Yesterday, online gaming services provider and Motley Fool Hidden Gems selection CryptoLogic
Investors often get excited when they see a share buyback announced -- it reduces the number of shares outstanding while earnings remain the same, thus automatically increasing earnings per share. Nonetheless, a buyback can actually hurt a company if the cash is put to work at prices above the company's true worth, or if cash needed to expand the business is instead used to buy back shares.
With this in mind, how does CryptoLogic's announcement stack up? We know that management is buying back shares because it believes the stock is undervalued, not to merely reduce the effects of stock option dilution. That's a positive.
We also know that over the last four fiscal years, CryptoLogic has generated an average of approximately $18 million per year in free cash flow, a very healthy 25% margin for a company with revenues of $73.8 million over the last 12 months. Operating and net margins similarly hover around 22%-23%, comparing favorably with CryptoLogic's competitors. In addition, the company has $86 million in cash on its balance sheet, which is more than enough to execute its share repurchase plan three times over. This tells me that CryptoLogic's repurchase program will not be diverting cash needed for expansion.
That leaves us with the question of valuation. There are a number of ways to go about this. A discounted cash flow analysis with conservative, average, and aggressive assumptions is my preferred method, but to save time, I sometimes prefer the shorthand method of comparing growth rates to price-to-earnings and price-to- free cash flow ratios. I've used the same process to evaluate ongoing share repurchases by Cisco Systems
The analyst estimates for CryptoLogic on Capital IQ show a 35% compounded growth rate over the next five years. That's much stronger growth than I'm willing to bet on; even though the poker side of CryptoLogic's business has been growing like a weed the last few years, there is the threat of losing at least one large client. To be a bit conservative, I'm going to cut that estimate in half, to 17.5%.
I calculate that the stock is currently trading at a multiple of 13 times free cash flow and 14 times diluted earnings. With both of these multiples coming in lower than my conservative estimate of CryptoLogic's long-term growth rate, this shorthand method confirms that the stock is reasonably valued, if not undervalued, and a share repurchase makes sense.
One should also note that the company has no debt, and its cash hoard currently amounts to a bit more than a third of its market cap. Based on my valuation analysis of the company's stock, it looks like the return on the repurchase of shares should exceed the interest that would have been earned on the cash. To sum up, the share repurchase makes a good deal of sense for CryptoLogic. It should improve shareholder returns, which is all an investor can ask for.
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Nathan Parmelee owns shares in CryptoLogic but has no financial interest in any of the other companies mentioned. The Motley Fool has an ironclad disclosure policy.
