Balance Sheets 101: Who Made the Grade

Editor's note: Last earnings season, Scott Rothbort graded several corporate balance sheets. As the current earnings season starts to wind down, Rothbort evaluates a new set of balance sheets, plus takes an updated look at Sirius Satellite Radio's balance sheet.

Sirius Passed -- Barely

Let's start off by taking a second look at Sirius Satellite Radio ( SIRI), which recently merged with XM Satellite Radio ( XMSR).

Last earnings season, I gave this combination an incomplete grade. The merger of these two companies was a long and arduous process. Missed opportunities -- especially for the new 2009 automobile production cycle -- and uncertainty over the merger have left the combined company in a capital and cash shortage. These companies have burned a huge amount of cash, while still carrying large amounts of debt. As a result, this week, Sirius issued hundreds of millions of dollars of stock and sold hundreds of millions of convertible debt in a private placement offering.

The motivation for the merger was to expand offerings to consumers and save about $400 million in 2009. The hopes are that the savings will increase earnings and pay down debt in the future.

However, this multibillion-dollar debt-riddled company is going to have an uphill battle to survive in its current form. The cost savings will go a long way to helping, but the interest on the low-graded debt is going to handcuff the company, leaving very little margin for error or operational shortfalls. Continued economic weakness could result in lost subscribers or failure to add new subscribers.

My prediction is that Sirius will have to reorganize in the future in a Charter 11 bankruptcy that would result in wiping out the shareholders and leaving the company to its creditors. Thus, owning Sirius debt may be a better investment than owning the equity.

Sirius' Balance Sheet Grade: D- (but at risk of failing).

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.

Best Buy ( BBY) is the premier retailer in the highly competitive consumer electronic industry segment. As of its most recent quarter (ended May 31, 2008), Best Buy sported nearly $1.5 billion in cash and short-term investments. The company held inventory of $5 billion versus accounts payable of $6 billion, most of which was assumed to purchase the inventory.

Best Buy's total debt (long-term plus short-term debt) was about $1.15 billion. That is down from higher levels just a few quarters ago. Best Buy continues to add new stores (they just did not far from my house in New Jersey) - primarily using current operating cash.

Now let's compare Best Buy's balance sheet to that of one of the premier "big box" retailers in the country, Macy's ( M).

Macy's ( M) has expanded through the acquisition of other retailers, such as Federated Department stores and the opening of new stores. The company's balance sheet is almost the complete opposite to that of Best Buy. As of the quarter that ended May 3, 2008, Macy's total debt was nearly $9.8 billion. That said, Macy's does deserve some credit for paring down its debt by about $1 billion over the last 12 months. However, here is one of my pet peeves that Macy's violates: The company is buying back stock rather than repaying it debt at a faster pace. Inventories stood at $5.5 billion, while payables were $4.6 billion. Cash and short-term investments were negligible in comparison, at under $400 million.

One final glaring item on the Macy's balance sheet is the enormous amount of goodwill it has recorded -- about $9.1 billion. Best Buy, on the other hand, had just under $1.1 billion. Goodwill is the excess of purchase price over book value that a company must assume when it makes an acquisition. The amortization of that goodwill is a charge to earnings thus impacting EPS. We are currently in the midst of a difficult economic and retail environment. A stronger balance sheet will protect a company more than a weaker one under these conditions. While shares of Best Buy have understandably declined in the past year, shares of Macy's have performed much worse. Part of that has to do with the large amount of debt that Macy's carries and has to pay debt on. Here is a comparison of the performance of both companies' stocks over the past year:

Click here for larger image.
Balance Sheet Grades: Best Buy: B+ (with room for improvement), Macy's: D.

Homework Time

The next time you're looking at company balance sheets, seek out financial strength by identifying:

  • Low debt.
  • The paying down of debt and the operational ability to pay down debt.
  • Manageable levels of inventory versus receivables and cash.
  • At the time of publication, Rothbort was long FCX, although positions can change at any time.

    Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

    Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

    Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

    For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.

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