I can understand my colleague W.D.'s disappointment with having bought a stock only to watch it rise and fall. However, it's important to note that when the company initially grew in the late 90's and into 2000, it did so on the back of one product -- its Breathe Right strips. Then poor sales planning and forecasting caused the stock to fall out of favor, but the company was always generating free cash flow. The difference now is that the company has two product lines that provide a fair amount of diversification.
Before I turn to some of the items in W.D.'s bear argument, I'd like to give him kudos for highlighting the inventory issue. The inventory is up 60% versus the same period last year, with sales growth of only 31%. So far, this is a one-quarter aberration and nothing to lose sleep over, but it certainly is a red flag and something that should be watched. That said, I do believe that a bit of caution is already priced into the shares.
While I admire W.D.'s inventory call, I don't agree with his findings on the company's stock option dilution. The facts that W.D. cites are mostly correct. Diluted shares outstanding did increase by 2.4% despite the fact that the company repurchased 2.4% of its shares. However, the total 4.8% share dilution figure in the past year is misleading because of the way the weighted average shares outstanding figure is calculated. Using a weighted average doesn't take into account the full impact of the buyback. To put it simply, if shares are repurchased at the end of a period, the company gets less credit than it would if the shares were repurchased at the beginning of the period.
Instead of looking at options the way my colleague did, I prefer to go about it in these two ways. The first is to look at the company's proxy statements (form DEF 14A filed with the SEC) to determine how many options were granted. In Motley Fool Hidden Gems pick CNS' (NASDAQ:CNXS) case, I see it granted approximately 243,172 options in fiscal 2005. No doubt it's granting some this year as well, which we'll see in the next proxy statement. Contrast the 243,172 granted last year with the 355,105 shares purchased for $7.3 million in the first six months of this year, and you see that the buyback is truly a sizable one, because it exceeds last year's total grants. But on the income statement, things look worse because share count is a weighted average and not a snapshot based on the exact share count at the end of the quarter.
I promise this will be the final paragraph on the share repurchase and options, but I think these share repurchases are a good use of cash and are better for shareholders than sitting on the cash. The $7.3 million for 355,105 shares works out to an average of $20.55 for each share repurchased. My conservative estimate of CNS' value is $23 per share. This means the share repurchases were executed at a 12% discount to my conservative estimate of the company's value and a 20% discount to the current price of $24.50.
Finally, the prospect of the company chasing an acquisition is a scary one, and the company has stated that it's on the lookout for an acquisition that makes sense. To date, the company hasn't pulled the trigger. So I think it's only fair that we base our argument on what we know now. Should the company make an acquisition that is senseless or overpay for an acquisition, I'll join in with the chorus that beats that deal down.
Foolish final thoughts
I understand that W.D. isn't impressed with 5% to 12% sales growth, and I can understand why. Those aren't numbers that get the heart pumping. However, this is a business that has pretty good operating leverage and is able to turn relatively small sales increases into larger increases in earnings. In my original argument, I made the case that the shares are priced for 8% to 10% growth in free cash flow and that anything above that should lead to higher prices, and 5% to 12% sales growth should be enough to deliver a market-beating return from here.
CNS is a Hidden Gems pick. For a 30-day free trial, clickhere.
Wait! You're not done. This is just a quarter of the Duel! Don't miss the Bear and Bull opening arguments and the Bear rebuttal. Even when you're done, you're still not done. You can vote and let us know who you think won this Duel.
Nathan Parmelee has a beneficial interest in shares of CNS but no financial stake in any of the other companies mentioned. The Motley Fool has an ironclad disclosure policy.
