Monthly Archives: August 2012

HP, Dell, Big Lots–what their results are saying about the US economy

August 24, 2012 By in Current Market Thoughts, earnings conference calls, Investment firms, Portfolio management, Retail, Securities regulation, Stock ideas, Technology Tags: , , , , , , , , , , Leave a comment

a qualifier

Actually, this post is more about how I interpret their results.

There’s always ambiguity in any assessment of how companies are doing, including management’s own statements.  There may be issues that managements are unaware of.  There will likely also be others that, especially in the case of a weaker firm, the top brass will tap dance around when speaking to investors.

It’s possible they may be in denial.  But no one is going to turn his earnings conference call into an advertisement for competitors by revealing that, say, “Lenovo has better products than we do, so they’re taking market share from us wherever we compete.”  That just speeds the customer exodus.

We are , however, in a slow-growth world today, where there’s simply not enough business for all market entrants.  During a boom, the top firms don’t have enough capacity to meet customers’ demands.  So buyers who need a product now have no choice but to purchase from second- or third-tier competitors.   In the current environment, in contrast, the number-ones have capacity.  And customers have more time to study competitive offerings before they choose.

the PC business:  Dell and HP

Both are icons of the PC business in the US.  But neither has kept up with the market. True, Windows Vista certainly didn’t help to enhance the reputation of either.  And both have lost market share to Apple.  Also, the market for Windows machines is being negatively affected at the moment by consumers’ reluctance to buy Windows 7 machines because Windows 8 is just around the corner. But as an ex-Dell user (now writing either on a Mac or an Asus machine), I know Dells weigh a ton, run hot and don’t last very long.  Customer service is awful.  HP isn’t much better.

Asian giants Lenovo, Acer and Asustek don’t yet have the support infrastructure in the US that they do  elsewhere.  But the performance of the US incumbents seems to be an open invitation to these firms to take a lot of market share from HP and Dell here–as they are already doing abroad.

Anyway, what I think we’re seeing in the HP and Dell results is the loss of share that weaker players experience in times like these–not evidence of overall economic malaise.

Big Lots

…another company with weak results.  I don’t think Big Lots’ poor performance is indicative of macroeconomic weakness, either.  On the contrary.  I see it as more evidence that consumers are trading up, because their personal economic fortunes are improving.

Trading up and down are complex phenomena.  In bad times, the Saks customer may shop at Target, the target customer at Wal-Mart, the Wal-Mart customer at the dollar stores.  The dollar store customer may just not consume or buy at venues that are below Wall Street’s radar screen.

(Of course, trading down among retailers isn’t the only effect of recession.  Overall, consumers buy less.  They also buy more plain-vanilla, less expensive items that they can use for a variety of purposes.)

In good times, the opposite occurs.

But in both situations, only the merchants at the bottom of the chain and at the top see unambiguous results.

I think two forces are at work in Big Lots’ sales:  rainy day customers are trading up; and, unlike the more progressive of the dollar stores, BIG hasn’t expanded its offerings enough to hang on to more affluent buyers.

my bottom line

I see the results for HP, Dell and Big Lots as simply what happens to weaker companies in a US growing at 2% a year.  The poor numbers aren’t reasons to run out and buy the S&P 500.  But, equally, they’re not a reason to sell, either.

capital spending and the business cycle: BHP as an illustration

August 23, 2012 By in Accounting, capital spending and the business cycle, Portfolio management Tags: , , , , , , , Leave a comment

BHP’s fiscal 2012 earnings report

When BHP Billiton made its full (fiscal) year earnings announcement, it indicated that it is rethinking its planned $20 billion expansion of the Olympic Dam copper/uranium mining project.  It hopes to restructure the expansion in a way that costs less.  The company also recorded $3.5 billion in asset writedowns (“impairment charges”) for the year, the largest being a $2.8 billion reduction in the value of its US shale gas assets.

some perspective

To put these items in perspective, even after the writedowns BHP still made $15.4 billion for the twelve months and had operating cash flow of $24.4 billion.  So, for BHP the announcements aren’t a big deal.  But they do provide the occasion for making several important points about corporate behavior.

1.  Companies rarely outspend their cash flow, no matter what they may say to the contrary.  And if they do borrow to fund capital projects, it’s almost always just after the bottom of the economic cycle, when evidence is accumulating that business is past the lows and is accelerating.  Otherwise, if a firm sees that its projected cash flow over the coming year–sometimes longer–is going to be less than previously thought, it cuts the capital budget.  That’s what’s happening here.

Borrowing to fund capital expenditure adds an additional element of risk because the assets developed are long-term and illiquid, not stuff companies want to stock up on when the future is iffy.

2.  Cash flow isn’t always as available as it might seem.  Companies often have principal repayments on debt.  They can also have mandatory progress payments on capital projects already contracted for.  They pay dividends.  They may need to finance working capital–meaning they need money to buy raw materials, pay workers and offer trade credit to customers.  And (in BHP’s case a minor point, but not always) they may be “capitalizing” interest payments for ongoing projects (BHP capitalized $314 million of interest in fiscal 2012).  Capitalizing means the interest payments are parked on the balance sheet until the associated project is complete.  The money is paid to the creditors, but doesn’t appear as an expense on the income statement.

All this means a large chunk of cash flow is already spoken for each year.  Under normal circumstances, the easiest item to shrink is capital spending on new projects.

3.  Asset writedowns are a form of corporate housekeeping.  Many times–like this one, in my opinion–they occur when earnings aren’t so stellar anyway.  The idea is that more bad news doesn’t stand out so much.  That’s not the whole story, though.

Take the $2.8 billion writedown of shale gas assets.

Taken literally, the asset reduction means that BHP no longer believes the holdings are worth the amount it has invested in them.  They’re actually worth $2.8 billion less.  Conceptually, the firm is required to make the writedown once it becomes convinced this is the case.  Practically speaking, companies have a lot of wiggle room to use to avoid doing so.

Suppose it’s right that BHP has lost $2.8 billion through investing in shale gas.  It has two choices:

–it can either reduced the carrying value of the assets now, to the point where it can maybe make a slim profit in the future–and do so at a time when the business is slack and investors don’t really care, or

–it can keep the $2.8 billion loss on the balance sheet and show it little by little as gas is brought to the surface and sold.  Losses would continue for the life of the operations, until the entire $2.8 billion flows through the income statement.  Most of the red ink would presumably occur during better economic times, when investors are more eager to see earnings gains and would respond more negatively to the losses.

In other words, BHP is (prudently) wiping the slate clean while no one is looking.  In the non-commonsensical way that professional investors think, the writeoff is the mark of a good company.

return on equity vs. return on capital: two important indicators

August 21, 2012 By in return on equity vs. return on capital Tags: , , , , , , 1 Comment

In a post a few days ago, I wrote about return on equity,  which is a standard measurement of the skill of the management of a company whose stock we might consider owning.  Services like Value Line provide statistical arrays for companies–and for the industries they’re a part of–that have these calculations,and a bunch of others, already done.

Today I want to add an important refinement–return on capital.

two forms of capital

Corporations have two sources of investment capital available to them.  One is equity, which is ownership interests in the firm that the corporation sells to shareholders.  The other is debt.  Debt comes is two flavors:  bonds issued by the company or bank loans that the firm takes out.

Debt holders have a call on corporate cash that’s superior to shareholders’.  On the other hand, as creditors, debtholders have no ownership rights. So, other than if the firm is in dire financial condition, they have no say over corporate operations.

Why take on debt?

It’s easier to raise capital this way, under normal circumstances.  Also, Americans, if no one else, believe that debt is a cheaper form of capital–meaning that shareholders can gain extra return by using it.

On the other hand, financial leverage (which is what having debt is typically called on Wall Street) brings risks with it.  So it’s important for investors to distinguish in a potential investment’s returns the portion that comes from employing capital in the company and the part that comes from using debt.

where return on capital comes in

Return on capital measures the first; return on equity measures the first plus the second.  Subtracting return on capital from return on equity gives return on financial leverage (a term I made up; the number doesn’t have a common name), or return from capital structure/financial engineering.

a simple example

1.  Let’s assume that a company has 100 units of equity and that it’s in a business where investing that 100 creates 100 units of annual sales (these numbers aren’t realistic; their virtue is simplicity).

Let’s also say that the company will earn 20 units of earnings before interest and taxes (ebit) from those sales.   We’ll also say that the company pays tax at 35%.

The income statement looks like this:

sales       100

ebit          20

tax at 35%    (7)

net income       13.

return on equity =   net income ÷ shareholders’ funds   =   13   ÷    100   =  13%.

2.  Same company, but it has borrowed 100 units of debt capital @ 5% interest.

sales       200

ebit          40

debt interest    (5)

tax at 35%        (12.25)

net income      22.75

return on equity  =  22.75  ÷  100    =    22.75%.

A huge difference!!

defining return on capital

return on capital  = (net income + aftertax cost of debt)   ÷  (total capital, i.e. equity + debt)

The aftertax cost of debt:  in the US, and in many other places, interest expense is deductible from otherwise taxable income.  The tax break is:  interest expense times the tax rate.  The aftertax cost of debt is:  interest expense – the tax break.

In our case, the aftertax cost of debt is 5 -1.75, or 3.25.   Return on capital = ( 22.75  + 3.25)  ÷  200 =   13%.

results

In this example, the unleveraged company earns a return of 13% on its invested capital.  This is the return that the company’s management can achieve from operating the business.  This may be good or it may be bad   …depending on the industry and the competition.

The leveraged company produces the same return from the business.  But it amplifies this by 9.75% by using a lot of debt capital.  (By the way, the tax system encourages this behavior by allowing a writeoff of interest costs as a business expense.)

The important thing to recognize is that leverage alters the risk profile of the business, in two ways:

–the principal amount of the debt must eventually be repaid.  If the debt is a bank loan, it could be subject to a repayment demand on extremely short notice, and

–a downturn in sales will squeeze profits for the leveraged company more than for the unleveraged, since the interest expense remains a constant.  In my experience, the negative effects of leverage working against you are much more severe than this simple example suggests.

what is a REIT?

August 20, 2012 By in Industry Analysis, Property/housing, REITs, Stock ideas Tags: , , , , , , Leave a comment

real estate stocks

Many global stock markets contain vibrant real estate sectors.  Real estate investment companies, specializing  in holding either residential, or commercial or office real estate, are the most common.  But a number of markets also feature real estate development firms as important index constituents.  And, of course, hotel companies are almost ubiquitous.

Except for hotels, this hasn’t been the case in the US.

REITs

Real Estate Investment Trusts are a US concept, enabled by the Real Estate Investment Trust Act of 1960.  Since then, they’ve become the most common form of stock market ownership of apartment houses, malls and office buildings.

The REIT Act permits the creation of highly specialized corporations, analogous to mutual funds, that hold real estate.  In general terms, REITs must accept restrictions on the types of activity they can engage in and the requirement that they distribute to shareholders virtually all the profits they generate.  In return, REITs avoid having to pay tax at the corporate level on their earnings.  This means distributable income can be over 50% higher than a regular corporation would have!!

Specifically, to qualify as a REIT, a company must:

–hold at least 75% of its assets in real estate

–generate at least 75% of its income from real estate

–distribute to shareholders virtually all of that income

–maintain a diversified portfolio of assets, in much the same way that mutual funds are required to do

–keep an open share register, in that no one entity can own over 50% of the outstanding shares.

updates to the law

There are two:

The Tax Reform Act of 1986 allows REITs to provide their own property management and leasing services, rather than having to hire third parties to do this for them.

The REIT Modernization Act of 1999 allows REITs to have their own taxable subsidiaries to provide maintenance and other services to the properties they own.

The effect of these two modifications is to make REITs much more like publicly traded real estate investment companies available in Asian or European markets.  But REITs still retain the important advantage that they’re not subject to corporate tax.

appeal widening

The attractiveness of REITs in the US stock market has increased significantly in recent years.  Three main factors:

1.  investor preferences are changing

The aging of the Baby Boom means that this important segment of the investing population is increasingly interested in income generating investments.  REITs are a natural area of interest.

2.  mature companies are turning themselves into REITs

This is partly a response to the growing receptivity of investors to income vehicles.

Part is an intelligent response by corporate managements to the increasing maturity of their businesses.  The more common tack has been for aging companies to plow their cash flow back into new capacity or into acquisitions (both of which invariably generate only losses) in a foolish attempt to regenerate lost youth.  This may make the CEO feel good, but it almost always destroys shareholder value.

Part is also an increasing liberal interpretation by Washington of what constitutes real estate.

examples of “unconventional” REITs

Forest products company Weyerhaeuser and cell tower owner American Tower have already converted themselves into REITs.  Iron Mountain, which stores/disposes of corporate documents is in the process of following suit.

It seems to me the appeal of REIT conversion can only increase, especially since the companies doing so are receiving a strong positive reaction in their stock prices.