When a stock has strong earnings growth, it can result in excellent stock returns, particularly if the investor paid a conservative price for the company's shares. What is often overlooked, however, is that earnings growth must be financed. That is, the company must spend on marketing, inventory, equipment and capacity before that growth can be realized. This can lead to a situation where a company runs out of cash, despite a rosy outlook, which can hurt investors caught unaware.
Consider Digital Ally (DGLY), a provider of in-car digital video equipment for law enforcement authorities. The company has grown its revenue sharply in the last five years, as demand for its products has grown considerably. Earnings appear poised to continue to grow, as the company has increased its sales staff internationally, and is starting to sell its products to new markets (e.g. taxis, private investigators, trucking companies, military, private security forces).
There's only one problem: liquidity. Even healthy companies that grow their earnings quickly need financing to fund that growth, and Digital Ally is no exception. Operating cash flow has been positive only once in the last five years, as cash has been needed to finance growth in the company's working capital. Cash requirements appear to continue to be high, as in the fourth quarter of 2009, the company had to spend on SG&A to grow its staff and capacity to take advantage of new market opportunities.
Now, however, with ambitious growth plans, the company sits with just $183 thousand of cash on hand. So what's it going to do? While the company does have an unused credit facility of $2.5 million, debt for a small company with volatile earnings could be expensive. Instead, the company appears to prefer to save cash by paying a large part of its expenses with stock options. In 2009 alone, the company paid $1.4 million of its SG&A in options, which is several times the company's current cash balance! As a result, the company has almost 5 million options outstanding, while the company only has 15 million shares!
Growing earnings are good, but shareholders must recognize that such companies require investment. If that investment cannot be made in cash, shareholders may be severely diluted, reducing the attractiveness of the investment. As a result, shareholders who don't consider the sources of cash that growing companies need may be unaware of the price they are paying.