Category Archives: Accounting

equity, debt and leases: an important balance sheet change in prospect

May 23, 2013 By in Constructing a Portfolio, Current Market Thoughts, leases Tags: , , , , , , , Leave a comment

financial strength

There’s a line of thought in academic finance that argues it doesn’t matter for a publicly traded company’s stock price how much of the capital in the business comes from equity (the owners’ cash) or debt (borrowed funds).

In the real world, that idea couldn’t be much more wrong.  Banks won’t lend to a firm that has too little cash put up by the owners.  They may even make a new equity offering a prerequisite for further loans.

Also, one of the main reasons I’m so fanatical about making a projected cash flow statement is to make sure that a company I’m interested in will have the money to service its debt, pay the dividend and still run the business.  My own rule of thumb, based on experience with a wide variety of companies, is that if a firm has so much debt that if it were to devote all its cash flow to paying back loans but couldn’t do so within three years, it’s potentially in real trouble.

debt vs. leases

Oddly, traditional financial accounting doesn’t consider leases as debt.  Even though leases may be ironclad promises to rent property or equipment for decades at a fixed price, they don’t appear on the balance sheet of the lessee as liabilities.  Lease information is disclosed, but there isn’t as much data as for bank loans or bond offerings.  What there is contained in the footnotes to the financial statements, not on the balance sheet itself.  Or course, every sensible investor should read the footnotes carefully as a matter of course.  But the reality is that even some professional securities analysts don’t.  And only the most expensive data services for screening stocks–out of the financial reach of individuals like you and me–will allow you to include leases when calculating debt/ equity ratios.

capital vs. operating leases

One exception:  at some point before my time on Wall Street began, someone got the bright idea of dressing loans up to look like leases, so they wouldn’t appear on the balance sheet.  The lessee would then appear (to anyone who didn’t read the footnotes) to be in better financial health than it actually was.

To remedy this abuse, the Financial Accounting Standards Board, the financial accounting industry watchdog, developed four tests to detect loans in lease clothing.   If the lease:

1.  calls for the leased asset to be turned over to the lessee at the end of the lease term, or

2.  allows the lessee to buy the asset at a bargain price at lease end, or

3.  lasts more than 75% of the useful life of the asset, or

4.  has payments with a total present value of over 90% of the purchase price of the asset,

then the lease is classified as a capital lease and has to appear as a liability on the balance sheet.

Leases that don’t meet any of the four criteria are called operating leases and can remain in the footnote shadows of the financials.

…until now

I haven’t made much of an attempt to find cases where the current way of accounting for leases creates a problem in company analysis.  But…

–most strip mall big box stores are stuck with long-term lease commitments for much more store space than they need.  If they can’t sublease store locations they’d like to close, however, or sublet portions of the locations they want to keep, they’re stuck paying for space they can’t use.  Borders is a case where this was an unusually difficult issue.

–on the other hand, one of the attractions of JCP (though not the most important) to its current hedge fund holders is its bargain-priced leases on retail locations.

new FASB rules…

…now in the process of being formulated would require that all leases that extend for more than a year must be shown on the balance sheet.

why this is important

Two reasons:

1.  The risks to bricks-and-mortar retailers contained in their long-term leases will become much more apparent once the new rules are in place.  Same thing for restaurant chains.  Airlines, too.  Small, fast-growing firms will likely be the worst impacted.

2.  This is a geeky, under-the-radar topic.  It probably won’t get much publicity until late this year.  Lots of time to check the lease footnotes for stock we own to make sure there are no nasty surprises lurking there.

J C Penney (JCP) just borrowed $850 million…why?

April 16, 2013 By in Current Market Thoughts, Recent Market Action, Retail, Stock ideas, working capital Tags: , , , , , , , Leave a comment

the 8-k

Yesterday, JCP announced in an 8-K filed with the SEC that it has borrowed $850 million on its newly expanded $1.8 billion bank credit line   …even though it doesn’t really need the money right now.  It also said it’s looking for other sources of new finance, which I interpret as meaning finding someone to purchase new bonds or stock.

My guess is that as the company needs seasonal working capital finance it will borrow more on the credit line rather than deplete its cash balances, which should now amount to around $1.8 billion.  This despite the fact that paying the current 5.25% interest rate on the $850 million will cost the company $44.6 million a year.

Why do this?

We know that the Ackman/Johnson regime inflicted terrible damage on JCP.  Part of this is actual–the stuff about lost sales and profits that we can read in the company’s financial statements.  Part of it is psychological–we don’t know how deeply JCP is wounded, how long it will take for the company to heal, nor even how much healing is possible.

a psychological plus

By borrowing the money now, JCP is in a sense buying itself an insurance policy on the psychological/confidence front by establishing several things:

— it now has enough cash to be able to weather two more ugly years like 2012, rather than one.  This gives it much more breathing room to negotiate any asset disposals, to say nothing of getting customers back into the stores.

–it has lessened the possibility that its banks will withdraw or reduce the credit line if sales continue to deteriorate.  After all, they now have their $850 million that’s in JCP’s hands to protect.

–it demonstrates to suppliers that the company has ample cash to pay for merchandise.  JCP will likely get better payment terms with the money on the balance sheet than without it, although it’s not clear to me that payables still won’t shrink this year.   More important, in my view, is that suppliers won’t restrict either the quantity or selection of merchandise they deliver to JCP for fear they won’t be paid.

–it avoids the negative publicity (see my 2011 post on Eastman Kodak) that would likely have been generated were JCP to wait until it genuinely needed the funds, or until its banks might be getting cold feet.

so far, so good

So far, Wall Street is taking the move in stride.  The stock showed no adverse effect from the announcement.  And in pre-market trading today, it’s up.

Ron Johnson out at J. C. Penney (JCP): implications

April 10, 2013 By in cash flow, earnings conference calls, Industry Analysis, Recent Market Action, Retail, Stock ideas Tags: , , , , , , Leave a comment

Yesterday, only a few weeks after major shareholder Bill Ackman gave Ron Johnson a ringing endorsement as CEO of JCP, Mr. Johnson is out.

Former CEO, Mike Ullman, who was unceremoniously dumped not that long ago to make room for Johnson, is back in.

Wow!

What can we make of this?     …quite a lot, I think.

1.  The change comes right after monthly sales results for JCP in March, the second month of the company’s fiscal year, would have been available.  Presumably they’re really bad (the Wall Street Journal is reporting that quarter-to-date sales are down at least 10% year on year).

This is a big problem.  JCP marks up merchandise by about 50% over what it pays.  It uses the gains from sales, called gross income, to cover the costs of running the store network (like advertising, rent, utilities, salaries…).  What’s left over is profit.

JCP’s sales in fiscal 2010 were $17.6 billion;  its pre-tax profit was $581 million.

In fiscal 2012, sales were $13.0 billion, or 26% lower than in fiscal 2010.  My back of the envelope calculation is that JCP lost just under $800 million from retailing last year–offset by a number of non-recurring gains (see my post).

To my mind, the largest factor in the profit decline is the loss of sales.  The March figures suggests sales may not have bottomed out yet.

2.  Since the company was quick to boot Mr. Ullman not so long ago, he’s probably not the company’s first choice as the new CEO.

I can see two possibilities:

–he may be the only experienced executive willing to take the job, or

–JCP may have been pressured into making the change quickly and Mr. Ullman was available on short notice (I’ve heard he was first contacted last weekend).

Neither possibility is encouraging.

3.  Where would outside pressure come from? The two main sources, as I see it, would be:

–suppliers.  Last year JCP generated $140 million in cash by getting suppliers to agree to wait longer to be paid. As the perceived riskiness of dealing with JCP rises, the standard response by suppliers would be to rethink a decision like this.  In a more extreme situation, suppliers would start to reconsider the amounts and types of merchandise they send to a customer.

–banks.  In its 4Q12 earnings conference call, JCP highlighted the fact that it had negotiated a $500 million increase in its bank credit lines, to just over $2 billion.  The message from this seemed to me to be that JCP had ample funds to weather any problems it might encounter in 2013.  Again, the standard response to continuing deterioration in sales would be for banks to reassess their exposure.  All it would likely take to reduce a credit line–something that would doubtless have adverse effects for JCP–would be one credit committee meeting.

There’s no direct evidence that either suppliers or banks have started down this road.  It’s conceivable, though, that one or both told JCP they’ll have to change their thinking if sales don’t perk up soon.  That might have been the final straw for Mr. Johnson.

deferred taxes (II): how they’re important

February 21, 2013 By in Accounting, deferred tax Tags: , , , , , , , Leave a comment

Yesterday I wrote about what deferred taxes are.  Today,

why it matters

1.  The two most important sources of money coming in the door (i.e., cash flow) for companies are net income and depreciation.  Deferred taxes–that is, tax expense that’s shown on the income statement but not actually paid to the tax authorities, are number three.

Most companies succeed in pushing back the tax bill for an extremely long time.  So although deferred taxes aren’t as rock-solid as net or depreciation as a source of cash flow, they can be pretty dependable.  This means that companies in a heavy investment mode (building new buildings, installing new machinery/computers…) have more money in their hands than the income statement shows.   Look at the cash flow statement–the statement of sources and uses of funds–to see what the effect of deferred taxes on cash flow may be.

Mature companies are gradually forced to pay the tax-break piper.  After all, we’re talking about taxes deferred, not forgiven.  So they have less money coming in than the income statement suggests.  Again, check the cash flow statement.

2.  Deferred taxes have a second, even less intuitively obvious, accounting use.  It’s crucial to understand, though, when dealing with “deep value” (read: really junky) companies.

Suppose the company has a pre-tax loss of $1,000,000 on its tax books.  It can typically “carry back” at least part of the loss, meaning it can retroactively apply it to prior years’ income and get a tax refund.  If it can’t, the after-tax loss is $1,000,000.  And the firm can “carry forward” the loss to use as an offset against taxable income in the future.  These loss carryforwards expire if they’re not used within a certain number of years, however. (Relevant information will be found in the tax footnote to the financials.)

Financial reporting treatment is different.  Normally the firm’s accountants will assume that the tax loss carryforwards will be used to offset future taxable income before they expire.  If so, and the firm has a pre-tax $1,000,000 loss on its shareholder books, the accountants will apply in the current statements a deferred tax credit of, say, $350,000.  So the financial reporting loss will not be $1,000,000 but $650,000.

In this case, the financial reporting books understate the loss.

the crucial issue

That’s not the crucial issue, though.  The accounting firm that prepares the company’s books will only allow the deferred tax deduction as long as it believes the firm will be a “going concern”  (read: will avoid bankruptcy) and will generate enough future taxable income to use the loss carryforwards.  If it decides otherwise, it must require that the company reverse some or all of the previously recorded deferred taxes.

The worst about this is, of course, not the change in accounting treatment, but it signals the words dead and duck have begun to dance across the auditors’ minds.

Check out my post on Mike Mayo and Citigroup for a real-life example.

deferred taxes (I): what they are

February 20, 2013 By in deferred tax Tags: , , , , , 2 Comments

Last week I wrote about how publicly traded companies typically maintain three sets of books:  tax books, management control books and financial reporting books.

The two sets we’ll be concerned about today are the financial reporting books and the tax books, the ones that outsiders get to see.

Hang onto your hat and let’s get started!

why deferred taxes?

It’s reasonable to ask whether these two accounting pictures of a company’s financial health exist in parallel universes–one to poor mouth the company in order to minimize taxes, the other to flatter results so that shareholders will be happier than maybe they should be     …or is there something that ties the two sets together?

they connect tax and shareholder records

There are, in fact, two ways in which these sets of books are connected.

First, the IRS doesn’t let a company pick radically different accounting methods for tax books from the ones it uses for shareholder reports.  Inventories–meaning all that FIFO or LIFO stuff–are an example.

In addition, there are deferred taxes.

what they are

The income tax line is the one place that financial accounting standards compel a company to reveal something about the books it keeps for tax authorities.

When the financial accountants work down the income statement, they start with the sales line.  They subtract various costs, like materials, marketing, interest payments…   from revenues as they work their way to net profit.  When they’ve figured out  pre-tax income, they apply the appropriate income tax rate and subtract to get to net income.  They do this country by country, local and national.  

Then they reconcile with the tax books

They do this by dividing the tax figure they’ve arrived at into two components:

–the tax actually paid to the IRS or its equivalent, called cash taxes; and

–the rest, called deferred taxes.  

The deferred tax figure can be positive, meaning the company is sending smaller check(s) to the tax authorities than the total amount of tax shown on the financial reporting books; or it can be negative, meaning the company is paying out more than the total tax charge shown on the shareholder records.

Sounds weird, doesn’t it?  That’s because it is.

But try to get used to the idea.  It can be important.

how deferred taxes come to be

Lots of ways.  But it’s all about timing differences.

for example

The simplest is this:  a company builds a factory that costs $1,000,000, has a useful life of 40 years and has no value after that.  On the shareholder books, the company allocates the factory expense evenly over the 40 years, at the rate of $25,000 a year.  Accountants call this the straight line depreciation method.

On the other hand, the national government may want to encourage companies to build factories of this type.  So it gives them tax breaks by, say, allowing firms to front-load the tax writeoffs.  Maybe it allows a firm to write off $250,000 of the total cost in the first year (lowering otherwise taxable income by that much), $100,000 in the second, and the rest in progressively smaller amounts over the following seven years.  This is an accelerated depreciation method.

Let’s assume this is the only difference between the company’s tax books and its shareholder books.  If so, in year one the tax books will show $225,000 less in pre-tax income than the shareholder books ($250,000 – $25,000), due to the faster timing of the factory writeoff on the former.  Depending on the rate of corporate income tax, the company will pay something like $80,000 less in cash taxes than the financial books show as due.  This amount will be recorded as deferred tax.

where you can see this stuff

Usually not on the income statement.

Two places:  in the tax footnote to the income statement, and in the cash flow statement   …not usually, however, on the income statement itself.

Tomorrow:  why this geeky stuff can be important