In FY 18, Cartrack Holdings Ltd (CTK) reported 106% cash conversion (not true free cash flow conversion, though, as you will see later) with 88% annuity income on earnings that saw revenue rise +16% y/y and HEPS grow +17% y/y. The Group generated an insane 58% Return on Equity with equally-high Return on Assets of 33%.
By any comparison, these are very impressive figures and probably more so when you consider the fact that the Group’s share trades on a 17.0x Price Earnings.
In Cartrack’s case, though, the devil is in the detail, and the detail here is how they account for their core product: telematic unit sales with attached services for Stolen Vehicle Recovery (SVR) and Fleet Management (FM).
Why is this a problem?
Well, firstly, the Group has the following accounting policy regarding these unit sales and their surrounding expenditure:
“Capital rental units are units installed in customers’ vehicles and the associated hardware is provided as part of a fixed term contract. The  hardware and  customer acquisition cost are capitalised over the duration of the contract which is usually  36 months. The group depreciates capital rental units on a straight-line basis over the term of the customer contract.  The hardware, consumable charges and installation charges are depreciated in the cost of sales.  The acquisition costs comprising commission costs, motor vehicle costs and technician salaries are depreciated as part of operating expenses. If a contract with a customer is cancelled before the expiry of its contract term, the future unamortised cost is recognised immediately in profit and loss.”
Ignoring the accounting policy above, the flow of capital is as follows:
- Cartrack buys a “capital rental unit’ (a.k.a. a unit). It is capitalized onto Cartrack’s balance sheet.
- Cartrack sells a unit to a customer. Any commissions or sales expenses are capitalized onto Cartrack’s balance sheet.
- The unit is installed in the customer’s vehicle. Any costs of the installation are capitalized onto Cartrack’s balance sheet.
- Customer starts to pay per their contract (normally, month-by-month).
- All the (1), (2) and (3) expenses capitalized by Cartrack are then depreciated by the Group and expensed over 36 months from the moment (4) occurs. (1) and (3) go into the Cost of Sales while (2) goes into Operating Expenses of the Group. They are, though, non-cash flow, as the cash was already spent by Cartrack at the stages when (1), (2) and (3) occurred. The depreciation is done on a straight-line basis over 36 months (i.e. 3 years), or until the customer cancels their contract (if sooner than 3 years).
In other words, Step (4) and (5) is captured by Cartrack’s income statement while Steps (1), (2) and (3) are only captured by Cartrack’s cash flow statement. In fact, the (1), (2) and (3) steps are captured in Cartrack’s “Net cash flow from investing activities” as “Purchase of property, plant and equipment”.
Why does this matter?
Cartrack reports that its average customer life cycle is currently 64 months.
In other words, if Cartrack stops buying new “units”, then 64 months from now Cartrack will not have a business. Or, alternatively, if Cartrack stops growing today, every 64 months the Group will have had to refinance its entire fleet of units out in the field (currently c.750,000 subscribers, I believe).
In other words, while accounting earnings are pretty and make Cartrack look fantastic on paper, the Group’s free cash flows (cash flow after capex) is nowhere near as nice. And the Group does not really have any discretion on this free cash flow. It has to spend it to survive and it has to spend even more to grow.
While Cartrack’s share is currently trading on a 17.0x PE, if you calculate the Group’s multiple of its free cash flow, you arrive at a much scarier 30.1x multiple (= R5bn market cap / (R589m operating cash flows less R420m “capex” spend)). This excludes taxes paid and other items that arguably make this multiple even higher.
In fact, FY 18’s solid results do a complete U-turn if you analyze them in terms of free cash flows. Suddenly, FY 17’s R207m free cash flows collapse c.18% down to R169m free cash flows in FY 18. If one judged Cartrack by its cash flows, FY 18 was a disaster…
Sure, growth takes capital and Cartrack are doing all the right things to keep this going. But when you have a 64-month treadmill to keep feeding or else you fall off a cliff, you are going to keep needing to spend capital. It is quite unlikely that Cartrack will ever be in a position where it is generating materially more free cash flow, unless it stops growing or, worse, it starts putting its business model at risk.
Finally, all of this is not even considering telematics pricing deflation, technology obsolescence and the cost of maintaining the platform and services element of the globally-competitive telematics business model.
I’m just saying, with Cartrack, the devil is in the detail.