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Horatio Gulash and Return on Capital
Posted by: John Emerson (IP Logged)
Date: June 4, 2012 05:16PM
If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." — Charlie Munger
We begin today's episode by fast-forwarding several years from the time when Horatio originally purchased "Old World Franks." Horatio has maintained a close relationship with the old man who sold him the business and has come to refer to him as "Pop."
Pop spends much of his time hanging around the stand when the weather is favorable, while talking and joking with some of his former customers. To honor Pop, Horatio created a sign with a caricature of the old man's face.
Pop's image will later become the major part of a business logo for "Old World Franks" helping to create a popular brand and enhance the legend of the unique-tasting hot dog. It is Horatio's method of memorializing Pop and paying homage to his special frankfurter. At this point in time Horatio has no concept of the long-term significance of that image. In years to come Pop's likeness will parallel the path of a certain "Chicken Colonel" from Kentucky. In future years, a good-spirited debate will arise between the companies: Which came first, the chicken or the frank?
Return on Capital and Old World Franks
Horatio's business has extremely low capital requirements and the fact that Pop has allowed him to enter the business with a no down payment, interest-deferred loan has given Horatio the illusion that he has not invested any monetary capital in the business. In reality, Horatio has invested a hefty sum into the business, specifically the two years of pretax earnings which he will be forced to pay back as well as the hours of toil which are required to run the business. However, once the loan is repaid, Horatio is looking forward to the day when he can keep all the after-tax profits which he is reaping.
Horatio has also learned another valuable lesson: Pretax earnings are considerably higher than after-tax earnings. Pop's percentage of the actual profits is much more than Horatio had anticipated. That realization eventually spurred Horatio to reduce costs to the bare minimum as he entered his second year without sacrificing any quality.
Horatio has used freezers to store large quantities of franks and buns which he purchases at more favorable prices. He no longer has any supplies delivered to the stand; instead he arises early in the morning, making his own purchases and deliveries.
Additionally, Horatio found that he had been leaving money on the table by selling out of franks too quickly. In his second year he took 25% more franks to the stand and he started selling a greater variety of drinks and chips. In the rare times he had left over franks when the game started, he quickly liquidated them by offering a 2 for 1 special. Since he started the special, ticket scalpers routinely visit the stand and liquidate any remaining hot dog inventory if Horatio remains open after the baseball game is underway.
Horatio has struck up business alliances with the ticket scalpers. He asks his patrons if they need tickets and directs them to the proper parties. In return, the scalpers promote "Old World Franks" as the best hot dog in St. Louis, sending hungry patrons to his stand.
Horatio also started to offer specials on days when the Cardinals were not in town. He started a punch card system for his regular patrons where they would get a free hot dog after they purchased five dogs within a month period. Slowly but surely new downtown clients became addicted to the allure of his franks which offers an inexpensive albeit unhealthy alternative to sit-down restaurants.
As Horatio works the stand he ponders about the advantages of his little enterprise as opposed to larger businesses. He gazes at the huge cranes which are rebuilding the downtown area. He wonders how the business could ever make enough money to pay off the loans on the enormous equipment. He also wonders if the owner could ever pocket any of the proceeds or whether the profits generated would merely be spent on new equipment, as well as the high wages and insurance costs it must take to conduct daily business.
Horatio's thoughts start drifting to Pop and the little enterprise which he started. Pop had started the business with almost no money; all he needed was a small grub stake to buy the stand, purchase a little inventory and secure a vendors license. Of course he needed a location, and that involved a little rent or fees to the city. But that was peanuts compared to the construction company and most other businesses.
It occurs to Horatio that he will be in exactly the same favorable position as Pop once he pays back the loan. Suddenly a revolutionary thought enters the mind of Horatio: If he was to employ just a tiny bit of his current profits on an additional hot dog cart, he might be able to greatly expand his profits without laying out enough capital to risk his livelihood.
Horatio is well aware he still owes Pop a good deal of money on his business loan so the capital investment would have to be small. If the new stand made money he could pay off the loan much quicker and start generating more cash which he could pocket or reinvest in the business. Of course the labor costs would be higher since he would need to hire an additional vendor, still the risk appeared low and the upside appeared extremely high.
Horatio has just conceptualized the role of return on capital (ROC) and Return on Invested Capital (ROIC) and their effect on the wealth accumulation of his business. Several key points before I launch into an in-depth discussion of ROC:
1) For my purposes ROC = Net Profit divided by (Equity + Debt) of Old World Franks
2) For my purposes ROIC = The Growth CAPEX allocated to finance additional hot dog stands.
Since Horatio has a choice of pocketing his profits or redeploying them for growth, it makes sense to separate the overall ROC from the ROIC which will be invested in additional stands. If Horatio separates the initial stand which he runs from the new stand, he can easily determine the overall return on investment (ROI) which he achieves from the new stands. Calculating an accurate ROI on growth is instrumental in determining whether investing in additional stands is a wise venture.
Why Is ROC and ROIC Important?
Calculating ROC and ROIC (Growth CAPEX in the case of Old World Franks) is worthwhile in evaluating the operating efficiency of a business, determining the extent of economic goodwill which a business possesses, measuring the effectiveness of management in capital allocation, and determining how a business should allocate their excess capital.
Publicly traded companies have four choices in allocating their excess capital. They can either pay dividends, repurchase shares, invest in growth internally or through acquisitions, or merely sit on the cash.
If the stock is undervalued, repurchasing shares or investing in growth are the two logical alternatives. If the stock is overvalued or growth prospects appear to be remote, returning money to shareholders in the form of dividends makes sense. The only time when it makes sense to hoard cash is during times of extreme financial distress or prior to impending down cycles in the business. At such times survival of the business (so long as it will return to profitability) becomes paramount. If the prospects of future profitability are remote the business should be dissolved.
In the case of Old World Franks, the extent of its economic goodwill could be tested by opening stands outside the downtown area of St. Louis. Additional locations would reveal whether Old World Franks contains any economic goodwill above and beyond its favorable downtown location.
It is important to note that growth is a poor option for businesses which possess little or no economic goodwill. Such businesses are unable to provide profits in excess of the market rate of return; therefore allocating capital towards growth provides no value to the business owner or shareholders in the case of a publicly traded company.
Take the example of Old World Franks. If additional carts do not provide a suitable ROI, they should be closed or relocated. Retail managers face similar decisions on a daily basis. If one lives in a town of any size they have probably seen a few McDonald's (MCD) franchises close down in certain locations.
In most cases, capital-intensive businesses possess much lower rates of ROC and typically carry much lower historical price to earnings multiples than businesses with low capital requirements. Capital-intensive businesses are also much more susceptible to the ravages of inflation since it becomes much more expensive to reproduce the assets which are necessary for growth in sales and profits.
For businesses such as Old World Franks which require little in the way of capital expenditures to growth profits, inflation is much less devastating. Further, if the business possesses any legitimate economic goodwill, Horatio will likely be able to institute price increases without affecting the total amount of hot dog sales per cart.
ROC vs. Return on Equity (ROE)
ROE is a poor measurement tool in highly leveraged companies since debt is not factored into the equation. Normally, companies which raise capital by selling debt rather than selling additional shares are going to show a much higher rate of ROE, particularly if they can borrow money at a low interest rate. The reason is simple; debt is carried on the balance sheet as a liability which is subtracted from the asset ledger which contains the proceeds of the loan. Thus the debt funding does not increase the book value of the company. Of course carrying debt is often a risky proposition; therefore the business should yield substantially higher returns to justify the added risk.
The age-old argument exists as to whether one should finance a company's growth through debt or equity offerings. Of course, the best companies finance the majority of their growth through their cash flow from operations.
Astute management raises capital though equity offerings only when the price of their stock is overvalued. During such times they might also finance an acquisition with company stock rather than currency. Conversely, astute management only repurchases shares of their stock when the price per share is undervalued and they should never make acquisitions with undervalued company stock.
The best time to raise capital through a debt-offering is when interest rates are favorable and the price per share of company stock is significantly undervalued. Additionally, increasing debt makes sense during inflationary periods or when borrowing rates are likely to rise in the not-too-distant future. The company can borrow money at low rates now and pay back the debt later in a depreciated currency. It seems that the Fed would concur with the latter statement.
I have strayed far away from the Horatio and the world of hot dog venders. The diversion will make more sense to Horatio when he decides to increase his fleet of hot dog carts. He will need to borrow money (raise capital through debt) or take on a partner (raise capital through equity) to fund his growth while repaying his loan to Pop, if he wishes to grow quickly. Otherwise his growth will have to wait until he can pay off his debt to Pop at which point he can utilize his cash flows from operations to increase his business.
ROC and Goodwill Impairment
One final point before I put this discussion about ROC to bed. Accounting rules have greatly distorted the true ROC of a number of companies which were forced to take excessive goodwill impairment charges following the credit crisis of 2008/2009.
ROC and ROE rates have magically increased in companies which were forced to write-down excessive amounts of accounting goodwill. When goodwill disappears from the balance sheet so does accounting equity; however, when profits return, the result is significantly distorted rates of ROC to the high side.
Let’s say Barth Widgets bought Bauer Ball Bearings in 2005. The purchase price was 10 million paid which was paid for with excess cash on the balance sheet. Let's further assume that Bauer Ball Bearings only had $5 million in tangible assets, thus Barth Widgets recorded the other $5 million as goodwill on their balance sheet. The resulting balance sheet of Barth Widgets showed a total equity of $25 million. Let’s further assume that the business recorded average net earnings of $5 million a year from fiscal 2005 to 2007 following the acquisition.
In 2008 and 2009 the company turns unprofitable and Barth Widgets is forced by accounting rules to impair the entire $5 million in goodwill from the Bauer acquisition. The company now has only $20 million in accounting equity on the balance sheet.
In 2010 Barth Widgets returns to its normal net income of 45 million. The profits of the company are exactly the same as they were prior to the credit crisis; however, the company has magically become much more efficient, at least in terms of ROC.
The reason being is the $10 million purchase of Bauer Ball Bearings is now recorded on the books at only $5 million resulting in a book value of only $20 million. The same company with the same profits now has increased its ROC (and ROE since the company holds no debt) from 20 to 25 percent. Anyone who is screening for stocks based upon an increasing rate of ROC or ROE is going to show a false positive.
Of course Horatio will not have to worry about such matters for the time being. He is much more focused upon how he can grow his earnings and still pay off Pop within five years.
In our next episode, Horatio starts an advertising campaign to increase his brand awareness and reinforce the competitive advantage of his hot dog business.
Stocks Discussed: MCD,