Category Archives: cash flow/share vs. earnings/share

one company, three sets of accounting records

February 15, 2013 By in cash flow, cash flow/share vs. earnings/share, project accounting, three sets of books Tags: , , , , , , , , , Leave a comment

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

August 16, 2012 By in Accounting, cash flow, cash flow/share vs. earnings/share, depreciation, working capital Tags: , , , , , , , Leave a comment

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.

higher taxes on dividends? –implications for stock markets

February 17, 2012 By in cash flow/share vs. earnings/share, Constructing a Portfolio, currency effects, Current Market Thoughts, Dividends, Industry Analysis, Investment firms, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , Leave a comment

the Obama proposal

President Obama has recently proposed that the current tax preference for corporate dividends paid to individuals be eliminated.  Instead of being taxed at most 15% of the amount received, dividends would be considered ordinary income and taxed by Washington at as high a rate as around 40%.

Personally, I’d prefer an overhaul–and simplification–of the current tax code instead of tweaks around the edges.  Rather than putting a foot into the  the quagmire of possible political motivations, however, let’s just take a look at what I think are likely results for US capital markets if it’s implemented.

what doesn’t change

1.  Tax-exempt and tax-deferred accounts would be unaffected.  For pension plans, 401ks and IRAs, and for non-profits, it will continue to make no difference whether they make money in the form of interest or dividend income, or of short-term or long-term capital gains.

2.  Aging Baby Boomers are developing an increasing preference for steady income over capital gains, which are sometimes there, sometimes not.  That won’t change either.

what does

3.  I think the biggest effect will be on company decisions to start making dividend payments or to increase a payout they already have.

It seems to me that most publicly traded corporations recognize the Baby Boom-induced change in investor preferences now happening in the US.  Understanding that a substantial, and rising, dividend is a positive for their stock, companies have been happy to return profits to shareholders this way.  They do this despite realizing that if you combine federal and state/local income levies, up to 25% of the payout will go to the taxman.

If dividends lose their tax preference, the percentage taken by the taxes will approach 50%.  That means a big drop in what the shareholder will retain, both numerically (a third) and psychologically.  For most companies, I suspect, it will tip the balance in favor of devoting free cash flow to share buybacks rather than dividend increases.

For my money, that takes a lot of the shine away from what I consider to be the most attractive part of the dividend-stock universe–companies with above-average dividends today and for which you can reasonably project a quickly rising free cash flow over the next few years.

4.  If the government continues to  keep interest rates at emergency lows and, by accident or design, it also removes much of the incentive for individuals to buy dividend-paying stocks, how do investors adjust?  Maybe there’s a boost in demand for junk bonds, although income-oriented investors have been buying riskier forms of fixed income for a long time.

I think biggest effect would be for investors to broaden their horizons further.  The 7%-8% yields on EU telecom stocks will suddenly look more attractive, despite currency risks.  So, too, emerging market securities, both bonds and dividend-paying stocks.

5.  Looking at #3 another way,  provided they’re large enough to lower the share count, stock buybacks raise earnings per share.  All other things being equal, that should mean a higher per share stock price.  If so, the higher share price would likely offset some or all of the negative effect of dividends increasing at a slower rate.  In other words, the mix of returns (price appreciation + dividend income) changes, and in a way that increases risk.  But the crucial investment question is whether the total return from both sources will be higher or lower than before.

No one knows the answer.  But if the total return is lower–that is, if the effect of higher taxes on dividends is to decrease the long-term value of US equities–then one would expect US investors of all stripes to look increasingly to stock markets outside the US.  In addition, on the margin, US companies might also begin to look to foreign venues to raise new capital, if they could achieve higher prices for their stock by doing so.

My bottom line:  this proposal is one to watch closely.  Like a snowball that starts rolling down a hill, its consequences could be far greater than just to raise taxes on older, upper middle class city dwellers.

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

December 28, 2011 By in Accounting, Basic Concepts, cash flow, cash flow/share vs. earnings/share, Stock ideas Tags: , , , , , , , , Leave a comment

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

earnings

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.

the two (possibly three) flavors of value: with and without a catalyst for change

May 3, 2011 By in book value, cash flow/share vs. earnings/share, growth vs value, two flavors of value Tags: , , , , , , , , , , , 1 Comment

As you know if you’ve been reading this blog for a while, I’m a growth investor.  But I started out my career as a value investor and spent over half my working years in shops that had either a value orientation or a substantial value presence.  For an outsider, then, I think I have a reasonable grasp of what value investors think and do.  I’m also laying the groundwork in this post for writing tomorrow about the titans of the personal computer industry, AAPL, INTC and MSFT.

how all value investors operate

Value investors like to invest in companies whose stocks are trading at very low ratios of price to book value (shareholders’ equity), price to cash flow, price to earnings and/or price to assets.  Many times such companies have gotten to low valuations because their managements have made strategic missteps.  Sometimes, though, the environment in which they work is highly cyclical and the cycle has turned against them.  Or it may just be that the industry in which the company operates is boring and seldom catches investors’ eyes.

In their pursuit of very cheap companies, value investors hold to two ground-level beliefs, namely:

–you can’t fall off the floor, and

–everything reverts to the mean, sooner or later (but mostly sooner).

The first dictum suggests that if a company’s stock is already all beaten up, at some point it just won’t go any lower.  So if buyers can locate and act at around this level, they have limited downside risk.

The second idea is that the company will eventually overcome the mistakes it has made–either with present management, new leadership, or as a division of a larger company.  In any of these events, the stock will go up …or the business cycle will turn in the company’s favor …or investors may just spontaneously wake up one morning and find the company’s industry much more fascinating (maybe as the first market entrant is taken over).

In any of these cases, the severe negative market emotion that has driven the stock to extremely low levels will dissipate and the stock will return to a more normal valuation–that is, one more in line with its past trading and with what companies with similar financial characteristics in other industries sell at.

All value investors believe this.

What sets them apart from one another?

For one thing, different investors may use somewhat different metrics.  One may be deeply convinced that he should only pay attention to price/book.  Another may be equally committed to price/cash flow.  A third may want to have another company in the same industry that’s very well run, whose (higher) margins may give a strong clue as to how good things might one day get.

In the final analysis, however, I don’t think these differences mean all that much.  Where I see the big divide for value practitioners is between those who want to see some catalyst that will encourage/force favorable change in the firm being analyzed before they’ll buy it, and those who don’t.

no catalyst

I understand the argument that the “no catalyst needed” camp makes.  They say that when things start to go bad for a company, investors can (and usually do) have a violent negative reaction that far exceeds anything that the (deteriorating) fundamentals justify.  The stock gets battered in a way it never will again, once the sellers are able regain a bit of their self-control.  Therefore, by buying when the blood is flowing the thickest in the streets, you get by far the best prices. You’re more than compensated for the risk early buying entails.

I understand the argument, but temperamentally I could never just look at the price/book (or whatever other metric) screens and jump in.  What if the stock turned out to be GM, or Enron, or Global Crossing?  As a result, I’ve never tried to investigate whether the approach works.  Unfortunately, I have seen it fail, though.

catalyst required, please

The second camp of value investors are those who insist on being able to see some sign, or catalyst, that convinces them that change for the better is under way.  It may not have to be much.  The retirement of a CEO and the appointment of a more capable successor might be enough   …or an activist investor approaching another laggard in the same industry   …or indications that the business cycle is changing in the company’s favor.  Although I’m not that interested in a regular diet of value names, I’m much more comfortable with this second approach.  But that’s just me.

where does GARP stand?

There is a third style that stands on the border between growth and value.  It’s called Growth at a Reasonable Price, or GARP.  I’ve often had colleagues describe me as a GARP investor, mostly, I think, because I don’t see a compelling reason to live exclusively on the bleeding edge of growth (with emphasis on bleeding).  But I’m not a GARP investor in the way value players would understand it.

As growth, GARP means having a forward PE that’s equal to or lower than the forward growth rate.  As value, in contrast, being a GARP investor means that you determine a forward PE level, say, 15x, above which you refuse to make a purchase, no matter what you think the forward growth rate will likely be.

For example, I have no problem paying 22x earnings for a company that will grow earnings at a 28% annual rate for at least the next few years.  In fact, I’d consider myself lucky to have discovered the stock before the PE rose further. I’d also be happy to pay 40x for a company that could grow at a 50% rate.

A value-oriented GARP investor, in contrast, would have drawn a line in the sign in the sand, probably between 15x-20x–certainly no higher, and would refuse to buy either.

That’s it for today.  Tomorrow, let’s apply this to INTC and MSFT.