Comcast Eyes the Eisner Discount

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Buying a great franchise that generates cash -- as evidenced by the stream of free cash flow -- is considered good investing. Wal-Mart (WMT - Cramer's Take - Stockpickr), Home Depot (HD - Cramer's Take - Stockpickr) and McDonald's (MCD - Cramer's Take - Stockpickr), for example, generate surplus free cash every day in every quarter, year in and year out.

But it's not enough to invest in great franchises that generate a lot of cash. You need to take it one step further and analyze management's ability to allocate capital. In my view, a CEO's single most important function is allocating capital. Over seven to eight years, on average, a CEO will allocate all of his or her company's capital.

Numbers Don't Lie

Disney (DIS - Cramer's Take - Stockpickr) Chairman and CEO Michael Eisner, who leads one of America's great franchises, is busily lobbying shareholders to keep his job as "Allocator-in-Chief" of Disney's capital. However, if he's talking to shareholders who understand financial statements, he has a problem. Numbers are not malleable. Parse through 10 years of Disney's financial statements and the numbers tell the cold, stark truth about Eisner's capital-allocation record:

• Nominal earnings have barely budged over a 10-year span. Annual earnings have increased from about $1.1 billion to $1.3 billion. Adjusted for inflation, there has been no growth.

• The capital base was $8.3 billion 10 years ago; it now stands at about $37 billion. Despite deploying four times as much capital, Disney generates roughly the same amount of nominal earnings!

• Debt has ballooned from $2.8 billion to $13 billion in 10 years.

• Revenue growth has been paltry to nonexistent (adjusted for inflation) for many years, despite the four-fold growth in the capital base.

President John Adams said, "Facts are stubborn things." The same is true for numbers. Sophisticated investors know that a CEO can increase earnings by swelling the capital base -- e.g., taking on debt, making acquisitions, etc.

Here's an example. Assume Disney expands its capital base by issuing debt to buy a profitable $1 billion company. The only requirement of this newly acquired company is to earn more than the cost of borrowing $1 billion. If that happens, Disney's earnings will increase accordingly. It's an easy way to provide a bump to earnings, although shareholders may not appreciate the extra debt burden.

But when the incremental return on the extra capital is sub-par, it harms shareholders. For the past decade, not only has Disney's performance on incremental capital been sub-par, but the return is barely above zero.