failing toll roads in the US-why?

I’m convinced that studying the behavior of Millennials –and in particular how it differs from previous generations’–will ultimately produce a treasure trove of equity investment ideas.

So my ears perked up when I began noticing recent reports of continuing failure of toll road investment projects that had been in vogue ten years or so.  Many were packaged by Australian investment bank Macquarie and/or Spain’s Ferrovial.

Chapter 11 filings have been attributed in the media to a sharp slowdown in total miles driven by Americans since 2007 (“…largest decline since World War II,” said one article).  Millennials’ aversion to autos and the suburbs are the supposed causes.

A quick check shows that’s not exactly right.

The Federal Highway Administration’s monthly Traffic Volumes Trends indicates that total miles driven by Americans has fallen from the peak of 3.03 trillion miles in 2007.  But the present level is still 2.98 trillion, a seven-year decline that totals only 1.65%.  Yes, this is a change from the pretty steady rise of just over 1% annually during the prior couple of decades.  But it’s hard to image that worst-case planning didn’t allow for a flattening out of traffic volume.

Two other characteristics of these deals stand out to my, admittedly cursory, glance, as being much more important:

–they’re very highly financially leveraged, and

–they contained a ton of derivative protection against rising interest rates–which backfired horribly, adding significantly to the already-high debt burden.

The deals also appear to have suffered from wildly overoptimistic projections of future road usage, although these were likely less linked to project survival and more to the possibility of above-average gains.

In any event, my main point is that this is not a story of differing Millennial behavior.  It’s all about bad project design and mistaken derivatives overlays.




rent vs. buy: financing and Solarcity (SCTY)

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.






one company, three sets of accounting records

In almost all countries publicly traded companies maintain three sets of accounting records.  They are:

–tax books in which the firm keeps track of the taxable income it generates, and the taxes due on that income, according to the rules of the appropriate tax authority.

Keeping the tax records may also involve a tax planning element.  A company may, for example, decide to recognize profits, to the extent it can, in a low-tax jurisdiction.  Or, as is often the case with US companies, it may decide not to repatriate profits earned abroad, at least partially because they would thereby become subject to a 35% tax.

Tax considerations can also have operational consequences.  For instance, a firm may choose to locate factories or sales offices in low tax jurisdictions over similar high tax alternatives mostly for tax reasons.

–financial reporting books, in which publicly traded firms keep track of profits, and report them to shareholders, according to Generally Accepted Accounting Principles (GAAP).

If the purpose of tax accounting is to yield the smallest amount of taxable income, and thereby the smallest amount of tax, the intent of financial reporting books can be seen as trying to present the same facts in the rosiest possible manner to shareholders.

The main difference between the two accounting systems comes in how long-lived assets are charged as costs against revenue.  Financial accounting rules allow such costs to be spread out evenly over long periods of time.  Tax accounting rules, which may be specifically designed to encourage investment, typically allow the firm to front-load a large chunk of the spending into one or two years.

The end result is that for most publicly traded companies, the net income reported to shareholders is far higher than that reported to the tax authorities.

management control books, kept according to cost accounting rules.  These are the records that a company’s top executives use to organize and direct the firm’s operations.  They set out company objectives and incentives, and are used to assess how each of its units are performing against corporate goals.  Not all parts of a firm are supposed to make profits.  Some may have the job of making, at the lowest possible cost, high quality components used elsewhere in the company.  A mature division may not have the job of growing itself anymore,  but of generating the largest possible amount of cash.

investment implications

Investors normally don’t get to see either a company’s tax books or its management control books.

Financial reporting books can sometimes give a picture that’s too rosy.  The two main culprits are deferred taxes and capitalized interest.  “Capitalized” interest is usually the interest on construction loans taken out for a project than’s underway but not yet finished.  Even though money is going out the door, under GAAP it’s not shown as a current expense.   I’ll explain deferred taxes next week.

In a very practical sense, you don’t need to understand either one too much (although it might be nice to).  Turn to the company’s cash flow statement in its latest SEC earnings filing.  Are there deferred tax or capitalized interest entries?  Do they add to cash flow or subtract from it?   …by how much?  If the answer is no, or that they add to cash flow, there’s nothing to worry about.  If they subtract–and a lot, on the other hand, there’s a potential problem.

Project accounting–production accounting

“Normal” accounting

Accounting statements typically measure the success (or lack of it) of geographical or functional units of a company.  The measurement is also usually organized through units of time, such as a fiscal quarter or a fiscal year.  So the accounting statements answer questions like “What were the profits of the Americas division for the third quarter?” or “What were the profits of the plate glass business last year?”

Project accounting

One notable exception to this rule is project accounting, which is designed to measure the economic performance of a specific task.  The task is typically relatively large and takes place over an extended period of time.  Examples include:  public works construction projects; government research and procurement, like work done under national defense contracts; and movies.

What characterizes this type of accounting, from an investor’s point of view, is the necessity for estimating revenues, costs or both over a multi-year period.  In the best of cases, this is a difficult task.  At worst, it gives great scope for a company to delude itself about the profits it is making.  And it leaves the door open to the possibility of fraud, through deliberately inflated revenue/cost estimates, which will likely not be detected until the project is finally completed.

A construction project

Here’s an example:

Let’s say a company wins in competitive bidding a contract for $1 billion to build a dam.  Construction will take two years.  It’s a fixed-price contract, meaning that the government body that has awarded the contract will make no adjustment to the contract amount for things like changes in materials or labor costs.

Our company has estimated that it will cost it $850 million to build the dam, so that it will have profits of $150 million and an operating profit margin of 15%.  How does it record on its financial statements the money it is earning on the project?

The usual method companies use is percentage of completion, meaning that from its project estimates it determines what constitutes 10% of the job, what constitutes 20%, and so on.  If, in a given quarter, it believes it has accomplished 10% of the job, it will report $100 million as revenue, $85 million as cost and $15 million as operating profit.

(Note:  The government body will have a parallel process for determining the progress of the project.  It will set milestones whose achievement trigger progress payments to the company from the $1 billion.  The sequence of these payments may be very different from what our company records on its income statement.  For example, the government body may make an initial payment of $100 million before any work is done.  Such differences are reconciled through entries on the balance sheet.  In this case, our company would enter $100 million in deferred revenues on the balance sheet.)

Typically a company will stick with its estimate unless there is overwhelming evidence that it has been too optimistic.  It’s usually very difficult for even professional investors to have any real sense that this may be happening, because projects are normally very complex with very long lives.  We also don’t often get to see the company’s project estimates in any detail.  So we may well get into the final quarter of year two, when the company has already booked $130 million in profit, only to learn that the area where the dam is not as geologically stable as the company thought and it has to spend $50 million more than anticipated to reinforce the structure of the dam.  What results from this?  a big writedown!

Early completion bonuses, late delivery penalties

It can also happen that the contract has provisions for a sizable bonus for early completion of the work, as well as hefty penalties for late completion.  No one that I’m aware of will factor the bonus into its estimates.  But neither will anyone plan on paying late-completion penalties.  But in construction it does happen that the company says the project is coming in on time until the very last minute, when it reveals a delay.  The result?…another writedown.

In sum, the issues with project accounting for an investor are that the project is hard to monitor form the outside, and that there’s always the potential for an ugly negative surprise at the end.

Movie production accounting

One special instance of project accounting worth mentioning is movie production accounting. The principles are the same, but –unlike the construction company that knew its revenue for certain but not its costs–in this case the key estimate the movie studio makes is what total revenue from a given film will be.  It knows pretty accurately what its costs have been.  (Note: movie accounting is as arcane, convoluted and jargon-filled as anything I’ve ever seen–even oil and gas accounting.  So my last sentence is a real simplification.)

From its revenue estimate, the studio gets a total operating profit estimate and an operating margin.  If it thinks it will get total revenue of $500 million from the film and $100 million comes in during the period, it will record that figure, deduct 20% of the movie’s cost, and get an operating profit.

The big current issue with movie accounting (the perennial issues are its opacity and perceived tendency to favor insiders) is that movie revenue comes from many sources, among them:  theatrical release, which may occur at different times in different countries; DVDs; video on demand; and TV rights.

Until the financial crisis, a good guess would be that DVD would account for at least half of a hit film’s revenues and be as much as 1.5x the size of the money a studio would earn from showing it in theaters.  But in the past two years or so, people have stopped buying DVDs.  And, as luck would have it, DVD revenue comes toward the tail end of the project.  So studio estimates for the profit of movie projects which have been started between 2007 and relatively recently are probably way too high.  Hence the rash of writedowns we are starting to see from movie companies.


Although I’ve concentrated on the uncertainties surrounding project accounting, I don’t want to say it’s a totally bad thing.  In the final analysis, even though the project accounting technique presents managements with more than the usual number of chances to hope against hope, the accounting uncertainties reflect the uncertainties inherent in taking on multi-year projects and making multi-year revenue and cost estimates.

Nevertheless, these uncertainties typically mean the companies in these industries trade at lower price-earnings multiples than those in other industries.