Category Archives: depreciation

return on equity (II): cleaning up a mess

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

a company as a project portfolio

Every company can be seen as a collection–maybe a portfolio–of investment projects, each with its own risk and return on investment characteristics.  This is not the only way of looking at a business.  And it’s probably not the best way, as the ugly collapse of the conglomerate craze in the US during the 1960s illustrates.  Nevertheless, looking at the business as a project portfolio highlights an issue that the top management of a firm can face.

the BCG growth/cash matrix

One common way of sorting projects  is to use the growth/cash generation matrix invented by the Boston Consulting Group in the 1960s: stars = high growth, high cash generation cash cows = low growth, high cash generation questions marks = high growth, low cash generation dogs = low growth, low cash generation. loaded with canines What do you do if you’re a company with a boatload of dogs?  ..or just one really big dog. To see the issue clearly, let’s simplify: –let’s say that equity is your only source of funding (no working capital or debt), and –let’s say you have only two projects, with 100 units of equity invested in Project 1, which earns 20/year, and 100 units in Project 2, which earns 1/year. the problem: the sterling 20% return on equity of Project 1 is obscured by the near breakeven status of Project 2. The overall return on equity for the company of 10.5%. Why is this bad? Wall Street loves high return on equity–and loathes low return.  And the computer screens that even many professional investors use to narrow down the vast universe of available stocks into a more manageable number to investigate will toss a company like this on the reject pile.  So you’ll be overlooked. What should management do? The possibilities: 1.  eliminate inefficiencies in Project 2 and in doing so raise the ROE to a respectable figure 2.  if that’s not possible, sell Project 2 to someone else who, mistakenly or not, thinks he can do #1 3.  close Project 2 down and write the equity off as a loss, or 4.  divide the company in two, and either (a) spin Project 2 off as a separate entity (that is, give it to shareholders) or (b) gradually sell it to the investing public.

cutting to the chase

Let’s skip down to #4, since what we’re ultimately concerned with is what motivates a company to create a REIT.

why #4?

How can a company get into a situation where solution #4 is the best alternative? In my experience, this almost always involves long-lived assets, where the investment is big, and a company puts all the money in upfront, in the hope of getting steady income over 20 or 30 years.  Examples: a chemical plant, container ships, hotels, or mineral leases. One of two things happens –either the company soon discovers it has wildly overpaid for the assets, or –some unforeseen change, like technological change or a sharp increase in input prices, alters the economics of the project in a fundamentally negative way.

two forms of cash generation

Any project generates cash in two ways: –a return of the capital invested in the project, and –profits. In describing Project 2 above, I said it produces 1 unit of profit per year.  But that profit is after subtracting an expense of, say, 5 as depreciation and amortization. D&A are ways of factoring into costs the gradual wearing out of the factory, the machines or the other investment assets that are used in making the project’s output. In the case of a motel, D&A is a charge for the gradual deterioration of the structure over the years, until the building is too shabby to be used any more and must be razed and rebuilt.  Similarly, big machines either wear out or become technologically obsolete. The key fact to note is that depreciation and amortization aren’t actual outflows of cash–they’re inflows.  But they’re classified as return of capital, not as profit.  (I think this make sense, but I’ve been analyzing companies for over 30 years.  Don’t worry if it doesn’t to you.  Fodder for another post on cash flow vs. profits, and why it makes a difference to investors.)

In the case of Project 2, the actual cash inflow is probably 6/year (depreciation and amortization of 5 + profit of 1).  That’s a 6% yield.  But it’s also a millstone around the neck of the company that launched the project.  It’s return on equity–a key stock market screening factor–will be depressed for as long as it owns the project. On the other hand, to an income-oriented buyer a yield of 6 units/year for the next 20 years is nothing to sneeze at.  At a price of 85, the yield would be an eye-popping 7%.

this has happened before

In the early 1980s, T Boone Pickens, a brilliant financial engineer if no great shakes as an oilman, wildly overpaid for a number of oil and gas leases in the Gulf of Mexico.  Once he realized these properties would struggle to make back his initial lease payment and would never make money, he repackaged them as a limited partnership and spun it off. Around the same time, Marriott did the same thing.  It made a similarly unwise decision to build a number of very expensive luxury hotels.  When bookings started to come in, the company saw the properties would provide large cash flow–but never any profits.  So it rolled them all up into a limited partnership, which it sold to retail investors. In both cases, management “repurposed” assets to emphasize their cash generation characteristics rather than their lack of profitability.  Both also used a tax-minimization structure to enhance the assets’ attractiveness to income-oriented individual investors. REITS do the same thing. More tomorrow.

subscription services: good or bad as stocks?

January 28, 2011 By in Accounting, cash flow/share vs. earnings/share, depreciation, Industry Analysis, internet Tags: , , , , , , , Leave a comment

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:

 

year
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.

 

year
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.

cash flow per share and earnings per share as valuation metrics (ll): cash flow per share

January 27, 2011 By in Accounting, cash flow, cash flow/share vs. earnings/share, depreciation, growth vs value Tags: , , , , , , , , , Leave a comment

investor preferences

A large number of investors in the US want to buy stocks where the underlying companies are growing profits rapidly.  The same is true in many other stock markets of the world.  For such investors, earnings per share growth is the main metric they look for when transacting.

This isn’t an immutable law of equity investing, however.  To a large degree, the search for growth is also a question of investor preferences.  In the US, the market I have the longest experience with, I’ve seen the mix of price and growth that investors prefer change dramatically several times.  This has been not so much because the macroeconomic environment has changed, but because the personal circumstances of investors (their age and wealth) did.

Also, I’ve seen other markets where preferences are quite different, where a “good” stock is one that pays a high dividend and where the company is mature enough that it has little need to spend capital on expansion.  These are markets where the search is for income, not for growth.  Taiwan in the 1980s is the first strong example I’ve encountered personally (technology stocks there couldn’t list unless they were willing to pay a 5% yield!).   But the US in the pre-WWII era seems to me to have been another.

the search for income

Not every company can grow at a rapid clip of a long time.  As well, some companies temporarily experience declining profits, either because the economy has turned against them cyclically, or because they’ve just lost their way.  In any of these cases, the large group of investors I’ve mentioned above lose interest in the stocks and more or less consign them to the equity junk pile.

There’s a whole set of other professional investors–in fact, in the US they are arguably in the majority–who evaluate stocks not on their earnings growth potential but on the companies’ ability to generate cash from operations.  There are many variations on this approach.  But all use cash flow per share as their main tool.  Such investors calculate an absolute worth for the company (usually a present value of cash flows over, say, ten years) and compare that with the share price.  They buy what they hope are the most undervalued stocks.

Around the globe, such value investors expect that at some point either the company’s fortunes will take a cyclical turn for the better, or that other investors will realize the undervaluation they see, or (in the US at least) that pressure will be brought to bear on the company to improve its operations.

[By the way, about two years ago, I wrote a series of posts on growth investing vs. value investing that you might want to read.  Take the test (which of two stocks would you buy) to see if you’ve got more growth or value tendencies.]

the stock as a quasi-bond

The key to this approach, viewing it through my growth investor eyes, is to regard the stock as a quasi-bond.

Let’s say the firm is now generating $1 a share in cash from profits and $2 a share in cash from depreciation and amortization.  That’s $3 a share in yearly cash flow.  Taking a ten-year investing horizon, the company will generate a total of $30, even with no growth at all–if the firm can get away without serious new capital investments.  If we were to assume that the company could achieve an inflation-matching rise in cash flow, then the present value of the stream of cash flow is $30.  (Yes, this is a vast oversimplification, but it is the thought process.  Remember, too, we’re also figuring there’s nothing left after ten years.)

What would a company like this sell for on Wall Street?  $20 a share?  …less?

We do have a yardstick, since if we reverse the profit and depreciation figures the description in the last paragraph is a rough approximation of INTC.  The value investor’s explanation for serious undervaluation is that people are so worried about the possibility that processors using designs from ARM Holdings will gradually eat in to INTC’s markets that they are overlooking the latter’s substantial cash generating power.

happy vs. unhappy shareholders

Another way of putting the difference between looking at earnings per share and cash flow per share–

–investors look at eps to gauge a firm’s value when they’re happy with the way the company is performing;

–they look at cash flow per share when they’re not, when they’re trying to figure out how much the company would be worth with different management, or in private hands, or after being acquired by a competitor.

The risk the first group takes is that all good things eventually come to an end.  The worry of the second group is that they’ve be unable to pry the company out of the hands of current management.

cash flow per share and earnings per share as valuation metrics (l): earnings per share

January 26, 2011 By in Accounting, cash flow, cash flow/share vs. earnings/share, depreciation Tags: , , , , , , , , , Leave a comment

two types of investors, two toolboxes

In the US and increasingly in the rest of the world, investors tend to fall into two psychological types:

—growth investors (like me) are dreamers.  We buy stocks based on the belief that future profit growth will be strong enough to make the stock rise in price.  Our mantra is:  better eps than expected for longer than expected.  We typically buy stock in well-managed, industry-leading companies and use projected future eps as our main tool.

—value investors (the more venerable [read: older] school)are pragmatists.  They buy stocks on the idea that they are undervalued based on what one can see in the here and now–the earning power of today’s well-understood businesses + the value of assets on the balance sheets.  They are happy to buy a mediocre company whose stock is trading on the mistaken belief that the firm is truly wretched.  They often have an eye to change of control.  They use both cash flow per share and eps as tools.

eps

Looking at earnings per share growth is, I think, pretty straightforward conceptually.  Earnings go up, the stock goes along for the ride.  The problem is that forecasting earnings with a reasonable degree of accuracy  even twelve months ahead is much more difficult than you’d imagine.  The evidence is that as a group even professional securities analysts, with lots of information at their fingertips and unparalleled access to company managements, fail at doing this.

One issue is that company managements understand the Wall Street game:  show surprisingly strong earnings and you’ll look like a genius and your stock (your stock options, too) will go up a lot.  So they pressure analysts to understate earnings.  Analysts, too, since their livelihood depends on investor interest in the stocks they cover, sometimes become like home town radio announcers for “their” industry and fail to notice trouble developing.

For growth investors, cash flow per share doesn’t come up in discussion very much.  For me–and I spent a little more than half my career in value shops)–three instances where  cash flow is important stand out:

–An emerging company has spent a lot on creating the infrastructure it needs to launch its products/ services, but they haven’t caught on yet.  The firm is showing small profits, or maybe losses at present.  This situation often creates the opportunity for significant operating leverage (large profit increases from small increases in sales).  So if you can find a convincing reason that the company will be successful, it is probably a very interesting investment.

–A more established company has persistently high cash flow but small profits.  This means cash flow consists mostly of depreciation.  Put another way, the company continues to make capital investments but then spends most of its time just trying to recover its (poorly conceived) outlays.  Value investors are drawn to this kind of firm like moths to a flame–thinking that either the board of directors, shareholders or activist investors will force changes.  Growth investors, in contrast, run away as fast as they can.

–A company has two divisions, one of which provides all the growth.  This happens more often than you might think.  In fact, WYNN (which I own) is in just this position.  Macau operations provide all the profits.  To my (growth investor) mind, a situation like this can provide very good performance.  That’s provided you can convince yourself that the second division–Las Vegas, in this case–won’t turn into a black hole of losses that devours the profitable division. This is where cash flow comes in as analytic tool.

As an investor, it’s not good but it is acceptable that the second division is losing money.  But it’s a great comfort if the division is in the black on a cash flow basis, as WYNN is in Nevada.  Operating leverage can be a worry if there’s a significant chance it can turn negative.  But it can be a longer-term plus, if you think there’s a bigger chance operating leverage can eventually turn positive.

That’s it for today.  Tomorrow, cash flow per share and value investors.

cash flow

January 25, 2011 By in Accounting, cash flow, depreciation Tags: , , , , , , Leave a comment

cash flow

Yesterday’s post probably contained more than you will ever need to know about depreciation.  Today’s topic is cash flow.  Tomorrow’s will be a discussion of whether cash flow or net profits is a better indicator to use in evaluating a stock.

four possible sources

What makes cash flow important is that it is a broader measure of a company’s ability to generate money from operations year after year than net profit is.  Professional investors normally consider four sources of funds in calculating cash flow. They are:

–net profit

–depreciation and amortization (which is essentially depreciation under another name)

–deferred taxes

–changes in working capital.

The four items should be found either in a company’s cash flow reconciliation statement or in the footnotes to the balance sheet.   In the US, all are contained in the “cash flows from operating activities” section of the cash flow statement.

I stick with two

Not everyone uses all four items.  There’s universal agreement (or as near as you can get in any human endeavor) that a cash flow calculation should include net profit + depreciation and amortization.  The question is whether to include the other two. And the issue is whether they provide a recurring source of cash.  My own opinion is, except in heavily government subsidized industries like mineral extraction where taxes always seem to be deferred, to exclude both deferred taxes and changed in working capital.

The worry about deferred taxes is that they arise from differences in the timing of when the tax expense is shown on the financial reports to shareholders and when the cash is ultimately paid to the tax authority.  So they often reverse themselves in relatively short order.

How can this happen?  One main reason is that governments often give companies a tax incentive to invest by allowing them to take rapid depreciation deductions.  In most countries (Japan is the only exception I can think of) financial reports use straight line depreciation, which slows and smooths the depreciation deduction.

An example:  For a $1000 item with a 5-year life and no salvage value, where government allows double declining balance depreciation, the yearly deprecation expense for taxes vs. for financial reporting looks like this:

tax     400     240     120     120     120

fin      200     200     200     200     200

Δ        200      40      (80)     (80)    (80).

Let’s assume (to keep things simple) that there are no other differences between the tax books and the financial reporting accounts.  If so, in year 1 the financial reporting accounts will deduct 200 from revenue for depreciation vs. 400 on the tax books.  Therefore, the report to shareholders will show pre-tax income that’s 200 higher than the tax books will show to the government.

What to do about the 200 in “phantom” income on the financial reporting books.  Not to worry, the financial reporting accountants will make a tax provision of 70 (assuming a 35% corporate tax rate) for the “extra” income.   They will label the 70 as deferred taxes and establish a balance sheet entry to hold the phantom tax payment.  They will also enter the 70 as a positive cash flow from operations on the consolidated cash flow statement, to show that the 70 hasn’t actually been paid to the tax authority.  (I’m not making this up.  This is what they do.  Don’t ask me why.)

In year 2, the procedure is similar to that of year 1, but the amount is 14.

In year 3, the depreciation deduction for financial reporting purposes is higher than that for the tax authority, so more actual taxes–an extra 28 per year–are paid.  Financial reporting accountants handle this by reversing their prior procedure–subtracting 28 in deferred taxes each year from the balance sheet, the tax entry on the income statement and the cash flow statement.

The details–bizarre as they are–aren’t so important.  The point to remember is that unless a company is continually investing, the deferred tax additions to cash flow will soon reverse themselves.  So they can’t be counted on as recurring sources of cash flow.

The other iffy item, in my view, is changes in working capital. There are negative working capital businesses.   Public utilities, restaurants, and hotels are examples.  Their customers pay for the companies’ products either in advance or very quickly after using them.  The companies, on the other hand, pay their suppliers only with a time lag, say, 30 days after delivery.  So such companies enjoy a “float” equal to perhaps 20 days worth of sales.  As long as sales are increasing, this “float” not only persists–it gets bigger!  The increase in payables minus receivables shows up on the cash flow statement as cash coming in from operations.  The amounts can be very large.

This isn’t exactly risk-free money, however. If sales begin to contract, so too will payables–meaning the company will have to return part of the float it has enjoyed from its suppliers.  And it better have the cash to be able to do so.  This is my reason for not counting working capital changes either.

(One other note about working capital, which I really consider a separate item for analysis.  There are firms whose market position is weak enough that their suppliers don’t give them much trade credit and they are also compelled to finance their customers’ purchases for long periods of time.  The worst I ever recall seeing was the Japanese sporting good company, Mizuno, which in the Eighties was giving its customers two years to pay.  In order for the company’s sales to grow, this trade financing–a use of corporate funds–had to grow as well.)

cash flow vs. free cash flow

Analysts often try to distinguish between (gross) cash flow as described above and (net or) free cash flow.  The latter is what’s left from profits + depreciation after all corporate calls on that cash have been satisfied.  These calls are generally:

–capital expenditure, i.e. reinvestment in maintaining and expanding plant and equipment

–working capital needs

–repayment of debt

–dividends to shareholders.

sounds good, but a somewhat nebulous concept

Although the concept of free cash flow is clear, arriving at a practical figure–especially when analyzing the company as an acquisition target–is a lot murkier than it might sound.  First of all, if you or I were acquiring a company, we probably wouldn’t pay dividends any more (we’d cancel our jet rentals and ride around on the corporate plane instead; we might have the company “invest” in a golf course in a resort area, too–and inspect it frequently).

We might think that the current owners’ capital spending plans were too aggressive or wasteful.  In either case, we could pare them back.  We might also think that the firm’s working capital management is very inefficient.  And we might feel we could refinance existing debt at a more favorable rate.

the unenviable case of utilities

However fuzzy the actual calculation may be,  we can probably best see what the distinction wants to highlight by considering a (highly simplified) public utility, like a local gas or electric distribution company.  Regulators in most countries grant such utilities a maximum allowable profit that’s calculated as a percentage of the utility’s net (meaning still undepreciated) plant and equipment.

Let’s say the allowable return is 5% and the net plant and equipment is 1000.  In the first year, the company is permitted to achieve a profit of 50.  During that year, the company records depreciation expense of 25.  Cash flow is therefore 75.

But starting out in year 2, absent any new building, the net plant is only 975.  Therefore the maximum allowable profit is 48.75–a fall of 2.5%.  In order to keep profits flat from year to year, the utility has to reinvest its depreciation to get the net plant back up to the prior year’s level.  To have, say, a 2.5% profit increase, the utility has to make its net plant grow by that amount–meaning it has to reinvest depreciation + another 25 (half its profit) back into the business.

This is the ultimate case of a company whose cash flow is not free.  Looking at the utility sections of stock services like Value Line, which calculate cash flow and price/cash flow ratios will show you what stunningly low multiples of cash flow pure utilities trade at.  The fact that most of the cash has to be plowed back into the business just to keep the ship afloat is the reason why.

That’s it for today.