Balance Sheets 101: Who Made the Grade
When you're deciding whether or not to invest in a specific company, having a firm understanding of the balance sheet is critical. So as another round of earnings has been announced, now is a perfect time to look back at recent quarterly reports and identify companies that passed "balance sheets 101" and those that might be in trouble.
Winnebago Passed -- Barely
When it comes to earnings and balance sheets, inventory levels matter.
Going into Winnebago's (WGO) most recent conference call, I was expecting to hear a lot of the typical current talk about how high energy prices, the slowing economy and systemic credit issues are negatively impacting the company's core recreational vehicle business. However, as I prepared for the call, I noted that while analysts are expecting a minor drop in EPS , actual sales are expected to take a dramatic decline.The only way that Winnebago could possibly achieve this is trick was through cost control, accounting mechanics or tax benefits. Those are all matters which would we would ascertain from the income statement. However, there was much more to be concerned about with Winnebago. Winnebago's "channel inventories" and "company inventories" are high. Channel inventories are products sold by the company to retail vendors, but remain unsold by those vendors. So what? As investors, we care about this metric because high channel inventories will decrease vendor orders from Winnebago as there is less of a need to replenish inventory. Company inventories were also high. This means that Winnebago over-produced inventory which the company could not sell to its retail distributors. Either of these inventory metrics portends trouble. Taken together, as in Winnebago's case, this combination of high inventory levels could cause a disaster in future quarters. There were more red flags on Winnebago balance sheet. At the end of the quarter, the company held $54.2 million of investments in highly rated tax-exempt auction rate securities (ARS). These were recorded as "long-term" investments, whereas, prior to that, they were recorded as "short-term" investments. What happened: during the quarter, the company was able to sell 10% of the investment portfolio, but by the time the quarter ended, almost every remaining holding experienced a full or partial "auction failure." The remaining maturities now range in duration from 16 years to 33 years. Why is the turning of short-term assets into long term investments problematic? Winnebago had relied on the liquid nature of the auction rate securities, but it can no longer do so. Winnebago's Balance Sheet Grade: D. Merrill Lynch Passed (and Is Improving) Merrill Lynch (MER) has a huge portfolio of asset-backed securities on its balance sheet -- the pricing of which has come under a great deal of scrutiny. Merrill has been "writing down" its mortgage and credit portfolios for the last two quarters as the company seeks to price its balance sheet to market. As a result, Merrill's balance sheet, capital position, credit worthiness and liquidity were subject to great deal of speculation. Merrill, which reported on April 17, was expected to write down its assets for a third straight quarter, this time for an additional $6 billion or so. Fears across Wall Street were that Merrill or Lehman Brothers (LEH) would suffer the same fate at Bear Stearns (BSC), which was brought to the brink of bankruptcy when it faced a severe liquidity crisis, despite statements to the contrary by company president Alan Schwartz. As expected, when Merrill reported its quarterly results to investors, the company wrote down another $6.6 billion in writedowns. While that was not pleasant news to shareholders, Merrill did deliver some other balance sheet related information that clearly differentiated that company's liquidity profile from that of Bear Stearns:
Delta-Northwest and XM-Sirius: Incomplete Can two weak balance sheets make one solid balance sheet? Sirius Satellite Radio (SIRI) and XM Satellite Radio (XMSR) are currently at the altar waiting for regulatory approval to consummate their merger. This week, Delta Air Lines (DAL) and Northwest Airlines (NWA) announced their engagement. Do these deals make sense from a balance sheet perspective? Consider this: all four companies have debt-riddled balance sheets. For the most part, these companies have not been very proficient at generating cash flow , except when the source of that cash flow is issuing more debt. The satellite radio business has yet to generate consistent profits and the long term survival of the business model is still questioned by many investors and analysts. And the airline industry is experiencing another wave of bankruptcies (three airlines filed for bankruptcy in the last month). The motivation to merge these companies comes from the potential ability to generate profits (or fewer losses) and cash flow from operational efficiency. Theoretically, if this occurs the resulting financial condition may permit the bond ratings agencies to upgrade the combined companies' credit ratings that would result in a lower cost of debt. Other than that, there is no benefit from a balance sheet perspective which would compel me to buy these companies pre- or post-merger. Cumulative Balance Sheet Grade: Incomplete.
General Electric Passed With Flying Colors
Sometimes bad earnings happened to balance sheets. Last week, General Electric (GE), one of the largest and most respected companies in the world, delivered a significant earnings disappointment that roiled the global financial markets. What happened: GE succumbed to some of the problems in the credit markets and took some credit losses in the process. Plus, the domestic economy's weakness reflected on poor healthcare and appliance sales. As a result, GE reported a 7 cent lower-than-expected EPS for the quarter. Beyond the negative headlines, if GE's financial services unit stood on its own, it would qualify as one of the largest financial companies in the world. So GE earning 44 cents instead of 51 cents is not exactly signs of a deteriorating company, especially given the current economic and financial environment. Upon closer inspection, had one listened to the GE earnings call, they would have been assured of the company's financial strength. Here are few highlights:
Select the service that is right for you!COMPARE ALL SERVICES
- $2.5+ million portfolio
- Large-cap and dividend focus
- Intraday trade alerts from Cramer
- Weekly roundups
Access the tool that DOMINATES the Russell 2000 and the S&P 500.
- Buy, hold, or sell recommendations for over 4,300 stocks
- Unlimited research reports on your favorite stocks
- A custom stock screener
- Upgrade/downgrade alerts
- Diversified model portfolio of dividend stocks
- Alerts when market news affect the portfolio
- Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
- Real Money + Doug Kass Plus 15 more Wall Street Pros
- Intraday commentary & news
- Ultra-actionable trading ideas
- 100+ monthly options trading ideas
- Actionable options commentary & news
- Real-time trading community
- Options TV