Editor's note: This is a special bonus column for TheStreet.com readers. Arne Alsin's commentary regularly appears on RealMoney.com, where this column appeared on Feb. 26. To sign up for RealMoney, where you can read his commentary every day, please click here for a free trial.

Buying a great franchise that generates cash -- as evidenced by the stream of free cash flow -- is considered good investing. Wal-Mart ( WMT), Home Depot ( HD) and McDonald's ( MCD), 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) 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.

Errors in Judgment

Ten years ago, the Disney franchise was flat-out impressive, generating a net profit margin of more than 11%, returns on shareholder equity above 20% and total capital in excess of 15%. These same metrics have been mired at less than half of these levels for several years.

With no real increase in earnings after a four-fold jump in debt, coincident with a four-fold increase in total capital, the "stubborn numbers" at Disney are hard to fathom. Capital-allocation mistakes have been made -- huge, multibillion-dollar mistakes.

The downward trajectory in capital allocation started nine years ago, after Eisner's successful debut at the helm of Disney. Beginning with the $18.9 billion acquisition of Capital Cities/ABC, negotiated in 1995 and completed in early 1996, it has been one capital-allocation mistake after another, from the ill-conceived Go.com to the acquisition of Fox Family, among others. Eisner even allocated shareholder capital to two sports franchises --- hardly the stuff of a careful capital allocator.

Disney shareholders who are preparing to vote in the upcoming board election should ask themselves this question: Why has Comcast ( CMCSA) made a takeover offer for Disney stock? The answer is simple: Comcast thinks Disney's asset value is higher than its stock value.

And why is the stock selling at a discount to the asset value? Again, I think the answer is simple: Call it the "Eisner discount." While Eisner frets every year about ABC's upcoming fall lineup (eight years later, this last-place network is still in turnaround mode), the core Disney business languishes. Universal and other competitors have caught up to Disney's theme parks. Saucy characters like Nickelodeon's Rugrats have made Donald Duck and Mickey what's-his-name less than relevant to the current generation of kids. Of course, there have also been several years of poorly allocated shareholder capital. An Eisner discount is more than justified.

At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to arne.alsin@thestreet.com. Click here to receive Arne's latest favorite stock picks from his newsletter, TheStreet.com Value Investor.

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