Negative Equity and Negative Working Capital

[Sleepwell]

Hey guys,

 

I've started noticing a couple of great companies that have negative equity (and some negative working capital) from an accounting perspective but achieve great return on assets and don't actually carry a lot of leverage (from a interest coverage and debt-EBITDA standpoint), some which come to mind are Marriott, AutoZone and TransDigm Group. All of these have achieved excellent returns on their stock prices.

 

My idea for the discussion topic is the following:

 

1) How do you approach the valuation of these companies?

2) What other great companies other than the ones I've listed have you found?

3) What are the advantages of having negative equity? What about negative working capital?

4) What are the main risks?

5) An explanation of the mechanics behind this from a financial/economics standpoint (for example I've heard Walmart as an example of a company that benefited from negative working capital, how did they get to that point?)

6) Any other relevant thoughts that come to mind on the subject

 

Thanks

[Graham Osborn]

Hey guys,

 

I've started noticing a couple of great companies that have negative equity (and some negative working capital) from an accounting perspective but achieve great return on assets and don't actually carry a lot of leverage (from a interest coverage and debt-EBITDA standpoint), some which come to mind are Marriott, AutoZone and TransDigm Group. All of these have achieved excellent returns on their stock prices.

 

My idea for the discussion topic is the following:

 

1) How do you approach the valuation of these companies?

2) What other great companies other than the ones I've listed have you found?

3) What are the advantages of having negative equity? What about negative working capital?

4) What are the main risks?

5) An explanation of the mechanics behind this from a financial/economics standpoint (for example I've heard Walmart as an example of a company that benefited from negative working capital, how did they get to that point?)

6) Any other relevant thoughts that come to mind on the subject

 

Thanks

 

It's a common misperception that you can ignore leverage if EBITDA or interest coverage are high enough.  It's like thinking a woman can be more or less pregnant depending on the dress she is wearing - it's semantic.  Leverage is a balance sheet definition, and it entails certain risks (as laid out in the indenture) even with zero-coupon bonds.

 

What is the risk?  Suppose you buy an asset for X with borrowed funds and the asset value falls to Y.  Now you have a shortfall of X-Y which may or not be be covered by the cash flows of the asset.  Worse, the repayment date may be a function of the asset value.  That's reflexivity.

 

Negative working capital certainly isn't something to brag about.  It's like have a high credit limit - it's useful in various situations, but the fact that you need it in the first place suggests certain business risks.  Walmart is a company that was borrowed to the hilt from the early days, and the fact that they could/ can operate with negative working capital is a reflection of generous credit terms with suppliers (because, historically, WMT had the stronger hand).  Does WMT carry increased risk as a result of this short-term leverage?  You bet.  Look at the Hanjin bankruptcy as a mini-example.

 

The companies you cite are highly leveraged - the appropriate measure is the D/ E (or D/ tangible book).  Don't get caught up in the "new era" definitions promulgated by central banks and the debt-laden blue chips they feed.  Someday people will look back on ZIRP as something both insane and transient.

[Poor Charlie]

This is a good discussion topic. 

 

I think it’s important to make the distinction between a business that truly doesn’t need any tangible capital and those that have negative equity due to the capital structure.

 

Take, for instance, a company like Transdigm.  TDG is basically a publicly traded LBO.  Their negative equity comes from constantly doing leveraged recaps (I believe they have a stated goal of maintaining leverage at 4x- to 6x-EBITDA).  As far as operating assets needed to run the business, there’s really nothing special about TDG: DSO = 60; DIO = 170; DPO = 40; and fixed asset turnover = 10.  Of course, what TDG lacks in capital efficiency they make up for with +50% operating margins.  But the fact still stands that they need to make investments in both working capital and fixed assets to operate the business. 

 

A business like Amazon’s retail operation, on the other hand, is a true negative equity business.  If you go back and look at AMZN’s financials when they were just retail (pre AWS – I’m using YE 2007 #s), it took negative $1.1b in tangible capital to generate almost $15b in sales.  Said differently, AMZN generated 7 cents in cash (1.1/15=.073) per dollar of sales at zero margin.  They were able to do this by efficiently managing assets (DIO = 38, FA Turnover = 27x) as well as delaying payment of liabilities (DPO = 89).

 

One more thing: negative invested capital really only comes into play if the business is growing.  If the business is flat-lining, all earnings dollars are created equal (I’d actually argue that an equivalent amount of earnings is worth more from the capital heavy business because cash can almost always be extracted from a bloated balance sheet – e.g., Dempster Mill).  And if the business is declining, earnings dollars from a capital heavy business are way more valuable than earnings dollars from a negative capital business (a negative capital business consumes cash as it shrinks – e.g., Ambassadors Group or the newspaper industry).  But if the business is negative capital and growing, you can grow as fast as the market will allow and still be awash in cash.  This is the business you buy and hold on to with both hands. 

 

[scorpioncapital]

Negative equity may be caused by amortizing or writing off an asset but not the liability. Or borrowing against an intangible asset with strong cash-flows. Like Graham said, many of these cases are highly leveraged scenarios on account of the credit of a strong cash-flow franchise. In an acquisition, you might have a large goodwill element against debt - like an LBO - but while this will show as positive equity, if the value of those cash-flows diminish, it's really negative equity. Many of these situations will be especially sensitive to changes and growth rates of cash-flows. There's nothing else to go on. Reminds me of negative interest rates. Using the entire business as a credit card. Not sure what is to be achieved by such high leverage. A zero equity is dicey enough and as the years go on, even a zero equity business will turn positive from retained earnings unless they are distributed. The faith in the cash-flows is really acute. You have to have a stellar situation and even then I think in a real global stress, these businesses are going to be more fragile than one with real assets that can be used for something - even if that something is selling firewood to keep the lights on.

[Sleepwell]

Thanks for all the comments guys, very interesting topic.

 

I also thought I'd share a post from John Huber's Base Hit Investing site which talks about capital light businesses and negative working capital as an advantage:

 

http://basehitinvesting.com/reinvestment-moat-follow-up-capital-light-compounders/

[Graham Osborn]

This is a good discussion topic. 

 

I think it’s important to make the distinction between a business that truly doesn’t need any tangible capital and those that have negative equity due to the capital structure.

 

Take, for instance, a company like Transdigm.  TDG is basically a publicly traded LBO.  Their negative equity comes from constantly doing leveraged recaps (I believe they have a stated goal of maintaining leverage at 4x- to 6x-EBITDA).  As far as operating assets needed to run the business, there’s really nothing special about TDG: DSO = 60; DIO = 170; DPO = 40; and fixed asset turnover = 10.  Of course, what TDG lacks in capital efficiency they make up for with +50% operating margins.  But the fact still stands that they need to make investments in both working capital and fixed assets to operate the business. 

 

A business like Amazon’s retail operation, on the other hand, is a true negative equity business.  If you go back and look at AMZN’s financials when they were just retail (pre AWS – I’m using YE 2007 #s), it took negative $1.1b in tangible capital to generate almost $15b in sales.  Said differently, AMZN generated 7 cents in cash (1.1/15=.073) per dollar of sales at zero margin.  They were able to do this by efficiently managing assets (DIO = 38, FA Turnover = 27x) as well as delaying payment of liabilities (DPO = 89).

 

One more thing: negative invested capital really only comes into play if the business is growing.  If the business is flat-lining, all earnings dollars are created equal (I’d actually argue that an equivalent amount of earnings is worth more from the capital heavy business because cash can almost always be extracted from a bloated balance sheet – e.g., Dempster Mill).  And if the business is declining, earnings dollars from a capital heavy business are way more valuable than earnings dollars from a negative capital business (a negative capital business consumes cash as it shrinks – e.g., Ambassadors Group or the newspaper industry).  But if the business is negative capital and growing, you can grow as fast as the market will allow and still be awash in cash.  This is the business you buy and hold on to with both hands.

 

Nice post, however I do find your comments on AMZN (as opposed to WMT) a bit confusing.  You seem to be arguing there is some kind of fundamental distinction between the 2 businesses which justifies a different capitalization.  ROA is where the money is, and WMT's is about double AMZN's.  WMT has a higher ROIC as well.  Of course, you can argue that part of AMZN's return is "intangible," e.g. wider moat/ market dominance/ whatever.  AMZN's valuation is based on its presumed ability to be a good business with stable returns (like WMT currently) in the future, not on some sort of redefinition of the valuation standards for a retail operation (IMO).  One you abandon the idea that the value of a business is what it could be liquidated for in cash at *some* point in the future, I think the process of valuation gets a bit dicey.

[Poor Charlie]

This is a good discussion topic. 

 

I think it’s important to make the distinction between a business that truly doesn’t need any tangible capital and those that have negative equity due to the capital structure.

 

Take, for instance, a company like Transdigm.  TDG is basically a publicly traded LBO.  Their negative equity comes from constantly doing leveraged recaps (I believe they have a stated goal of maintaining leverage at 4x- to 6x-EBITDA).  As far as operating assets needed to run the business, there’s really nothing special about TDG: DSO = 60; DIO = 170; DPO = 40; and fixed asset turnover = 10.  Of course, what TDG lacks in capital efficiency they make up for with +50% operating margins.  But the fact still stands that they need to make investments in both working capital and fixed assets to operate the business. 

 

A business like Amazon’s retail operation, on the other hand, is a true negative equity business.  If you go back and look at AMZN’s financials when they were just retail (pre AWS – I’m using YE 2007 #s), it took negative $1.1b in tangible capital to generate almost $15b in sales.  Said differently, AMZN generated 7 cents in cash (1.1/15=.073) per dollar of sales at zero margin.  They were able to do this by efficiently managing assets (DIO = 38, FA Turnover = 27x) as well as delaying payment of liabilities (DPO = 89).

 

One more thing: negative invested capital really only comes into play if the business is growing.  If the business is flat-lining, all earnings dollars are created equal (I’d actually argue that an equivalent amount of earnings is worth more from the capital heavy business because cash can almost always be extracted from a bloated balance sheet – e.g., Dempster Mill).  And if the business is declining, earnings dollars from a capital heavy business are way more valuable than earnings dollars from a negative capital business (a negative capital business consumes cash as it shrinks – e.g., Ambassadors Group or the newspaper industry).  But if the business is negative capital and growing, you can grow as fast as the market will allow and still be awash in cash.  This is the business you buy and hold on to with both hands.

 

Nice post, however I do find your comments on AMZN (as opposed to WMT) a bit confusing.  You seem to be arguing there is some kind of fundamental distinction between the 2 businesses which justifies a different capitalization.  ROA is where the money is, and WMT's is about double AMZN's.  WMT has a higher ROIC as well.  Of course, you can argue that part of AMZN's return is "intangible," e.g. wider moat/ market dominance/ whatever.  AMZN's valuation is based on its presumed ability to be a good business with stable returns (like WMT currently) in the future, not on some sort of redefinition of the valuation standards for a retail operation (IMO).  One you abandon the idea that the value of a business is what it could be liquidated for in cash at *some* point in the future, I think the process of valuation gets a bit dicey.

 

The distinction I was trying to make was between the two most common reasons a company would operate with negative equity on the b/s (i.e., more liabilities than assets):

 

[*]They are highly leveraged due to the sponsors extracting cash via cash-outs (dividends/recaps/sale to a leveraged buyer) or buybacks.

[*]They are able to manage their capital so efficiently that the operating assets needed to produce the goods and services they sell are less than the liabilities they owe to their trade creditors (and to some lesser extent employees – accrued expenses – and customers – deferred revenues). 

 

I then went on to say that businesses in the second category can be amazing performers (Operationally.  Not necessarily from an investment standpoint) because they are not constrained by their funding sources: A business can only grow internally as fast as their ROE allows them (growth = ROE * retention rate).  If you earn infinite ROEs (no or negative invested capital), your growth rate is constrained instead only by the rate the market will allow you to grow at.  Kind of like having a car that’s limited only by the length of the road and not the speedometer. 

 

As for AMZN vs WMT?  In my post I don’t think I was really making any distinction between the two.  I do think there is a very interesting lesson to be learned by making a distinction though. 

 

Consider this-

 

Take a look at Wal-Mat during their earlier years as a public company (70s/80s – the financials are on their website).  WMT was a monster.  They had almost limitless ways to productively deploy capital and were growing by something like 30% (going off memory?).  However, their growth was still constrained by some finite ROIC.  In fact, because their ROE was below their growth rate they had to go outside for capital a bunch of times: on b/s sheet leverage was something like ¼ of capital and they did a number of equity raises.  They also used a ton of leases that didn’t show up on the b/s sheet but are (to me) clearly a funding source.  Anecdotally, to show just how capital constrained their growth was consider that Sam Walton’s daughter (paraphrasing from the autobiography) told her elementary school class that the thing that terrified her most in life was the debt her family was taking on to fund the business (apparently this was what the dinner table conversation revolved around).

 

Amazon (focusing on the retail business) is different.  Their ability to efficiently manage assets (DIO = 40-something and fixed asset turnover = 20-something) and stretch out non-interest bearing, revolving liabilities (AP, accrued and deferred revenues) enables them to operate without any tangible capital.  If they don’t need any capital to run the business then, by definition, they produce infinite ROEs (if you exclude cash, that is indeed the case).  And if they produce infinite ROEs then they can self-fund as much growth as they want to take on.  This is most evident in AMZN’s ability to grow at 30% and still produce tons of cash.  Some of this cash does of course come from the crazy option issuances and operating leases (similar to WMT in the 70s), but they still produce an insane amount of cash for an unprofitable (GAAP-basis) company that is growing at such a fast clip.  (BTW I don’t own AMZN; just think it’s an interesting case study when compared to WMT.)

 

 

 

One more thing: you mention “ROA is where the money is.”  I would say ROIC is where the money is.  Focusing on ROA and not ROIC (FCF / (Working Capital + Fixed Assets – cash not needed to run the business)) means that your operating liabilities don’t matter.  Cheap, durable, revolving liabilities are what Buffett built his career on.  They’re also the only reason most businesses earn a return high enough to justify their existence (ROE > treasuries). 

 

Consider this passage from Buffett:

 

Any company's level of profitability is determined by three items:  (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of "leverage" that is, the degree to which its assets are funded by liabilities rather than by equity.  Over the years, we have done well on Point 1, having produced high returns on our assets.  But we have also benefitted greatly to a degree that is not generally well-understood because our liabilities have cost us very little.  An important reason for this low cost is that we have obtained float on very advantageous terms. 

 

[Graham Osborn]

I'm not sure either of us is trying to make a specific point, but just a few comments on the above:

 

1.  WMT was indeed capital constrained early in its growth, not because of anything special about its capital structure but rather that it was a small business unfamiliar to Wall Street banks and hence Walton was trying to cross-finance off regional banks which was a source of significant personal anguish.  After the IPO so far as I know financing was less of an issue.

 

2.  Using ROE to measure a business's ability to grow using existing capital (except perhaps for businesses like GOOGL with very little debt or goodwill/ intangibles) seems a bit naive.  Give me any business in any industry and I can give you a capitalization such that ROE is infinite.  That's why Mike Burry called ROE "deceptive and dangerous" except in very special cases.

 

3.  I think you may be glorifying AMZN as a retailer a bit over-much.  It may be true that a company that can conduct a large volume of business with little capital can generate fabulous returns (like currency traders), but leverage cuts both ways.  People always forget that until a little competition comes along, the economy tanks a little, or whatever.  Until AMZN starts converting their revenues into cash, which they are doing much more poorly than a GOOGL for example (except maybe AWS), they are worth far less than the 2000 and current valuations would suggest IMO.

[Poor Charlie]

1.  WMT was indeed capital constrained early in its growth, not because of anything special about its capital structure but rather that it was a small business unfamiliar to Wall Street banks and hence Walton was trying to cross-finance off regional banks which was a source of significant personal anguish.  After the IPO so far as I know financing was less of an issue.

My point on WMT being unable to fund 30% growth had absolutely nothing to do with if funding came from a regional bank or BB.  My whole point was that their finite (20%-something) ROEs were insufficient to provide the internal funding engine (growth = ROE * retention rate), and so they HAD to go get outside capital to grow at 30%.  Whether it was Shylock or Goldman Sachs makes no difference at all.  (Please note - the reason for the WMT/AMZN comparison I made was to demonstrate the merits of a negative capital business that is growing.  Talking about funding sources was just a way of making my point.)

 

2.  Using ROE to measure a business's ability to grow using existing capital (except perhaps for businesses like GOOGL with very little debt or goodwill/ intangibles) seems a bit naive. 

Using ROE as one of the factors that limits growth (the other being retention rate) is not some random idea I cooked up – it’s a fact of capitalism (please look it up).  Businesses can only grow as fast as their ROE will let them (before they are forced to go to the capital markets).  Once again: Growth Rate = Return on Equity X Retention Rate.

 

Until AMZN starts converting their revenues into cash, which they are doing much more poorly than a GOOGL for example (except maybe AWS), they are worth far less than the 2000 and current valuations would suggest IMO.

What matters is the ability to convert net income into free cash flow.  Only looking at cash flows as a % of revenues would dismiss all the high return businesses that generate their economics from the 'high-turn, low-margin' model. (BTW I'm not talking about the investment merits of AMZN.  I would never pay those prices for any business)

 

I'd like to think we're just talking past each other, but I'm leaning more towards either you're not reading my posts correctly or you don't understand some of things I'm talking about.