Hidden debts. How to analyse companies with hidden debts.

 If you are thinking of investing in the shares of airline, rail or retail companies, and many others, you need to understand of the biggest risks that you will face as a shareholder - hidden debts.

By understanding what hidden debts are and how to analyse companies that have them, you will make better investment decisions and take on less risk.

Retail company with big future rent commitments

Where a company has big future rent commitments, there are 2 useful things you can do:

1.  Calculate a company's fixed charge cover.

2.  Calculate the capitalised value of operating leases.

1.  Fixed charge cover

Fixed charge cover = (EBIT + operating lease expense) / (net interest + operating lease)

A result within the range of 1.5 to 2 is not unusual.  

Fixed charge cover of 1.3 times is the lowest level investors should tolerate, as the risk of financial distress becomes significant below that level.

Fixed charge cover has been a great way to spot retailers in trouble in the past, such as HMV, Game Group and Woolworth.  These companies did not have huge amounts of debt on their balance sheets, but the rental commitments crippled them when profits start falling.  

In 2005, Woolworth's fixed charge cover was only 1.3 times which was right at the limit of what is normally comfortable.  Once profits started to fall in the following year, the company was in the danger zone.  By 2007, the company's finances were close to breaking point.  It filed for bankruptchy in January 2009.  Prudent investors would not have invested even in 2005.

For the year to December 2015, Domino's had normalised EBIT of Sterling 73.6m, rental expenses of Sterling 21.3m and normalised net interest expenses of Sterling 0.02m.  Its fixed charge cover was therefore:

(73.6 + 21.3) / (0.02 + 21.3) = 4.5 times

This is a healthy figure.

Domino's fixed charge cover has been consistently healthy despite the rapid growth in new stores.  As the profitability of new stores increases, the fixed charge cover should improve.

Domino is a franchising business.  It sublets the building it is renting out to its franchisees:  the franchisee commits to pay the rent.  This gives it an extra level of protection and explains why its fixed charge cover is not a matter for concern.

2.  Capitalising the value of operating leases

There are two ways to estimate the value of hidden debt by taking an approach that is referred to as capitalising operating leases.  In other words, you are working out what the total amount of the future liability might be in today's money. 

a)  The first way is to discount the future lease commitments to their present value using an interest rate similar to the interest rate paid on existing borrowings.

b)  A quicker way, used by the credit rating agencies.  Multiply the current annual rental expenses by a multiple between 6 and 8.  (Use this which is simpler and much more straightforward).

Using the simpler method of multiplying by a number between 6 and 8 with the company's annual rental expense.  Look for this in the annual accounts labelled "operating lease payments" or something similar.  

For example, for 2015, the lease or rent expenses for Domino's was Sterling 21,313m.

Sterling m                 2015        2014

Rent expense          21,313    20,874

Capitalised at 8x       170.5     167.0

Capitalised at 7x       149;2     146.1

Capitalised at 6x       127.9     125.2

Domino's hidden debts has evolved over the years.  They have been growing as the company has opened more Pizza shops.

How are these calculations useful to an investor?

The impact on ROCE

Many retailers rent rather than own their high street stores, which means they have a lot of hidden debts.

Without taking these debts into account these companies can look like very good businesses with very high ROCEs.  Once the debts are factored in, this changes.

There is nothing wrong with investing in companies with hidden debts, but it makes sense to ensure that they pass the tests of quality and safety, meaning:

- a minimum adjusted ROCE of 15%.

- a minimum fixed charge cover of at least 2.

Example

All in Sterling

Company                                                   Next                         WH Smith

Capital employed                                    1501.9                         188.0

Lease adjusted Capital employed            3004.1                       1987.0

Estimated hidden debt                             1502.2                       1799.0

ROCE (%)                                                 60.2%                        33.2%

Lease adjusted ROCE                                33.2%                        12.9%

Using Lease adjusted ROCE gives you a truer picture of a company's financial performance.  In most cases, ROCE will decline when hidden debts are included.

Once the hidden debts are factored in, ROCE changes.  In the above example, Netx still looks good, but WH Smith sees a big fall in ROCE.

Be wary of sale and leasebacks

In recent times, one of the easiest ways for companies to raise cash has been to sell some of their properties to property companies or investment funds and then rent them back.  This is known as a sale and leaseback transactions.

For supermarket companies, such as Tesco, this was a big warning sign that all was not well.

Without the cash proceeds from selling supermarket stores to property companies, Tesco would have been struggling to find the free cash flow to pay dividends or invest in its business.  The cash inflow from property sales made it look as if Tesco's debt was nothing to worry about, but the off-balance sheet debt ((Tesco's future rent obligations) increased at a rapid rate from 2005 to 2013.

After selling a number of its stores, Tesco tied itself into long-term rent agreements for stores that aren't as profitable as they used to be.  This was one of the main reasons why Tesco had to stop paying a dividend in 2015.  Trying to get out of these rented stores could prove to be very expensive for Tesco in the future.  This is a good example of why investors ignore hidden debt at their peril.

Warren Buffett says Berkshire is reversing course on airlines – again

Mon, 4 May 2020

Berkshire Hathaway's 2020 Shareholder Meeting


The billionaire investor said Berkshire Hathaway Inc completely exited its stakes in the four major US airlines. The sales of shares of Delta Air Lines Inc, Southwest Airlines Co, American Airlines Group Inc and United Airlines Holdings Inc made up most of the company’s US$6.5bil in equity sales in April.

During his live-streamed annual meeting, Buffett said the business has fundamentally changed following the economic fallout from the coronavirus pandemic. He declined to blame the performance of the airline executives, saying they’ve done a good job of raising money to get through the crisis.

“The world changed for airlines and I wish them well, ” Buffett said Saturday. He clarified that he made the decision and that he lost money on his investments. “That was my mistake.”

Buffett’s had a complicated relationship with the airline industry over the years. After a troublesome investment in USAir, Buffett joked that he would call an 800 number to declare he was an “air-o-holic” if he ever got the urge to invest in airlines again.

Then in 2016, Berkshire dove into the industry again, amassing stakes in the four largest US airlines. At the end of 2019, those stakes amounted to almost US$10bil. Buffett’s renewed faith in the industry prompted speculation that he might one day own one of the carriers.

But now, he’s cut those investments again. Berkshire disclosed in April that it had at least trimmed its Delta and Southwest stakes, both of which had previously been above a 10% ownership level.

“The airline business - and I may be wrong and I hope I’m wrong - but I think it’s changed in a very major way, ” Buffett said. “The future is much less clear to me.”

The disclosure was among the most significant at the annual meeting, which was notable for its different feel this year as the event that usually draws tens of thousands was done was hosted virtually.

Buffett, 89, shared the stage with a top deputy, Greg Abel, who runs Berkshire’s non-insurance operating units. Vice-chairman Charlie Munger, 96, didn’t join, though Buffett said his long-time business partner was in good health.

Buffett said he didn’t know how consumer travel habits will change after the pandemic subsides, but any reduction in travel could leave airlines with higher-than-necessary fixed costs. Any impact could filter down to suppliers like Boeing Co.

- Bloomberg

Buffett admits a mistake with airline stocks

There's been a lot of speculation about the moves that Berkshire Hathaway has recently made with its airline stock holdings. In early April, Berkshire sold substantial amounts of its holdings in Delta Air Lines (NYSE:DAL) and Southwest Airlines (NYSE:LUV), with disclosures necessary because of Berkshire's having held more than 10% of the two airlines' outstanding shares. At the time, it seemed as though Buffett might simply be reducing its positions below 10% to avoid future complications.

However, Buffett reported selling a total of $6.5 billion in stock during April, far more than the Delta and Southwest sales that had been reported and also including shares of United Airlines Holdings (NASDAQ:UAL) and American Airlines Group (NASDAQ:AAL) as well. Questioned later, the Berkshire CEO said that the company sold off its entire positions in the four airlines. As he explained it, he "just decided I made a mistake." He had initially figured that investing $7 billion to $8 billion to buy 10% stakes in the four biggest U.S. airlines would give him about $1 billion in underlying earnings, which seemed like a reasonable value. However, Buffett said, "It turned out I was wrong about the business."

Buffett didn't blame airline CEOs, who managed their companies well and did a lot of things right. However, the Berkshire leader no longer feels comfortable that airlines will ever recover to their pre-coronavirus levels, and even two to three years from now, it's possible that not nearly as many people will be flying. Unfortunately, even if airlines recover 70% to 80% of their pre-crisis passenger loads, they'll still have far too many planes. With airlines selling stock to raise capital, upside is limited. Buffett concluded, "The world changed for airlines, and we wish them well."

https://www.fool.com/investing/2020/05/02/what-warren-buffett-said-at-berkshires-2020-shareh.aspx





Related article:

Warren Buffett Adds to Delta Investment as Airlines Plunge to Value Territory

https://myinvestingnotes.blogspot.com/2020/03/warren-buffett-adds-to-delta-investment.html

Berkshire's Top Equity Holdings

Berkshire still holds3 over $180 billion in the common stock of many publicly-traded companies. Approximately 69% of the aggregate fair value was concentrated in these five companies:

• American Express Co. (AXP): $13.0 billion
• Apple Inc. (AAPL): $63.8 billion
• Bank of America Corp. (BAC): $20.2 billion
• The Coca-Cola Company (KO): $17.7 billion
• Wells Fargo & Co. (WFC): $9.9 billion

The Approach Warren Buffett uses in deciding whether or not to invest in a company

BRINGING IT ALL TOGETHER

The remarks of Warren Buffet and analysis by Buffett authors suggest that, at the very least, Warren Buffett looks at the following aspects of a corporation and its operations. They can be put in the form of questions that any sensible investor should ask before considering a stock investment.

BASIC QUESTIONS TO ASK

1. Does the company sell brand name products that are likely to endure?
2. Is the business of the company easily understood?
3. Does the company invest in and operate businesses within its area of expertise?
4. Does the company have the ability to maintain or increase profitability by raising prices?
5. Is the company, looking at both long-term debt, and the current position, conservatively financed?
6. Does the company show consistently high returns on equity and capital?
7. Have the earnings per share and sales per share of the company shown consistent growth above market averages over a period of at least five years?
8. Hs the company been buying back its shares, and if so, has it bought them responsibly?
9. Has management wisely used retained earnings to increase the rate of return to shareholders?
10. Is the company likely to require large capital sums to ensure continuing profitability?

See case studies.

This would only be the first stage of the process. The next, and most important question, is determining the price that an investor such as Warren Buffet would pay for the stock, allowing for the margin of safety.

CASE STUDIES

These examples will take you through the method of company analysis advanced on this website, which we believe to be similar to the approach Warren Buffett uses in deciding whether or not to invest in a company.

COCA COLA - CASE STUDY

In answering the question for ourselves whether Coca Cola is a company worth consideration as an investment, at the right price, we have used summary and other figures available from Value Line.

QUESTION 1: DOES THE COMPANY SELL BRAND NAME PRODUCTS THAT ARE LIKELY TO ENDURE?

The answer to this seems quite simple. The major product of the company has been around for many years, is sold worldwide and is considered the best-known brand name in the world. More importantly, its customers would not do without it, and have demonstrated a loyalty that makes it unlikely it would change to other products. It also has other well-known brands on its books – Sprite, Fanta, Evian, Minute Maid, PowerAde.

2. IS THE BUSINESS OF THE COMPANY EASILY UNDERSTOOD?

We think so. Its core operation is the production and distribution, both for itself and under franchise, of non-alcoholic beverages and associated products.

3. DOES THE COMPANY INVEST IN AND OPERATE BUSINESSES WITHIN ITS AREA OF EXPERTISE?

We would think so. Consideration of the Value Line information suggests that the company restricts itself to its core operations. We do not see it dabbling in areas outside its expertise.

4. DOES THE COMPANY HAVE THE ABILITY TO MAINTAIN OR INCREASE PROFITABILITY BY RAISING PRICES?

The real question here is whether, if Coke were to lift its prices by a margin that would allow it to keep pace with inflation, sales would suffer. This is unlikely.

5. IS THE COMPANY, LOOKING AT BOTH LONG-TERM DEBT, AND THE CURRENT POSITION, CONSERVATIVELY FINANCED?

a) Long term debt to profitability

The long-term debt of this company in 2002 was 2700 million dollars. The profit for that year was 4134 million dollars. At this rate, Coke could wipe out its long-term debt in .65 of a year, just over six months.

b) Current ratio

In 2002, Coke had current assets of 7352 million dollars and current liabilities of 7341 million dollars, a ratio of debt to assets of .99. This is lower than would be the desired ratio for industrial companies, but having regard to the nature of the business, and the ready cash flow, is acceptable.

c) Long term debt to equity

In 2002 the long-term debt was 2700 million dollars and shareholders equity was 11800 million dollars a comfortable ratio of .22.

6. DOES THE COMPANY SHOW CONSISTENTLY HIGH RETURNS ON EQUITY AND CAPITAL?

The company has shown an average rate of return on equity over the past five years of 37.08%. In the same period, it showed an average return on capital of 33.6% .The figures are consistent.

Year	ROE	ROC
1998	42.0	39.1
1999	34.0	31.5
2000	39.4	36.4
2001	35.0	31.9
2002	35.0	29.1
Average	37.08	33.6

7. HAVE THE EARNINGS PER SHARE AND SALES PER SHARE OF THE COMPANY SHOWN CONSISTENT GROWTH ABOVE MARKET AVERAGES OVER A PERIOD OF AT LEAST FIVE YEARS?

The figures for this period are as follows.

Year	EPS	+ or - %	SPS	+ or - %
1997	1.64		7.64
1998	1.42	-13.4	7.63	-.13
1999	1.30	-8.45	8.01	+4.98
2000	1.48	+13.85	8.23	+2.74
2001	1.60	+8.11	7.06	-14.2
2002	1.66	+3.75	7.92	+12.18

Looking at a five-year rolling period, we can calculate, using a hand-held Texas Instruments BA-35 Solar Calculator, the increase in earnings and sales over the rolling five-year period 1998-2002. For earnings, this is 16.9 %, for sales only 3.8%. The compound rate of return for earnings is 3.185, for sales, .75%.

This is not a strong rise in earnings or sales, and the question would be whether this is as a result of a slow-down in the US and world economies over this period or whether there is some more structural reason.

8. HS THE COMPANY BEEN BUYING BACK ITS SHARES, AND IF SO, HAS IT BOUGHT THEM RESPONSIBLY?

In 1998, the company had common shares outstanding of 2465.5 million. In 2002, the figure was 2471 million. The shares on issue are basically unchanged.

9. HAS MANAGEMENT WISELY USED RETAINED EARNINGS TO INCREASE THE RATE OF RETURN TO SHAREHOLDERS?

The company has the following earnings per share and dividend per share record over a five-year period.

Year	EPS	DPS
1998	1.42	.60
1999	1.30	.64
2000	1.48	.68
2001	1.60	.72
2002	1.66	.80
Total	7.46	3.44

The company has therefore retained earnings totalling $4.02. In 1998, the shares reached a low of $53.6. In 2002, the shares reached a high of $57.9. An investor who bought at the lowest price in 1998 and still had them at the highest price in 2002 would have been showing a profit of $4.30. Thus the shares would have just slotted into Warren Buffett’s requirement for showing an increase in market value of a dollar for every dollar retained.

Using the approach of Mary Buffett and David Clark, we could calculate the percentage increase in earnings per share resulting from the retained profits. EPS in 1998 were 1.42, and in 2002 were 1.66, an increase of .24. Thus, from the total earnings retained of $4.02, earnings have increased by a total of .22, a percentage increase of 5.97%: not high.

10. IS THE COMPANY LIKELY TO REQUIRE LARGE CAPITAL SUMS TO ENSURE CONTINUING PROFITABILITY?

Value Line suggests that in the two years following 2002, the company would be spending about .40 a share on capital items. The long-term average is .31, unadjusted for inflation. These figures seem to be in line with historical expenditures.

This case study is a demonstration only and is not intended to influence or persuade visitors to this site to make any investment decisions; they should make their own decisions, based on their own research, personal and financial circumstances, and after consultation with their own financial or investment advisers.

BOEING (BA) - CASE STUDY

In answering the question for ourselves whether Boeing is a company worth consideration as an investment, at the right price, we have used summary and other figures available from Value Line.

QUESTION 1: DOES THE COMPANY SELL BRAND NAME PRODUCTS THAT ARE LIKELY TO ENDURE?

The answer to this seems quite simple. The major product of the company has been around for many years, is sold worldwide, and is recognised as a brand name by airlines and air passengers. In recent years, other passenger brand names such as Airbus have added competition. The choice of which airplane an airline buys is a matter of preference, rather than compulsion, and will depend upon factors such as price, safety, back up and design.

The brand name is good, but so is the competition.

2. IS THE BUSINESS OF THE COMPANY EASILY UNDERSTOOD?

We think so. Its core operation is the design and manufacture of airplanes.

3. DOES THE COMPANY INVEST IN AND OPERATE BUSINESSES WITHIN ITS AREA OF EXPERTISE?

We would think so. Consideration of the Value Line information suggests that the company restricts itself to its core operations. We do not see it dabbling in areas outside its expertise.

4. DOES THE COMPANY HAVE THE ABILITY TO MAINTAIN OR INCREASE PROFITABILITY BY RAISING PRICES?

This will totally depend upon the condition of the airline industry and the extent of the competition at any given time. The near certainty that people will continue to fly in ever-increasing numbers is dampened by the possibility of any one of a number of things that could reduce passenger flights – terrorism, crashes, other and more serious SARS type disease outbreaks.

5. IS THE COMPANY, LOOKING AT BOTH LONG-TERM DEBT, AND THE CURRENT POSITION, CONSERVATIVELY FINANCED?

a) Long term debt to profitability

The long-term debt of this company in 2002 was 12589 million dollars. The profit for that year was 2275 million dollars. At this rate, Boeing could wipe out its long-term debt in 5.53 years. This is a long period.

b) Current ratio

In 2002, Boeing had current assets of 16855 million dollars and current liabilities of 19810 million dollars, a ratio of debt to assets of .85. This is lower than would be the desired ratio for industrial companies.

c) Long term debt to equity

In 2002 the long-term debt was 12589 million dollars and shareholders equity was 7696 million dollars a very high ratio of debt to equity of 1.64. Benjamin Graham thought that an industrial company should not have a ratio in excess of 1.

6. DOES THE COMPANY SHOW CONSISTENTLY HIGH RETURNS ON EQUITY AND CAPITAL?

The company has shown an average rate of return on equity over the past five years of 20.12%. In the same period, it showed an average return on capital of 12.02% .The figures indicate that use of debt financing has helped to increase the company returns on equity.

Year	ROE	ROC
1998	9.1	7.4
1999	17.7	12.9
2000	22.8	14.7
2001	21.4	12.2
2002	29.6	12.9
Average	20.12	12.02

7. HAVE THE EARNINGS PER SHARE AND SALES PER SHARE OF THE COMPANY SHOWN CONSISTENT GROWTH ABOVE MARKET AVERAGES OVER A PERIOD OF AT LEAST FIVE YEARS?

The figures for this period are as follows.

Year	EPS	+ or - %	SPS	+ or - %
1997	.63		47.05
1998	1.15	82.54	59.87	27.25
1999	2.19	90.43	66.60	11.24
2000	2.84	29.6	61.36	-7.87
2001	2.79	-1.76	72.94	18.87
2002	2.82	1.07	67.61	-7.30

Looking at a five-year rolling period, we can calculate, using a hand-held Texas Instruments BA-35 Solar Calculator, the increase in earnings and sales over the rolling five-year period 1998-2002. For earnings, this is very high; EPS has risen from $1.15 to $2.82, a total percentage rise of 145.21 %. Sales have risen per share from $59.87 to $67.61, a total rise of only 12.92%. The compound rate of return for earnings is 19.65%, for sales, 2.46%.

The disparity between earnings growth and sales growth suggests that the company has, for whatever reasons, managed to increase profitability well in excess of the rise in sales. Any person considering investment in this company would try and find out why.

8. HS THE COMPANY BEEN BUYING BACK ITS SHARES, AND IF SO, HAS IT BOUGHT THEM RESPONSIBLY?

In 1998, the company had common shares outstanding of 937.6 million. In 2002, the figure was 799.6 million. The number of shares on issue has been substantially reduced, suggesting a share buy back that may be one reason for increased earnings per share ratios.

9. HAS MANAGEMENT WISELY USED RETAINED EARNINGS TO INCREASE THE RATE OF RETURN TO SHAREHOLDERS?

The company has the following earnings per share and dividend per share record over a five-year period.

Year	EPS	DPS
1998	1.15	.56
1999	2.19	.56
2000	2.84	.59
2001	2.79	.68
2002	2.82	.68
Total	11.79	3.07

The company has therefore retained earnings totalling $8.72. In 1998, the shares reached a low of $29. In 2002, the shares reached a high of $51.10. An investor who bought at the lowest price in 1998 and still had them at the highest price in 2002 would have been showing a profit of $22.10. Thus the shares would have easily slotted into Warren Buffett’s requirement for showing an increase in market value of a dollar for every dollar retained.

Of course, and this shows Mr Market as a real factor, an investor who bought at the 1998 high price of $56.30, and sold at the 2002 low price of $28.50 would be showing a substantial loss on the investment.

Using the approach of Mary Buffett and David Clark,in The New Buffettology,  we could calculate the percentage increase in earnings per share resulting from the retained profits. EPS in 1998 were 1.15, and in 2002 were 2.82, an increase of 1.67. Thus, from the total earnings retained of $8.72, earnings have increased by a total of $1.67, a percentage increase of 19.15%: above market rates of return.

10. IS THE COMPANY LIKELY TO REQUIRE LARGE CAPITAL SUMS TO ENSURE CONTINUING PROFITABILITY?

Value Line suggests that in the two years following 2002, the company would be spending about $1.00 a share on capital items. The long-term average is $1.33, unadjusted for inflation. These figures seem to be a little less than historical expenditures.

This case study is a demonstration only and is not intended to influence or persuade visitors to this site to make any investment decisions; they should make their own decisions, based on their own research, personal and financial circumstances, and after consultation with their own financial or investment advisers.

http://www.buffettsecrets.com/bringing-it-all-together.htm

Low dividend payout by AirAsia if any

Tuesday August 24, 2010

Low dividend payout by AirAsia if any
By LEONG HUNG YEE
hungyee@thestar.com.my


PETALING JAYA: While analysts approve of AirAsia Bhd’s move to pay dividends, they expect the dividend payout will not be significant yet.

The budget carrier, which has been listed since 2004, do not have a dividend policy. However, the group is now considering to pay dividend to its shareholders.

HwangDBS Vickers Research said that although the dividend payment was positive for AirAsia’s shareholders, it did not expect yield to be attractive, considering AirAsia’s huge capital commitment as it was still at its expansion phase.

A local analyst said although AirAsia could afford to start paying dividend, it need not do so as no one expected the airline to pay dividend.

“Its cashflows are okay but the questions is not about the decision to pay, but by what quantum. It (quantum) makes a difference, for example paying one sen – which still constitutes a dividend although it’s not material – and a payout which gives a decent yield such as 10 sen,” he added.

A bank-backed analyst concurred that AirAsia could afford to pay dividend based on its current cashflow but it would not be as significant yet. He added that investors could invest in dividend stocks such as British American Tobacco if dividend was what they were after.

“AirAsia is a growing company. Investors invest in AirAsia for its growth story. They could pay half a sen to one sen in dividend and it may be more symbolic in the next three years,” he added.

The analyst also said AirAsia needed to restructure its Thai and Indonesian units as both were currently leveraging on its balance sheet.

Another analyst said AirAsia was currently on an expansion phase and would required large capital commitment. Hence, its dividend yield would not be as attractive.

“I don’t think it will be that much. In terms of yield, it may not be that attractive,” she said.

Yesterday, a local daily reported group CEO Datuk Seri Tony Fernandes as saying the group was planning to propose a dividend policy by the third quarter of this year.

AirAsia has been mulling over a dividend for some time. In June, Fernandes said AirAsia was in a much better position to consider paying dividends to its shareholders after solving some issues within the group.

Although it has announced its intention to pay its maiden dividend, the carrier has not given any indication on when the first payout will be.

As at June 30, AirAsia has a short and long-term borrowing of RM7.58bil and a deposit, bank and cash balances of RM858.1mil.

“The borrowings are mainly in the form of term loans which are for the purchase of new Airbus A320-200 aircraft,” it said in notes accompanying its latest quarterly results.

For the quarter ended June 30, AirAsia posted a net profit of RM198.9mil for the three months to June 30, a 43% jumped from RM139.2mil in the previous corresponding period, on a turnover of RM940.6mil.

http://biz.thestar.com.my/news/story.asp?file=/2010/8/24/business/6906547&sec=business

Investor's Checklist: Hard-Asset-Based Businesses

Companies in the hard asset based subsector depend on big investments in fixed assets to grow their businesses.  Airlines, waste haulers and expedited delivery companies all fall into this subsector.  In general, these companies aren't as attractive as technology-based businesses, but investors can still find some wide-moat stocks and good investments in this area.

Industry Structure

Growth for hard asset based businesses inevitably requires large incremental outlays for fixed assets.  After all, once an airline is flying full planes, the only way to get more passengers from point A to point B is to acquire an additional aircraft, which can cost US $35 million or more.

Because the incremental fixed investment occurs before asset deployment, companies in this sector generally finance their growth with external funding.  Debt can be used to finance almost all of the asset's cost, so lenders generally require the asset to provide collateral against the loan.  With this model, high leverage is not necessarily a bad thing, provided that the company can make enough money deploying the asset to cover the cost of debt financing and earn a reasonable return for shareholders.

Subsector:  Airlines


(With this in mind, airlines are generally the least attractive investment of all the companies in this subsector.  Airlines must bear enormous fixed costs to maintain their fleets and meet the demands of expensive labour contracts, yet they sell a commodity service that's difficult to differentiate.  As a result, price competition is intense, profit margins are razor-thin - and often non-existent - and operating leverage is so high that the firms can swing from being wildly profitable to nearly bankrupt in a short time.  If you don't think this sounds like a recipe for good long-term investments, you're right - airlines have lost a collective $11 billion (excluding the impact of recent government handouts) between deregulation in 1978 and 2002.  Over the same time period, 125 airlines had filed for Chapter 11 bankruptcy protection and 12 of them filed for Chapter 7 liquidation.)

Hallmarks of Success for Hard-Asset-Based Businesses

Cost leadership:  Because hard-asset based companies have large fixed costs, those that deliver their products most efficiently have a strong advantage and can achieve superior financial performance, such as Southwest in the airline industry.  To get an idea about how efficiently a company operates, look at its fixed asset turnover, operating margins and ROIC - and compare its numbers to industry peers.

Prudent financing:  Remember, having a load of debt is not itself a bad thing.  Having a load of debt that cannot be easily financed by the cash flow of the business is a recipe for disaster.  When analysing companies with high debt, always be sure that the debt can be serviced from free cash flow, even under a downside scenario.

Investor's Checklist:  Hard-Asset-Based Businesses

• Understand the business model.  Knowing a company leverages on hard assets will provide insight as to the kind of financial results the company may produce.
• Look for scale and operating leverage.  These characteristics can provide significant barriers to entry and lead to impressive financial performance.
• Look for recurring revenue.  Long-term customer contracts can guarantee certain levels of revenue for years into the future.  This can provide a degree of stability in financial results.
• Focus on cash flow.  Investors ultimately earn returns based on a company's cash-generating ability.  Avoid investments that aren't expected to generate adequate cash flow.
• Size the market opportunity.  Industries with big, untapped market opportunities provide an attractive environment for high growth.  In addition, companies chasing markets perceived to be big enough to accommodate growth for all industry participants are less likely to compete on price alone.
• Examine growth expectations.  Understand what kind of growth rates are incorporated into the share price.  If the rates of growth are unrealistic, avoid the stock.

The Five Rules for Successful Stock Investing

by Pat Dorsey

Understanding the business model: Hard-Asset-Based Businesses

Companies in the hard-asset-based subsector depend on big investments in fixed assets to grow their businesses. Airlines, waste haulers (Waste Management, Allied Waste, Republic Services), and expedited delivery companies (FedEx, UPS) all fall into this subsector.

In general, these companies aren't as attractive as technology-based businesses, but investors can still find some wide-moat stocks and good investments in this area.

Industry Structure

Growth for hard-asset-based businesses inevitably requires large incremental outlays for fixed assets. After all, once an airline is flyinng full planes, the only way to get more passengers from point A to point B is to acquire an additional aircraft, which can cost $35 million or more.

Because the incremental fixed investment occurs before asset deployment, companies in this sector generally finance their growth with external funding. Debt can be used to finance almost all of the asset's cost, so lenders generally require the asset to provide collateral against the loan. With this model, high leverage is not necessarily a bad thing, provided that the company can make enough money deploying the asset to cover the cost of debt financing and earn a reasonable return for shareholders.

With this in mind, airlines are generally the least attractive investment of all the companies in this subsector. Airlines must bear enormous fixed costs to maintain their fleets and meet the demands of expensive labour contracts, yet they sell a commodity service that's difficult to differentiate. As a result price competition is intense, profit margins are razor-thin - and often non-existent - and operating leverage is so high that the firms can swing from being wildly profitable to nearly bankrupt in a short time. If you don't think this sounds like a recipe for good long-term investments, you're right - airlines have lost a collective $11 billion (excluding the impact of recent government handouts) between deregulation in 1987 and 2002. Over the same time period, 125 airlines had filed for Chapter 11 bankruptcy protection, and 12 of them filed for Chapter 7 liquidation.

But despite the terrible performance for airlines in general, a few carriers have fared very well. Southwest, for one, has been profitable for 30 consecutive years - an amazing achievement considering the cyclicality of its business and the dismal operating environment for the industry in 2002. Southwest's superior financial performance is largely because of its main strategic advantage: a low cost structure driven by its practice of flying one type of aircraft for all its no frills, point-to-point routes. In an industry with less-than-desirable fundamentals, Southwest has achieved superior financial results by deploying a different and dominant, business strategy.

Other characteristics of hard-asset-based businesses make this segment worth watching. The idea of limited or shrinking assets, for example, can go a long way to provide stability in the competitive landscape for these companies. Because of the NIMBY (not in my back yard) principle, it is very difficult to get approval for new landfill sites. As a result, it is highly unlikely that new competitors will enter the landfill side of the waste management business. That puts a company such as Waste Management, which owns 40 percent of the total U.S. disposal capacity via its 300 landfills, at an advantage.

The majority of hard-asset-based companies fall into the narrow- or no-moat buckets. With few, if any, competitive advantages for many of these companies, investors should look for a pretty steep discount to a fair value estimate before buying shares.

Hallmark of Success for Hard-Asset-Based Businesses

Cost leadership: Because hard-asset-based companies have large fixed costs, those that deliver their products most efficiently have a strong advantage and can achieve superior financial performance, such as Southwest in the airline industry. Firms don't usually advertise their cost structures per se, so to get an idea about how efficiently a company operatees, look at its fixed assets turnover, operating margins, and ROIC - and compare its numbers to industry peers.

Unique assets: When limited assets are required to fulfill the delivery of a particular service, ownership of those assets is key. For example, Waste Management's numerous, well-located landfill assets represent a significant competitive advantage and brrier to entry in the waste management market because it's unlikely that enough new landfill locations will get government approval to diminish its share of this business.

Prudent financing: Remember, having a load of debt is not itself a bad thing. Having a load of debt that cannot be easily financed by the cash flow of the business is a reccipe for disaster. When analyzing companies with high debt, always be sure that the debt can be serviced from free cash flow, even under a downside scenario.

(Some Malaysian companies in this hard-asset-based businesses are Air Asia, MAS, Maybulk and Transmile.)



Ref: The Five Rules for Successful Stock Investing by Pat Dorsey

Swine flu: the UK shares affected

Swine flu: the UK shares affected

The outbreak of swine flu, which has killed more than 100 people in Mexico and spread to the US, Canada and New Zealand, has hit UK shares linked to travel and agriculture, and give a boost to pharmaceuticals companies. Some of the biggest companies affected are listed below.

By Amy Wilson
Last Updated: 10:26AM BST 27 Apr 2009

GlaxoSmithKline
Shire
British Airways
Easyjet
Thomas Cook Group
TUI Travel
Carnival
InterContinental Hotels Group
Cranswick
Genus

Pharmaceuticals

GlaxoSmithKline: its shares rose as much as 44p, or 4.4pc to 1,050p. Glaxo makes a flu drug called Relenza, which could be bought up by governments seeking to treat and halt the spread of swine flu. Relenza has been shown to work against viral samples of the disease.

Roche: The shares rose in Swiss trading. Roche's Tamiflu drug can reduce the symptoms of swine flu and said it has an ample supply of the drug as the outbreak spread outside Mexico.

Shire: the drugs company’s shares rose in sympathy with Glaxo's.

Airlines:

British Airways: The airline has been hit along with others in the sector, on fear the swine flu outbreak will reduce demand for travel.

easyJet: The low-cost airline fell.

Ryanair: the Irish budget airline was also under pressure.

Travel companies:

Thomas Cook: The holiday company fell on concern the spread of swine fever will curb foreign travel. Mexico has been a popular destination for holidaymakers trying to avoid countries using the euro while it remains so strong against the pound.

TUI Travel: The Thomson holiday group also declined.

Carnival: the cruise operator, whose Caribben cruises take in Mexico, dropped.

Intercontinental: Shares in the hotel operator also fell.

Agriculture:

Cranswick: The food firm, which has just bought a Norfolk-based supplier of pork for Tesco and a number of other major retailers, fell on concern shoppers will avoid pork products as a result of swine flu.

Genus: The pig breeding specialist declined.

http://www.telegraph.co.uk/finance/markets/5229079/Swine-flu-the-UK-shares-affected.html

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