In episode 628, we were asked this question from listener Jon:
“I have identified a handful of companies with a price to cash ratio below 6–7. What surprised me is that most of these companies have very high debt identified in the debt/equity ratios. Is this why they have so much cash? Isn’t this dangerous in the current economic/interest rate cycle/conditions? Examples are MQG, ANZ and BHP. I deduct intangibles from total assets when calculating debt to equity. Experience has taught me intangibles are called intangibles for a reason. I assume intangibles refer to the past purchase of businesses or goodwill. They can be valued at whatever someone is willing to pay. Curious to know what you both think about the debt/equity ratio and intangibles.”
Tony:
Goodwill, in terms of dollars and cents, is what you’ve paid above what the assets are valued at when you bought a company. So, sometimes it’s called control premium if it’s a listed share. It’s the premium you’ve paid. So, you’ve bought some assets. Let’s say I bought a coffee shop next door, and I had to pay them above what I could have gone out and bought those assets for to make it worth their while to sell to me. And that goes on to the balance sheet. You have to record the assets of their realised value, but because you paid more for it, the rest is goodwill. By definition it’s intangible because you could have haggled harder and got a cheaper price. They could have held out for a higher price. Even though the market has a value on the company at x dollars, you’re buying assets which in their books have been bought for y dollars or depreciated down to y dollars. So, that’s what goodwill is. And that’s why it’s intangible, because it’s hasn’t gone through an accounting process based on the asset price. Take, for example, Auto Sports Group. That’s a car dealership company and it has lots of intangibles, i.e., goodwill, on its balance sheet because its business model was to go and buy car dealerships and to roll them up. From memory it had a Mini dealership, it had a BMW dealership, Volvos, etc. But to buy those businesses off their current shareholders, they had to offer more than what the assets were worth. And so they had to book that as an intangible or goodwill. And they had lots of that on their balance sheet. The thing I think that’s important is that, okay, you’ve got a company that has lots of debt, and it has lots of intangibles, but the real question is, can it service the debt? And that’s where operating cash flow comes in. If ASG or any of these other examples that John’s listed, MQG, ANZ, BHP, for example, have intangibles, have lots of debt, but not much cash flow, then they’re gonna go broke because you can’t service it. So, all of these companies have one thing in common, and that is that they’ve got enough cash flow to service their debt. So, that’s the important thing. In terms of intangibles, it’s a bit like horses for courses. And BHP is the company I’ll single out, because in the dim-dark past when I was first getting into investing, it had an atrocious record of overpaying for assets. They basically had bought things at the peak of the commodity cycle and paid too much for them, and then when the cycle dipped, they had these intangibles, they had the debt for the purchase, and they weren’t getting the cash flow to cover it, and now they’re in a bit of trouble. So, you do have to be careful with these things. But I think we focus on Stock Doctor’s Financial Health, which one of the criteria they use is both the ability for the company to pay its debts, which is operating cash flow, but also the leverage it has. So, the debt to equity. If anyone ever wants to look up these sorts of metrics, they are in Stock Doctor, and if you click on the financial health, it will take you through to a table. I’ll do that now for BHP just so I get that clear for people. If I look at BHP and I click on their financial health, which is strong, by the way, I get a big table here of all the Stock Doctor financial ratios — which is the basis for Stock Doctor. It’s using all of these different ratios to first of all work out what the common scores would be for companies before they went broke, and then to reverse them; to say, if they are at the other end of the spectrum, that it’s a strong financial company. The balance sheet ratio Stock Doctor uses is total liabilities over total tangible assets. For BHP that’s actually in early warning, but it’s still only a ratio of point five, so 50%, so it’s not too bad. But the three companies that John’s outlined are all blue-chip companies, and if they were having problems with their debt servicing ability, we would know about them, because they’re well covered anyway. But interestingly enough, I did look at those three companies, and the intangibles weren’t very big on those three. For example, BHP has about $2 billion worth of intangibles with $129 billion worth of total assets. So, the proportion of intangibles to tangible assets was quite low. One thing to be aware of with the banks is that deposits are counted as a liability, so that can also come up in their intangibles. And that’s probably fair, because if there’s a run on deposits, they can go broke. But it’s not, strictly speaking, debt the way that we think of it, as no borrowings there, and the banks tend to issue lots of bonds to make up the difference between their deposits and the mortgages that they’ve lent out. But the thing with the banks is that they’re regulated by APRA and stress tested by APRA, so they do have pretty good risk controls independently opposed imposed on them. That’s not to say they can’t go broke, and they certainly had to raise capital during the GFC, for example. But the companies that we’re talking about here are pretty solid from a financial point of view. So, I’m not going to be worried about their intangibles or their debt levels. I’ve never actually called out debt to equity as one of the things on the checklist, because it’s part of the Stock Doctor methodology, and I tend to think of things as debt to assets rather than debt to equity, which is just a different way of looking at it. And I like to see companies have less than 50% debt to assets, preferably 33%. So, that’s the kind of range I’m looking at. But again, it can be horses for courses. If someone did go out and launch an acquisition for another company, and they did that using debt, but they thought that the operating cash flow from the company they bought was going to pay down their debt quickly. I’d probably turn a blind eye to that sort of increase in their debt to equity, which is a short-term basis. I think we’re covered with the Stock Doctor Financial Health. Our focus on operating cash flow is the real thing, I think, which gets us through. If you’ve got a company throwing off lots of cash, then it can handle some level of indebtedness. But of course, there is a risk in there that if there are intangible assets that they can’t sell, and they’re having trouble servicing their debt, they’ll be in trouble. But I can’t think of any companies that have been on our buy list or that I’ve bought that have fallen into that category.
Cameron:
In my email reply to Jon, I actually said, “look, I think you’re right, high levels of debt and high levels of intangibles could be an issue for some businesses. But a couple of things for us is, one, for a company to end up on our buy list it’s got to pass a whole bunch of metrics. If it has high levels of debt or high levels of intangibles but passes all of our other financial health metrics, value metrics, we’ve got a buffer between what we’re paying for it because we’re getting in at a discount to the valuation. It’s a heatmap approach. Sentiment is positive for it, all of those things, analysts giving it a good thumbs up, etc. I think intangibles and high levels of debt can actually be a good thing in the right hands. If you’re buying good quality businesses with a good track record of running their business year after year, which is the sort of businesses we tend to see on our buy list, then they probably know what to do with the debt, they probably know what to do with the intangibles. We’re not buying tech start-ups with high levels of debt and no cash flow, and their equity is all made up of intangibles, like it’s just an office with three developers and a very expensive logo. We’re buying really solid businesses, sometimes that have been through a rough trot, but they’re turning it around, because they got good quality management, and they fix the problems, etc. So I’m not worried about those things when it’s part of an overall picture of the opportunity of buying into the company. And I think that’s one of the things that QAV does a good job of, is looking at a whole bunch of metrics. We’re not just looking at one or two.
Tony:
Yeah, no, you’re right. And just a couple of other points to add to what you’ve said. I’m not scared of debt, I think debt can be our friend, because if we’re onto a good thing, we may as well leverage into it as well. Not over-leveraged but take on some more debt to expose us to that opportunity even more. And there’s a thing that economists call a lazy balance sheet, which you don’t see that much these days, but I remember back in the 80s and 90s a lot of companies were being called out for having ungeared balance sheets. And then people would say you can take on a certain amount of gearing, maybe 30%, and grow because of that leverage, and you’ve got plenty of cash to pay it down. Generally, companies try and land in that sweet spot of about 30–50% debt to assets or debt to equity, depending on how you look at it. That’s the first thing. The other thing I wanted to just say was the three examples that were in Jon’s question, Macquarie Group, ANZ and BHP, they’ve all been on the buy list in the past, but they’re not there now. As I said before, Macquarie is negative operating cash flow, I think ANZ is below our cut-off in terms of QAV score, and I’m not sure about BHP, but it’s not there either. There may be reasons for that, but we’re screening for these things all the time. So, if they do have too high debt or too many intangibles, they may not be there. The flip side is ASG, which I just spoke about, is on the buy list and it does have lots of intangibles. But it has lots of operating cash flow to service the debt on that company.
Now ASG being a car sales group, they have long term and short-term debt. A lot of the short-term debt is there to buy cars to then sell. So, that kind of backs the inventory. It’s not quite that back-to-back, but I guess they’re buying it wholesale and then selling it retail. But in terms of the long-term debt, which would be the debt that’s being used to acquire franchises, long term debt is $273 million, intangibles are $494 million, and then property plant and equipment is $374 million. So, they’ve got enough assets to cover the debt. Intangibles are certainly high and long-term debt is high, but they’ve got heaps of operating cash flow to cover it and service it, and overtime pay it down as well. So, I’m not worried about that. If they ever decide to sell off a car franchise because they are having debt problems, that’s when you see whether the goodwill is at the right value or not. And that’s the other thing about goodwill, is that in other cases, it’s carried an undervaluation of what the asset might be worth now from a brand point of view. For example, if ASG bought a Mini Cooper franchise and there was $100 million of goodwill in doing that, if they expanded that franchise and built it up and then sold the business for $200 million above its assets, then they’ve actually been holding the goodwill at a lower value than what it’s worth on their balance sheet. And there’s no scope in the accounting standards as I’m aware of to revalue goodwill upwards. It can cut both ways with an intangible asset on your balance sheet. The last point I’ll make is that these big companies, they’re not pulling debt out of the air, they’ve got to go and convince a banker or someone who wants to buy a bond that they can repay it. There are financial people crawling all over their balance sheets all the time before they get the debt to make sure that they can service it.
Cameron:
Yeah, these are well run businesses with solid management. I assume they’re being cautious. Their auditors are looking at everything. We’re looking at the audit reports for any issues. We have a degree of trust that they are doing a good job and handling it responsibly, that the goodwill is at a responsible valuation, etc. They’re not fly-by-night operations that we tend to be investing in, dodgy cowboy companies.
Tony:
Yeah, the price to operating cash flow is a really key metric and all that, and if you’ve got lots of cash, you can service the debt. Down the road there could be problems, and that’s when the financial health ratios can be helpful as well. But yeah, we’ll sell it when we need to.
Cameron:
And I said that, too, again, if we get it wrong our stop losses get us out pretty quickly.
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