Cobalt Engineering: Dividend, Buyback and Working-Capital Trade-offs
Cobalt Engineering plc has £60m cash, £140m debt, EBITDA of £95m and a covenant limiting net debt/EBITDA to 2.5×. It has announced a maintained dividend of 12p on 80m shares and a £25m buyback. Next year's operating cash flow is forecast at £70m, capex £38m, working-capital absorption £16m from a large Middle East contract, and tax £12m. A bolt-on acquisition costing £30m is also under consideration. The finance director proposes cutting the dividend to 6p and suspending the buyback to fund growth; the chair worries about income funds holding 25% of the register and about signalling. The company runs a DRP with 30% take-up and a 1.5% reinvestment cost. Revenue is £520m, cost of sales £390m and purchases £380m. Working-capital days are inventory 84, receivables 62 and payables 48; the treasurer believes 70, 55 and 55 respectively are achievable within a year.
1. Calculate Cobalt's free cash flow after planned investment and assess whether the dividend and buyback are sustainable within the covenant.
Read the worked answer
Free cash flow after planned investment = 70 − 38 − 16 − 12 = £4m. Dividend = 12p × 80m = £9.6m; buyback £25m; total distributions £34.6m. The shortfall is £30.6m, funded from cash or debt.
Net debt is currently 140 − 60 = £80m, or 0.84× EBITDA. After the shortfall, net debt is £110.6m; after the £30m acquisition, £140.6m. That is 140.6/95 = 1.48× EBITDA, below the 2.5× covenant. If EBITDA falls 15% to £80.75m, gearing is 1.74×, still inside. Interest cover also looks comfortable: gross debt of about £170.6m at 6% gives interest of £10.2m and cover of 9.3×.
So the covenant is not the immediate constraint; cash generation is. The company cannot sustain a £25m buyback plus a £9.6m dividend out of £4m of FCF without increasing debt. The buyback is discretionary and should be suspended first. The dividend is affordable if the buyback is cancelled, especially with the DRP. The acquisition could be funded from the released buyback cash and existing facilities, but only if post-deal leverage stays within the board's target.
2. Evaluate the FD's proposal to cut the dividend to 6p and suspend the buyback. Quantify the cash retained and discuss the signalling and clientele effects.
Read the worked answer
Cutting the dividend to 6p saves 6p × 80m = £4.8m gross. With 30% DRP take-up, only 70% is paid in cash, so the cash saving is £3.36m, not £4.8m. Suspending the buyback saves £25m. Total cash retained = £28.36m, which together with £4m FCF gives £32.36m - enough to fund the £30m acquisition.
But the signalling and clientele effects are serious. Income funds holding 25% of the register may sell, pushing up the cost of equity; a halved dividend is read as distress even if the cash is reinvested. The company could instead suspend the buyback only, retaining £25m + £4m = £29m, almost the acquisition cost, and fund the small gap with debt. At 1.48× pro forma leverage there is capacity: at a 2.0× target, debt capacity is 2.0 × 95 − 80 = £110m. So the dividend need not be cut.
Recommendation: suspend the buyback, maintain the 12p dividend, use the DRP to reduce cash outflow, and fund the acquisition with the released cash plus a modest drawdown. If the acquisition is cancelled, retain the buyback suspension to rebuild headroom. Only cut the dividend if forecast EBITDA falls materially or the covenant is threatened.
3. Calculate the cash released if working-capital days improve to 70/55/55, and advise on priorities.
Read the worked answer
Inventory = 84/365 × 390 = £89.8m; at 70 days = 70/365 × 390 = £74.8m; release £15.0m. Receivables = 62/365 × 520 = £88.3m; at 55 days = 55/365 × 520 = £78.4m; release £9.9m. Payables = 48/365 × 380 = £50.0m; at 55 days = 55/365 × 380 = £57.3m; increase in payables £7.3m, which is a cash inflow. Total potential release = 15.0 + 9.9 + 7.3 = £32.2m, enough to fund the acquisition without cutting the dividend.
Priorities: inventory is the largest release but carries the most operational risk, especially with a complex Middle East contract; target components and work-in-progress first. Receivables need credit control and milestone billing, but the customer may demand longer terms. Payables stretching beyond agreed terms can damage supplier relationships and lose early-settlement discounts; calculate the cost of losing a 2% early-payment discount, which can exceed 20% annualised. A supply-chain finance programme may release cash without stretching terms. Set realistic targets, monitor weekly, and avoid using one-off working-capital release to fund a permanent dividend commitment.