Balance Sheets 101: Who Made the Grade

Freeport-McMoRan Passed

Recently, I discussed the impact of commodity prices on corporate earnings. One of the companies I focused on was Freeport-McMoRan Copper & Gold (FCX). In November 2006, Freeport-McMoRan announced that it was going to acquire Phelps Dodge in a cash and stock deal, whereby Freeport-McMoRan would have to borrow around $7.5 billion to complete the deal. From December 2006 to June 2007, Freeport-McMoRan's long-term debt exploded from about $1 billion to $9.6 billion.

When Freeport-McMoRan reported its latest quarterly earnings last week, the company's debt had shrunk to $7.4 billion. How? The new combined company has been using the cash it generates to support its mining operations, repay debt, pay dividends and repurchase stock. Freeport-McMoRan estimated that after paying dividends to common and preferred shareholders that it would have from $3 billion to $4 billion in annual cash flow for investments, debt reduction and share buybacks.

Simply put, Freeport-McMoRan was able to opportunistically use cost savings from its merger and increased cash flow from operations to pay down the debt from the Phelps Doge acquisition. While $7.4 billion is still a hefty amount of debt, Freeport-McMoRan is clearly paring down that debt, while still running a successful mining business. I expect this debt reduction to continue over the next few years.

Freeport-McMoRan's Balance Sheet Grade: B- (and improving).

Best Buy Passed, While Macy's Barley Passed

In retail there are three important components to success. First, sales margins, which are the percentage of sales that a company earns after its cost of goods. Next, same store sales, which quantify the sales increase at stores from one year to another (for stores open at least 13 months). Finally, organic growth, which comes from expansion based on opening of new stores.

Retailers seeking to open new stores do so through two sources: the cash that they generate from their current stores or borrowed cash. Furthermore, retailers carry large amounts of inventory, particularly for the busy winter holiday shopping season. This is typically financed through short-term borrowing, with the hope that inventory sales will pay off the borrowed money, thus earning the company their sales margins. Whether it is new store expansion or inventory control, retailers with strong balance sheets will outperform relative to chains with weaker ones.

Let's look at two retailers.