oil at $80 a barrel–a Saudi plot?

I don’t think so  …and if the Saudis are trying to keep oil prices low in order to drive American shale oil out of business, it’s a pretty pathetic one  (Tom Randall of Bloomberg, for example, recently wrote an otherwise excellent article in which he supports the plot view).

Here’s why:

Any oil project starts with geology work to locate prospective acreage for drilling.  The oil firm then purchases mineral rights from the owner of the land where it intends to drill.  Next comes the actual drilling, which can cost $5 million – $10 million a well.  The driller also needs some way of getting output to market, which may entail building a spur to the nearest pipeline, or at least paving the local roads so that trucks he hires can get to the wellsite.

All that outlay comes before the exploration company can collect a penny from the oil or gas that comes to the surface.

In other words, the project costs are significantly front-end loaded.  This is important.  It means the economics of the situation change dramatically according to whether you’ve already made the up-front investment or not.

An example:

I took a quick look at the latest 10-Q for EOG Resources, a shale oil driller.

Over the first six months of the year, EOG took in $6.5 billion from selling oil and gas, and had net income of $1.4 billion.  That’s a net margin of 21.5%.  At first blush, it looks like a 20% drop in prices would put EOG in big trouble.

Look at the cash flow statement, however, and a different picture emerges.  The $1.4 billion in net comes after a provision of $1.9 billion for depreciation of some of those upfront expenses and after another provision of $479 million for deferred (that is, not actually paid yet) income taxes.  So the actual cash that came into EOG’s hands during the period was $3.8 billion.  That’s a margin of 58.4%–meaning that prices could be more than cut in half and EOG would still be getting money by continuing to operate existing wells.

Yes, at $70 a barrel, new shale oil projects are probably not sure-fire winners.  But oil companies will continue to operate oil share wells, even at prices below this in order to recover capital investments they have already made.  The right time for Saudi Arabia to throw a monkey wrench in to the shale oil works would have been three or four years ago, not today.

The wider point:  once a new entrant has made a big capital investment to get into any industry, it’s very hard to get the newcomer out.  Even if incumbents make the new firm’s position untenable, the latter’s goal just shifts away from making money to minimizing its mistake by extracting as much of its capital as it can.  It will be willing to destroy the industry pricing structure if necessary to do so.




Ron Johnson out at J. C. Penney (JCP): implications

Yesterday, only a few weeks after major shareholder Bill Ackman gave Ron Johnson a ringing endorsement as CEO of JCP, Mr. Johnson is out.

Former CEO, Mike Ullman, who was unceremoniously dumped not that long ago to make room for Johnson, is back in.


What can we make of this?     …quite a lot, I think.

1.  The change comes right after monthly sales results for JCP in March, the second month of the company’s fiscal year, would have been available.  Presumably they’re really bad (the Wall Street Journal is reporting that quarter-to-date sales are down at least 10% year on year).

This is a big problem.  JCP marks up merchandise by about 50% over what it pays.  It uses the gains from sales, called gross income, to cover the costs of running the store network (like advertising, rent, utilities, salaries…).  What’s left over is profit.

JCP’s sales in fiscal 2010 were $17.6 billion;  its pre-tax profit was $581 million.

In fiscal 2012, sales were $13.0 billion, or 26% lower than in fiscal 2010.  My back of the envelope calculation is that JCP lost just under $800 million from retailing last year–offset by a number of non-recurring gains (see my post).

To my mind, the largest factor in the profit decline is the loss of sales.  The March figures suggests sales may not have bottomed out yet.

2.  Since the company was quick to boot Mr. Ullman not so long ago, he’s probably not the company’s first choice as the new CEO.

I can see two possibilities:

–he may be the only experienced executive willing to take the job, or

–JCP may have been pressured into making the change quickly and Mr. Ullman was available on short notice (I’ve heard he was first contacted last weekend).

Neither possibility is encouraging.

3.  Where would outside pressure come from? The two main sources, as I see it, would be:

–suppliers.  Last year JCP generated $140 million in cash by getting suppliers to agree to wait longer to be paid. As the perceived riskiness of dealing with JCP rises, the standard response by suppliers would be to rethink a decision like this.  In a more extreme situation, suppliers would start to reconsider the amounts and types of merchandise they send to a customer.

–banks.  In its 4Q12 earnings conference call, JCP highlighted the fact that it had negotiated a $500 million increase in its bank credit lines, to just over $2 billion.  The message from this seemed to me to be that JCP had ample funds to weather any problems it might encounter in 2013.  Again, the standard response to continuing deterioration in sales would be for banks to reassess their exposure.  All it would likely take to reduce a credit line–something that would doubtless have adverse effects for JCP–would be one credit committee meeting.

There’s no direct evidence that either suppliers or banks have started down this road.  It’s conceivable, though, that one or both told JCP they’ll have to change their thinking if sales don’t perk up soon.  That might have been the final straw for Mr. Johnson.

one company, three sets of accounting records

In almost all countries publicly traded companies maintain three sets of accounting records.  They are:

–tax books in which the firm keeps track of the taxable income it generates, and the taxes due on that income, according to the rules of the appropriate tax authority.

Keeping the tax records may also involve a tax planning element.  A company may, for example, decide to recognize profits, to the extent it can, in a low-tax jurisdiction.  Or, as is often the case with US companies, it may decide not to repatriate profits earned abroad, at least partially because they would thereby become subject to a 35% tax.

Tax considerations can also have operational consequences.  For instance, a firm may choose to locate factories or sales offices in low tax jurisdictions over similar high tax alternatives mostly for tax reasons.

–financial reporting books, in which publicly traded firms keep track of profits, and report them to shareholders, according to Generally Accepted Accounting Principles (GAAP).

If the purpose of tax accounting is to yield the smallest amount of taxable income, and thereby the smallest amount of tax, the intent of financial reporting books can be seen as trying to present the same facts in the rosiest possible manner to shareholders.

The main difference between the two accounting systems comes in how long-lived assets are charged as costs against revenue.  Financial accounting rules allow such costs to be spread out evenly over long periods of time.  Tax accounting rules, which may be specifically designed to encourage investment, typically allow the firm to front-load a large chunk of the spending into one or two years.

The end result is that for most publicly traded companies, the net income reported to shareholders is far higher than that reported to the tax authorities.

management control books, kept according to cost accounting rules.  These are the records that a company’s top executives use to organize and direct the firm’s operations.  They set out company objectives and incentives, and are used to assess how each of its units are performing against corporate goals.  Not all parts of a firm are supposed to make profits.  Some may have the job of making, at the lowest possible cost, high quality components used elsewhere in the company.  A mature division may not have the job of growing itself anymore,  but of generating the largest possible amount of cash.

investment implications

Investors normally don’t get to see either a company’s tax books or its management control books.

Financial reporting books can sometimes give a picture that’s too rosy.  The two main culprits are deferred taxes and capitalized interest.  “Capitalized” interest is usually the interest on construction loans taken out for a project than’s underway but not yet finished.  Even though money is going out the door, under GAAP it’s not shown as a current expense.   I’ll explain deferred taxes next week.

In a very practical sense, you don’t need to understand either one too much (although it might be nice to).  Turn to the company’s cash flow statement in its latest SEC earnings filing.  Are there deferred tax or capitalized interest entries?  Do they add to cash flow or subtract from it?   …by how much?  If the answer is no, or that they add to cash flow, there’s nothing to worry about.  If they subtract–and a lot, on the other hand, there’s a potential problem.

return on equity (II): cleaning up a mess

a company as a project portfolio

Every company can be seen as a collection–maybe a portfolio–of investment projects, each with its own risk and return on investment characteristics.  This is not the only way of looking at a business.  And it’s probably not the best way, as the ugly collapse of the conglomerate craze in the US during the 1960s illustrates.  Nevertheless, looking at the business as a project portfolio highlights an issue that the top management of a firm can face.

the BCG growth/cash matrix

One common way of sorting projects  is to use the growth/cash generation matrix invented by the Boston Consulting Group in the 1960s: stars = high growth, high cash generation cash cows = low growth, high cash generation questions marks = high growth, low cash generation dogs = low growth, low cash generation. loaded with canines What do you do if you’re a company with a boatload of dogs?  ..or just one really big dog. To see the issue clearly, let’s simplify: –let’s say that equity is your only source of funding (no working capital or debt), and –let’s say you have only two projects, with 100 units of equity invested in Project 1, which earns 20/year, and 100 units in Project 2, which earns 1/year. the problem: the sterling 20% return on equity of Project 1 is obscured by the near breakeven status of Project 2. The overall return on equity for the company of 10.5%. Why is this bad? Wall Street loves high return on equity–and loathes low return.  And the computer screens that even many professional investors use to narrow down the vast universe of available stocks into a more manageable number to investigate will toss a company like this on the reject pile.  So you’ll be overlooked. What should management do? The possibilities: 1.  eliminate inefficiencies in Project 2 and in doing so raise the ROE to a respectable figure 2.  if that’s not possible, sell Project 2 to someone else who, mistakenly or not, thinks he can do #1 3.  close Project 2 down and write the equity off as a loss, or 4.  divide the company in two, and either (a) spin Project 2 off as a separate entity (that is, give it to shareholders) or (b) gradually sell it to the investing public.

cutting to the chase

Let’s skip down to #4, since what we’re ultimately concerned with is what motivates a company to create a REIT.

why #4?

How can a company get into a situation where solution #4 is the best alternative? In my experience, this almost always involves long-lived assets, where the investment is big, and a company puts all the money in upfront, in the hope of getting steady income over 20 or 30 years.  Examples: a chemical plant, container ships, hotels, or mineral leases. One of two things happens –either the company soon discovers it has wildly overpaid for the assets, or –some unforeseen change, like technological change or a sharp increase in input prices, alters the economics of the project in a fundamentally negative way.

two forms of cash generation

Any project generates cash in two ways: –a return of the capital invested in the project, and –profits. In describing Project 2 above, I said it produces 1 unit of profit per year.  But that profit is after subtracting an expense of, say, 5 as depreciation and amortization. D&A are ways of factoring into costs the gradual wearing out of the factory, the machines or the other investment assets that are used in making the project’s output. In the case of a motel, D&A is a charge for the gradual deterioration of the structure over the years, until the building is too shabby to be used any more and must be razed and rebuilt.  Similarly, big machines either wear out or become technologically obsolete. The key fact to note is that depreciation and amortization aren’t actual outflows of cash–they’re inflows.  But they’re classified as return of capital, not as profit.  (I think this make sense, but I’ve been analyzing companies for over 30 years.  Don’t worry if it doesn’t to you.  Fodder for another post on cash flow vs. profits, and why it makes a difference to investors.)

In the case of Project 2, the actual cash inflow is probably 6/year (depreciation and amortization of 5 + profit of 1).  That’s a 6% yield.  But it’s also a millstone around the neck of the company that launched the project.  It’s return on equity–a key stock market screening factor–will be depressed for as long as it owns the project. On the other hand, to an income-oriented buyer a yield of 6 units/year for the next 20 years is nothing to sneeze at.  At a price of 85, the yield would be an eye-popping 7%.

this has happened before

In the early 1980s, T Boone Pickens, a brilliant financial engineer if no great shakes as an oilman, wildly overpaid for a number of oil and gas leases in the Gulf of Mexico.  Once he realized these properties would struggle to make back his initial lease payment and would never make money, he repackaged them as a limited partnership and spun it off. Around the same time, Marriott did the same thing.  It made a similarly unwise decision to build a number of very expensive luxury hotels.  When bookings started to come in, the company saw the properties would provide large cash flow–but never any profits.  So it rolled them all up into a limited partnership, which it sold to retail investors. In both cases, management “repurposed” assets to emphasize their cash generation characteristics rather than their lack of profitability.  Both also used a tax-minimization structure to enhance the assets’ attractiveness to income-oriented individual investors. REITS do the same thing. More tomorrow.

importance of the cash flow statement: it’s like mushrooms

why project a cash flow statement?

While I was in graduate school, I spent a year in Germany studying at Eberhard Karls University in Tübingen.  Before school started I lived for a while with a German family.  Every Saturday morning we would roam the local woods in search of the mushrooms that would comprise one or two of our meals during the following week.  Since I had no clue what I was doing, my hosts would scrutinize any mushrooms I found very carefully to make sure they weren’t poisonous.

One type, the death cap–which I never stumbled across–still stands vividly in my mind.  According to my family and to public service announcements on tv, not only was this mushroom deadly, but the first symptoms of its effects only developed after the poisoning was too far advanced to be treated.

There’s an analog to this situation in the investment world.  These are cases where the financial results of past management actions narrow the scope of future possible outcomes to the point where one or two become highly probable–if not unavoidable. In these cases, management is never going to spell out the constraints it it working under.  Nevertheless, the current financial condition probably makes their future actions very highly predictable.

Projecting a cash flow statement for such a company is the way to uncover and evaluate.  (An analyst should do this for every company under coverage.  In my experience, most don’t.  In “mushroom” cases, however, the cash flow statement is crucial.)


a toy company

In the early Nineties I was following–and for a while owned shares in–a small publicly owned toy company.  It earned, say, $10 million annually.  One year it had a surprisingly successful spring-driven flying toy doll for girls.  The following year it decided to make a similar toy for boys, with a martial theme and a stronger spring.  As I recall, the firm decided to spend $40 million on materials and labor for this toy (a real roll of the dice at 4x total corporate earnings).  It got the money through trade financing and borrowing from its bank.  The risk was especially high, since all the manufacturing had to be done at one time, in preparation for the yearend holiday selling season.  On the other hand, the prior year’s toy had been a smash hit; the firm really understood the boy market and felt this one would be, as well.

Soon after the toy was on the shelves of toy stores, the company began to get reports that the combination of a strong spring and curious young boys was resulting in severe eye injuries to users.  The government mandated a recall.  The $20 million in profits the company had envisioned was up in smoke.  The inventory that had cost $40 million to make was now worth close to zero.

Do the math.  At most $10 million in earnings from other toys vs. $40 million in short-term financing needing to be repaid = no way out.

the Mets

The New York Times published a recent article on the Mets’ finances, titled “For Mets, Vast Debt and Not a Lot of Time.”  There isn’t enough publicly available information to draw a firm conclusion, but if the figures in the article are correct, the Mets don’t have much wiggle room.  The current club drive to lower the total player salary bill may be the only real option it has.  Specifically,

Sources of funds:

The Mets lost $70 million (I’m presuming that this is a pre-tax figure, but this isn’t clear) last season, with a player payroll of about $150 million.  Let’s say the actual pre-tax cash outflow was $30 million.

If we make the (optimistic) assumption that ticket sales and concession revenue in 2012 is constant with 2011, then lowering payroll to $100 million will result in a pre-tax loss of $20 million for 2012.  Cash flow should be positive, at about $20 million.

2013 cash inflow = $40 million ?

2014 cash inflow = $50 million ?

Uses of funds:

repayment of $25 million to Major League Baseball, now overdue

repayment of $40 million Bank of America bridge loan

repayment of $430 million team loan in 2014.

If, again, the NYT figures are correct and the cash inflow numbers I’ve made up for 2012-14 are anywhere close, the Mets won’t be able to make much of a dent in the 2014 principal repayment requirement.  It seems to me that dealing with the $430 million that comes due in three years is the major management issue.

What I’ve written above is just the bare bones.  The Mets are attempting to find outside investors who are willing to accept having no say in the running of the organization.  Suit by the Madoff trustee is pending.  And, of course, there’s the tangled relationship between the Mets and SNY, the Wilpon-controlled cable network to which the club has sold broadcast rights.


Eastman Kodak has been supporting its ongoing turnaround through outside financing and asset sales.   Looking at the cash flow statement for the past couple of years and projecting it forward for the next few will be highly instructive.

Current market worries about Italy’s sovereign debt also have a cash flow basis.   The issue is the current high cost of refinancing maturing debt.  Unlike the previous corporate instances, Italy’s new government has much greater scope for initiating reforms that can change market perceptions quickly.  And perceptions, rather than the amount of outstanding debt (which is typically the corporate issue), are the main concern here.  Still, projecting sources and uses of funds forward for several years will give a much clearer grasp on the issues than simply watching current yields.







Sony/Samsung LCD jv restructuring: a study in cash flow vs. earnings

the Sony/Samsung LCD-making joint venture

On Monday Sony and Samsung announced a restructuring of the joint venture they entered into during 2004 to manufacture large liquid crystal displays for televisions.

The joint venture developed out of Sony’s dire need of LCD manufacturing capacity (it had badly underestimated how quickly flat panels would replace traditional CRTs) and Samsung’s desire to achieve economies of scale and its hope for technology transfer.  But after seven years, in a world awash in LCD-making factories, and given Samsung’s technological dominance over Sony, the jv had outlived its usefulness.

I haven’t looked at Sony carefully for years.  My overall impression continues to be that the firm is a mess.  But that’s not what I want to write about.

terms of the jv restructuring

The essentials of the recasting of the LCD joint venture are:

–Samsung will buy out Sony’s interest (50% minus one share) for around $950 million in cash,

–Sony agrees to buy LCDs from Samsung (no details of the arrangement given),

–Sony will record a loss of $850 million on the sale, implying its ownership interest is being carried on the balance sheet as worth $1.8 billion, and

–Sony expects to save about $160 million a quarter–a combination of savings on LCD purchases and being freed of the need to make new investments in the jv.

earnings and cash flow implications for Sony


The writeoff of its 2004 investment will depress Sony’s March 2012 earnings by $850 million.  The $950 million payment will be treated as a return of capital and won’t show on the income statement.

If we assume that the jv is simply breaking even, which is probably much too optimistic, there will be no effect, positive or negative, on future eps for Sony from its dissolution.  To the degree that the jv is loss-making, that red ink will disappear from the income statement.

cash flow

Here’s where the significant positive impact comes.  The transaction turns a loss-making asset into significant positive cash flow.

First, of course, Sony takes in $950 million in cash early next year, an amount equal to roughly 5% of the company’s market cap.

Second, it avoids having an outflow of money that it estimates at $160 million per quarter.  In other words, Sony enhances its cash flow by that amount.

Two positives from this:

–Sony can reallocate the cash saved to more productive activities, and

–my quick perusal of Sony’s most recent form 6-K (on page 18) suggests that the $160 million a quarter the jv was using up is virtually all the cash flow Sony is currently generating.

my point

This kind of transaction is a staple of value investing, where a loss-making asset that earnings-oriented investors regard as worthless is sold–and thereby is shown to have substantially more value than the market has realized.  In the case of larger sales or smaller companies, transactions like these can be transformative.

cash flow per share and earnings per share as valuation metrics (ll): cash flow per share

investor preferences

A large number of investors in the US want to buy stocks where the underlying companies are growing profits rapidly.  The same is true in many other stock markets of the world.  For such investors, earnings per share growth is the main metric they look for when transacting.

This isn’t an immutable law of equity investing, however.  To a large degree, the search for growth is also a question of investor preferences.  In the US, the market I have the longest experience with, I’ve seen the mix of price and growth that investors prefer change dramatically several times.  This has been not so much because the macroeconomic environment has changed, but because the personal circumstances of investors (their age and wealth) did.

Also, I’ve seen other markets where preferences are quite different, where a “good” stock is one that pays a high dividend and where the company is mature enough that it has little need to spend capital on expansion.  These are markets where the search is for income, not for growth.  Taiwan in the 1980s is the first strong example I’ve encountered personally (technology stocks there couldn’t list unless they were willing to pay a 5% yield!).   But the US in the pre-WWII era seems to me to have been another.

the search for income

Not every company can grow at a rapid clip of a long time.  As well, some companies temporarily experience declining profits, either because the economy has turned against them cyclically, or because they’ve just lost their way.  In any of these cases, the large group of investors I’ve mentioned above lose interest in the stocks and more or less consign them to the equity junk pile.

There’s a whole set of other professional investors–in fact, in the US they are arguably in the majority–who evaluate stocks not on their earnings growth potential but on the companies’ ability to generate cash from operations.  There are many variations on this approach.  But all use cash flow per share as their main tool.  Such investors calculate an absolute worth for the company (usually a present value of cash flows over, say, ten years) and compare that with the share price.  They buy what they hope are the most undervalued stocks.

Around the globe, such value investors expect that at some point either the company’s fortunes will take a cyclical turn for the better, or that other investors will realize the undervaluation they see, or (in the US at least) that pressure will be brought to bear on the company to improve its operations.

[By the way, about two years ago, I wrote a series of posts on growth investing vs. value investing that you might want to read.  Take the test (which of two stocks would you buy) to see if you’ve got more growth or value tendencies.]

the stock as a quasi-bond

The key to this approach, viewing it through my growth investor eyes, is to regard the stock as a quasi-bond.

Let’s say the firm is now generating $1 a share in cash from profits and $2 a share in cash from depreciation and amortization.  That’s $3 a share in yearly cash flow.  Taking a ten-year investing horizon, the company will generate a total of $30, even with no growth at all–if the firm can get away without serious new capital investments.  If we were to assume that the company could achieve an inflation-matching rise in cash flow, then the present value of the stream of cash flow is $30.  (Yes, this is a vast oversimplification, but it is the thought process.  Remember, too, we’re also figuring there’s nothing left after ten years.)

What would a company like this sell for on Wall Street?  $20 a share?  …less?

We do have a yardstick, since if we reverse the profit and depreciation figures the description in the last paragraph is a rough approximation of INTC.  The value investor’s explanation for serious undervaluation is that people are so worried about the possibility that processors using designs from ARM Holdings will gradually eat in to INTC’s markets that they are overlooking the latter’s substantial cash generating power.

happy vs. unhappy shareholders

Another way of putting the difference between looking at earnings per share and cash flow per share–

–investors look at eps to gauge a firm’s value when they’re happy with the way the company is performing;

–they look at cash flow per share when they’re not, when they’re trying to figure out how much the company would be worth with different management, or in private hands, or after being acquired by a competitor.

The risk the first group takes is that all good things eventually come to an end.  The worry of the second group is that they’ve be unable to pry the company out of the hands of current management.


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