Tag Archives: Accounting

there may be a real life for contingent convertibles, after all

February 14, 2012 By in Banks, hybrid bonds/contingent convertibles, Industry Analysis Tags: , , , , , , , Leave a comment

why I don’t like co-cos…or, (more) evidence investment bankers are on the dark side

Investing is conceptually very simple but emotionally very difficult.

Under most conditions, professionals can resist the Dr. Frankenstein-like impulses of investment banks to create bizarre security hybrids.  Not at the top of the market, though.  There’s something in the air that makes portfolio managers throw away their pocket protectors and revel in the purchase of the trashiest securities.

PMs will rue these buys for the rest of their careers–which may, incidentally, be quite short periods of time if they don’t recover their senses and sell the stuff on while a market for them still exists.

One of my favorites in this genre was a convertible bond issued in 1993 by Hong Kong-based New World Development, an indifferently managed family-owned property conglomerate.  It carried no coupon and was convertible on undisclosed terms into shares of a mainland Chinese company that did not yet exist.

And you ask me why I’m not a fan of investment bankers.

As it turned out, the issue met with high demand despite its dubious character–a sure sign that the markets were in the grip of speculative fever.  Right afterward, I was chatting about it with a highly skilled colleague, who confessed she had actually taken part in the deal.  Her reasoning?  In her peer universe there might be a half-dozen offerings during the year that would make or break performance versus competitors.  She felt she couldn’t take the chance that the deal would not only be successful but would trade up strongly in the aftermarket.  She didn’t want to be left in the unusual (for her) position of eating competitors’ dust.

co-cos, the brokers’ latest creation

Contingent convertibles are more recent spawn of the investment banking tendency to birth nightmarish creatures.

The idea is that the vehicles, known as “co-cos,” would be issued by financial companies, especially banks, that are required to maintain minimum levels of equity capital.  They start out as bonds.  But if the issuer’s financial condition deteriorates beyond a certain level, they automatically convert into equity.  Therefore, investment banking proponents argued, they should be considered as equity by the regulators even before conversion.  (True to form, when the original idea was floated, the intention was to not specify in the offering documents what circumstances would trigger conversion.)

not a winner…

Co-cos have never taken off.

The obvious flaw, other than that no one would know what would prompt conversion, is that the buyers would be bond portfolios.  They’d be reeled in with the promise of higher-than-average coupons.

If the issuer’s capital ratios deteriorated, its stock would sag significantly.  If conversion of the co-cos followed, that would leave large amounts of stock in the hands of PMs whose client agreements don’t allow them to hold equities.  So they’d have to dump the securities right away into a depressed market, sending the issuer’s stock lower and making its problems worse.  In fact, anticipation of conversion might launch the stock of the issuer into a severe downward spiral.

Also, the Bank of International Settlements said the idea wouldn’t fly.  Finally, the co-co idea also came too close to the disastrous demise of their close cousins, hybrid bonds.

…until now

It now looks like co-cos may actually have a use, according to the Wall Street Journal.  The buyers won’t be private investors, however.  They’ll be the governments of Spain and Portugal, which will use the vehicles to inject money into ailing banks.

Why use co-cos? Three reasons:

–the injections of money will look like investments, not the bailouts they really are,

–Spain and Portugal will get securities in return for the money they pour in, so their government deficits won’t increase, at least on paper, and

–Madrid and Lisboa won’t appear to be partially nationalizing the weak banks, which is what buying equity directly would mean.

I’ve never seen this before–an instance where a crackpot, top-of-the-market, caveat emptor ploy by investment bankers to boost their bonus pool is actually useful.  It’s nothing like what the i-bankers envisioned, of course, but still…

profit margins: how I look at them

February 10, 2012 By in Constructing a Portfolio, economics, margins, Portfolio management Tags: , , , , , , , , , Leave a comment

what they are

They’re the portion of revenue, usually expressed as a percentage, that remains after costs of s certain type have been deducted.  The most common types of margins used in financial analysis are:

gross margin, meaning what’s left after deducting the direct costs of providing the goods or services

operating margin, meaning what’s left after deducting both direct costs and sales, general and administrative (SG&A) expenses.  Sometimes depreciation is also considered an operating cost, sometimes not, depending on the convention being used.

pre-tax margin, meaning what remains after deducting all costs other than taxes

after-tax margin, meaning income remaining after all costs, including taxes–but not including preferred stock dividends, if any.

do high margins mean a good company?

Many growth investors, especially tech-oriented ones, look for high margins as proof that a company owns patents, copyrights or other intellectual property that defend it against competition.  MSFT or INTC might be good examples.

Low margins, these investors believe, are indicators that a firm is in a commodity business.  This means that competition forces revenues down to levels very close to the cost of production.  Profits accrue either to no one or mostly to the low-cost operator.  Entrants in such industries are continually in a dog-eat-dog fight to push their costs below those of rivals.  No one stays in the low-cost seat for long.

Value investors, with their customary dour dispositions, take the opposite view.  They think high margins are like waving a red flag in front of a bull.  Firms that demonstrate them are disasters waiting to happen.  Sooner than you’d expect, they opine, competition will emerge, margins will compress and the stock will implode.

I line up more or less with the value guys on this one, even though I don’t agree with them 100%.  There are some perennial high-margin firms, where competition hasn’t proved an issue over decades.  Nevertheless, it’s hard to argue that either MSFT or INTC have been anything but disasters as stocks so far in this century, despite their near-monopoly positions.

taking margins at face value is foolish, in my view

How so?

–If you assume that margins at any level are fixed, you’ll miss perhaps the crucial element in forecasting future earnings–operating leverage.  This is the idea that some costs are fixed and don’t rise in line with unit volume.  As a result, the expense involved in selling an extra unit may be much less than that of selling the average unit.

–Rising margins almost always do invite competition.   Companies like MSFT are the exception, not the rule, in my view.  In most industries, the best companies will reinvest much “extra” margin in lowering their costs, as a way of discouraging new entrants.

–High margins usually aren’t “free.”  Jewelry or furniture companies, for example, have very high margins.  But they have to maintain very high inventories, which they turn only once or twice a year.  That’s risky.  The high margins in these cases don’t signal “free lunch”; they signal risk.

–I think the distribution company model–low margin, high inventory turnover–is attractive.  Distribution companies can be very high growth, high profit firms.  They can also have lost of operating leverage.  WMT in its heyday is an example, as is any industrial wholesaler.  Anyone fixated on high margins will miss this important class of firms completely.

What do I use instead of margins in projecting the income statement?  I break down unit costs–labor, raw materials,…–as much as I can and forecast each.  Some are simple functions of unit volume.  Many, however, like advertising, administration, or sometimes labor, are relatively unchanged as volume increases.  That’s where operating leverage and earnings surprises lie.

what is a carried interest?

January 20, 2012 By in carried interest, hedge funds, Investment firms, Securities regulation Tags: , , , , , , , , Leave a comment

Mitt Romney’s taxes

Mitt Romney’s partial disclosure of his tax situation has reopened debate on the issue of how private equity managers and some hedge funds use carried interest as a device to shelter their earnings from tax.

Since Mr. Romney left the private equity business a decade ago, it seems to me that he isn’t currently using carried interest as a tax shelter.  In all likelihood, it’s some combination of itemized deductions, like charitable contributions or state and local taxes paid, and the favorable treatment of long-term gains on investments that’s producing his low tax rate.  But he was a prominent figure in the private equity community, so the press–and his political opponents–have made the connection anyway.

Powerful lobbying efforts by the private equity industry have defeated repeated attempts to close the tax loophole it uses to lower its executives’ tax burden.

I wrote about this topic in mid-2010.  But I haven’t read anything, wither in the current discussion or in the past, that explains exactly what a carried interest is.  Hence this post.

carried interest

A carried interest is a participation in an investment venture where the holder gets a share of the cash generated by the project (profits or cash flow) without having to contribute anything to the venture’s costs.  The holder of such an interest is “carried” in the sense that the other venture participants pick up the burden of his share of project expenses.

Carried interests aren’t just a private equity phenomenon.  They’re very common in the mining industry, which is where I first encountered them thirty years ago.  But they also occur in lots of other industries, particularly those where highly specialized experience or skills, or possession of crucial physical resources are key to a project’s success.  In the extractive industries, holders of mineral rights may be carried.  The fund raisers or organizers of any sort of projects may be carried, as well.  So, too, famous actors or holders of key intellectual property.

variations on the theme

As with everything in practical economic life, there are myriad variations on this basic idea.  For example,

–a party may not be carried for the entire life of the project, but only up to a certain point–say, when cash flow turns positive.

–the other parties may be entitled to recover the “extra” costs they’ve paid to subsidize the carried interest before the carried interest receives a dime (there are also lots of variations on the cost recovery theme), or

–the carried interest may only be paid if the project exceeds specified return criteria.

In plain-vanilla projects, the carried interest receives a portion of the recurring revenue that the venture generates.  This is ordinary income and taxed as such.  The private equity case is different.

private equity and carried interest

Private equity raises equity money from institutions or wealthy individuals, arranges financing of, say, 3x -5x that amount, and uses the assembled war chest to make acquisitions.  It targets mostly badly run companies.  It spruces them up and resells them a few years later.  There’s no conclusive evidence that this process adds any economic value, although it certainly sets the process of “creative destruction” in motion in the affected company–but that’s another issue.

Private equity companies appear to me to act as a blend of business consultants and managers of a highly concentrated (and extremely highly leveraged) equity portfolio.  What’s really unique about them is their pay structure.

Private equity charges its clients a recurring management fee of, say, 2% of the assets under management plus a large performance bonus if the turnaround projects they select are successful.  This bonus is structured as a carried interest (an equity holding) in each individual project.  Because the projects last several years and result in an equity sale, the bonus payments are capital gains, not ordinary income.  This means the private equity executives’ tax bill is much less than half what it would be if the payments were income.

my thoughts

You’ve got to admit that turning investment management income into capital gains is a clever trick.  Should the loophole be closed?  When I first wrote about this I thought so.  I still do.  But I’d prefer to see more comprehensive tax reform that achieves this result rather than specific legislation that targets the private equity industry.  I also find it somewhat disturbing that private equity political contributions and lobbying allow them to “own” this issue in Congress, despite the fact that private equity’s taxation is clearly different from other investment managers’, from management consultants’ and from corporate executives’ for basically the same activities.

importance of the cash flow statement: it’s like mushrooms

December 29, 2011 By in Accounting, cash flow, economics Tags: , , , , , , , Leave a comment

why project a cash flow statement?

While I was in graduate school, I spent a year in Germany studying at Eberhard Karls University in Tübingen.  Before school started I lived for a while with a German family.  Every Saturday morning we would roam the local woods in search of the mushrooms that would comprise one or two of our meals during the following week.  Since I had no clue what I was doing, my hosts would scrutinize any mushrooms I found very carefully to make sure they weren’t poisonous.

One type, the death cap–which I never stumbled across–still stands vividly in my mind.  According to my family and to public service announcements on tv, not only was this mushroom deadly, but the first symptoms of its effects only developed after the poisoning was too far advanced to be treated.

There’s an analog to this situation in the investment world.  These are cases where the financial results of past management actions narrow the scope of future possible outcomes to the point where one or two become highly probable–if not unavoidable. In these cases, management is never going to spell out the constraints it it working under.  Nevertheless, the current financial condition probably makes their future actions very highly predictable.

Projecting a cash flow statement for such a company is the way to uncover and evaluate.  (An analyst should do this for every company under coverage.  In my experience, most don’t.  In “mushroom” cases, however, the cash flow statement is crucial.)

examples

a toy company

In the early Nineties I was following–and for a while owned shares in–a small publicly owned toy company.  It earned, say, $10 million annually.  One year it had a surprisingly successful spring-driven flying toy doll for girls.  The following year it decided to make a similar toy for boys, with a martial theme and a stronger spring.  As I recall, the firm decided to spend $40 million on materials and labor for this toy (a real roll of the dice at 4x total corporate earnings).  It got the money through trade financing and borrowing from its bank.  The risk was especially high, since all the manufacturing had to be done at one time, in preparation for the yearend holiday selling season.  On the other hand, the prior year’s toy had been a smash hit; the firm really understood the boy market and felt this one would be, as well.

Soon after the toy was on the shelves of toy stores, the company began to get reports that the combination of a strong spring and curious young boys was resulting in severe eye injuries to users.  The government mandated a recall.  The $20 million in profits the company had envisioned was up in smoke.  The inventory that had cost $40 million to make was now worth close to zero.

Do the math.  At most $10 million in earnings from other toys vs. $40 million in short-term financing needing to be repaid = no way out.

the Mets

The New York Times published a recent article on the Mets’ finances, titled “For Mets, Vast Debt and Not a Lot of Time.”  There isn’t enough publicly available information to draw a firm conclusion, but if the figures in the article are correct, the Mets don’t have much wiggle room.  The current club drive to lower the total player salary bill may be the only real option it has.  Specifically,

Sources of funds:

The Mets lost $70 million (I’m presuming that this is a pre-tax figure, but this isn’t clear) last season, with a player payroll of about $150 million.  Let’s say the actual pre-tax cash outflow was $30 million.

If we make the (optimistic) assumption that ticket sales and concession revenue in 2012 is constant with 2011, then lowering payroll to $100 million will result in a pre-tax loss of $20 million for 2012.  Cash flow should be positive, at about $20 million.

2013 cash inflow = $40 million ?

2014 cash inflow = $50 million ?

Uses of funds:

repayment of $25 million to Major League Baseball, now overdue

repayment of $40 million Bank of America bridge loan

repayment of $430 million team loan in 2014.

If, again, the NYT figures are correct and the cash inflow numbers I’ve made up for 2012-14 are anywhere close, the Mets won’t be able to make much of a dent in the 2014 principal repayment requirement.  It seems to me that dealing with the $430 million that comes due in three years is the major management issue.

What I’ve written above is just the bare bones.  The Mets are attempting to find outside investors who are willing to accept having no say in the running of the organization.  Suit by the Madoff trustee is pending.  And, of course, there’s the tangled relationship between the Mets and SNY, the Wilpon-controlled cable network to which the club has sold broadcast rights.

others

Eastman Kodak has been supporting its ongoing turnaround through outside financing and asset sales.   Looking at the cash flow statement for the past couple of years and projecting it forward for the next few will be highly instructive.

Current market worries about Italy’s sovereign debt also have a cash flow basis.   The issue is the current high cost of refinancing maturing debt.  Unlike the previous corporate instances, Italy’s new government has much greater scope for initiating reforms that can change market perceptions quickly.  And perceptions, rather than the amount of outstanding debt (which is typically the corporate issue), are the main concern here.  Still, projecting sources and uses of funds forward for several years will give a much clearer grasp on the issues than simply watching current yields.

 

 

 

 

 

 

Sony/Samsung LCD jv restructuring: a study in cash flow vs. earnings

December 28, 2011 By in Accounting, Basic Concepts, cash flow, cash flow/share vs. earnings/share, Stock ideas Tags: , , , , , , , , Leave a comment

the Sony/Samsung LCD-making joint venture

On Monday Sony and Samsung announced a restructuring of the joint venture they entered into during 2004 to manufacture large liquid crystal displays for televisions.

The joint venture developed out of Sony’s dire need of LCD manufacturing capacity (it had badly underestimated how quickly flat panels would replace traditional CRTs) and Samsung’s desire to achieve economies of scale and its hope for technology transfer.  But after seven years, in a world awash in LCD-making factories, and given Samsung’s technological dominance over Sony, the jv had outlived its usefulness.

I haven’t looked at Sony carefully for years.  My overall impression continues to be that the firm is a mess.  But that’s not what I want to write about.

terms of the jv restructuring

The essentials of the recasting of the LCD joint venture are:

–Samsung will buy out Sony’s interest (50% minus one share) for around $950 million in cash,

–Sony agrees to buy LCDs from Samsung (no details of the arrangement given),

–Sony will record a loss of $850 million on the sale, implying its ownership interest is being carried on the balance sheet as worth $1.8 billion, and

–Sony expects to save about $160 million a quarter–a combination of savings on LCD purchases and being freed of the need to make new investments in the jv.

earnings and cash flow implications for Sony

earnings

The writeoff of its 2004 investment will depress Sony’s March 2012 earnings by $850 million.  The $950 million payment will be treated as a return of capital and won’t show on the income statement.

If we assume that the jv is simply breaking even, which is probably much too optimistic, there will be no effect, positive or negative, on future eps for Sony from its dissolution.  To the degree that the jv is loss-making, that red ink will disappear from the income statement.

cash flow

Here’s where the significant positive impact comes.  The transaction turns a loss-making asset into significant positive cash flow.

First, of course, Sony takes in $950 million in cash early next year, an amount equal to roughly 5% of the company’s market cap.

Second, it avoids having an outflow of money that it estimates at $160 million per quarter.  In other words, Sony enhances its cash flow by that amount.

Two positives from this:

–Sony can reallocate the cash saved to more productive activities, and

–my quick perusal of Sony’s most recent form 6-K (on page 18) suggests that the $160 million a quarter the jv was using up is virtually all the cash flow Sony is currently generating.

my point

This kind of transaction is a staple of value investing, where a loss-making asset that earnings-oriented investors regard as worthless is sold–and thereby is shown to have substantially more value than the market has realized.  In the case of larger sales or smaller companies, transactions like these can be transformative.