The Canadian Investor - Episode 26 - Why free cash flow is so important and Cargojet

Episode Date: April 30, 2020

We start the episode by discussing the cash flow statement and why we think free cash flow is so important. We then talk about the Cargojet and provide our thoughts on it. We finish the episode with o...ur Tip of the D’eh!Tickers of stocks mentioned : CJT.TO, CNR.TO, CP.TO. TFII.TO , XPO, CTC-A.TO, HD--- Send in a voice message: https://anchor.fm/the-canadian-investor/messageSee omnystudio.com/listener for privacy information.

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Starting point is 00:00:00 Welcome back into the show. This is the Canadian Investor Podcast, made possible by our friends and show sponsor, EQ Bank, which helps Canadians make bank with high interest and no fees on everyday banking. We also love their savings and investment products like GICs, which offer some of the best rates on the market. I personally, and I know Simone as well, is using the GICs, which offer some of the best rates on the market. I personally, and I know Simone as well, is using the GICs on a regular basis to set money aside for personal income taxes in April of every year. Their GICs are perfect because the interest rate is guaranteed, and I know I won't be able to touch that money until I need it for tax time. Whether you're looking to set some money aside for a rainy day or a big purchase is
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Starting point is 00:01:32 I'm joined by my co-host Brayden Dennis. This is actually take two of this recording. We had some technical issues yesterday and it was a complete beep show. So we had to redo it because if not, it would have taken forever to do. So yeah, welcome back. Today we'll talk about the cash flow statement. After that, we'll talk about the Canadian company Cargojet, if I remember correctly, they're from Mississauga.
Starting point is 00:02:00 And we'll finish off with our tip of the day. Brayden, how's it going in Toronto? It's good, man. You mentioned that this is the second time recording this episode. That is true. This is Groundhog Day. We gave it a shot yesterday, but we had the whole thing. We had the dogs barking, the fire truck whizzing by my house,
Starting point is 00:02:21 the internet going out, my computer crashing. So here we go. It's the second period, but we're going to finish strong here. It's good to be here. We're going to talk about the free cash flow, the cash flow statement in general. Yeah, a darling out of Mississauga, Ontario, Cargojet, that stock's been on an absolute tear recently so simon and i are going to give our take on it talk about the actual fundamentals and then we're going to give our tip of the day uh which is a fun one uh if you read any of peter lynch's books which i recommend people should he talks about this all the time and i think it's kind of fun too so do you want to kick it off with the cash flow statement
Starting point is 00:03:05 and explain why we talk about the metric free cash flow so often? Yeah, definitely. So I'll explain why we never shut up about the cash flow statement. And there's a good reason for that. So as you guys, you're probably listening either if you're getting into investing or you have a bit of experience. You'll notice when you see headlines, they tend to talk about earnings. It's always about earnings. Problem with earnings is oftentimes they can be a bit misleading. So it's really important to not only look at the statement of earnings, the sales, the net profit, growth profit, all of that. But it's also important to look at the cash flow statement. So when you look at the cash flow statement, you essentially get
Starting point is 00:03:49 the net income, so the net profits. And then you add back in some non-cash items that were deducted in your earnings, so as cost basically. So type of things that are added back in is one of the easy ones to wrap your heads around it is take for example a real estate company. So they own real estate whether it's apartments for example. While those apartment buildings they have to record depreciations on those. Problem with that is it's usually not necessarily a reflection of reality for real estate REITs or real estate companies, but for other types of business as well, even though it may be warranted that they reduce the value of the actual assets, well, it's actually not a cash charge. So even though it's deducted as an
Starting point is 00:04:46 expense in the earnings, it actually is put back in the cash flow statement. So that really, that shows you a bit more the cash flow statement. The purpose of it is actually to show you exactly what's coming in and out in terms of cash for the company. So you'll have the cash from operating activities. There's a bit more to that and Brayden can elaborate a bit more on that. There's the cash flow from investing activities and cash flow from financing activities. So the one metric Brayden and I tend to look at and talk a lot about on the podcast is free cash flow. So free cash flow, you just end up taking the cash from operating activities and you subtract capital expenditures. So the capital expenditures will actually be, you'll see that amount in the cash flow from
Starting point is 00:05:39 investing activities. You'll either see it as capital expenditure. A lot of people refer to it as CapEx, or you might see it as well as purchase of property, plant, and equipment. So those are usually the things that you'll see. So when you take the cash flow from operating activities, you subtract the capital expenditure, and that'll give you your free cash flow. That's really important because it gives you a good idea of what cash is left after that and what the company can actually pay out as dividend or use to reinvest in the business or buy back shares.
Starting point is 00:06:16 That's another use that we've seen a lot of companies do in recent years. That's a great summary. So let's break it down for what it is okay so the reason we're talking about free cash flow and some people are like oh i already know about free cash flow but a lot of people don't and some people go years of investing with only looking at net profit or net earnings on the income statement um before they realize free cash flow is a very useful metric so we're gonna help some people leapfrog that discovery by talking about it now. Okay, so let's break it down for what it is. Free, the word free. Think of it as I am CFO, CEO of company X. And this is the money that I am
Starting point is 00:07:00 freely able to use to allocate in the business. And there's three kind of branches you can think about how a company can allocate money with free cash flow. So number one, reward shareholders by paying a dividend. So that's why you hear Simon and I talk about what's how much are they paying out compared to free cash flow. So that'll get an idea of an idea of how safe the dividend is. So they can, one, pay a dividend. Two, buy back stock. We've seen companies do this a lot in the last decade. Number three, invest back in the business. So this branch leads to a myriad of a million different decisions on how they want to allocate capital back into the business. But those are the three main ones. So in summary, reward shareholders with dividends to buy back stock, or three, invest back in the business. So why is that important?
Starting point is 00:07:59 Right? If we look at the actual formula, let's break it down. So it is operating cash flow minus capital expenditure. But let's break that down even further. What is operating cash flow? So the start of the cash flow statement is actually net income. So the bottom of the income statement is the top of the cash flow statement. So we got net income. And then what we're going to do is we're going to unravel all of the weird accounting that happens on the income statement. Because let's think about it. Think about your own bank account, right? Why would
Starting point is 00:08:39 you not include some of these things like capital expenditure? Or why would we include things that are not real cash transactions like depreciation? So what we're going to do is we're going to take net income, we're going to add back depreciation and amortization because those never should have got subtracted anyways. Sure, we want to account for them as manufacturing plants and real estate, depreciating value, put that on the book, sure, whatever. But there's no real cash transaction from that happening. So we're going to add back depreciation. We're going to add back amortization. We're going to add back the changes in cash and the changes in your inventories and merchandise that you have on the books.
Starting point is 00:09:26 We're going to adjust for all that stuff that is not a real cash transaction. And then after that, we have operating cash flow. And then we're going to reduce capital expenditures. Why would we do that? Okay, let's think about it. If you own your home and you're looking at all the money you're able to invest back in the business or invest in your brokerage account, sorry, and you have some kitchen renovation that you need to do or something, why would that not be included in terms of the actual cash, the free cash they're able to then go invest later or do whatever you wish with it. That is the actual amount of cash they're able to use. So think of free cash flow like that. Now, I will say one more thing. The reason earnings is useful for a screening perspective
Starting point is 00:10:20 is because it's more predictable. Because if company A has some big investment in property, plant, and equipment, which is the same as capital expenditures, it's easier for us to look at it because it's more predictable. So you might be screening out really, really good companies because free cash flow was down a bunch last year. So it goes up and down more, but the long-term trend is very important, but not very useful if you're screening on, did their free cash flow increase more from last year? You're going to miss out on a bunch of great businesses. And the reason for that is primarily because of capital expenditures. So think of free cash flow as just kind of how I summarized it earlier, the amount of cash that the business can truly use to grow or reward shareholders.
Starting point is 00:11:24 Yeah, and that's exactly how you should see it. And you'll see that some businesses, they actually are not, you know, they'll be free cash flow negative, but they'll still buy back shares and they'll still pay a dividend. Well, how can they do that? Well, usually it's pretty simple. They're boring to do with it. So it's one thing if it's like a one-off for a year, but if it's something that's consistent with that business, that should raise some red flags for you. And I mean, if you're invested in those type of businesses and you've been for a while, you've probably been hit pretty hard by the recent downturn, unfortunately, because those businesses are being exposed, usually because they have too much debt. So that's
Starting point is 00:12:05 something to keep in mind. And the free cash flow is so powerful because it shows you a true picture. If the company didn't want to borrow, didn't want to do anything else, well, their business is still sustainable and they can reinvest in the business. They can still potentially pay a dividend. They don't always need to pay a dividend. it's still a good thing to have free cash flow regardless and keep in mind too that you can have a business that will be that will have negative earnings so negative profit but then they'll actually be free cash flow positive and you'll see that the opposite as well so you'll have a business that you'll be like oh my god they're doing awesome profits.
Starting point is 00:12:47 They're doing great. Then you look at their cash flow statement and you're like, oh, well, look at that. It's not really as rosy as I thought it was. Well, that's because it's a lot easier to put, let's say, play around in the earnings, in the income statement than it is in the cash flow statement cash flow statement tends to give you a much clearer picture of what's going on the income statement is really good too you should always look at both especially obviously sales you want to look at that but there's
Starting point is 00:13:19 certain things in the income statement that you should always be careful and definitely use that income statement with the cash flow statement that you should always be careful and definitely use that income statement with the cash flow statement when you do your analysis. As do-it-yourself investors, we want to keep our fees low. That's why Simone and I have been using Questrade as our online broker for so many years now. Questrade is Canada's number one rated online broker by MoneySense. And with them, you can buy all North American ETFs, not just a few select ones, all commission free, so that you can choose the ETFs that you want. And they charge no annual RRSP or TFSA account fees.
Starting point is 00:13:57 They have an award-winning customer service team with real people that are ready to help if you have questions along the way. As a customer myself, I've been impressed with Questrade's customer service. Whenever I call or email, every support rep is very knowledgeable and they get exactly what I need done quickly. Switch for free today and keep more of your money. Visit questrade.com for details. That is questrade.com. That is questtrade.com. Here on the show, we talk about companies with strong two-sided networks make for the best products. I'm going to spend this coming February and March in an Airbnb in South Florida for a combination of work and vacation and realized, hey, my place could be a great Airbnb while I'm away.
Starting point is 00:14:48 Since it's just going to be sitting empty, it could make some extra income. But there are still so many people who don't even think about hosting on Airbnb or think it's a lot of work to get started. But now it is easier than ever with Airbnb's new co-host network. You can hire a local quality co-host to take care of your home and guests. It's a win-win since you make some extra money hosting on Airbnb, but can still focus on enjoying your time away. Find a co-host at airbnb.ca forward slash host. That is airbnb.ca forward slash host. That's a great summary. So let's switch gears to CargoJet,
Starting point is 00:15:34 ticker CJT, traded on the Toronto Stock Exchange. It got absolutely pummeled as the market fell. It fell 40%. And then, boom, since March 18th, the stock is up 87%. So it has come back in a major way. Year to date, the stock, everything else is down pretty much in 2020. And the stock's up 35%. Let's give you some more numbers on how well this has done since it's IPO in 2011. Cargojet is up over 1500%. This has been an
Starting point is 00:16:17 incredible performer for shareholders. It would have been a pretty small company when they first IPO'd but they're still not that big now so I love companies in this little sweet spot of 2 billion in market cap really gaining some momentum but lots of room for growth let's throw some more numbers at you I know this is a podcast and you're probably like ah can you repeat those but here we go so from an earnings multiple, it's really not helpful to look at it because the stock did, earnings wise, did not do great in 2019. So you're like, ah, it's 158 times multiple and on trailing 12 months, but that's not helpful. It's about a four times sales multiple in terms of valuation. They have grown the dividend at around 10% a year, I see.
Starting point is 00:17:12 Earnings went way down in 2018, so payout ratios inflated again. It's honestly way more helpful to look at this stock from 2018 numbers. Revenue growth, you're looking at high double digit like like 17 percent 50 percent in 2014 and then went down a little bit so i'm gonna give let simon give his quick take on it as well before i talk about the most important thing to discuss when you're talking about cargo jet and that is their relationship with big bad amazon yeah so cargo jet just to give you guys a bit more of an idea so they like it kind of they have a pretty good name if you ask me so it explains pretty quickly what they do um so they
Starting point is 00:17:59 actually do overnight i think most of their business is actually overnight shipping through um to jets obviously so they have relationships with all the major airports so they have well relationship i mean they they go from all the major airports in canada east to west like brayden just said they actually have a pretty close relationship with amazon i know it's not their only client and unfortunately they don't disclose what percentage of their business is allocated with Amazon and all the other clients. They're not obligated to do so. I wish they did. Some companies do say it, which one is their major clients, what percentage of the business. But they do a lot of business obviously with them and it's a good company if you want a bit of the online e-commerce play so what's going on right now so for them it'll definitely be I
Starting point is 00:18:53 think a tailwind I know reading a bit of press releases that they have gone out recently they haven't gone too much into detail about COVID-19, but it was a top priority for them for the health and safety of their employees. I know one other thing is that for the most part, they're not unionized, but I think their pilots, if I remember correctly, I saw that they have a bargaining contract until 2023. So that's good because it gives them a bit more certainty. There's definitely probably going to be a bit more costs for them related to COVID-19. However, they may benefit from lower gas prices because jet fuel is very dependent on that. So that might be a good thing for them where their costs will go down a bit. However, I don't know how much they've edged in the past for gasoline or for jet fuel.
Starting point is 00:19:51 So that is one thing. They might have had contracts that go beyond, you know, right the next couple months to guarantee a price. But if they can benefit from the lower gas prices, lower jet fuel prices, it could be good for them. from the lower gas prices, lower jet fuel prices, it could be good for them. In terms of the numbers, it is going up at, I think, high single digits every year. So I don't know in terms of what they're forecasting. My inkling is probably that management will pull guidance when they come out with their next earning report, which is pretty standard for pretty much any business that's open or any type
Starting point is 00:20:28 of publicly listed company right now. So that's a brief overview on it. I might add a few more things after Braden's done, but you can go ahead, Braden. Yeah, sure. So the company's been firing on all cylinders. It does get annoying in your analysis when Q4 of 2019, they lost 33 cents a share. So it kind of throws off a lot of the numbers when you're doing your typical analysis on the story you're looking to see. But I promise you, if you look deeper, you know, this company has been on a tear. And the stock has been also on an incredible tear. So let's talk about the relationship with Amazon. So in 2019, Amazon purchased 9.9% of the company because there's regulation around if they own 10%. And with that 9.9% is like, you know, an agreement that they can buy another 5% in a few years, if they meet some amount of volume of goods moved for Amazon. And, you know, Amazon, Bezos is not afraid to just cut out
Starting point is 00:21:49 middlemen. I used to FedEx got absolutely slashed last year, when Amazon said we can do it ourself. So to be able to have that tie with directly with cargo jet in terms of, you know, their interest being in the success of cargo jet is really, really important. And as an investor, it feels good when you know that most of their business or a lot of their business is coming from Amazon, which is not surprising at all. So when I look at this company, it says airline on it. When you look at the stock. It's an airline, yes. They operate airplanes. But this is a transportation logistics company. It is not a, you know, let's get on a plane to Mexico type airline. This is a logistics company. So when you're comparing other companies in this space, we're talking
Starting point is 00:22:46 about CN Rail, CP Rail, TFI International, and Estates, XPO Logistics, all those companies. So I really like that space. They've all been tremendous performers. They got stable cash flow, dividend aristocrats, dividend growers numbers are great i really like this stock i think the valuation is quite rich in the balance sheet uh you know the current ratio being quite low i think they'll be they'll be fine though so the end of my hot take is man i i really like the stock i don't own a position but uh i would be very tempted i got a real you know uh i think it's right in the sweet spot the tsx has a lot of great companies in that 2 to 10 billion mid-cap uh market cap and man this is this
Starting point is 00:23:40 is a really good company and the market agrees with me. It's been on an absolute tear. Yeah, and there's, I mean, obviously e-commerce is going to get a big boost this year overall with what's going on and people not going physically into stores. And I think for them, it's going to be a big tailwind. It's going to be a big tailwind. One thing you guys will notice when you look at the cash flow statement is that they are free cash flow negative and have been for quite a few years. It's not something I would be overly worried about, mostly because they've been investing a lot of new equipment, new airplanes. I checked their investor relations and they've been investing and buying purchasing a lot of larger airplanes on their fleet so that is understandable so that's the one thing you want to look at is when it comes to capital expenditures like does it make sense as well for the company to be investing
Starting point is 00:24:39 in that kind of equipment and i think it does considering that their business is growing quite quickly every year, their sales are increasing nicely. It's good to have the backing of Amazon. Obviously, if they did not, and if Amazon did not have a vested interest, I'd be a bit worried because something like FedEx in the States where Amazon basically instead told their third party sellers not to use Fed FedEx and before that FedEx had said that they would ditch Fulfilled by Amazon as well so I mean that's something you have to be careful because when you have such a powerful partner if they decide to just go another way and obviously Amazon if they wanted even with that vested interest if they wanted to do their own thing, they could easily do it. So that is, I guess it's good, but it is still a little bit of a risk on my end.
Starting point is 00:25:30 It's a company I would definitely have on my watch list, especially if you're looking to get some exposure to e-commerce and logistics space. As do-it-yourself investors, we want to keep our fees low. That's why Simone and I have been using Questrade as our online broker for so many years now. Questrade is Canada's number one rated online broker by MoneySense. And with them, you can buy all North American ETFs, not just a few select ones, all commission free so that you can choose the ETFs that you want. And they charge no annual RRSP or TFSA account fees. They have an award-winning customer service team with real people that are ready to help if you have questions along the way. As a customer myself, I've been impressed with Questrade's customer service. Whenever I call or email,
Starting point is 00:26:20 every support rep is very knowledgeable and they get exactly what I need done quickly. Switch for free today and keep more of your money. Visit questrade.com for details. That is questrade.com. Here on the show, we talk about companies with strong two-sided networks make for the best products. I'm going to spend this coming February and March in an Airbnb in South Florida for a combination of work and vacation and realized, hey, my place could be a great Airbnb while I'm away. Since it's just going to be sitting empty, it could make some extra income. But there are still so many people who don't even think about hosting on Airbnb or think it's a lot of work to
Starting point is 00:27:12 get started. But now it is easier than ever with Airbnb's new co-host network. You can hire a local quality co-host to take care of your home and guests. It's a win-win since you make some extra money hosting on Airbnb, but can still focus on enjoying your time away. Find a co-host at Airbnb.ca forward slash host. That is Airbnb.ca forward slash host. It's true, man. Don't try to fight Amazon. Try to work with them everyone has lost that fight
Starting point is 00:27:48 uh in the last 10 years so if you if they have a vested interest in the company in your company and uh that is definitely a good thing especially when we don't know which percentage, but probably a large percentage up the slack on getting fulfillment online. You noticed that the website was just not working. And, you know, that's just not what you want to see. So Simon has a tip of the day for you as an investor. Things to be looking out for. You know, we can be eyes and ears on the ground. Yeah, just things. If you're looking to invest
Starting point is 00:28:47 in certain companies, so our tip of the day is just keep an eye out for those companies. There's a lot of companies that you deal with on a daily basis that are publicly listed. Probably a lot of them are listed in the States, but regardless, they're still listed and they're still public companies. So I noticed recently, so that's a personal experience. We moved in into a new house in January. I guess our timing was actually pretty good on that before this whole lockdown started. So we moved into a new house in January and we had to buy a lawnmower because we have a lawn. And we had to buy a few things like a rake and stuff
Starting point is 00:29:25 and I think a few garbage cans so the first thing we looked we were kind of like oh we'll go on Canadian Tire so my girlfriend started to look I found the lawnmower we wanted she had a few more things in the cart and she just couldn't check out could not manage to check out so we tried three days in a row same problem the last day what started happening is they had a notice on their website saying oh we're not taking any orders online but give us a call and we'll take your order and then you can come and pick it up like i'm sorry i'm not like not calling someone first of all like like the guy you know there's probably someone first of all like like the guy you know there's probably people that are not necessarily super knowledgeable for all their products so how the hell am i going to explain which one i want
Starting point is 00:30:12 it's not very convenient so we essentially at that point we're like screw this we decided to just go on home depot the order went through right away we found what we were looking for within a week they had received our items at their store we went over picked it up took about half an hour just waited in our car they came and just dropped it off in our car and we were good to go after that and it really goes to show that home depot i that i was aware of they invested a lot in the past five years in their online present and you can tell that they did because it's much smoother than Canadian Tire so personally I know we talked
Starting point is 00:30:52 about Canadian Tire in a previous episode we were already lukewarm on them if I was even closely considering them this is the one thing that would never, even I don't care how cheap they are, I would not invest in them based on that. This brings me back to one up on Wall Street by Peter Lynch, and he talks about, look around, you know, in the mall, when you're driving around, you know, which companies do you see doing things right versus companies you see clearly doing things wrong and i mean if i 10 years ago walking into an apple store you're like whoa this place is crushing it um yeah that stock's done outrageously well grown to you know the largest company in the world there for a while i think myself pass passed them by a little bit in market cap. So yeah, do some research beyond just financial statements. I have done some sneaky things before.
Starting point is 00:31:57 I have called Investor Relations. Go on their website. Go on Investor Relations. Do you have a burning question? Send an email to like investor relations at company.com and this will be on their website they have to if they're publicly listed by law they have to have some sort of ability for investors to ask questions so it is unbelievable the amount of information you can find out and i I have, true story, been replied to by the CEO
Starting point is 00:32:27 themself of a company I'm invested in. So you know what, you can definitely talk to the people you need to talk to. So don't be afraid to do some research beyond, you know, the typical stuff. And I think this kind of reconnaissance work is kind of fun. I enjoy it. And it gives you some confidence because if you don't truly understand the business, how are you going to react when it goes down in a major way? If you don't understand the business, the ins and outs, when the market goes down wildly, you're going to panic sell because you're going to think they know something that you don't. Instead of probably the correct thing to do is to buy more. But how are you supposed to know that buying more is the correct thing to do when you don't truly understand the ins and outs of the business?
Starting point is 00:33:21 So that's our recommendation for the day. of the business. So that's our recommendation for the day. Get creative when it comes to research and it can definitely be a ton of fun. Thank you so much. Everyone messaging me on Instagram saying they love the podcast. The emails love it. It's great. Simon and I appreciate it a lot. Go rate it on five, go rate it five stars on Apple Podcasts, Spotify, wherever you listen. We appreciate that quite a bit. Getstockmarket.com. I'm about to update the list. Get all of the companies there I'm looking at in the Canadian-US markets.
Starting point is 00:33:59 Every metric that you could think of from a screening perspective is there. And you also get some content written by myself, Braden, on a regular schedule. So you can go to getstockmarket.com. And we will see you guys potentially next week. I have to move. So maybe it'll be a later in the week episode. And we will catch you guys next week. Bye bye. Hey, guys, I have some awesome news for you. If you're already on Twitter, if you're not, well, it's definitely time to join because we've created the official Canadian investor podcast. You guys can follow us at CDN underscore investing, all lowercase. Our goal with this Twitter account is really to engage with you
Starting point is 00:34:45 guys even more. We love when you guys reach out to us and ask us questions, and this will make it even easier for you to do so. So if you don't already have Twitter, there's no better time to create an account. So go on Twitter, create your account, and then just give us a follow at CDN underscore investing. The Canadian investor is not to be taken as investment advice. Braden or Simone may own securities mentioned on this podcast. Always make sure to do your own research and due diligence before making investment decisions. Thanks for listening to this episode of the Canadian investor. To get a list of the top Canadian dividend stocks right now and other valuable investing resources,
Starting point is 00:35:27 go to GetStockMarket.com.

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