3 ways companies bury their debt

One company that boosts its ROA this way is drugstore chain Walgreen (WAG, news, msgs). Divide fiscal 2007 earnings of $2 billion by reported assets of $19.3 billion and Walgreen has an ROA of 10.5%. By this measure, Walgreen looks superior to competitor Wal-Mart Stores (WMT, news, msgs), which has an ROA of just 8.7%.

Walgreen's "better" performance seems to make sense. The company gets 65% of its revenue from prescription drugs -- sales of which are growing rapidly. Walgreen filled about 583 million prescriptions in its fiscal 2007, 10% more than the previous year. With 6,000 stores, it has a vast reach; about 139 million people in the country live within two miles of a Walgreen store.

But Walgreen trumps Wal-Mart on ROA merely because of leases. Trainer calculates Walgreen has $21 billion worth of off-balance-sheet debt in the form of store leases. Add that amount to its asset base when calculating ROA, and Walgreen's number drops to 5%, well below that of Wal-Mart.

Wal-Mart has some off-balance-sheet debt as well, but not enough to bring its ROA down so dramatically. By Trainer's calculations, Wal-Mart has off-balance-sheet debt worth only 4% of its market value, or capitalization, compared with 58% at Walgreen.

Walgreen says a better way to measure performance is to look at return on invested capital (ROIC), which you get by dividing earnings by an estimate of how much money has really been invested in the business -- including a share for the leases. Walgreen has an ROIC of 10.5%, which is decent for a retailer.

Leases hide debt risks

Keeping leases out of sight can also fool investors about the amount of risk in a stock, says accounting expert Charles Mulford. He's the director of the Financial Analysis Lab at Georgia Institute of Technology's College of Management.

Companies with higher debt tend to have more-volatile stocks. More of their costs are fixed, so if business slows down, they have less freedom to trim costs, says Mulford, a co-author of a great book on deciphering accounting tricks called "Created Cash Flow Reporting: Uncovering Sustainable Financial Performance." Those companies are also considered riskier because they'll have to make interest payments even when profits slow down.

Off-balance-sheet leases hide that risk. To see how, let's look at Walgreen competitor CVS Caremark (CVS, news, msgs).

On the surface, it looks like Caremark has a comfy debt-to-equity ratio of 31%, if you weigh its $9.9 billion in debt as a percentage of shareholder equity, $31.8 billion. But add in Trainer’s estimated $17 billion in leases, and Caremark’s debt-to-equity ratio moves up to 85%.

"We strongly disagree with your inference that CVS Caremark's financial condition is at all risky," responds finance chief Dave Rickard. "We have enormous free cash flow -- $2 billion in 2007 and a projected $3 billion in 2008." CVS also has solid credit ratings, he adds.

Rickard says his company is constrained by accounting rules to leave leases off the balance sheet and report them in footnotes.

"You appear to be under the misperception that it is a choice," he says. "Your premise may be a popular theme among the financially unsophisticated, but for anyone who understands financial statements, it is just plain wrong."

And Walgreen? Its debt-to-equity ratio jumps to 200% from an innocent looking 12% when you add Trainer’s estimate of $21.6 billion in lease obligations to its reported $1.4 billion in debt.

Walgreen responds that it has a high credit rating of A+ from Standard & Poor's and that some analysts think it should take on more debt to fund further growth.

More expensive than it looks

Keeping leases off the books can also make a stock look cheaper than it really is.

A common way to value companies is to look at enterprise value -- market capitalization plus debt -- compared with cash flow. To calculate this ratio, analysts use a proxy for cash flow called earnings before interest, tax, depreciation and amortization expenses (EBITDA).

When a company moves a lot of its debt off the balance sheet, it lowers enterprise value, or EV. This reduces the EV/EBITDA value measure, making a stock look cheaper -- and thus more attractive.

Let's look at an example: On the surface, it looks like Walgreen has a value of $36.6 billion -- a market cap of $35.2 billion plus $1.4 billion in reported debt. With cash flow of $3.2 billion, it appears to have an EV/EBITDA ratio of 11.4, reasonable for a big retailer. Add the $21.6 billion in leases to the debt mix and the EV/EBITDA valuation measure goes up to 18, which looks expensive for a retailer.

Hidden employee options

Because of new accounting rules, companies now have to account for a portion of the employee options they issue each year. But balance sheets don't include a clear picture of the total cost of all the employee options a company has ever issued, Trainer says. That's buried in a table deep inside filings.

This number matters a lot to shareholders. When employees exercise options, companies have to either cut into profits to buy back stock or issue more shares so they can pass them to the employees. Either way, existing shareholders lose.

"We have been indoctrinated to think that all stock buybacks are good, with no distinction made between buybacks that shrink the share count and those that merely offset the dilution created by stock options," says Albert Meyer, a money manager at Bastiat Capital. Meyer manages the Mirzam Capital Appreciation Fund (MIRZX), up 7.8% since its August launch, compared with a decline of 7.9% for the S&P 500.

Meyer says he gets those outsized returns in part by carefully avoiding companies that have issued so many stock options that they will have to divert too much future cash flow away from shareholders.

Here are some of the bigger offenders in this department, according to Trainer's research:

Cisco Systems (CSCO, news, msgs) had $8.6 billion worth of outstanding employee stock options at the end of its fiscal 2007 last summer (the most recent data available). That's enough to eat up 10% of Cisco's $10 billion in annual cash flow from operations for the next eight years, money that could otherwise be used to invest in growth or support dividends.

"Cisco views stock options as an important tool for employee attraction and retention," company spokeswoman Heather Dickinson says. Cisco also says Trainer's estimated options costs are based on out-of-date information.

Trainer used data from Cisco's 10-K released last summer; he says today's wouldn't be substantially different.

Cisco also questions assumptions used by Trainer but has declined to provide an options estimate of its own. Trainer says he uses assumptions drawn from company financials.

Hewlett-Packard (HPQ, news, msgs) had $6.5 billion worth of options outstanding as of October, the end of its most recent fiscal year, or 67% of last year's $9.6 billion in cash from operations. The company declined to comment.

Procter & Gamble (PG, news, msgs) had $6 billion outstanding last June, at the end of its most recent fiscal year, or 45% of its $13.4 billion in cash from operations. The company says it plans to buy back $8 billion to $10 billion in stock a year for the next three years and that the buybacks will more than offset any earnings dilution from options.

Procter & Gamble did not respond to requests for comment.

At the time of publication, Michael Brush did not own or control shares of any of the companies mentioned in this column.

< previous |  1 | 2 |