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.




capitalizing, expensing and the internet (ii)

Back when I entered the stock market, and when the CFA Institute was run by professional investors, that organization published an industry-by-industry guide to securities analysis written by veteran industry specialists.

The section on technology was a real eye-opener.  It was a litany of virtually every accounting fraud known to man.  The abuses ran in two related areas:

–capitalizing (and therefore delaying recording as expense) almost everything, especially research and development expense, and

–setting unrealistically lenient schedules for depreciating or amortizing these balance sheet accounts.

The result (and intent) of this chicanery was income statements that showed profits far in excess of the “real” amounts–even paper “profits” when a company was actually bleeding red ink.

The abuses were so blatant that the accounting rules were changed in the US to force virtually all companies to expense R&D costs as incurred, rather than store them up on the balance sheet.  Virtually all companies still write off against income the cost of their plant and equipment much more slowly in their financial reporting to shareholders than they do in their tax reporting to the IRS.

Fast forward to the present.

What effect does the long-ago change in accounting rules for R&D have on today’s publicly traded companies?  For hardware-dependent firms, not that much.  Yes, computers may wear out or become obsolete much faster than, say, a cement plant.  But the presentation of profits to actual and potential shareholders of a semiconductor foundry, a server farm or a steel mill allow for a more or less apples to apples comparison.

Not so for software-oriented firms.

Let’s take AMZN as an example and do a back-of-the-envelope calculation.

During the first half of 2013, AMZN spent $2.97 billion on technology and content.  If we assume that all of that were capitalized instead of expenses (an aggressive assumption) but that any resulting financial reporting profits were subject to tax at the very-high US rates, then I figure AMZN would have shown earnings of $4.50 per share so far in 2013 instead of the $.46 actually reported.  This would suggest, in ballpark figures, $10 a share in EPS for the full year.

Maybe the multiple isn’t so crazy.

Just as important, the same adjustment should apply to any other R&D-centric firm.   R&D may be creating important long-term intellectual property assets for a company, but the accounting rules (for sound historical reasons) portray this activity as a minus.



capitalizing, expensing and the internet (i)

finitude and stocks

I’ve been having memento mori thoughts recently.

No, not about me personally or anyone I know.  Instead, I’ve been thinking about the role of value investing in today’s world.

Several things have turned my mind in this direction:

–as I travel, I can’t help but notice the increasing numbers of businesses that are giving up the ghost in rural and suburban areas–restaurants, inns, whole strip malls either shuttered or never opened

–I realize that I’m part of the problem as, to my wife’s dismay, I order increasing amounts of stuff through Amazon

–I sometimes wonder what investors are thinking when they pay over $300/share for AMZN, a company whose book value is under $20 and whose high-water mark for earnings was $2.53/share, pre-Great Recession.  Don’t misunderstand me–I’m not saying there aren’t reasons for buying AMZN (after all, I own SPLK (Splunk–great name).  I don;t own AMZN, though.).  I just wonder whether people have thought through what they’re doing or whether they’re just going with the flow.

value investing

What does this have to do with value investing?

When a company spends money, it has two basic choices about how to account for the expenditure.  It can:

–record the money as an expense against current earnings.  In this case the money appears on the income statement as a cost–e.g., raw materials, marketing expense, salary…–and then disappears forever, or

–record the spending as an asset on the balance sheet and dribble the amount as a cost into the income statement over a long (possibly very long) period of time.  The fancy name for this process is capitalizing and it’s normally done only with assets that have long useful lives, like office buildings, stores or factories.  (The company will disclose the rules it uses for the gradual writeoff of asset value in the footnotes to its financial statements.)

The money has already left the building in either case.  The difference is a decision about what revenues to use to match what costs to.

is capitalizing a problem?

I think so.

Value investors like to look at per share book value (also called shareholders’ equity, or net asset value)–i.e., the value of the assets listed on the balance sheet minus any liabilities–and compare this with the stock price.  They consider a stock trading at a discount to book value to be a potential bargain and one trading at a premium (or, like AMZN, at 15x book!) to be potentially overvalued.

The rationale behind this is that:

–the asset base is a defense against competition.  A potential rival would presumably have to spend a similar amount just to enter the business.

–book value is based on the actual prices paid, and is not adjusted for inflation.  A company with a long history may well have assets whose value has increased over time but whose cost has already been partly or completely written off against income.  Therefore, book value may significantly understate the actual value of the company’s assets.

I have two concerns

In the current time of deep social and technological change, having a lot of capital sunk into yesterday may not be such a great thing. After all, it didn’t help Toys R Us or Borders or Circuit City.

Also, my experience is that US companies are very reluctant to decrease the balance sheet value of not-so-hot assets.  And auditors are not inclined to push the issue.  The more dead real estate I see, the more I wonder whether corporate balance sheets are as up-to-date as they’re supposed to be.


Amazon is the polar opposite of the book value enthusiast’s ideal stock.  How much of that is reality, how much accounting quirks?  That’s tomorrow’s topic.

contribution margin

several sets of corporate books

As I’ve written in a previous post, publicly listed companies have three sets of books:

–financial reporting books, which tend to portray a rosy picture to shareholders,

–tax books, that tend to show a relatively grim picture of profitability to the taxman, and

–management control or cost accounting books, by which the company is actually run.

Contribution margin is an important concept for this last set of books, the management control ones.

what contribution margin is 

The first thing to be clear on is that people call contribution margin is not always a margin, that is, a percentage.  More often a contribution margin is expressed in absolute dollar amounts.  Don’t ask me why.

But what is it?

It’s the amount by which the revenue from selling an item exceeds the direct cost of production and thus “contributes” to defraying corporate overhead. It can be positive or negative.  Negative is very bad. The concept can be used at every level of corporate activity, from an individual widget made in a plant, to the total output of the plant, to a mammoth division inside a multi-line company. It’s not a measure of profit; it’s the basic measure of cash generation.  The question it answers at any level is, “Does this operation generate a positive return,  before loading in charges for corporate ‘extras’ –like the CEO’s salary, R&D, image advertising, the corporate jet fleet…”

why it’s an important concept

It makes you focus on incremental cost, not total cost.  For example,

1.  It tells you the point at which a company begins to consider shutting an operation down–namely, when the contribution margin turns negative.

I was reading a report the other day about the gold industry that maintained the gold price was in the process of bottoming because the “all in” or “fully loaded” price of producing an ounce of gold for the global gold mining industry is about $1,100 an ounce.  How embarrassing for the author!  That’s not right.  Yes, at under $1,100 an ounce, a generic mine may be showing a financial reporting loss.  But it’s still generating cash–in fact, the lowest-cost mines are probably generating $500 in cash an ounce.  Only the highest cost operators will think about ceasing mining.

What will firms do instead?  They’ll cut corporate overhead, for one thing.  If they decide that the value of their plant and equipment is permanently impaired, they’ll write off part of the carrying value of this investment on their balance sheets.  That will lower ongoing depreciation charges, by. let’s say, $100 an ounce (a number I just made up).  That will magically transform the financial accounts from red ink to black.  But this change won’t alter the cash flow generation from operations.

2.  It highlights an operation’s value.  Suppose an operation has a contribution margin of $1 million a year, but all that–and more–is eaten up by corporate charges.  It can be sold to, or merged with, another operation in a similar situation.  The ” synergy” of eliminating duplicative administrative functions may turn two apparent losers into a combined money-maker.  In any event, the $1 million yearly contribution to overhead has a significant value.

3.  It invites you to look at breakeven points–and the often explosively strong effect that finally covering overhead costs can have on profits.  Hotels are the example I often thing of.  As a general rule of thumb, a hotel is breakeven on a cash flow basis at 50% occupancy.  It breaks even on a financial reporting basis at 60% occupancy.  Above that, profit flows like water into the accounts.  IN this case, a relatively modest shift in occupancy can change the profit picture dramatically–and that’s without regarding the possibility of room-rate increases.

when the dust clears, I’m buying a generator

no power–again!

I live in a detached house in the northeast US.  Hurricane Sandy is the third occasion in a little over a year for my neighborhood to lose electric power for an extended period–a phenomenon I associate more with emerging nations than developed ones.  This means no lights, no heat, no hot water for 5-10 days.  No TV, no refrigerator, no internet, either.  It’s back to checks instead of the bank website to pay bills.  For many people (not us, though) it also means no water at all, so, among other negatives, the toilets don’t work.

bad luck?   …no

I think that our recent experience isn’t simply horrible bad luck.  The more I think about it, the more I’m convinced that long power outages are going to occur routinely where we live from now on (hopefully less frequently than once every few months).

My conclusion has in principle little to do with global warming, although global warming makes the problem potentially much worse.

utilities are a little like banks

For decades, economists have pointed to the potentially disastrous consequences of the dual nature of banks in the developed world.    On the one hand, they have an important social function–they’re the main vehicle for transmitting national monetary policy from the central bank to the economy at large.  On the other, they’re publicly traded companies whose managements aim at making steadily increasing profits to please shareholders.

Sometimes, these two roles are incompatible.

If the banks take too much risk in seeking net income rises, they’ll lick their wounds and refuse to lend, no matter what signals the central bank sends them.  Less often–the only example I can think of is the decade leading up to the US housing collapse–the banks can listen to crazy signals from the government (thanks, Mr. Greenspan), make a pile of unbelievably stupid loans, and bankrupt themselves.

I’m coming to realize that electric utilities are a poor man’s version of the phenomenon of having two conflicting social roles.  Actually, I’ve known this in theory for a long while.  But we appear to have hit a tipping point here in the Northeast, so that the negative effects of the arrangement are becoming apparent.

my reasoning


Typically, because of the immense expense involved in establishing and expanding an electricity generation and transmission network, governments grant a single company a monopoly over service provision in a given area.  In return, that company accepts government regulation of the rates it charges.  The economic sense used in the rate-setting process is that the company is entitled to a certain rate of return on its net plant and equipment investment.  The big question is what that rate will be.

a growing service area

When a community is growing, the regulators are content to allow generous rates of return.  This makes it easier for the utility to raise the capital needed to expand its network.  The prospect of high returns on a growing capital base makes banks willing to lend.  The promise of rising dividends makes equity investors willing to bid up the company’s stock and to subscribe for new shares in public offerings.  Everyone is happy.

a mature area

When the area matures, however, and expansion slows/stops, the dynamic changes in two ways:

–since there’s no necessity to attract new capital, the government sees no need to continue to grant rate increases.  More than that, it sees there’s a political advantage to lowering the rate of return.  What can the utility do–rip out its lines and leave?

–for a company, the operating profit it gets from providing its services is based on net plant–that is, its initial investment minus yearly depreciation charges.  So if it can’t add new plant, the money it receive doesn’t remain constant.  It begins to decline as yearly depreciation whittles down the net plant figure.

Voters are happy because utility charges aren’t rising.  The utility company, however, undergoes an enormous squeeze.

the utility response

Every capital-intensive company becomes a price taker (meaning it has little or no influence over the price it receives for its goods/services) once its capital investment has been made.  It’s true for a cruise ship, a hotel, a cement plant–and a public utility.  All it can control is its costs.  All it can do to increase profits is to cut costs (the firm can also become a holding company and invest part of its cash flow in non-utility areas, but in this post let’s keep focused on the utility) .

It can merge with other utilities to eliminate administrative overhead.  It can also shift from gold-plated repair and maintenance to some less expansive variety.  It does so by reducing the number of local employees, planning instead to borrow from neighboring states in case of emergency.  It cuts back on inventories of replacement parts. It tries to nurse senescent plant and equipment into working for “just one more year.”   Aging infrastructure makes the whole system more fragile.  As a result, the utility may be more vulnerable to shocks and less able to respond quickly to emergencies.

My diagnosis is that this is what’s happening in the Northeast US now.  Hence my belief that the lengthy power outages of the past year or so aren’t just unfortunate coincidences but indications of what life will be like in the future.  Ergo, my upcoming generator purchase.

investment implications?

My main conclusion is that the situation I describe is a negative for utilities in mature areas of the US.  One caveat is the possibility that regulators might boost allowed returns in order to get utilities to invest more in their plant and staff.  But recent legislation allowing third parties to sell cheap electric power through the existing utility distribution networks cuts against this idea.

I don’t want to point the finger at any one party as having caused the current state of affairs.  The bottom line is that we have the utility system we’re willing to pay for.

I can imagine that continuing power outages will accelerate population drift away from the affected areas toward the growing regions of the country in the South and West.

On a more (useful and) micro level, outages should shift internet usage more quickly to mobile.  In our area, VZ coverage seems to be proving far superior to that of T, so outages may encourage customer switching to the former.

If we’re still looking for anyone whose “fault” the situation I’m describing may be, try blaming Adam Smith.  His “invisible hand,” is, after all, the basis for the idea that leaving everyone to pursue his own self-interest somehow produces the best social outcome.

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.

subscription services: good or bad as stocks?

subscription services

Everyday life is filled with examples of subscription services.  They range from newspapers and magazines, where one pays in advance for copies that are delivered over, say, the subsequent year; to monitoring services that guard against burglary or fire; to cellphones, where the network operator offers a handset at a subsidized price in return for the customer signing a long-term contract; to cloud computing, where a customer “rents” storage space or other hardware, or software tools to run his enterprise.

All these kinds of companies have common characteristics.  Apart from the cost of setting up or participating in a delivery system (from coaxial/fiber optic cables to the postal or telephone service), the key variables are:

–the number of customers

–changes in that number as time progresses

–per customer revenue

–per customer operating costs

–customer acquisition costs, and

–the length of time the average customer retains the service.

These are the bare bones.  Of course, there can be other considerations, like a company’s ability to sell add-on services after the initial customer relationship is established, or the fact of general, administrative and (possibly) financing costs.  But let’s put them to the side.

my point

The point I want to make in this post is that these companies sometimes exhibit earnings patterns that equity markets find difficult to understand and value.  In some cases, this has meant that companies are ultimately taken private after their stocks have languished in price in the public markets for an extended period of time.

An example:

Consider a company that provides burglar and fire alarm monitoring to residential customers.  Typically, the firm will offer “free” installation of monitoring equipment in return for a two-year monitoring contract.

Let’s say installation expenses are 300, that the customer pays 20 per month in fees and that the average customer remains with the monitoring company for a long as he owns his house.  Assume that’s 10 years–but it could be a lot longer.  Let’s also assume that the cost of setting up the remote monitoring station is trivial, but that manning it costs 100,000 a year.

the company take on its business

The company probably does a present value calculation to evaluate how much it gains by adding a customer.  Ten years of revenues at 240 per year = 2400.  Subtract installation costs of 300 and the customer’s share of monitoring costs, say, 250.  Then the net value of a new addition is 1850.  Present value is lower, but the possibility of rate increases and operating leverage in expenses mitigates this to some degree.  Yes, I could have done a “real” calculation on a spreadsheet that would be much more sophisticated (though perhaps not much more accurate), but this is the basic idea.

the stock market’s view

Here’s what the income statement for the first five years of such a company’s existence might look like:


1 2 3 4 5
new subs% 50% 50% 20% 10%
total subs 1000 1500 2250 2700 2970
total revs 240000 360000 540000 648000 712800
op costs -100000 -100000 -100000 -100000 -100000
startup cost -300000 -150000 -225000 -135000 -81000
net profit -160000 110000 215000 413000 531800

In year 1, the company is unprofitable, even though on a present value  or “asset” basis it has added 1,850,000 in value.

In year 2, the company becomes profitable on a financial reporting basis, but still has negative net worth.

In year 3, earnings explode, even though the firm is adding less asset value than it did in year 1.

Year 4 is the really interesting one.  Reported earnings continue to rise at an astronomical clip.  Yes, profits are only up 92%, vs 94% in the year earlier.  But is this something to really be concerned about?

Actually, yes.  The concern isn’t about profits but about revenues.  In year 4, subscriber additions show a sharp drop, from 750 in the year prior to 450 in the current period.  There are two reasons the earnings are still so strong, and don’t reflect this falloff:  lower expense for new installations (startup costs) and positive operating leverage from monitoring costs being spread over a larger number of customers.

How does the stock market treat a case like this?  In my experience, the answer is “badly.”  Investors are accustomed to looking at earnings per share or at cash flow per share and this kind of company doesn’t fit either template.  While the company is expanding rapidly, the costs of linking up new customers depresses eps, and cash flow may be negative.  Paradoxically, the profit numbers look their best only when the firm begins to show signs of maturing.  But investors will begin to take fright when they see that revenue growth is slowing.

This situation is a big reason that most monitoring companies have either been taken private or are divisions of larger companies, where the unusual earnings pattern isn’t so evident.

One other observation.

This concerns accounting technique.  In the example above, the installation costs have been expensed in the year incurred.  What would the financials look like if those costs had been capitalized and depreciated over ten years.  Take a look.


1 2 3 4 5
new subs% 50% 50% 20% 10%
total subs 1000 1500 2250 2700 2970
total revs 240000 360000 540000 648000 712800
op costs -100000 -100000 -100000 -100000 -100000
startup cost -30000 -45000 -67500 -81000 -89100
net profit 110000 215000 372500 467000 523700

In the first four years, the company now looks a lot more profitable and cash flow looks better.  In other words, the monitoring company looks like a conventional firm that equity investors would have no trouble evaluating.  Expense deferral only starts to catch up with the company in year 5, when the growth rate drops off significantly.

why expense instead of capitalize/depreciate?

For one thing, expensing is the more conservative technique.  For another, in the case of a monitoring company, there’s no capital equipment.  The sensors being installed are all low-cost items that are normally expensed.  Labor cost is probably the biggest factor in the installation.

relevance for cloud computing?

As this industry develops, it will be important, I think, to distinguish between companies that rent hardware (which can be depreciated) and those that rent software (whose costs may be expensed as R&D).  Their income statements may look very different, as the monitoring case illustrates.

There may also be wide company to company differences in accounting technique for basically the same services.  More speculative firms may capitalize all the customer acquisition costs they can–and maybe some that they aren’t supposed to.  Others may have a much more conservative bent.  It’s not clear that brokerage house analysts will appreciate the differences, or flag them in their reports.

In addition, there may be firms whose financials will mimic those of the security monitoring industry.  Absent considerable shareholder education, such firms may have less positive experience for their stocks than the company performance merits.