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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:
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.
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%.
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.
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.
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.
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.
double taxation of dividends
In the US, and most often, elsewhere, dividend payments to shareholders must be made from income on which domestic taxes have already been paid. Recipients pay income tax again on any dividend income they receive.
(In contrast, the IRS regards interest payments on bonds as an expense. So these payments are made from pre-tax income, and serve to lower the firm’s tax bill. No wonder some companies leverage themselves too much.)
For a mature, low growth, business that throws off cash and doesn’t have many good ways to reinvest the money, stock buy backs and dividend payments are the two common methods of returning these funds to shareholders. Personally, I think stock buy backs are almost always a scam. At the very least, they’re not a very dependable source of funds for income oriented investors. And double taxation means that a sizable chunk of the money available for distribution–just over a third, in the US–is lost to the taxman.
There has to be a better way!
For many firms, there is. It’s called a Real Estate Investment Trust ( REIT), and it’s becoming an increasingly popular corporate solution to the mature business problem.
Briefly, a REIT is a special form of corporation, somewhat akin to a mutual fund. It accepts restrictions on the kinds of activity it can take part in, and agrees to distribute virtually all the income it generates to shareholders. In return, it is exempt from corporate income tax.
Details on Monday.
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.
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.
I want to eventually write about the attractiveness of REITs and the increasing tendency of mature companies in the US to turn themselves–or at least part of themselves–into them. This is the first in a series of posts to lay the foundation for that discussion.
a new company, a blank slate
Imagine that we’re forming a new company. On Day 1, the books and accounts of the new firm are just empty pages.
Then we inject some cash to get the firm going. We get shares of stock, representing our ownership interest in the new firm, in exchange. The balance sheet of the new firm will reflect this transaction by recording the cash inflow on the asset side, and the same value under “shareholders’ equity” on the other (the liabilities + equity side).
The new management of our company–maybe us, maybe professionals we’ve hired–invests the cash in (we hope) high-return projects that generate a lot of income. We, or our accountants, will periodically create an income statement to record how much money we’ve earned (or lost) during a given period of time. In real life, the money is coming in every day and being spent or invested almost simultaneously.
where the money goes
In the simplest conceptual terms, two things can happen to the money the firm earns. It can be reinvested in the firm’s operations, in which case we can think of it as entering the balance sheet as cash (in + or – amounts) on the asset side (and then being invested in working capital or plant and equipment, which are other categories on the asset side) and as corresponding changes to shareholders’ equity on the other. Or it can be paid out to shareholders as dividends.
If the firm makes a new stock offering to raise additional capital, the balance sheet activity will be similar to what happened at the firm’s birth: cash is entered on the asset side of the balance sheet; shareholders’ equity rises by the same amount on the other.
One way of summarizing this process–the one we need today–is that shareholders’ equity represents the amount of money the management of our firm has to work with: the initial capital, the proceeds from further equity issues, plus accumulated profits (minus any amounts paid out to shareholders).
measuring management’s skill
How do we measure management success? One straightforward method, for both actual and potential shareholders, is to look at the income the firm produces with the money it has invested. In other words:
— annual profit ÷ shareholders’ equity, which is known as return on equity.
Astute readers will recognize that shareholders’ equity is also known as book value. Regular readers may remember that I’m not particularly a fan of book value as a valuation metric. True, but let’s put that aside for the moment.
return on equity
The virtue of using return on equity is its simplicity. A return on equity of 3% a year is bad. A return on equity of 15%+ is good. In today’s world it’s very good.
stock market adjustment
For publicly traded companies, firms that consistently achieve only a 3% return on shareholders’ equity will probably trade at a huge discount to book value. If Wall Street believes that a firm should be able to earn 10% a year on the money it has to work with, then the 3% company might trade at 1/3 of book (in reality, the market will likely expect either the company’s board of directors or an activist outsider to force a change of management. So the discount won’t be as deep as it otherwise should be).
On the other hand, a firm that consistently earns 15% on equity will doubtless trade at a premium.
Bad companies can sometimes have high returns on equity. One of my favorite examples is Fotomat, which had kiosks in mall parking lots where it collected undeveloped camera film ad returned prints to customers the next day. I remember a shareholder calling me up one day to criticize me about my negative view, citing the company’s current 15% return on equity. I pointed out that the prior year the company had a mammoth loss, which cut its equity in half!! Shrinking the denominator is not the best way to achieve good return numbers.
Suppose we invested $100/share in a gold exploration venture–and our geologists discover gold worth at least $1000/share. The stock will trade at 5x, or 10x, or some higher x, book value–even though production hasn’t started (in fact, the Wall Street cliché is that the stock peaks the day the mine opens). Other kinds of natural resource companies can experience this phenomenon, as well.
prisoners of the past?
If we imagine the assets of a company as being a collection of investment projects–some successful, some not–how do we deal with the clunkers? In particular, what do we do if we’ve just been hired to run a firm and see (from low historical returns on equity) that the company is filled with terrible past investment projects? Or how do we keep the inevitable mistakes from tarnishing our record forever?
On August 7th, DIS released profit results for 3Q12 (the DIS fiscal year ends in September). The company posted its highest quarterly profits ever–$1.83 billion. At $11.1 billion, revenues were up 4% year on year for the period. EPS were $1.01. That was 29% from the $.78 posted for 3Q11. It also compares favorably with the Wall Street consensus estimate of $.93/share.
The stock initially broke through the $50 barrier on the upside on the news. It has since settled back a bit below that mark.
This segment makes up 2/3 of DIS’s operating income. It’s mostly cable; and of that, the lion’s share of profits come from ESPN.
Operating income was flat, yoy, at $2.13 billion. But a change in contract terms with Comcast has shifted into 1Q and 2Q $139 million in payments normally recognized in 3Q. There are other underlying complicating factors (the norm for this segment, and for DIS overall) as well. On an apples-to-apples basis, op income for Media Networks is probably growing at 10%+.
parks and resorts
This segment represents a bit less than 20% of DIS’s op income.
Parks and Resorts were up 21% yoy during 3Q12, at $630 million. The comparison is flattered, however, by higher yoy royalty payments from Tokyo Disneyland, based on a rebound in attendance from the earthquake/nuclear disaster-depressed 3Q11. DIS also received in the current quarter an insurance settlement for business interruption at Tokyo Disneyland last year.
Business is recovering strongly at DIS’s domestic theme parks–thanks in part to the successful makeover of the California Adventure park at Disneyland. The company has new cruise ships and bookings are perking up as well.
Normalized growth for Parks and Resorts is probably closer to 10%.
Movie results were up over 6x to $313 billion, thanks to the Avengers film, which has taken close to $1.5 billion worldwide. Even so, films now represent less than 10% of DIS’s overall operating income. Of course, successful movies can also have positive rub-off effects on the theme parks. They’re the foundation of much of DIS’s merchandise sales, as well.
To some degree, Consumer Products earnings are affected by internal negotiations about revenue sharing among segments about sales of character-related merchandise. That was a yoy positive in 3Q12, when this segment posted op income of $209 million on sales of $742 million. Growing at maybe 10% yoy, Consumer Products represents considerably less than 10% of DIS.
DIS’s gaming and internet businesses continue to make losses. The good news is that interactive is gradually approaching breakeven. The segment lost $42 million in the current quarter, less than half the deficit in the year-ago period.
a shift in international strategy at ESPN
For the past couple of years, DIS has spoken enthusiastically about international expansion possibilities for ESPN. Its initial foray was to be soccer broadcasting in the UK. the company’s tone was somewhat less positive a quarter ago.
During Q&A after the 3Q12 earnings announcement (you can get transcripts for free from Seeking Alpha–a really very valuable service), DIS management said in effect that it is reining in its European expansion plans after losing in the bidding for Premier League broadcasting rights. It has also ended its Asian jv with News Corp. ESPN is now concentrating on expansion in Latin America.
It’s too simplistic to characterize the UK expansion attempt as a mistake. Rather, incumbents there (correctly, in my view) recognized the threat that ESPN posed and were willing to take substantial near-term losses in order to deny a powerful new competitor a foothold in their market. Not pleasant for them, but the correct strategic move.
As for ESPN, this removes the near-term possibility of large positive earnings surprise from a new profit source. But the immense popularity of its sports programming in the US make it a steady grower at 15% or so for the foreseeable future.
theme park cap ex is peaking
Other than for its theme parks, DIS isn’t in very capital-intensive businesses. Of its total segment capital expenditure of $2.5 billion so far in fiscal 2012, $2.3 billion is attributable to expansion at Disneyland and Disneyland Paris, as well as construction of Shanghai Disney. With Disneyland expenditure finished, the company is beginning work on overhauling Fantasyland in Disney World. Despite this expense, company cap ex will likely gradually decline from the current level, providing higher free cash flow for dividend increases and further stock buybacks.
Year to date, DIS has repurchased 55 million shares of its stock at an average price of a bit over $38 each. During 3Q12, the buyback pace slowed somewhat, with 8.6 million shares bought at an average price of $43.37.
In its earnings conference call, however, DIS made it very clear that it regards its intrinsic value as significantly higher than the current share price–and that, therefore, buybacks will continue. It intends to devote about a third of its free cash flow to a combination of buybacks and dividend increases.
my take on the stock
Accounting quirks aside, DIS seems to me capable of delivering 15% annual earnings growth, with limited cyclicality. The stock is trading at a slight premium to the S&P 500. It has strong management and a collection of iconic brands, the most important of which is ESPN. My guess is it will be a mild outperformer over the year ahead.