlines, but investors need to remember that cash pays the dividend, not the profit. A business that is not generating sufficient cash from its profits should be avoided.

Operating cash flow - tax - capital expenditure =
Free cash flow to the firm

Another method is free cash flow to equity, which shows how much capital a company has to pay its ordinary shareholders.

Operating cash flow - interest - tax - capex - preference dividends = Free cash flow to equity

Another way to assess how efficiently a company is turning its profit into cash is to work out its operating cash flow conversion.

(Operating cash flow ÷ operating profit) x 100 = its operating cash flow conversion

The result should be as close as possible to 100%, if not this is a sign that too much of a company’s cash is being used to run the business and is not available to return to shareholders. Investors need to think hard about backing such companies, especially income-focused investors.

A quick way of assessing the quality of a company’s cash flow earnings is to calculate its free cash conversion rate, which shows how much of a business’ earnings per share converts into cash.

Free cash flow ÷ normal EPS X 100 = free cash conversion

Shares’ key picks

Card Factory (CARD) 363.5p

Market Cap: £1.24 billion

Prospective PE Jan 2016: 19.8

Prospective PE Jan 2017: 17.8

Investors seeking a chunky capital return might consider budget greeting cards-to-gifts retailer Card Factory (CARD), where a special dividend looks imminent. Founded in 1997 with just one store, Card Factory has expanded into a nationwide chain of 783 stores, delivering like-for-like growth in every year since.

Its vertically integrated model, spanning in-house design and printing, then retailing to the customer, is a key point of differentiation, reducing the company’s external costs which it can then pass on to customers. Besides sector-leading EBITDA margins of around 25%, the model also generates copious amounts of cash, which Card Factory can invest in the business and also use to fund a progressive ordinary dividend and return excess cash. Record preliminary results (25 Mar ‘15) highlighted the strength of Card Factory’s value-focused market position, with sales up 8% plus to £353 million and EBITDA margins 40 basis points higher at 25%.

The numbers also showcase Card Factory’s cash-generative business model, with net debt down from £160 million at IPO (15 May ‘14) to £104 million. A subsequent first quarter update (27 May ‘15) flagged further progress with the new store roll out and online business, and a further reduction in net debt to £92 million. Card Factory announced a planned return of surplus cash towards the end of the current financial year to January. Details on the size, method and timing of the return are promised alongside the interims (22 Sept), though a special dividend appears more likely than a buyback with the shares 62% north of their 225p issue price.

On Investec Securities’ estimates, investors could receive around £120 million were Card Factory to return all surplus cash during the fiscal years to January 2016-2018.

(Click on chart to enlarge)

Even without a cash windfall, Card Factory offers exposure to an exciting store roll-out story, with a 1,200 store target suggesting a visible growth runway ahead. Bears might argue the rise of digital greetings cards presents a threat, though the greetings card market has proved resilient and Card Factory benefits from its value proposition, as UK shoppers are well and truly weaned on affordable product. For the year to January 2016, Investec forecasts improved pre-tax profits of £80.3 million for near-10% growth in earnings to 18.4p (2015: 16.8p), ahead of £87.8 million PBT and 20.4p EPS by 2017.

The ordinary dividend is forecast to rise from 6.8p to 7.4p this year, ahead of 8.1p next. (JC)

[broker_consensus 3 0 3 0]

Lancashire (LRE) 647.5p

Market cap: £1.2 billion

Lloyd’s of London insurer Lancashire (LRE) may have had a quiet first quarter by its standards, but generating a $51.5 million pre-tax profit points to another good year despite difficult market conditions.

The Bermuda-registered company, which covers property, energy, marine and aviation, reported a $226.5 million pre-tax profit for 2014, smashing the $188.1 million forecast by Westhouse Securities.

This was achieved despite pressure on premiums due to competition and a lack of price-rising storm activity, while investment returns remain limited by low interest rates and falling government bond yields.

Despite profits in the opening three months of 2015 being slightly down on those recorded a year earlier Lancashire continues to kick out cash. It paid a 10 cents per share normal dividend for the period and a 50 cents special dividend, putting the stock on a 6% yield in the first quarter. In 2014 the stock yielded 18.5% after paying a 15 cent normal dividend and a 170 cents special dividend, a total of 185 cents, and more is expected.

(Click on chart to enlarge)

Lancashire also bought $25 million of its own shares in 2014, a signal that management believe the company was undervalued by the market. Including dividends and buybacks Lancashire handed $137.7 million back to shareholders in 2014. Westhouse estimates that it will return some 90% of its profits to investors this year.

A tight rein on costs and sound underwriting performance is driving growth. A combined ratio of 72%, meaning that for every £1 it collects in premiums it pays out almost 72p in expenses and claims, gives the insurer plenty of room to navigate through the current low growth market. Lancashire has proved before that it has the capacity to surprise and the strength of its core business could be the driver for future upgrades.

Alternative uses for its cash include buying another company while valuations are believed to be low. Lancashire, however, has already expanded its operations through buying another business.

In August 2013 it spent £135 million buying underwriting house Cathedral Capital for £266 million. The deal increased Lancashire’s scale and has strengthened its hand when negotiating deals with insurance brokers.

This deal was part of a wider consolidation trend in the non-life industry with companies spending their cash on buying growth. Lancashire’s underwriting expertise and cash flows could put the stock on someone’s acquisition radar. (MD)

[broker_consensus 2 2 4 0]

REDDE (REDD:AIM) 128p

Market value: £365 million

Overcapitalised and undervalued insurance outsourcer Redde (REDD) looks a prime pick for investors searching for yield.

Providing courtesy cars to insurance customers, the opportunity at Redde comes from its swelling coffers and improving financial performance after a restructuring which involved the cancellation of bank debt and new money raised from shareholders.

Delayed payment of invoices, regulatory uncertainty as well as operational mishaps put strain on the Bath-headquartered firm’s ability to service its escalating debt load in 2010 and 2011.

Recapitalised in stages between 2011 and 2013, £365 million cap Redde reported balance sheet cash of £63.3 million at its last results update for the six months to end-December. Debt was a negligible £350,000 and finance lease liabilities totalled £14.9 million.

‘Net cash on the balance sheet - it’s about as conservative a balance sheet as you can get in the credit hire insurance market,’ says Cenkos analyst Sandy Chen.

Steps taken to bolster the balance sheet coincide with a turnaround in operational performance at the business.

Better management of working capital, investment in technology and optimisation of its vehicle fleet - as well as buoyant end-markets - helped earnings before interest, tax, depreciation and amortisation (EBITDA) grow 84% at the half-year stage to £14.3 million.

Net cash generated from operations was even higher at £16.2 million and net capex was negligible, comfortably covering a dividend payment of £9.8 million in the period.

After the period-end, Redde paid out a 4p interim dividend putting it on course for a full-year pay-out of 7.5p and a prospective yield of 5.8%.

It’s important to note forecast earnings per share at Redde is also 7.5p. The high dividend yield in part reflects management’s policy to pay out 100% of earnings to shareholders.

‘Redde’s dividend yield remains attractive at circa 6% and should positive performance persist during Q4, upgrades would prompt an increase in expected pay-out in line with the 100% distribution policy,’ wrote Andrew Watson at house broker N+1 Singer on 27 April.

‘We see potential for price appreciation towards and beyond 150p should the yield converge towards the current market yield (3.8% consensus).’

Earnings per share and the dividend pay-out will fall slightly in the 2015/2016 financial year to 7.4p and 7.1p per share respectively according to Watson’s forecasts before resuming an upward trajectory the year after.

Supported by net cash on the balance sheet and the potential to re-lever the company’s balance sheet (within sensible limits), Redde looks capable of delivering solid dividend pay-outs for years to come. The odd special dividend pay-out could also be part of the mix.

Shares in Redde have rallied 39.9%, including dividends, since we highlighted the attractions of the stock at 94.5p (2 Feb 2015, Cover story). That compares to a gain of 5% on the FTSE All-Share, with dividends reinvested.

Despite significant gains on the stock following the restructuring there looks to be a sufficient margin of safety at Redde to remain bullish, in our view.

Key risks include a weakening of the auto insurance market, regulation, availability of vehicle finance and recovery of receivables. (WC)

[broker_consensus 1 0 0 0]

OTHER CASH RETURN STORIES

QinetiQ (QQ.) 236.4p

The new chief executive at technology-orientated defence stock QinetiQ (QQ.) has a choice to make. Steve Wadey took the job in April and has been left a pretty decent legacy following the repair job done by his predecessor Leo Quinn (now looking to repeat the trick at troubled construction play Balfour Beatty (BBY)). Having initially struggled amid a wave of industry spending cuts, the leaner, more cash generative business now enjoys considerable balance sheet strength. Net cash stands at £195.5 million as of the end of March.

Wadey could use these funds to invest in organic and acquisitive growth both overseas and at home or he could return excess cash to shareholders and wait for UK defence spending to recover. The latter would probably be the safer choice and the company is set to complete a £150 million buyback in July - launched after the disposal of its US services arm in spring 2014. UK defence budget uncertainty is unhelpful. 57% of March 2015 revenues were from the UK Ministry of Defence (MoD). On 4 June George Osborne said the MoD would face £500 million worth of cuts just this year.

The Strategic Defence and Security Review later this year - the first such review since 2010 - may offer an indication of where these cuts will fall. Arguably this creates a need to diversify away from the UK in order to protect profits, thereby putting hopes for bumper cash returns on the back-burner. We may have to be patient in finding out Wadey’s thoughts. As Investec notes: ‘Investors waiting for an indication on the direction and strategy of the incoming CEO will have to wait until later in the year, at the earliest.’ (TS)

Minds + Machines (MMX:AIM) 8.45p

Internet domain name registry business Minds + Machines (MMX:AIM) is a play on the explosion of so-called top level domain (TLD) names. These are the letters at the end of a web address such as .com, .co.uk, .org and so on. In the coming years more than a 1,000 more could become available ranging from city names like .NYC to niche areas like .beer. Some names have been allocated uncontested, others have required a little negotiation to secure, while a number of the really in-demand TLDs have gone to auction. The auction process has a strange quirk to it whereby the winner hands over the cash not to the industry’s governing body ICANN but to the losing bidders. This has proved a lucrative money-spinner for Minds + Machines - generating one-off gains of $34 million in 2014 from ‘losing’ in 20 of these auctions.

In 2015, the group has several new top level domains to launch such as .law, .abogado, .miami and others that are expected to drive cash sales. The majority of 2015 revenue is expected to come in the second half as the group launches new TLDs and as it begins to see renewal registrations from the existing TLDs it launched late in 2014. The group is also involved in 10 contested auctions in the remainder of 2015 and it has indicated that once these activities are completed it will be in a good position to assess its long-term cash needs with a view to potentially introducing a progressive dividend policy or a one-off dividend or share buyback. We view the latter as more likely given the lumpy nature of its cash flow. (TS)

EVENLODE'S DIVIDEND WINNERS

Evenlode Investments, which manages the UK equity income fund Evenlode Income (GB00B42KPP53), has identified its preferred 10 solid income plays over the next five years.

The £293 million fund, led by founder Hugh Yarrow and co-manager Ben Peters, targets sustainable real dividend growth, so it backs companies with high returns on capital and strong free cash flow.

This means stocks with intangible assets, such as brands, intellectual property and customer relationships. ‘We are income investors and we are focused on delivering not only dividends today, but sustainable growth in dividends over the long term,’ Yarrow tells Shares. ‘The only way that a dividend can grow sustainably is if the company that is producing that dividend is able to grow its free cash flow.’

Reckitt Benckiser (RB.) £57.31

Evenlode says: Brands include Dettol and Finish. Long-term potential in emerging markets is excellent, representing
more than half of the company’s sales.

Burberry (BRBY) £16.59

Evenlode says: One of the UK’s strongest international fashion brands with plenty of growth potential. It also has a strong online presence.

Sage (SGE) 549.5p

Evenlode says: More than 6 million customers in 160 countries buy Sage’s products, such as its accountancy software. It routinely converts profit to cash flow and as well as the historic growth in ordinary dividends, special dividends have been a feature in the past.

Spectris (SXS) £22.14

Evenlode says: Spectris makes devices and systems that help other manufacturers and producers to become more efficient. It has plenty of potential for growth over coming years.

PZ Cussons (PZC) 358.1p

With brands including Imperial Leather, Carex and Cussons Baby. Has good growth potential in emerging markets long-term, with leading positions in Africa and Indonesia.

Euromoney (ERM) £11.90

Subscription-based products make up more than 50% of the business-to-business media company’s revenues.

WS Atkins (ATK) £14.66

A market leading UK engineering consultancy with strong positions overseas. A solid balance sheet and high free cash flow cover supports a progressive dividend policy.

Rotork (ROR) 254.2p

Evenlode says: A highly cash generative business model and strong balance sheet equip it well for paying sustainable dividends, and special dividends have been a feature.

Diploma (DPLM) 810p

You turn to Diploma when you need anything from a replacement part for your dump truck’s hydraulic cylinder to a chemical reagent for a diagnostic blood test. These are niche markets which Diploma has come to dominate over the years.

PayPoint (PAY) £10.60

A payment technology company that helps people pay utility bills, top up mobile phones, pay tax, buy parking tickets and send parcels. Limited capital requirements, a strong balance sheet and free cash flow support a healthy dividend yield. Management takes a pragmatic attitude to returning excess cash to shareholders, which has included special dividends in the past.