Why do certain companies’ accounts show losses when in fact the company is doing extremely well? Let me answer that question.
The example I will use is a cable bracket broadband telephone company that provides internet telephone and TV services via cable. We call these ‘cable companies’. As they grow, cable companies spend a huge amount on capital expenditure; for example, putting cables on the ground connecting companies and houses to the network, and spending money to acquire new customers. This expense is often put through the profit and loss in one year only, while the customer retention may last for years or decades. So we have to adjust spending on capital to life for spending that is to grow the business, i.e. growth capital expenditure; and capital that is required to maintain the existing business, i.e. maintenance capital expenditure.
In the company accounts, capital expenditure is one line item, while the maintenance part of the expenditure may only be say 25% of the total capital expenditure. So if the company is growing aggressively and using most of its Free Cash Flow to grow and acquire new users, this cost of capital expenditure appears to take away the bulk of the profit. It is good to imagine the company without taking into account this money spent on growth, and if you restate the accounts in this instance you can see the companies making fantastic profit and great returns on capital.
If a company makes great returns on its capital and it can continue to invest in growth at a high rate of return, then it is best to invest all it’s Free Cash Flow in this growth. This is fantastic for the shareholders and is also very tax efficient.
To help understand this further it is helpful to share a question asked by one of my clients about a news report on Chicago Bridge and Iron (CBI):
“Given that EPS (earnings per share) is so important… What is the difference between all the EPS values in this post?! And should I even be bothered?”
￼￼￼￼￼￼￼(The link he posted contains reports on EPS and if you read it makes little sense and seems negative and confusing – hence the question)
My answer: Sometimes the Google alerts pull up websites like this one that auto- create stories using data. This is content spam. The site above, Equitiesfocus, gets the EPS (earnings per share) from databases, and in this case it is last year’s data, when CBI wrote down a failed acquisition. You can see how websites like this one just help push the price down as most investors don’t have the time or inclination to work out what is really going on. Good news for us!
The golden rule is don’t believe anything you read anywhere. Only trust the companies’ official reports, e.g. the 10k and 10Q, (SEC annual and quarterly reports respectively) and do your own research. I will explain more later.
You need to understand the business to restate the accounts and work out what I call the ‘owner’s earnings’.
A made-up example to demonstrate: CBI buys the IP of a new gas processing technology which they can immediately plug into their current clients. This costs them $1bn but they know it will make them $150m per year. CBI thinks the IP will last at least 20 years but the Generally Accepted Accounting Principles (GAAP) mean this asset has to be written down over 5 years.
The official (GAAP) profit and loss accounts for this project in the next year look like this:
- Write down of IP purchase (amortization): -$200m
- Operating profit from IP purchase: $150m
- Net Profit: -$50m
Looks bad, hey?
However, as business owners we know that something else is going on, so we calculate our restated owner’s earnings:
- Write down of IP purchase over 20 years (amortisation):-$50m
- Operating profit from IP purchase: $150m
- Owner’s earnings: $100mNow that’s better!
If the company had 1 million shares, then the EPS looks like either -$50 or $100 — an enormous difference.
To understand the EPS we need to understand the company and how the CEO works things. That is where our research work comes in. In the public markets, we have different research tools: Company reports, company presentations, earnings call transcripts, AGMs, industry press, and books that all allow us to understand really how the company works. With this information we work out the ‘owner’s earnings’.
￼￼￼￼￼￼Right, let’s look at CBI again through our owner’s earnings lens, this time using its actual reported data in this example. Our data source for this example is direct from the company using their quarterly 10Q statement.
Checking the cash flow statement in the 10Q we adjust for non-cash items like depreciation, allow some capital expenditure and make a few other non-cash adjustments to give a profit of approx. $300m for the last six months. It doesn’t matter if we get this 100% exact, but it really matters that we get it 100% right within a range, so let’s say $250m-$350m.
We can also find the number of out standard shares in this 10Q report:
“The number of shares outstanding of the registrant’s common stock as of July 18, 2016 – 103,157,837”
So we have profit of $300m divided between 103,157,837 giving an EPS (with our “owner’s earning” hat on) of $2.91 for the last six months, taking the assumption that trading is steady then we expect annual EPS of $5.81.
CBI is trading at $33.36.
$5.81 divided by $28.90 = 17.4% return. Not bad for a company that over decades has consistently grown its EPS.
But it gets better as they report in a recent news item! The good news is they are buying shares back and in fact CBI recently bought back 3.6m shares — 3% of the company! So with your share of the profit that they don’t pay out as dividends, they are reinvesting at the rate of return of 17% through the buyback. The low share price is excellent for those of us that want to hold it for the long term.
So CBI is good. Clearly, there is negative sentiment in the energy industry but it seems sensible to assume there will be a demand for energy and natural gas processing for a long period of time.
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