Saturday, July 7, 2012

Viable Stock Market Investments – Part V

Profits are the revenues of a company minus the costs of its products which are sometimes called operating expenses. These profits are similar to the net operating income from a rental property. Those who read my earlier posts about viable real estate investments must see the next step coming: “How is all this financed?” What is the financial structure of this investment?

In real estate, the rental property is paid for by the down payment (investor equity) and the mortgage. In the corporation, this is in fact exactly the same. The company’s assets that enable it to operate (produce and sell its products or services) are financed also out of shareholder equity and corporate debt. Corporate debts are typically loans that are virtually never repaid. This is similar to government bonds. 
The corporation usually pays interest but rarely pays back the principal or loan amount; the face value of the bond. In this it differs from classic real estate where the debt service payments comprise both interest and repayment of some of the outstanding debt or mortgage principal.
So, you may have figured out by now that just like with real estate, Net Operating Income or Operating Profit or Funds from operations, don’t encompass the entire income statement. We have to pay interest on debt and strangely enough, we also have to pay taxes!  And finally, one of the tools that is so often abused in corporate finance and contrary to most real estate, our machinery and equipment is used up – it gets worn out or becomes obsolete. This is what we call ‘depreciation’ or when it involves paying off a major multi-year expense it may be called ‘amortization’.
Thus the Operating Profit is sometimes called “Earnings before Interest, Taxes, Depreciation and Amortization’ which is then abbreviated to EBITDA. Basically, depreciation is nothing more than a ‘savings account’ where part of the profits are ‘put aside’ to replace machinery that gets worn out and that needs to be replaced somewhere in the future. Amortization is a bit similar, but relates to building and land expenses that really don’t get ‘worn out’ but whose purchase price is not paid out of the operating profits at once but bit by bit over many years – Amortized is the official term.
I said that corporate debt, like government debt, is rarely repaid. The reason is that ‘leverage’ increases the earnings per share as discussed in our previous posts. Thus, a corporate bond often has an expiry date at which time the lenders or creditors have to be repaid. Repayment is often done by taking out another corporate loan or ‘bond’ at the time of expiry of the older bond and the proceeds are used to pay back the older bond. “The debt is rolled over” in other words, the debt will never repaid. Bonds and other forms of debt (e.g. bank loans) that expire within the current operating year are called current liabilities. Current liabilities are also invoices that haven’t been paid yet; ‘accounts payable’ which are basically short term loans provided by the corporation’s suppliers. Also, there may be deferred taxes owed to the government that are due and they also form part of the ‘current liabilities’.
Offsetting the current liabilities are current assets. Current assets (or working capital) are readily available for operations (e.g. to pay salaries, rent, etc.), they include cash and short term investments (e.g. money market funds),accounts receivable (bills to be collected within the current year), pre-paid expenses and goodies that are in inventory and that are to be sold within the operating year. So current assets are offset by current liabilities and the difference is called ‘Net working capital’. Net working capital is an indicator as to how liquid or capable a company is to fund current operations and expiring debt.
Working capital and the fixed assets such as machinery and buildings are making up the corporation’s operating capital which is in turn funded by shareholder equity, corporate debt and other liabilities. Enough said; time for Microsoft!
In 2011, Microsoft has no debts that require significant interest payments. It has to pay taxes though. There is no equipment or significant depreciation or amortization. All its research and product development is paid out of sales revenue and considered part of the production costs. Now talk about being profitable!
There are other companies that have very little assets, Engineering Procurement Companies (EPCs) like SNC-Lavalin. They can rent their offices and hire and fire their assets - engineering and support staff - with little notice. Of course, staff can leave the company as well and start working for a competitor or the EPC’s clients on short notice. SNC’s real assets are its client base and the project contracts. So what are you buying when you invest in SNC or Fluor or Bantrel?  Recognize some risk?
Microsoft has ‘only’ $12 billion in long term debt.  But it also owes another $11 billion in deferred taxes (read interest free loan from the government) and other liabilities such as moneys reserved for legal liabilities in ongoing court cases as well as patents and licenses that have to be paid for; etc.  If you add this all up then in 2011 Microsoft had $51 billion in liabilities (both current as well as long term) and $57 billion in shareholder equity. Total assets (operating capital) were $51 plus $57 billion or $108 billion.
So let’s now first complete the income statement:
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In 2011, EBITDA or operating profits were $28 billion; it paid no interest but owed $5 billion income taxes. Thus its NET INCOME, the profits owned by its shareholders, was $23 billion! That is $23 billion buckaroos to be divided amongst 8.4 billion shares or $2.75 per share. The company’s shares trade currently for $30 per share or a price earnings ratio of 9.37

What do shareholders do with their net earnings? Well, here lies the problem: Shareholders own but do not control the profits. That is done by management and the board. They determine how much of the profits are paid out to shareholders as dividends, how much is paid for share-repurchasing and how much is used for re-investment in corporate growth.
Now the question arises from those that read my postings about how debt increases corporate net earnings and earnings per share: how much leverage does Microsoft use? You could say $11.9 billion or you could say 11.9 billion plus $39.7 billion in interest free other liabilities, i.e. $51 billion.

But really, did you forget about Microsoft’s current assets? What about its cash and short term investments to be precise? Some is needed to pay for daily expenses but all $53 billion? Are you kidding? Basically, Microsoft has so much cash that most of it is just laying around ‘doing nothing’. All this cash is waiting for what? Paying off Microsoft’s interest free liabilities? Why? Maybe Microsoft should pay of its low interest $11.9 billion in debt? It could be done in one fell swoop and its net operating earnings would not suffer and its profit margin would still be an incredible 40%. Or…
Fifty-two billion buckeroos owned by 8.5 billion shares or $6.26 per share could be paid out tomorrow as a special dividend. That would be on top of its normal dividend of $5.3 billion and another $8.2 billion paid out as share buybacks out of net income!
So really, when you own a Microsoft share of $30 you could tomorrow receive $6.26 cash if Bill Gates and Steve Balmer say so (because you have no control). Your real Microsoft share price is: $30-6.26= $23.74 and with that you earned $2.75 in 2011 and possible 10 to 15% more next year! Microsoft’s real P/E is 8.6 which is unheard of so cheap! You pay a P/E of 11 for the typical Canadian Bank one of the most solid and stale investments in the world!  In 2001 investors were willing to buy Microsoft for a P/E of 60!
Oh BTW, those 2001 investors did not receive a dividend of $0.64 per share and per year nor did the company buy back its shares at a rate of 2.6% per year. The $14.6 billion of 2009 net earnings had to be shared by 8.9 billion shares or $1.62 per share. Since then Microsoft has bought back nearly 500 million shares. If that same profit was divided by Microsoft’s current 8.4 billion outstanding shares each share earned: $1.72 instead of $1.62. Buying back shares is a different way of paying shareholders that is tax free!  In fact, although net earnings overall have increased by 29.4% per year, earnings per share have increased an even more impressive $33.8% PER YEAR!
In the meantime the current black mood in the markets doesn’t recognize the stellar performance of this company. To be honest, the stellar performance of Apple is barely recognized either.  It is not that companies don’t perform in the current economy. Rather it is the investor who can’t recognize true value when it is dangled right in front of his nose! A nose that is plugged with the soot of the European Crisis and the ‘slow growth’ of the North American economy!
Many of the multinational companies offer incredible rewards for investors willing to buy them in today’s stock market. They will be doubly rewarded when corporations once again use leverage to fund their operations. Yes, of course leverage will come back, it will be used appropriately by current managers and boards or it will be done for them by new management as nearly happened a couple of years ago at BCE. Boy; did that company wake up! Or as happened a few months back at sleepy CP Rail!  That is capitalism for you! If current management does not use its resources in a prudent but efficient manner a new management will come in appointed by the shareholders or by a corporate raider who merges with or takes over the company. Yes as individual shareholders we don’t have control but if a corporation does not perform to its full potential the market will somehow force it. In requiem Blackberry?
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