Category Archives: working capital

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.

operating leverage (III)

August 29, 2012 By in Accounting, growth vs value, operating leverage, working capital Tags: , , , , , , Leave a comment

You may notice that I’m working my way down the income statement in discussing operating leverage.  Yesterday I wrote about the leverage that comes from product manufacturing.  The key to finding this leverage is identifying fixed costs.

All the profit action takes place between the sales and gross profit lines.  This is also the most important place to look for operating leverage for most firms.

operating leverage in SG&A

Today’s topic is the operating leverage that occurs in the Sales, General and Administrative (SG&A) section of the income statement.

The general idea is that large parts of SG&A expense rise in line with inflation, not sales.  So if a company is growing at 10% a year while inflation is 2%, SG&A should slowly but surely shrink in relative terms.  And the company will have an additional force making profits grow faster than sales.

For many non-manufacturing companies, this is the major source of operating leverage.

why this leverage happens

There are several reasons for SG&A leverage:

–most administrative support functions reside in cost centers, meaning their management objective is to keep expenses in check.  Employees here are not directly involved in generating profits, so they have no reason to demand that their pay rise as fast as sales.

–as a company gets bigger and gains more experience, it will usually change the mix of administrative tasks it performs in-house and those it outsources, in a way that lowers overall expense.

–a small company, especially in a retail-oriented business, may initially do a lot of advertising to establish its brand name.  As it becomes larger and better-known, it may begin to qualify for media discounts and be able to afford more effective types of advertising.  At the same time, it will be able to rely increasingly on word-of-mouth to gain new customers.  In addition, it will also doubtless be shifting to more-effective, lower-cost internet/social media methods to spread its message.

negative working capital

Strictly speaking, this isn’t a form of operating leverage.  It has its effect on the interest expense line.  And in today’s near-zero short-term rate environment, it’s not as important as it normally is.  But, on the other hand, one day we’ll be back to normal–when being in a negative working capital situation will be more important.  It’s also one of my favorite concepts.

If a company can collect money from customers before it has to pay its suppliers, it can collect a financial “float” that it can earn interest on.  The higher sales grow, the bigger the amount of the float.  If the company is big enough (or, sometimes, crazy enough) it can even use a portion of the float to fund capital expenditures.  The risk is that the float is only there if sales are flat or rising.  If sales begin to decline, either because of a cyclical economic downturn or some more serious problem, the float begins to evaporate, as payments to suppliers exceed the cash inflow from customers.

Lots of businesses are like this.  For example, you eat at a restaurant.  You pay cash.  But the restaurant only pays employees and suppliers every two weeks.  And it pays is utility bills at the end of the month.

Hotels are the same way.  Utility companies, too.  Amazon and Dell, as well.

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.

Looking at inventory (II): figuring operating leverage

February 23, 2010 By in Accounting, FIFO and LIFO, Vocabulary, working capital Tags: , , , , , , Leave a comment

Analysts get information from company financials by comparing two or more sets

Even if a company’s financial statements have an almost photographic fidelity to the structure and inner workings of the enterprise they represent, it’s very difficult for the outside observer to understand what is being portrayed from one set of financials alone–unless, of course, the company is in disastrous financial shape.

Instead, the analyst gets his information from comparison of two or more sets of financials, preferably covering relatively short periods of time, with one another.  In many ways, sequential quarters are the best, since there is the smallest lapse of time between the observation points.  For companies with significant seasonality in their product mix, however, comparison of year over year quarters will produce the fewest distortions.

Question #1:  is there leverage?

One of the first and most basic question you should ask yourself about a company you are starting to look at is whether it has either financial or operating leverage.  A company with leverage is one where a change in revenue produces disproportionately large changes in operating income.  Leverage comes in two types:

—Financial leverage comes from a company’s capital structure.  The idea is that a company that uses debt to finance expansion will produce higher returns on equity as long as the operating profits produced by expansion are higher than the interest expense on the borrowings.

You can do the calculations yourself, but publications like Value Line have statistical arrays that do the work for you.  Look at the lines for “Return on Capital” and “Return on Equity.”  If the numbers are different, the company has financial leverage.  Hopefully the returns on equity are higher than the returns on capital (debt + equity).  That’s the way it’s supposed to work.

—Operating leverage, which comes from the operating structure of the company.  Firms with operating leverage typically have high fixed expenses of maintaining a manufacturing (or service) operation, but low variable costs of making each unit sold.

FIFO companies

For a company that uses FIFO accounting (see the first post in this series), finding out the operating profit on an incremental unit of production is easy.

1.  Take the revenue figure for the more recent of the quarter you’re comparing and subtract from it the revenue for the more distant quarter in time.  That gives you incremental revenue.

2.  Do the same for the two operating income figures.  That gives you incremental income.

3.  Divide incremental income by incremental revenue and you get an incremental margin.

4.  Compare this figure with the operating margin for either of the two comparison quarters.  If the incremental margin is larger than the average margin for the quarters, the firm in question has operating leverage.  And, if so, you know that in forecasting future quarters, incremental revenue will earn the incremental profit margin.  Therefore, even small increases in revenue can produce positive earnings surprises.  Conversely, even small revenue shortfalls can produce earnigs disappointments.

LIFO companies

For a company that uses LIFO, however, the situation isn’t as straightforward.  Under LIFO accounting, every quarter after the first can be a kind of mid-course correction to the estimates the company employed in arriving at first-quarter cost of goods.

I think it’s reasonable to assume that a company uses a consistent estimating methodology from one year to the next.  If the company chose last year to add in a little safety margin for earnings later in the year by making a high initial estimate for cost of goods, then it’s a good bet that they’ll do the same for this year.

Therefore, it’s a pretty safe assumption that we can analyze incremental margins using the first quarters of two consecutive years.  In any event, it’s the best we can do.

On the other hand, we take a real risk if we use second through fourth quarters by themselves in a year on year comparison.  We can’t rule out the possibility that they’re just residuals left from the re-estimating process.  But we can use (Q1 + Q2) of the current year vs (Q1 + Q2) of last year to do the incremental calculation described in the FIFO section above.  Similarly, we can use Q1 + Q2 + Q3 or the full year as our comparison base.

For the same reason we should hesitate to  use Q2, Q3 or Q4 alone, we also probably shouldn’t use sequential quarters to do the calculation.

For a professional securities analyst, it may make sense to do quarterly year on year or sequential comparisons for a LIFO company anyway.  If you look at enough years, you may find that there’s a consistent pattern to the LIFO adjustments, so you can anticipate with the company is likely to do in the coming quarters.  Even if there isn’t, you may learn enough to make this a topic of conversation with the company’s management.  If someone is willing to take the time to explain how they approach LIFO estimates, you’ll doubtless learn a lot of things from the explanation that you’d never have thought about otherwise.