Ratios for evaluating turnarounds

On not inventing a new ratio If you like a good car crash, you must read Neomonic's post on the lessons he learned from a bum trade in Game, the video game retailer that seems poised on the edge of administration. He may have changed how I evaluate turnarounds.Neomonic's Game experience has convinced him to switch from comparing the value of equity to the value of total assets in judging whether a company is financially strong, to comparing tangible equity to total assets. The difference is intangibles, most often goodwill, and, as Neomonic says, the value of goodwill is not reliable if, for example, the company needs to raise cash. Goodwill is the historical cost of acquiring businesses above the value of the physical assets acquired and if the company paid too much, and has subsequently failed to earn a satisfactory return from its investment, it's unlikely to be able to sell it for much. For turnarounds and deeply cyclical stocks, I made the decision to use tangible book value as my benchmark for value some time ago, for the same reason. You can't really count on the intangibles. It makes particular sense for turnarounds because they often over-invest in good times and then write off substantial chunks of that investment when things go sour. Counting the goodwill would be optimistic at best. But I still use the ratio of total equity to total assets to gauge financial strength, which is incongruous, and equally optimistic. And from that observation stems a third, embarrassingly obvious notion. That in judging the company's earning power, I should use return on tangible equity. The idea of ROTE was so new to me (though thinking about it, it's a bit like Greenblatt's definition of return on capital), I had to Google it just to check it exists. It does. And it may explain why 'bargain' companies selling at prices below tangible book value look so bad in terms of earning power. One reason is of course they're not earning much, but another reason could be that by using equity in the denominator of the profitability calculation we're including all sorts of crud (a technical term for goodwill) that won't actually contribute to future earnings.

Comments

Richard, an interesting evolution of the logic that I need to have a long think about!

Some initial thoughts / questions:

- I do like this idea. How would it apply to businesses like pharma which tend to have negative tangible equity. Will you simply not invest?

- are you also removing intangibles from the calculation?

- doesn't this mean the resulting ROTE will be higher? Depending on how you use ROE in the earnings power this will mean you'll have to revise the multiples used or you could overestimate it. Is that your pllan?

- you might also end up favouring asset heavy businesses, like printers, house builders, telecoms rather than 'clever' businesses with lots of IP. Is that right?

Certainly food for thought!

-

Hi Neo, thanks for giving me a chance to explain myself!

The first thing to say is I only apply PTBV and therefore will only be trying out TE/TA (tangible equity/total assets) and ROTE (return on total equity) to turnarounds so if the company in question is what I call a stalwart, a company with a consistent record of profitability, then by default I'll will apply different metrics (typically 10y earnings yield for valuation, return on equity for profitability, equity to assets for financial strength).

So to answer your question about companies in negative equity, yes I'd probably avoid them if they are turnarounds (kept me out of HMV, not a bad thing!) but it doesn't matter for stalwarts because there I'm interested in earning power (and reckon the past is probably indicative of the future).

Yes ROTE is return on tangible equity so intangibles are removed. This would make ROTE higher than ROE but that fits the type of company I'm looking at. What we're effectively saying is the company is a turnaround. The intangibles are evidence of wasted investment in the past. We can't count on them having any value so the operating business does not depend on them in the future and we can ignore them in assessing profitability.

I would add though that profitability is less of a consideration for these companies. The resulting ROTE ratio shows potential. There's not much certainty. The case for adding the shares rests primarily on their cheapness and their financial strength.

Finally yes, it will favour companies with tangible assets, but as I said, I look for other kinds of companies in other ways.

Having read Neonomic's post - the first thing that struck me was being tempted by a net profit margin of 3.5%. That's very skinny, especially for a retailer. One of the big things that I've taken from my reading on Buffett is that high gross profit and operating margins are very important in judging a company's safety margin - high margins provide some protection against operational difficulties which all companies run into from time to time, be it a recession or a self inflicted mistake. Pocketing £3.50 for every £100 of sales would leave little cover when things turn sour. And I'd say the same at 5%.

When I look at balance sheets I like to calculate the the ROCE. And if everything is stacking up and looking attractive I do more work on the balance sheet which generally is made up of four components:

- Intangibles (quite often the goodwill on acquisitions, but I'm very wary of companies growing by acquisition, so don't pay too much attention to this as a number, preferring to trawl through the narratives in earlier accounts to try and understand whether the limited acquisitions have been generally positive);
- Fixed assets (I'll come back to this)
- Working capital (again I don't pay a great deal of attention to this other than checking that it looks "right" for the company. I take the view that working capital is just the journey of converting the company's trade into cash); and
- borrowings (normally on the balance sheet as the means of funding the intangibles, so most companies I'm interested in won't have much in the way of borrowings.

Anyway, I like looking at the company's return on its fixed assets as an interesting metric. It's a cost that only finds it's way into the P&L in a deferred fashion (depreciation) and taken with the GP and operating profit margins tells you a lot about how good the business is.

But I think it's an approach that probably works only with companies that largely grow organically. If there's a lot of debt and intangibles - you'd be ignoring a lot of the companies history and more importantly it's debt exposure.

I better give an example - another beaten up retailer (Topps Tiles), suffering because of the recession. Currently, it's fixed assets (mostly outlet and warehouses) are c£37m. It's operating profits are £18m - but that equates to 10% of sales. It's operating profit margin before the credit squeeze was over 20% (those fixed assets were really doing the job). So, the company had a big safety margin going into the recession which is holding it up now. Yes, there's lots of bet on the balance sheet, but it's not there because of operational reasons but because it thought it could improve earnings by a having a more "efficient' balance sheet - and borrowed to finance a large distribution and buy back.

And yes Richard - it's got operating lease exposure.

Anyway, apologies for the long post - but I really think it's worthwhile digging into the balance sheet components to understand how the "return" figures breakdown; and I really think it's worth thinking very hard about investing in something with an operating profit margin shy of 10%.

I largely agree with your appraoch (earnings or tangible assets), but I am not sure my reasoning is the same.

Firstly, I think goodwill and other intangible assets are very different, but I would usually be inclined to strip both out.

This is an argument I have been repeating regularly with lot of people for at least 15 years: goodwill should ALWAYS be stripped out. It reflects the history of a company, not its current position.

The exception is when you are analyzing the effectiveness of management including how good its takeovers have been: so you may want to retain goodwill in a ROIC, for example.

Other intangibles suffer from the same problem, or are uncertain, so they should not be in most ratios, BUT they often either generate sales directly or errect barriers to entry. Both those are covered elsewhere in your process, so excluding them from financial strength ratios for turnarounds is fine.

Let me put my point about goodwill another way. It is a balancing figure to make double entry bookkeeping work for acquisitions. It is the difference between net assets per share and the share price at the point of acquisition. Market cap minus NAV.

Is there any reason why the past share price of what is now a part of (or subsidiary of) the company should affect its NAV from our point of view?

Hi Trident, please don't apologise for leaving a long comment!

I'm not sure whether you think Topp's operating margins give the business an adequate margin of safety now (given they're at the bottom end of your range and they have already halved).

Clearly profitability is a factor in a company's financial strength, but I don't think it's enough. Profitability can just evaporate, as it will have done in many turnaround situations, so when the first line of defence is breached you need to look at the assets and liabilities. Can it finance itself if profitability collapses again?

I'd be concerned about Topp's second line of defence, which could become the first line, and if as you say it has a lot of debt and operating lease commitments, I think I'd be concerned.

Thanks for your comment Graeme, and for making me think about other intangibles!

That's very well put.

You say that Goodwill is is the difference between the net assets of a company and the price of acquisition. Is that the tangible net assets of the company or does it include intangibles? I must admit I've always assumed the former.

If it's the latter, the net assets of the company being acquired could include goodwill we can't strip out from the company that acquired it, when we calculate tangible equity or assets.

I hope that makes sense!

In fact, when you put it that way including goodwill in numbers used to value the company (like book value) breaks a cardinal rule of value investing - which is not to use price as a factor in determining value.

Hi Trident, pleased you read the post.

I did raise the net profit (after tax) hurdle to 5% after this experience. I agree with you and am currently considering raising it a little more.

Hi Richard
just on your question about whether I think Topps' operating margins are adequate now at 10%. I think the answer is a qualified yes.

I think their business model is sound but that it is a cyclical play, as a retailer exposed to the housing market. The state of the economy is, in my view, the biggest risk to an investor in the company, and as we're at, or I would think near the bottom, and the company can still generate a 10% turn on sales then it would suggest they can weather the storm and benefit from any upturn. But it's a qualified yes - because things could stay bad for some time. The share price though looks too expensive for my taste.

I chose Topps as my example because bad stuff has happened to the company which I think it's managed to survive because of it's high gross and operating profit margins.

(And all retailers have high operating lease exposures).

Thanks Trident.

I don't know Topps but from your descriptions operating margins are now at the bottom of your comfort zone while the investment case is predicated on the economy not getting much worse.

Naturally I ask what if it does get worse?! But I think we're saying the same thing because you think the price is high, presumably too high to compensate for the risk.

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