by Alpha and Vega, an Investor and a Trader
July 20th, 2010
1) Finding the Value Drivers that Make a Business
2) The Credit Card Industry – American Express and Capital One
3) The Airline Industry – Southwest and JetBlue
4) The Cable and Satellite TV Industry – Comcast and DirectTV
5) Footnotes are like Snowflakes: No Two are the Same
Appendix: Ben Graham’s Satire on Accounting, or How to Abuse a Footnote (only in pdf version)
The first letter in the “How to Read Financial Statements” series went over basics on finding them and how to approach them. The second letter got into the guts of a 10-K, into the first level of analysis. This third letter shows how to finesse the footnotes and creatively assess the value drivers behind a business.
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1) Finding the Value Drivers that Make a Business
The million-dollar skill in reading financial statements is simplifying complexity. I’ve seen valuation analyses that fit on 25 Excel tabs, more than a hundred printed pages (murder by model). Other analyses could fit on one double-sided page. Shorter is harder and often better. KISS – Keep it simple, stupid. That is, an analyst must know how to read and understand dozens of tables of numbers, such as revenues, costs, margins, earnings, cash flows, assets, debt maturity walls, etc., to find the value drivers of a business. She must condense.
A value driver is a fundamental, causative business variable that effects accounting data (revenues, margins, earnings, cash flows, etc.). Accounting data are then used to calculate ratios to show the strength of a business and the intrinsic value (or estimated value range) of its securities. Value drivers make up the economic ghost inside the financial machine. They are the economic forces that drive financial outputs and metrics. Value drivers tend to be specific to industries or sub-industries, sometimes even specific to an individual business. Good management teams focus on value drivers; the bad teams don’t even know what they are.
Here are some examples of value drivers in different industries:
• Retail banking: At its core, retail depository banks make their profits/earnings from borrowing cheaply and lending at a higher rate. The core value driver is the “net interest margin” (NIM), a measure of the difference between a bank’s interest income and the amount of interest paid out to their lenders (for example, deposits), relative to the amount of their (interest-earning) assets. NIM is usually expressed as a percentage of what the financial institution earns on loans in a time period and other assets minus the interest paid on borrowed funds divided by the average amount of the assets on which it earned income in that time period (the average earning assets). NIM takes both rates and dollar amounts into account, whereas the “net interest spread” just looks at the rate differential or “spread.”
• Apparel Clothing: Niche business like Polo Ralph Lauren Corp. (RL) may have many products and lines of business (basic, middle-market, premium, etc.). However, the vast majority of earnings are generated by a handful of product staples, and for RL the basic items are polo and cotton shirts, khaki pants, sweaters, and so on. While RL has many outlets, by far the most profitable are its wholesale and internet outlets. Hence a business with hundreds of products and many outlets can be simplified into: How many units of staple goods are being sold, and in what channel? Also, are the total costs of marketing worth it, and are the dud goods not eating up all the profits?
• Property-Casualty (P-C) Insurance: The basic model for insurance is to take in premiums (up front protection payments) and pay out expenses (claims for losses plus operating expenses). An insurer’s “combined ratio” is basically claims plus operating expenses divided by net premiums (this can be broken into a loss ratio and an expense ratio). However, the net premiums that insurers collect, the “float”, can be profitably invested while the company holds it. So if an insurer has positive investment returns greater than the loss from the combined ratio, it can still be profitable. To wit, an insurance company can be poor at underwriting and make up losses through good investing. A low combined ratio along with high investment returns (good use of float) is what makes a great insurer. Warren Buffett explains float well in his 2005 Chairman’s Letter in the Berkshire Hathaway annual report:
“Float” is money that doesn’t belong to us but that we temporarily hold. Most of our float arises because (1) premiums are paid upfront though the service we provide – insurance protection – is delivered over a period that usually covers a year and; (2) loss events that occur today do not always result in our immediately paying claims, because it sometimes takes many years for losses to be reported (asbestos losses would be an example), negotiated and settled.
Float is wonderful – if it doesn’t come at a high price. Its cost is determined by underwriting results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have received. When an insurer earns an underwriting profit – as has been the case at Berkshire in about half of the 39 years we have been in the insurance business – float is better than free. In such years, we are actually paid for holding other people’s money. For most insurers, however, life has been far more difficult: In aggregate, the property-casualty industry almost invariably operates at an underwriting loss. When that loss is large, float becomes expensive, sometimes devastatingly so.
Other insurance industry value drivers are: renewal rates for policy holders; the costs to acquire a new policy; and the composition/attribution of investment returns.
The second most valuable skill in reading financial statement footnotes is being able to verify/validate/examine basic accounting figures, and to catch fraud and shenanigans. This is detective work.
Some examples of why footnotes are important:
• All revenues are not equal. Some revenues are generated through cash payments, others through IOU slips call receivables which may never be paid. Footnotes discuss revenue recognition policies. Also, a company may get most of its revenues from 2-3 buyers, and this is a dangerous and unhealthy relationship (I know because one of my early, bad investments, in 2000, was in a company which derived 80% of its revenues from 4 customers, who then faced their own difficulties and stopped buying – there’s no learning that sticks better than losing money).
• Earnings may be manipulated. A company may report high earnings but a negative operating cash flow, suggesting earnings are being gamed. Enron (formerly ENE) did that for a few years, and then came up with a complicated scheme to create fake operating cash flows. Footnotes explain why reported positive earnings differ from reported negative cash flows.
• A healthy company could go bankrupt due to debt. The debt maturity wall of a healthy, levered business may signal an impending default, severely hurting unsuspecting equity holders (a healthy business may be poorly financed). In the 2008-2009 credit crunch, General Growth Properties (GGP) was a healthy mall company that had a bad financial structure, leading it into technical default. Footnotes explain the cost and timeframe for maturing debt.
This letter will look at pairs of companies in three industries: credit cards, airlines, and cable/satellite TV to further delve into the importance of value drivers and footnotes. The point isn’t to illuminate any industry in particular, but more generally to suggest how one should think about a company’s value drivers and footnotes within the context of its industry.
2) The Credit Card Industry – American Express and Capital One
American Express (AXP) and Capital One Financial Corp. (COF) are two of the largest stand-alone credit card companies in the US (if not the world). Their market caps as of early June 2010 are $46 billion and $17 billion, respectively. Credit card companies make money by borrowing money from capital markets to: i) make loans to cardholders at higher rates, and ii) hold an investment portfolio earning high returns.
The value drivers behind a stand-alone credit card business such as AMX aren’t horribly complicated:
• Spread Revenues: The company lends to cardholders and then charges them a high interest rate (in the 10% to 30% range) and also fees galore. Multiplying the spread by the size of the loan book generates most revenues. In the footnotes to AMX’s 2010 10-K on p. 51, it had interest-bearing liabilities of $79 billion, at an average rate cost of 2.8%. Roughly $24 billion was invested in investment securities (mostly state and muni debt, agencies, and USTs), yielding 4.3% on average (p. 53). Roughly $33 billion was loaned to cardholders, earning 11-17% (p. 49).
• Write-off Costs: The biggest loss is through written-off loans (and the probability that nonperforming loans will have to be written off). The operating expense of running and marketing a large card network is also high. A card company with good underwriting standards has write-offs that are less than its allowance for losses (its planning account set up to estimate write-offs). To see how much AMX is losing to writeoffs, compared writeoffs to its entire cardholder loans outstanding. The table on p. 60 shows this is a high (and unsustainable) 8.5%, much higher than previous experience of 3.5%. If AMX can only charge 11% for loans, and has to pay 2% for funding liabilities (see below), it has 9% left for write-offs and all operating expenses. So 8.5% just for writeoffs is too high (operating and marketing expenses are much more than 0.5%).
• Liability/Debt Funding Costs: Most credit card companies allow cardholders to keep a balance. The card companies therefore need to borrow money through bonds and the wholesale funding market, and they relend that out to cardholders who have a balance. In the footnotes to AMX’s 2010 10-K on p. 66, its short term borrowing fell from $17.7 billion in 2007 to $2.4 billion in 2009, as the funding markets shut down (AMX almost went bust trying to hustle and obtain longer-term funding, but TARP money from the US government helped ease the transition). Note that the cost of the short-term funding fell from 4%-5.15% in 2007 to 0.7%-1.50% in 2009. So AMX is getting cheaper money to borrow, but also much less of it. More importantly, AMX has $52 billion in long-term debt, with an average rate of 4.11%, plus customer deposits of $26 billion (cost not stated). The maturity wall of when debt comes due is put on a table in p. 96 in the portions of the annual report:
Securitization and other fee income make the AMX credit card business model more complex, but I won’t go into that now.
The value drivers behind Capital One (COF) are slightly more complicated, as it has three businesses: credit cards ($23 billion in reported loans), commercial banking ($30 billion in loans to real estate and middle market firms), and consumer/retail banking ($38 billion in loans). However, COF’s core credit card business is similar to AMX, as shown below:
• Spread Revenues: COF states metrics in the “Selected Financial Data” table, showing that the NIM is 5.3%, the net charge-off (writeoff) rate is 4.58%, and the return on overage assets is 0.58%. In the footnotes to COF’s 2010 10-K on p. 48, it had total deposits of $116bn and other borrowings of $12 billion. COF’s average revenue margin on its domestic credit card book (about $65 billion in loans) is about 15.5%, of which 12.8% comes from yield (the rest, presumably, being fees). The table on p. 82 lists the domestic yield as 10.3%, which is inexplicably lower. COF also holds about $39 billion is securities, from which its yield is 3.6% to 5.0% (pp. 118-119).
• Write-off Costs: COF’s net domestic charge-off (writeoff) rate of 9.7% is higher than AMX’s 8.5%. If you add the 30+ day performing delinquency rate of 5.9%, COF will have to writeoff nearly 16% of its total credit card loan book!
• Liability/Debt Funding Costs: The vast majority of COF’s liabilities are interest-bearing deposits, at nearly $116 billion. It also borrows another $12 billion from other sources (which COF admirably gives a full listing of the notes, with their coupon, par values, and maturity date (p. 133). The interest-bearing deposits have a very low cost of 2.0% (see footnote one to the footnote on page 133). This is the killer competitive advantage for COF, buried very deeply in its footnotes.
One can see that the credit card industry reduces to a few value drivers: the size of the loan book; the average interest rate yield and the average cost of funds; the net writeoff rate. Of course, the SG&A expense structure matters too. Next I turn to airlines.
3) The Airline Industry – Southwest and JetBlue
Southwest Airlines (LUV) and Jet Blue Airways (JBLU) are two of the largest discount airplane companies in the US, both known for their great service, innovative business models, and profitability (unlike most airlines, which are unprofitable and poorly run). The largest value drivers are:
• revenue passenger miles (the total number of revenue-paying passengers multiplied by the number of miles they flew);
• passenger revenue yield per revenue passenger mile (how much was made on each passenger for each mile they flew);
• fuel costs (average cost per gallon), which is the largest single cost for an airline;
• the load factor (how many revenue passenger miles were booked for the available seat miles that an airplane could fill, a higher number showing that an airline is operating efficiently and closer to “capacity”);
• and average fleet age (as older fleets need to be replaced sooner, at high cost, and are more expensive to operate).
Southwest, because it is so efficient, is the largest air carrier in the US (measured by the number of originating passengers boarded). It runs a point-to-point service instead of a typical hub-and-spoke service, and keeps costs down by having only one type of plane, a Boeing 737.
Southwest, being a very well-run company, prominently lists the value drivers on page 23 of its 2009 10-K.
JetBlue is also a very well run company, emphasizing high quality service (ranked the best in the US by JD Power for the last 5 years) and focus of running planes out of the New York metro market. JetBlue even states openly the nature of the industry on pages 4-5 of its 2009 10-K: “Airline profits are sensitive to even slight changes in fuel costs, average fare levels and passenger demand. Passenger demand and fare levels historically have been influenced by, among other things, the general state of the economy, international events, industry capacity and pricing actions taken by other airlines. The principal competitive factors in the airline industry are fares, customer service, routes served, flight schedules, types of aircraft, safety record and reputation, code-sharing relationships, capacity, in-flight entertainment systems and frequent flyer programs.” JetBlue has given both the value drivers and the competitive factors behind the value driver metrics. It offers the actual metrics on page 26.
JetBlue conveniently explains the metrics in detail:
• “Revenue passengers” represents the total number of paying passengers flown on all flight segments.
• “Revenue passenger miles” represents the number of miles flown by revenue passengers.
• “Available seat miles” represents the number of seats available for passengers multiplied by the number of miles the seats are flown.
• “Load factor” represents the percentage of aircraft seating capacity that is actually utilized (revenue passenger miles divided by available seat miles).
• “Aircraft utilization” represents the average number of block hours operated per day per aircraft for the total fleet of aircraft.
• “Average fare” represents the average one-way fare paid per flight segment by a revenue passenger.
• “Yield per passenger mile” represents the average amount one passenger pays to fly one mile.
• “Passenger revenue per available seat mile” represents passenger revenue divided by available seat miles.
• “Operating revenue per available seat mile” represents operating revenues divided by available seat miles.
• “Operating expense per available seat mile” represents operating expenses divided by available seat miles.
• “Operating expense per available seat mile, excluding fuel” represents operating expenses, less aircraft fuel, divided by available seat miles.
• “Average stage length” represents the average number of miles flown per flight.
• “Average fuel cost per gallon” represents total aircraft fuel costs, including fuel taxes and effective portion of fuel hedging, divided by the total number of fuel gallons consumed.
One final footnote about airlines is worth examining: their debt levels and fuel hedge books. First, airlines are highly levered businesses, in that their financial leverage is high, and their operating leverage (their ability to bring down their operating cost structure) is moderate to high. It’s a bad combination for the equity investor, as unexpected events could push companies into bankruptcy (the 9-11 terrorist attacks pushed the entire industry to the edge, and even with monies from Congress some companies filed for Chapter 11). Second, fuel hedges are important because they can save a company much money, or destroy much capital, based on prudent hedging or reckless speculating (the line between the two is thin) in the derivatives markets.
• Southwest, in a footnote buried on pages 38 and 54 lists its “Contractual Obligations” (more than $14 billion, split three ways between long-term debt, flight equipment obligations, and financing obligations). One great thing about Southwest is that most of its debt is long-term, with maturities from 2014 to 2039 (far better than many indebted companies).
• Southwest discusses its hedging strategy in the footnotes on pages 70-73. Their strategy: “Our current approach is to enter into hedges solely on a discretionary basis without a targeted hedge percentage of expected fuel needs in order to mitigate liquidity issues and cap fuel prices, when possible.” (p. 71) Economically, Southwest hedged between 23%-59% of its fuel needs from 2007-2009, making $77 million and $17 million in 2007 and 2009, but losing $104 million in 2008 (in comprehensive income).
• JetBlue lists on total contractual obligations of $11 billion, of which $5 billion is long-term debt or interest commitments, and $5.8 billion is in operating lease or aircraft purchase commitments. (p. 36)
• JetBlue claims it has a broad management/governance oversight structure for its fuel hedging program. It does not forswear trading, like Southwest, but rather states: “The Company utilizes financial derivative instruments, on both a short-term and a long-term basis, as a form of insurance against the potential for significant increases in fuel prices.” (p. 45) As JetBlue has done a poor job in hedging, it shows a negative position of $480 million in fuel derivatives and has given or pledged $510 million in cash and assets to its counterparties.
As you can see, the value drivers behind airlines are very different than those behind credit cards. Even analyzing liabilities is a different exercise, as credit card companies rely on short-term, ultra-cheap debt, whereas airline companies have mostly long term-debt, and commitments to purchase aircraft or rent large facilities that are expensive.
4) The Cable and Satellite TV Industry – Comcast and DirectTV
The cable and satellite industries sell a monthly subscription service. Cable companies can provide TV, internet, and telephony, whereas satellite companies usually just provide TV and internet. Comcast (CMCSK) is the largest cable company in the US, and DirecTV (DTV) is the largest satellite TV company (and arguably the biggest competitor to Comcast, at least in line with Time-Warner Cable, DISH, Cablevision, etc.). The value drivers behind these businesses are simple, and these include:
• What’s the total market size that a company can physically serve (due to load and infrastructure constraints)? What percentage is actually being served (the penetration rate)?
• What is the average monthly subscription fee or cash flow from each subscriber? What percentage of customers are subject to rate regulation (how easy is it to raise prices)?
• How much pricing power do the distribution companies have over the content/programming companies, who charge them top dollar for access to their product?
• How sticky is the business? Basically, what is the customer retention rate?
• What is the cost of acquiring a new customer, and is this less than lifetime total estimated value of a customer?
Instead of focusing on the many value drivers in the cable/satellite business, I shall focus on the debt, property and equipment, and legal footnotes. These are asset-heavy companies with mounds of debt – they also get sued often. Being debt-heavy is tax efficient, as the businesses have a steady, monopoly-like cash flow stream, so large of amounts of debt can be serviced, while the companies pay reduced taxes due to depreciation and the debt/interest payment tax shield.
Below are some key debt footnotes to look at:
• Comcast Debt Profile: Comcast has $28 billion of debt (almost as large as its tangible plant, below), with most maturing after 6 years ($22 billion) or 10 years ($12 billion). It has various sources of financing: a commercial paper program ($2.25 billion), a bank loan facility ($6.8 billion), lines/letters of credit ($6.4 billion), and subordinated debt. Comcast also has commitments to content creators in the form of programming license agreements that it must honor, and these add up to another $9 billion.
• DirecTV debt profile: With over $20.2 billion in total obligations, $9.1 billion is in long-term debt, $9.7 billion is in purchase obligations (for content), and the rest is mostly for capital and operating leases. Much of the long-term debt comes due from 2014-2016.
• Security ratings on the debt: DirecTV gets a stable, investment-grade rating of BBB-, Baa2, and BBB from S&P, Moody’s, and Fitch, for its sizable $8 billion of debt.
• Collar loan: DirecTV has a complicated equity collar and collar loan it set up in relation to a Liberty transaction (as presumably John Malone likes to protect his transaction values with collars).
Below are some key plant and equipment (P&E) footnotes:
• Comcast has a gross plant and equipment of $52 billion, charged $28 billion in depreciation (a stunning number!), and has a net P&E of $24 billion. The two biggest pieces are cable transmission equipment ($16 billion) and customer premises equipment ($20 billion).
• DirecTV’s biggest asset is their satellites, with a gross value of $3.2 billion and a net value of $2.4 billion.
Legal proceedings against or by a company are a final item that is required in all 10-Ks, something that most investors just don’t want to consider. Yet it is a legitimate risk:
• DirecTV is engaged in numerous lawsuits regarding intellectual property, early cancellation fees, and an inherited lawsuit against Liberty Media. None so far looks to be significant.
• Comcast is embroiled in antitrust cases, ERISA pension litigation, and so on. None so far looks to be significant.
The bottom line is that an analyst should examine the footnotes relevant to each industry and sub-industry. Debt levels don’t matter in the software industry (where most companies take little debt). It matters a lot in the cable/satellite industry, as large asset and debt loads are the norm.
5) Footnotes are Idiosyncratic
No footnote is the same. Despite clear, stringent rules from the SEC and FASB on how a 10-K should be organized and how detailed footnotes should be, accountants have creative control to jigger financial statements and bury key information in footnotes. The only way to get better at reading footnotes is to know the economics behind an industry and to read many footnotes. Thousands and thousands of them. Each year. Below are some further reading recommendations.
Three great books I suggest on reading between the lines and dissecting footnotes:
• H. Schilit, Financial Shenanigans
• K. Staley, The Art of Short Selling
• C. Mulford, Sustainable Free Cash Flow
Two books on understanding business models and industries:
• M. Porter, Competitive Strategy
• R. Suutari, Business Strategy and Security Analysis: The Key to Long Term Investment Profits
One great resource to consult regarding footnotes:
I also recommend Ciesielski’s “Accounting Observer,” but you need to subscribe to the (costly) service:
Your footnote loving analyst,
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