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.
Monthly Archives: August 2012
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.
return on equity: a measure of management prowess
REITS …eventually
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.
balance sheet
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).
income statement
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.
some caveats
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?
More tomorrow.
DIS 3Q12 earnings–highest all-time profits
the report
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.
the details
media networks
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%.
studio entertainment
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.
consumer products
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.
interactive
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.
buybacks continue
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.
wealthy Asians are ditching western wealth management products
…that according to a recent article by Bloomberg.
how so?
Two quotes in the article seem to me to sum up the situation: “We felt we could do better ourselves,” and “There is a disparity between banks’ income requirements and clients’ interest.”
The conclusion doesn’t surprise me very much. After all, Americans have been leaving traditional brokers for a do-it-yourself approach for years. What is news to me is that wealthy Europeans appear to be increasing their reliance on wealth managers, not paring back their exposure.
unattractive products
There are two basic reasons I find most “sophisticated” wealth management products less than compelling.
the deal structure may be poor
In many traditional tax shelter products, for example, the upfront fees and commissions that clients, as limited partners, pay can be as much as 20% of the money they put in.
Their cash flow share is usually disproportionately small. The general partner will contribute, say, 20% of the partnership assets but collects 40% of the cash flow. The limited partner puts in 80% and collects the remainder. The general partner’s contribution may not be cash, but rather assets whose appraisal value is open to question–something which could tilt the sharing of cash flow further against the limited partner.
the client may not get access to the best assets
Marketing materials invariably illustrate how the investor will hold equity in, say, fast-growing privately held firms in areas where foreign ownership is severely restricted. The apparent promise is of extraordinarily high gains. If, however, you examine the returns investors have achieved in the past from similar offerings by the same local promoter, they’re probably equivalent to those of the local stock market. Lots of sizzle, then, but little steak.
pressure to cover high fixed costs
Traditional wealth managers can have surprisingly high fixed costs. They will likely have offices in high-rent buildings. They may have extensive administrative and support staffs. Successful salesmen may have guaranteed contracts at high compensation. As a result, firms may need to sell a lot of products each year–whether good deals are available or not–just to cover their costs and make a contribution to corporate overhead. In a situation like this, the pressure is typically to push iffy deals to clients with fingers crossed in the hope they will succeed.
inherited wealth in Europe?
Why are Europeans content with at best so-so treatment? I don’t know.
Bloomberg says it’s because wealthy Europeans tend to have inherited their money, and are therefore more patient (does this mean clueless?), while wealthy Asians (at least potential wealth management clients) are self-made men and tend to be less tolerant.
“good” families and “bad”
I’d offer a slightly different thought.
Anyone who studies Asian equity markets soon realizes that the region contains many family owned conglomerates. Virtually always, the family will have its assets in both privately held and publicly held companies. In all cases, the private company does better than the public one. That’s just life.
What separates the public companies of “good” families from “bad” is how they treat minority shareholders in the public entities. “Good” families will select assets/projects for the public to hold that have strong profit characteristics; “bad” families will select ones where they have already squeezed out most of the profit potential in the private company. In the former case, the public investors can consider themselves sort of junior family members, maybe distant cousins. In the latter, they’re just a disposal service.
I think wealthy Asian investors have concluded that western wealth management looks much more like the work of “bad” families than “good.” They’re probably right.
European clients may not be as hands-on, and their more mature equity markets may not invite the same good company/bad company comparison.