Saturday, February 27, 2010

Analyzing Non-Core Risks

This article was also a featured link on The Reformed Broker. 

My view on risks when analyzing a business is that there are two types of broad risks that investors take: core and non-core. "Core" risks are ones that are inherent to being in a business: input costs, competitive actions, regulations, pricing dynamics, lawsuits, even employee embezzlement, and so on. Then, in many businesses, there are "non-core" risks: these are risks that are above and beyond the regular business operations. The problems with non-core risks is that they are not always obvious and that they are harder to quantify, so it is difficult to know whether you, as the owner, get paid to bear them.

Let's look at some examples of non-core risks that an investor should be cognizant of.

Post-retirement liability risk

The two kinds I am looking at are pensions and healthcare. Like stock options, pension promises are a compensation expense that defers present cash payments for a future promise. The shortsightedness and the incentives of a number of management teams has been a factor in overpromising benefits to lower shorter-term cash costs. Many firms currently realize that taking on these kinds of liabilities is dangerous, and have discontinued their "defined benefit" plans. But the existing liabilities are on the books already, and the zero equity returns and extraordinarily low bond rates over the last 10 years have made meeting the target returns difficult.

-Pensions: The assets of the plan are well known, the liabilities are not. This is the essence of the "non core" risk: large cash outlays may be required in the future, lowering the equity value. Anyone with an iota of knowledge of pension accounting knows that it involves a number of actuarial assumptions including projected asset returns, projected worker tenure, worker compensation rates and worker lifespan. On top, these assumptions can be "massaged" by management for short-term gains.

- Post-retirement health benefits: some plans offer post-retirement health benefits. Normally these are unfunded: the costs are recorded as incurred without prior funding. Knowing what has been going on with health costs, would you buy a business that is paying for the healthcare of someone who finished working there 20 years ago? Ask Motors Liquidation Company, aka "Old GM." And I am not even discussing if employers should be involved in providing healthcare to being with.

Financing arm risk

There are financing businesses (banks, credit card companies, specialty finance co.'s) that are in the business of providing financing. And then there are goods- or service-producing businesses that end up providing financing to their customers. This is a non-core risk in my view. It is not a problem until it is, leading to unexpected losses. Some recent high-profile incidents are GMAC that got into a number of non-core areas, Harley-Davidson's financing arm, Target and J.W. Nordstrom with their own credit cards.
Think of it this way: providing both the product and the financing means you are "double-long" your customers. If you max out your Target card at the store, and then default on it, Target effectively "gave away the store". If you do not make the payments on your new Harley, and it gets repossessed, HD takes the hit both on the resale value and on the receivables. Further, as we saw during the credit crunch, trying to fund the in-house financing operations is impossible once the securitization markets freeze.

Hidden short-term funding risk

Again, one of those "not a problem until it is." Many businesses mix shorter and longer-term debt funding. Overreliance on short-term funding, with its constant roll-over can trip event the bluest of the blue chips. GE had problems with its commercial paper program, usually a low-cost, liquid form of financing even before Lehman (the largest CP player, I think) blew up. This risk can be mitigated if the company has access to ample revolving credit lines. It does involve reading the footnotes in the financial statements, of course.

"Cash-equivalent" risk

Another credit crunch issue, remember when the auction-rate securities markets froze completely? A number of completely unrelated businesses had parked cash there and had to reclassify those assets when they had no access to them. I am not aware of it being fatal for any particular business, but it is a good example of a hardly-disclosed non-core risk. You can be sure that Wall Street will come up with the next "better" product to push on their clients in the treasury departments, but we won't find out about it until it becomes a problem.

Unrelated equity investments risk

Surely there are legitimate, "core business" equity investments. These might include joint ventures with other industry players to develop a new product, or equity investments in foreign subsidiaries in partnership with a local entity, or equity ownership prior to a complete separation of a faster-growing business unit (i.e. McDonalds/Chipotle). But then, some companies, for historical or other reasons, have substantial chunks of completely unrelated businesses. Ralcorp, a mid-tier food company, is an example of such company: RAH has a sizable share in Vail Resorts, a resort operator. Deltic Timber has a golf course investment (seems legit, right?). Vector Group, a small cigarette maker, is also an owner of CBRE, a NY-area real estate brokerage. Medallion Financial, a specialty finance business that funds taxi "medallion" purchases in cities that have those, also has stakes in two SPACs (and BTW NYC yellow cab medallions cost 750k+ for a corporate, 500k+ for individual). One needs to think "do I get paid to bear all this additional, non-core risk here?" This risk also has potential upsides, if one can accurately identify a mispricing like we had with the Palm/3Com situation a while back.

Governance risks

Governance risks are anything related to management actions (outside of running the business) that presents a potential harm to shareholders. There are a number of these, but I will look at two.

-Related party transaction risk: these are generally disclosed in the filings. But disclosure does not mean that the transaction is not harmful to the shareholders, even when it is "approved" by the boards. For example, if a company rents office or warehouse space from a senior manager somewhere in town XYZ, I have no idea if the price is fair. There have been some really egregious examples, including using a manager's wife's architectural firm for all new bank branches (Commerce Bancorp had paid $50 mm to the CEO's wife's firm; he was asked to leave by federal regulators, which also shows how useless the board really was).

-Retroactive option expense increases: this one hit me last year when the stock market tanked. All of a sudden, companies started re-pricing their employees' stock options at lower prices! The whole purpose of having stock options is that employees are incentivized to bring the share price up. When the market moved lower last winter through March, shareholders took losses all along. But some employees did not: they had their options repriced at the new, lower levels which defeats the purpose of having incentive compensation. This way the shareholders took a hit in the market, and are much more likely to get diluted down the road. I think the biggest offender there was Google. The "do no evil" folks over in Mountain View last March (note the timing) repriced over 6 million options from $500 strike down to $308. This is creating Silicon Valley millionaires not by sweat but by expropriation. So, the employees had no downside when the stock moved down, while the owners are hit twice, once with the stock loss and, second, with additional dilution.

The point of this missive is: as a shareholder (=business owner), you are likely to bear risks above and beyond the ones that come with the business. It is important to recognize that those come in a wide variety of flavors and it is often impossible to tell if one gets compensated adequately for them. With that, we are going to wrap it up for today.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

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