Category Archives: Accounting

analyzing sales rather than earnings (ii)

September 12, 2014 By in activist investing, capitalizing vs. expensing, sales/share vs. earnings/share, stock market Tags: , , , , , Leave a comment

The answer the Bloomberg Radio reporter gave to the question, “Why sales, not earnings?” was that sales are harder for a less-than-honest company to manipulate.  In some highly abstract and technical way this might be true, but in any practical sense the reply is ridiculous.  Stuffing the channel is a time-honored, easy to do way of inflating sales.

Still, there are instances where an investor will want to look at sales rather than earnings.

1.  Value investors looking for turnaround situations will seek out companies with lots of sales but little in the way of earnings.  They’ll benchmark the poorly performing firm against a healthy rival in the same industry.  They figure that if the two firms have comparable plant, equipment and intellectual property, then a change of management should enable the weaker firm to achieve results that are at least close to what the stronger one is posting now.

As I see it, this mindset is what separates value investors from their growth counterparts.  The latter, myself included, begin to salivate when they see a strong bottom line; the former are magnetically attracted to big sales/no profits firms instead.

2.  Especially in the tech world, companies often go public before they become profitable.  AMZN, which didn’t report black ink for eight years after its IPO, is the poster child for this phenomenon.

Potential investors routinely look at the size of the market a given firm is addressing and the rate of its sales growth as a way of gauging its potential value.  This is a tricky thing to do, since it requires us to decide how much of the money the company is now spending is akin to capital spending–one-time foundation laying that won’t recur–and how much is spending that’s needed to generate each new sale.  Put a different way, it’s a decision on what is SG&A and what is cost of goods.  As AMZN illustrated, there’s huge scope for error here.

(An aside:  I attended an AMZN IPO roadshow presentation.  Management mostly said that during the PC era investors could have bought then-obscure companies like MSFT and CSCO and made a fortune.  The internet age was dawning and AMZN offered a similar chance.  Nothing but concept.)

3.  A simpler variation on #1  + #2, which is currently being worked vigorously by activist investors at the present time, is to find companies that may not break out results by line of business but which in fact operate in two different areas.  In the most favorable case for activists, the target firm will look like nothing special but have one high-growth, high-profit area whose strong performance is being obscured by a low-growth low/no-profit sibling.  The activist forces a separation, after which growth investors bid up the price of one area, value investors the other.

 

Obviously, no one uses just one metric.  But the way I look at it, the only persuasive case for using sales as the keystone to analysis is the value investor use I outlines in #1.

 

publicly traded US companies have about $1 trillion in cash stashed abroad

April 23, 2014 By in Accounting, income tax rates Tags: , , , , , , , , Leave a comment

That’s the best number I could come up with–admittedly through a fast internet search.

It’s not the exact figure that I find interesting, though, but the motives companies have for doing so.  Three of them are well-known, two less so.

the well-known

–Multinational companies have operations in many countries.  It may be that much of their growth–and all of their possible acquisitions–will be outside the US.  It makes no sense to move money back to the US, pay 35¢ on the dollar in Federal income tax and then resending the net amount abroad to make a foreign acquisition.  A CEO might, and probably should, lose his job for allowing this to happen.  Also the official reason companies cite for not returning cash to the US is that the funds are permanently invested internationally.

–Versus other countries, the IRS is unusually harsh in the way it taxes earnings repatriated from abroad.  There has already been one discount deal, the Homeland Investment Act of 2004, offered by the IRS to allow corporates to repatriate cash without the stiff tax bill.  The terms were:  tax at 5.25%, but all money brought back had to be invested in hiring new workers or building new plant.

As it turns out, aggregate hiring and plant construction didn’t rise during the amnesty period, even though about $300 billion was repatriated, making the case for another HIA a bit shaky.  Nevertheless, the possibility of a new HIA is a powerful deterrent to repatriation.  Who wants to be that idiot who paid $3.5 billion on a $10 billion repatriation a month before HIA II is enacted?

–Big corporates can borrow a ton of money very cheaply in the US.  APPL did it last year, for example, and the company seems to be warming up for another tranche in the near future.

the other two

–Companies have found a workaround.  It doesn’t count as repatriation if you keep the money in the US for less than 90 days and don’t get money again from the same source for a certain amount of time.  So multinationals have created daisychains of intracorporate loans, whose effect is to keep cash permanently in the US.  The first loan comes, say, from Hong Kong.  Three months later, it is repaid with cash from, say, Ireland.  That loan is repaid with money from, say, Switzerland.  And the Swiss loan is repaid with fresh funds from Hong Kong…  Ingenious, yes, but most owners would wish, I think, that corporate minds be put to more productive uses.

–In recent years, companies have boosted eps growth by tax planning, that is, by opting to recognize profits in low-tax jurisdictions.  A generation ago, investors wouldn’t have allowed this.  The market back then would only pay a discount PE for earnings that weren’t fully taxed at the rate prevailing in the firm’s home country.

No longer.  As far as I can see, investors are now indifferent to the tax rate firms pay.  The market no longer discounts earnings taxed at a low rate.  So managements have every incentive to recognize profits in low-tax countries.  After all, it takes $1.50 in pre-tax earnings in the US to produce a dollar of net.  That’s 50% more than a US firm needs to produce the same net from Hong Kong.

More than that, suppose a firm suddenly got it into its head to recognize all its earnings in the US.  What would happen to profits?  There’s an easy way to find out.  Just look at the actual corporate tax rate and adjust it to 35%.  If the actual rate is 25%, then each dollar of pre-tax becomes 75¢ of net.  At 35%, each dollar of pre-tax would be 65¢ of net–a 14% drop.  What CEO wants to report that earnings growth is slowing–or worse, disappearing–because he’s monkeying around with the tax rate?

 

 

 

 

 

rent vs. buy: financing and Solarcity (SCTY)

April 4, 2014 By in cloud services, leases, project accounting, securities markets Tags: , , , , , , , Leave a comment

My California son, Brendan, got me interested in SCTY a while ago.  SCTY rents solar panels that generate electricity to individuals and to companies.

From an analytic point of view, it’s a complex and interesting firm.  It may also eventually turn out to be an important component of the nation’s power generation.  But it’s by at least a mile the riskiest stock I own (both Brendan and I hold small positions).  For instance, SCTY is a JOBS Act company , so the financials it has published to date aren’t ready for prime time.  Its business is heavily dependent on government subsidies of one type or another–and they’re shrinking.  It’s part of–but not at the heart of–the Elon Musk empire.  So holding it runs counter to the time-honored rule that you have your money as close as possible to where the entrepreneur has his–in this case, that would be Tesla, I think.

In this post, I want to use SCTY to  illustrate that in the rental model, a company can have an immense call for capital in advance of the business generating much revenue.  This can pose a significant risk.

Here goes:

First, note that I’m making the numbers simple (read:  pretty much making them up) and that there are many, many more moving parts to what SCTY does than I’m going to write about here.  But I think what I do say gets to the essence of the matter.

the business basics

1.  Look at a typical rooftop solar panel array that SCTY installs on a single family house.

–the panels cost $10,000 to build and install

–they have a 30-year life

–the homeowner signs a 20-year contract to pay $50 a month to rent them.

2.  In this industry, there’s some urgency to get panels installed on rooftops, at the very least because once someone has signed a 20-year contract, he’s not going to switch to another provider.  So the first mover has a key advantage.

financing new customers

Suppose SCTY installed panel arrays on 50,000 rooftops last year and wants to install another 100,000 this year.  What do the money flows look like?

Well, $30 million is coming in in rental income from last year’s installs.  But this year’s installation program will require $1 billion!! in capital to complete.  Where is this money going to come from?

In many senses, SCTY is a startup.  It doesn’t have deep pockets or an existing cash-generating business to use to fund the panels.  So raising $1 billion, and presumably more than that next year, is a formidable obstacle.

my point

That’s the point of this post–that the upfront capital committment in a rental business–especially involving physical stuff–can be very large.  From a financial point of view, some rental/service companies aren’t that much different from owning, say, an oil tanker, a steel blast furnace or a cement plant.  Not so glamorous if you look at them this way.

what SCTY does

The SCTY solution?  …the installed solar arrays are each sort of like a bond, that is, they pay a fixed amount of money each month for twenty years.  At the end of that period, the array still has ten years of useful life and therefore hopefully a substantial residual value.  If you package up a big bunch of them, the result doesn’t look that different from a collection of car loans or home mortgages.  In other words, the bundle is a security that you can sell to institutional investors who are looking for fixed income investments.  That’s a bare-bones version of what SCTY does.  Of course, it doesn’t hurt that SCTY is run by a financial entrepreneur.  Not every solar panel company is going to have the size or credibility to do this.

 

 

 

 

 

rent vs. buy: why rent a product instead of selling it?

April 2, 2014 By in cloud services, Industry Analysis, internet, inventory days, leases, software, Technology Tags: , , , , , , Leave a comment

Adobe (ADBE) used to sell physical copies of a given edition of its Creative Suite of products to individuals or small businesses for $2600 apiece.  Now it rents the same thing as Creative Cloud for $50 a month.  In 2012, selling physical copies (let’s ignore the other cloud-based tools ADBE sells–the big change is in its media tools), ADBE made $1.66 a share in profit and had $2.24 in cash flow.  This year, having gone totally digital the company says it will have earnings of around $.30 a share and will generate, I think, $1 or so in cash flow.

How can this be a good deal?  It takes over four years of rental income to generate the same revenue that a sale would do all at once.  In addition, in a world where interest rates were back to normal, present value considerations make the rental stream worth less than cash in hand today.

So why switch?

I can think of four reasons:

—pricing umbrella   $2600 for Creative Suite, or $700 for Photoshop alone, leaves the door wide open for a competitor to enter the market with a lower-priced product–even a shareware entry–that does more or less the same thing as an ADBE product.

—piracy  I’ve seen bootleg copies of Creative Suite on Craigslist for $100.  Yes, they’re illegal and, yes, maybe they won’t all work forever, but still the price difference is enormous!  Back when I was following Microsoft carefully–which is over a decade ago–that company thought that almost half of the copies of its Office suite being used by small- or mid-sized companies were stolen.  Because the rental model matches the cost of the software more closely with the potential buyer’s cash flow, stealing the software becomes much harder to justify.  If it’s all on the cloud, it’s impossible for most people to do.

—upgrades (or lack thereof)  Before I signed up for the cloud version of Photoshop, I was using a version (CS5) that was several years old.  I’m sure there are individuals and businesses using much older versions.  Same general argument as for piracy–using outdated tools become much less worthwhile.

—selling direct  Delivering Creative Cloud products through downloads eliminates the commissions paid to distributors of physical copies.  It also eliminates the expense of making the physical copies, but I think that’s a minor expense (the box and shrink-wrap are probably the largest cost elements).

 

ADBE thinks it will make $2 a share in 2015 and $3 a share in 2016 because of switching to the cloud for its media tools.  I’m not sure these number make the stock cheap at today’s price (I have a small position and would be a buyer at lower levels), assuming they come in as ADBE anticipates.  But I’m convinced that the piracy thing is real and that the incremental cost of selling an extra copy is as close to zero as you can get.  Also, once you start using the better tools it’s highly unlikely you’re going to go back.  You’ve probably thrown out the disks anyway.

Therefore, there’s at least a shot that number s are better than that.

But in this post, my main point is that the rental model is an extremely powerful one.

Examples tomorrow–Anixter, Olympus and EA.

the inventory problem: holding costs vs. stockout risks

December 4, 2013 By in Inventory Cycle, inventory days, operating leverage, the inventory problem: stockout vs. carrying costs, working capital Tags: , , , , 1 Comment

The domestic auto industry reported November vehicle sales yesterday.  The numbers were very good.  But most of the (negative) media attention centered on the elevated level of inventories–about three months worth of sales–on dealer lots. Yes, that may eventually be a worry, but I don’t think it’s the right way to look at the current situation.

The auto news also gives me the occasion to write about the balancing act every manufacturer and retailer faces in deciding how much inventory to have.

the simplified story

There’s an often convoluted dance between supplier and distributor/end user about return policy, payment terms, co-op advertising…in negotiating over how much of a product to buy and at what price.  Nevertheless, the decision about how much inventory to hold ultimately comes down to weighing two opposing risks:

—stockout costs.  This is when your brilliant national advertising campaign, your sterling reputation for high quality and service–or sometimes just random factors–prompt a potential customer to either go online or enter a physical store with the intention of buying an item.

You’re out of stock.  You try to interest him in a substitute, or promise to have the item tomorrow.  He says thanks, leaves and buys the item somewhere else.

You’ve lost a sale.  And the person you’ve disappointed is at least marginally less likely to have you first on his list next time he’s shopping.

That’s stockout costs.

—inventory holding costs are much more straightforwardly quantifiable.

There are three main factors:

-financing costs, which in today’s world are negligible;

-liquidity risk of having your capital tied up in inventory rather than in cash during the time it tales you to make a sale; and

-the possibility that the items either become obsolete, go out of style, or–like fresh food–exceed their shelf life before they can be sold.  Then your asset has become a wirtedown.

complications

(In the stock market, there are always complications.)

In good times, companies want to hold more inventory (because they see stockout as a greater risk than holding costs); in bad times sentiment reverses and everyone wants to hold as little as possible.

If prices are rising, procurement managers see the chance to make windfall profits and order more than they need; if prices are falling–as is chronically the case in industries like consumer electronics–inventories are kept trimmed to the bone (except in really good times, when everyone throws caution to the winds).

In industries with low fixed, high variable costs, manufacturers see no percentage in upping production volumes.  In industries like autos, with high fixed costs and therefore tons of potential operating leverage, there’s a tremendous incentive to make extra units once a firm reaches breakeven.

The competitive structure of an industry doesn’t change the nature of inventory risk, but it can change who it is who’s assuming them.  This may not always be obvious from even a detailed study of the working capital sections of the balance sheet.  If a manufacturer were to have a policy of unlimited returns (that would be crazy, but let’s just suppose), then it–not anyone farther down the distribution chain–would ultimately be responsible for any unsold goods.

 

More tomorrow.