Tag Archives: Accounting

Toshiba and the Japanese business establishment

July 22, 2015 By in Abenomics, Asian economic development, Japanese development Tags: , , , , , 2 Comments

First there was the Fukushima Dai-ichi nuclear disaster, where nuclear power plants were installed incorrectly and both the utility and government regulators falsified inspection reports to cover this up.

Then there was Olympus Optical, whose tip management lost billions in stock market speculation because it was unwilling to restructure loss-making operations and covered up the fact for over a decade by fabricating its financial statements.

Now there’s Toshiba, which falsified results for years, under pressure from unrealistic profit goals set by a series of CEOs  (shades of Jack Welsh at GE).

 

Not that surprising, in my view, given the Japanese corporate world’s widespread adherence to a samurai-like code of absolute, unquestioning obedience to instructions given by older/more senior managers in one’s company.  After all, many of these enterprises have their origin in samurai cast adrift as regional warlords were marginalized during the early shogun days.

This mindset is also a reason why a lot of Japanese business is still stuck in the 1980s–that the world is changing at a fast clip, but you pretty much have to have white hair before anyone will listen to what you have to say.  To be clear, I don’t think this samurai-ness is a universal attitude in Japan as a whole.  Unfortunately,it thrives in the Tokyo/Osaka-based, export-oriented industrial sector which is the primarily beneficiary of the deep depreciation of the yen engineered by PM Abe.

Why don’t out-of-date sixty- and seventy-somethings just retire and let a younger generation take the reins?

For one thing, speaking as a sixty-something myself, it’s hard to go from being king of the world to being just another nameless retiree.

I think, however,that there may also be a deeper, more damaging reason than the ego problems of the people in charge:

One of the first companies I followed as an analyst was a small copier manufacturer/distributor.  The firm was in enough financial trouble that it bought breathing room by selling a large chunk of its plant and equipment and leasing it back from a bank.  That netted $50 million or so in cash.

Soon afterward, Carl Icahn bought  5%-10% of the company’s stock and threatened to make a hostile bid for the rest.  The firm quickly bought back Icahn’s shares for, as I recall, about a 30% premium.  I was shocked.  I didn’t get it at all.

Only when the firm subsequently went into Chapter 11 did I learn the CEO, a former accountant, had been fiddling with the books for years.  That fact was the real leverage Icahn had over his target, whether he knew it or not.  The CEO couldn’t let an outsider in, because the accounting shenanigans would be discovered and he would be disgraced.

I don’t know, but I suspect–because I’ve seen the same pattern in numerous smaller firms in Japan that Olympus and Toshiba are only the tip of the iceberg in Tokyo.  If I’m correct, Abenomics is even more problematic than I’ve been writing.

 

 

 

 

 

 

contribution margin

April 15, 2015 By in contribution margin, three sets of books Tags: , , , , Leave a comment

three sets of books

A couple of years ago, I wrote a post about the three sets of accounts that a publicly traded company maintains:

–tax books, where the objective is to pay the smallest amount of tax legally possible–in other words, to fool the IRS,

–financial reporting books, where a more liberal view of when and how revenues and expense occur allow a company to put its best foot forward with owners–in other words, to fool shareholders, and

–management control books, also called cost accounting books, which the company uses to actually run its operations.

contribution margin

Contribution margin is a cost accounting concept.

The first thing to note is that despite its name it’s not really a margin–that is, it’s not a percentage.

Instead, it’s the amount by which an activity or a  line of business exceeds its own direct costs and makes a contribution to corporate overhead.  This isn’t the same as making a standalone profit, meaning after covering total costs.

Take a restaurant that’s now open for lunch and dinner and makes money doing so.

Should it open for breakfast, as well?

In the simplest case, the question is whether the restaurant can generate enough revenue to offset the cost of paying for the food and the staff.  If so, it makes a positive contribution margin.  If we were to allocate, say, 20% of the restaurant’s total expense for rent, electricity and depreciation of equipment,  breakfast might be bleeding red ink.  But those costs are there anyway, whether breakfast is or not.  As long as the contribution margin is positive, the firm is better off with breakfast than without.  (Yes, the actual situation is more complicated   …is the wear and tear higher because of breakfast?   …does breakfast cannibalize the other meals?   But I’m keeping it simple to illustrate a point.)

Another case.   Some lines of business may never have been intended to create growing profits, or may no longer be capable of doing so, even if they once were.  A manufacturer may make precision components in-house.  The component division will typically be run as a cost center, not a profit center.  It’s mission will be to provide high quality parts at the lowest price, not to maximize profits.  Its managers will be evaluated by their ability to provide output more cheaply than third-party alternatives can.  Again, the division may not be profitable after allocation of its share of corporate overhead.  Still, it may be very valuable.  Its value will be measured by contribution margin, defined as the difference between in-house and third-party component costs.

Why is this important?

It’s a mindset thing.  Not every part of a company may be intended to grow.  Rising stars may eventually turn into cash cows as businesses evolve.  It’s important both for company management and investors to understand the role an activity should be playing in the overall enterprise.

 

 

Warren Buffett’s latest portfolio moves: the 4Q14 13-f

February 18, 2015 By in Constructing a Portfolio, earnings conference calls, Portfolio management, securities markets, Securities regulation, stock market Tags: , , , , , , 4 Comments

Investment managers subject to SEC regulation (meaning basically everyone other than hedge funds) must file a quarterly report with the agency detailing significant changes in their portfolios.  It’s called a 13-f.  Today Berkshire Hathaway filed its 13-f for 4Q14.  I can’t find it yet on the Edgar website, but there has been plenty of media coverage.

Mr. Buffett has built up his media and industrial holdings, as well as adding to his IBM.  The more interesting aspect of the report is that it shows him selling off major energy holdings–ExxonMobil, which he had acquired about two years ago, and ConocoPhillips, which he had been selling for some time.  Neither has worked out well.

There’s also a smaller sale of shares in oilfield services firm National Oilwell Varco and a buy of tar sands miner Suncor–both presumably moves made by one of the two prospective heirs working as portfolio managers at the firm (whose portfolios are much smaller than Buffett’s.  Buffett has told investors to figure smaller buys and sells are theirs.)

Three observations:

–the Buffett moves would have been exciting–maybe even daring–in 1980.  Today, they seem more like changing exhibits in a museum.

–if I were interested in Energy and thought it more likely that oil prices would rise than fall, I’d be selling XOM, too.  After all, it’s one of the lowest beta (that is, least sensitive to oil price changes) members of the sector.

But I’d be buying shale oil and tar sands companies that have solid operations and that have been trampled on Wall Street in the rush to the door of the past half-year or so.  That doesn’t appear to be Mr. Buffett’s strategy, however.  His idea seems to be to cut his losses and shift to areas like Consumer discretionary. (A more aggressive stance would be to increase energy holdings by buying the high beta stocks now, with the intention of paring back later by selling things like XOM as prices begin to rise.)  NOTE:  I’m not recommending that anyone actually do this stuff.  I’m just commenting on what the holdings changes imply about what Mr. Buffett’s strategy must be.

–early in my career, I interviewed for a job (which I didn’t get) with a CIO who was building a research department for a new venture.  I was a candidate because I was, at the time, an expert on natural resources.   The CIO said the thought there were three key positions any research department must fill:  technology, finance and natural resources.  All require specialized knowledge.    I’d toss healthcare into the ring, as well.  I’d also observe that stock performance in these more technical areas is influenced much less by the companies’ financial statements than is the case with standard industrial or consumer names.

Mr. Buffett is an expert on financials–he runs a gigantic insurance company, after all.  On tech and resources, not so much, in my opinion.  Financials are the second-largest sector in the S&P 500, making up 16% of the total.  Tech makes up 19.5%; Energy is 8.3%; Healthcare 14.9%.  The latter three total 42.7% of the index.  As a portfolio manager, it’s hard enough to beat the index in the first place.  Being weak in two-fifths of it makes the task even harder.

Shaping a portfolio for 2015 (iii): currency movements

December 8, 2014 By in currency effects, Shaping a portfolio for 2015, Strategy Tags: , , , , , Leave a comment

When economies are deviate from the path that government policy would like them to follow, two basic options are available to get them back on track:

–internal adjustment, meaning the government alters tax/spending/interest rate policy to speed up/slow down the pace of growth; or

–external adjustment, meaning it changes policy with the aim of strengthening/weakening the currency.

In almost all cases, raising interest rates or raising taxes creates economic hardship and makes voters angry.  In bad times politicians have an overwhelming preference for external adjustment through currency movements, because the pain can’t be traced back to a given legislator’s votes.

rising/falling currency

A rise in a country’s currency acts like an increase in interest rates.  It slows down economic activity.  A decline in the currency does the opposite.

Either move has the secondary effect of shifting the composition of growth, as well.  A strong currency increases national wealth; it favors importers and hurts exporters and import-competing industries.  A weak currency does the opposite.

Right now, the EU and Japan are both following weak currency strategies aimed at simulating growth by devaluing their currencies.  In contrast, the US is about to begin the process of raising interest rates to wean its economy away from the emergency monetary stimulus it began in 2009.  The withdrawal of extra money will result in higher interest rates.  These differing policies are already having an effect on relative currency values, and therefore on publicly traded securities.

stocks in a weak currency country

The weak currency tends to stimulate overall economic activity.  Therefore, surprises in domestic earnings growth will tend to be positive–and good for stock prices.  Investors will also seek to benefit from foreign currency strength (i.e., the US$) by rotating their portfolios toward strong currency earners.  These will either be multinationals with significant operations/assets in the strong currency country or exporters.  They will also tend to shun importers, whose offerings will be more expensive and therefore less attractive.

stocks in a strong currency country

Holders of strong currency assets get more bang for their buck in buying weak currency goods and services (like vacations).  They are better off simply from the fact of local currency appreciation.  But for the local stock market, the currency appreciation isn’t an adulterated plus.  Quite the opposite.

The appreciation slows down domestic economic activity, making negative earnings surprises a greater possibility.  In addition, the strong currency value of a firm’s foreign (weak currency) earnings and assets is diminished.   Both will mean that year-on-year earnings comparisons in foreign operations will be unfavorable.  Neither is easy to predict, so the possibility of earnings disappointment will increase.

Therefore, holding stocks in a strong currency country isn’t always just a walk in the park.

Stock market participants typically deal with this issue by rotating their holdings toward importers and purely domestic firms.

other investor influences

carry trade

Weak currency fixed income investors may shift their holdings toward strong currency sovereign bonds.  We’re seeing this already being done this year by EU portfolio managers, who are buying Treasury bonds in large amounts.  To them buying Treasures seems like shooting fish in a barrel.  They get an immediate yield pickup plus a potential currency gain.

EU alternative investors can amplify their returns by shorting their own sovereign bonds and using the funds to buy Treasuries.  That’s the carry trade.

Although the Fed controls the overnight-money Fed Funds rate, foreign portfolio investors may well keep long-term US interest rates lower than they would be if domestic investors were the only market participants.

foreign investment

Foreigners may judge that the currency gain they achieve by buying US stocks will more than offset possible stock price softness due to slower earnings growth. There’s no general rule I know of to decide whether this is a good move or not.  In the 1980s, the return on Mexican stocks was fabulous, even though the peso lost virtually all its value during the decade.  Japanese stocks were also super in the same time frame, even though the currency was very strong.

for 2015

My experience is that traders in the currency markets are way ahead of me in evaluating where currencies should be.  I think I’m better off concentrating on general trends–orienting my active stock holdings in the US toward strong currency beneficiaries and my foreign positions toward weak currency beneficiaries.

One other tactic is to try to find companies that are growing fast enough that currency won’t matter much  (see my post on Pandora).

One final note:  the 1997 Asian economic crisis was triggered by dollar strength.  Many regional firms had borrowed extremely heavily in dollars because interest rates on local debt were much higher.  Balance sheets were destroyed when the dollar appreciated.  If there’s similar trouble in 2015 look for it in South American and Africa, not Asia.

 

 

 

financial inversions are proliferating

May 28, 2014 By in Current Market Thoughts, financial inversion, Stock ideas, Strategy Tags: , , , , , , , Leave a comment

A while ago, I wrote about the financial or tax, “inversions” that have been sweeping the US pharmaceuticals industry.  Basically, a US company that pays a full 35% Federal corporate tax bill can reincorporate in a low-tax foreign jurisdiction–purely on paper–by taking over a foreign firm already set up there.  This is financial engineering at its finest/worst.  No one has to move; offices and plants remain untouched.  Certain conditions do have to be met, however.  The US acquirer must fold itself into the foreign acquiree so that the foreign entity is the survivor.  And foreigners must own 20% of the shares of the merged company.  Otherwise, it’s pure financial gravy.

Consider a US company that has $1,000,000,000 in pre-tax income.  After Federal tax, that’s $650,000,000.  If the firm can “invert” itself and end up with a 20% tax rate on that income, the after-Federal-tax number becomes $800,000,00.  That’s an annual savings of $150,000,000–a 23% jump in the funds that can be used for capital investment or paying dividends.

IHG

It’s no longer just drug companies, though.  Last weekend, media reports that Intercontinental Hotels Group, PLC (IHG) had been approached by a US hotelier, speculated to be Starwood (HOT), about a combination of this type.  IHG supposedly rejected a $10 billion takeover offer.  (IHG’s stock price indicates we may not have heard the last chapter of this story, since the quote rose to just about the reputed offer price after the news came out.

investment implications

1.  Back in the Stone Age (the late 1970s), when I entered the investment business, investors were very sensitive to the rate at which a company’s profits were taxed.  At that time, the prevailing view has that the higher the tax rate, the better quality the earnings were.  The rationale was that in order to be used for dividend payments, cash generated in low-tax jurisdictions would need to be repatriated and local corporate tax paid.  Therefore, the apparent profits generated in low tax areas were illusory and not to be trusted.

Now, that view seems very Austin Power-ish.  As I see it, for good or ill, over the past decade or more investors have been indifferent to the rate at which profits are tax.  It’s solely profit growth that counts.  Whether it’s achieved through selling more products or by astute tax planning doesn’t matter.

But the “modern” view has to be changing again, I think, as inversions become more popular.  It’s now a distinct investment plus to be a foreign company in a low-tax jurisdiction.  This means that, sooner or later, a US firm in the same industry will make a takeover bid.

2.  As the US corporate tax base begins to erode through financial inversions, there should be a response from Washington.  The rational one, in my view, would be to simplify the tax code and lower the levy on corporations to what’s normal in the rest of the world.

But no.  So far the only movement in Congress is to retroactively make inversions illegal.  This is the kind of thing that has helped give India its current reputation as a high risk area to do business in.

Still, reform of corporate taxes would potentially create a whole raft of winners and losers.  So it’s something to keep an eye out for.