Follow the money.
Great advice whether you’re trying to unravel political skullduggery or separate stock market winners from wannabees.
Too many investors, though, think that the money they should be following is earnings, the most familiar but also most easily manipulated of financial measures. The great financial crisis, which still has the world economy in its grip, should have taught us that companies can continue to generate fabulous earnings growth even as they rot from the inside.
No, if you want to follow the real money concentrate on balance sheets, the best single source of information about a company’s health.
Right now, as so many companies are still recovering from their near death experience in the land of debt and leverage, watching balance sheets for the moment when a company goes from intensive care to the recovery room is one of the best ways to look for bargain-priced stocks that are on the mend.
Let’s take Ford Motor (F) and then Australian mining company Lynas (LYSCY.pk) as examples of what following the balance sheet can tell you about a company and about whether or not—and when—you want to buy its shares.
Ford made the front page of business sections across the country on November 3 by announcing a startling $1 billion profit for the third quarter of 2009. In the quarter, Ford generated earnings of 29 cents a share, a huge improvement over the loss of 7 cents a share, or $161 million, in the third quarter of 2008.
Other earnings numbers were just as impressive. For example, Ford’s North American unit generated its first profit from operations—as opposed to from rearranging financial deckchairs on a Taurus—in four-and-a-half years.
Overall, the company will be solidly profitable in 2011, Ford has told Wall Street analysts.
Time to buy, right?
Not before you look at Ford’s balance sheet.
From that financial report you’ll get a better idea of how much progress Ford has made and how much farther it has to go.
Because Ford is the only one of the three U.S. auto makers to avoid bankruptcy, the company still carries the full burden of its debt. And a very full burden it is, too.
The company’s total liabilities will come to $38 billion in 2011, according to Barclay’s Capital. That compares to just $22.3 billion for General Motors (GM), which has been able to shed substantial debt in its passage through bankruptcy.
Indicative of Ford’s new-found relative financial health, rather than drowning in that sea of red ink, the company is going to be able to re-finance much of it. Ford has announced that it will raise $3 billion to pay down debt. The cash will come from a $1 billion offering of common stock and the sale of $2 billion in senior notes. The notes can be converted to common stock or cash in 2016.
Ford’s stock has climbed 208% in 2009 from $2.46 a share on January 2 to $7.58 on November 2.
That’s given Ford the chance to raise money in the equity market at something less than a crushing price. To raise that $1 billion the company only has to sell 132 million shares at $7.58 a share. Compare that to the 407 million shares the company would have had to sell at $2.46 a share, the price at the start of the year.
The rally in Ford’s stock price is the difference between selling 4.1% of the company to raise $1 billion and selling 12.7% to generate the same amount of cash.
Ford’s higher stock price also makes it possible for the company to sell the senior notes at a lower price since investors who buy that issue have the promise of a potential gain from converting their debt holdings into stock in 2016.
What will Ford do with this $3 billion? It will use the money to pay down 25% of its revolving line of credit. That reduction, in turn, has enabled the company to convince the other lenders representing $6 billion on its credit line to extend the maturity of that debt from December 2011 to November 2013. In other words, rather than having to find the cash to pay off that $6 billion in a little over two years, Ford has put off the bill on that debt to 2013. (The company is negotiating to extend the maturity on the rest of its revolving line of credit too.)
What do the lenders get in return? A 1 percentage point increase in their interest rate margin, an increase in fees, an upfront payment, and a 25% reduction in amount that Ford can drawn down on this line of credit.
All this means that lenders, who have opportunity to do far more extensive due diligence than any individual investors can hope for—whether they use that information to make good decisions is another issue entirely—have given Ford a balance sheet seal of approval. They believe that the company is on the comeback and they’ve backed up that belief by giving Ford a chance to strengthen its balance sheet. That, in turn, will make the company significantly less vulnerable if sales volume in the auto industry doesn’t pick up again as quickly as everyone now expects.
I’d take that kind of balance sheet improvement over any announcement of a one-quarter gain in earnings as evidence of a turnaround any day.
But this kind of balance sheet analysis also convinces me that I don’t want to buy Ford’s shares quite yet. Remember that the company is going to issue 132 million new shares to raise that $1 billion in its stock offering. After the offering current investors will own 4.1% less of the company. That amount of ownership will have passed to investors who buy the next shares. Before that sale of stock current shareholders owned all of the 20 cents a share that Standard & Poor’s projects Ford will earn in 2010. After the sale they’ll own just 19 cents in earnings per share.
How important is that swing of a penny? Not very. Even if you assume that Ford will trade at a price-to-earnings ratio of 71 in 2010 (that was the stock’s price-to-earnings ratio in 2002, the last time the stock swung from a huge loss–$5.4 billion in 2001—to a solid profit–$651 million in 2002), the difference of a penny a share is a difference in stock price between $14.20 and $13.49 or just 71 cents a share. (A PE ratio of 71? Who do I think I’m kidding? No one, I hope. Ford is a cyclical company, which means that its PE is highest when it is just coming out of the earnings trough. That’s when earnings per share are positive, generating a PE for the first time in the bust stage of the cycle, but still very, very small. A cyclical stock’s PE ratio actually goes down as a recovery continues since earnings climb much faster than the share price.)
Hardly enough to deter any investor looking at a buy at $7.58 a share now.
But the difference does start to become significant if you believe that Ford’s $1 billion stock offering in 2009 won’t be the last time the company has to go to the well. Even if Ford uses all the $3 billion it raises in cash to reduce debt, it will still have $35 billion in liabilities at the end of the process.
So investors, who are encouraged by Ford balance sheet improvement, have to ask themselves how many more times will Ford have to raise capital—and how many more times will they see their ownership of earnings diluted by 4% or more before Ford’s balance sheet isn’t just better than it was but is actually reasonably solid.
Let’s compare Fords balance sheet story to that of a very different company, Lynas (LYSCY), an Australian mining startup that owns the world’s richest deposit of rate earth minerals. (See my September 11 post http://jubakpicks.com/2009/09/11/rare-earths-you-cant-build-hybrids-or-wind-turbines-without-them-and-china-is-putting-the-squeeze-on-supplies/ for why you want to own a rar earth mining company.)
Here’s a company that’s back from the balance-sheet dead. In February 2009 Lynas had to cancel a draw down of $95 million (US$) from a convertible bond offering when the company could not meet the terms of the offering. That, in turn, led to the cancellation of a $105 (US$) million senior note. And that led to the suspension of work on the company’s rare earth mine with exploratory drilling complete and stock piles starting to build
Along came a Chinese investor, China Non-ferrous Mining, that offered to put up $252 million (AUS$) in exchange for more than 50% of the company. That deal, which would have the company back in business but concentrated even more of the global supply of rare earth minerals in Chinese ownership (China controls 95%-97% of global rare earth production), fell apart when Australian regulators said No to Chinese majority ownership. (For the complete story of this deal see my September 25 post http://jubakpicks.com/2009/09/25/china-pulls-out-of-australian-rare-earths-deal-time-to-put-lynas-lyscy-on-your-watch-list/ .)
But thanks to the recovery in global financial markets and to the recovery in commodity stocks since the start of this rally on March 9, Lynas was able to raise $408 million (US$) in a stock offering. The dilution to existing shareholders was huge—shares outstanding have gone to 1.3 billion on November 3 from 655 million on June 30, 2009. Each shareholder on June 30 owns about half as much of the company now as he or she did on June 30.
But what those June 30 investors now own–instead of a mine that has suspended production and construction– is a smaller part of a company with the cash to complete construction of its concentration plant so it can begin to ship its rare earth production instead of just storing it and to complete a plant in Malaysia to process that concentrated ore into rare earths for sale.
New shareholders, anyone who buys in after the new shares were issued on November 3 and started trading on November 4, don’t suffer that dilution. And they also get a piece of a company with enough capital—with a strong enough balance sheet–to complete Phase 1 of its rare earths project and to raise the capital that it needs for further future expansion.
That expansion will require raising more capital and raising that capital will also certainly result in dilution of existing shareholders of both the June 30 and November 3 variety.
But the collapse of the China deal has already given some of that future dilution back to anyone who buys the shares now. The Chinese bid sent the stock into a frenzy that took the price of Australian traded shares to 91 cents on September 23. The collapse of that deal—and the near-death experience for Lynas cut the share price in half. The Australian shares traded for just 45 cent on November 3.
If you buy today, you get twice as big a piece of the company as you would have on September 23. That’s some payback for future dilution.
And remember that you are getting a piece of a company with a balance sheet that’s strong enough to say that it actually does have a future. And where raising $400 million instead of billions as with Ford makes a difference between night and day for the shares.
I’m adding this stock to Jubak’s Picks with this post. I’ll be buying the U.S.-traded ADRs (LYSCY) for the portfolio rather than the Australian shares because they are easier for U.S.-based investors to buy.
Check my post later today for the detailed logic on this buy and a word of advice on buying the ADRs (American Depository Receipts) as well as a target price.
Full disclosure: Jim Jubak owns shares of Lynas in his personal portfolio. I will buy more three days after this is posted.
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