FOOL ON THE HILL
An Investment Opinion
Fortune Brands: Cheap for a Reason Dale Wettlaufer (TMF Ralegh)
October 21, 1999
Last Saturday I sat down to peruse Barron's, as usual, and went right to the Fortune Brands (NYSE: FO) article. It never fails -- I see the company mentioned somewhere and think of their great array of products, which includes Titleist (the best golf gloves and balls anywhere, and some excellent golf clubs, too), Cobra golf (kind of stodgy these days, but respectable), Pinnacle (great off a metal wood, but they're rocks around the greens; still a popular ball), and FootJoy (classic shoes and the Sta-Sof glove is a classic). For the 19th hole, they're the maker of Jim Beam and Knob Creek bourbons, as well as a wide variety of spirits. The company also manufactures Master Lock products, Aristokraft cabinet, Moen faucets, Day-Timer personal organizers, and a number of other products. For pure brand-name familiarity, the company is a powerhouse.
As far as its representation of itself through its accounting, however, the company is perplexingly weak. Incoming CEO Norm Wesley told Barron's that the market just wasn't getting the quality of Fortune Brands and that it didn't understand the real cash earnings part of the story. The problem with that is that the market is sophisticated and efficient enough that it is able to parse cash earnings from GAAP earnings when the divergence between the two is due simply to goodwill amortization. It's just NOT that tough a concept to deal with.
So what do you do when you think the market's just not getting it? Write off the goodwill, dummy! Instant earnings CAN be yours. From this morning's press release:
"Fortune Brands, Inc... today reported strong 1999 third quarter earnings growth propelled by record operating company contribution from the home, golf and spirits and wine businesses. Diluted EPS before charges reached 42 cents, up 31% from 32 cents a year ago."
At least the company was good enough to explain where nearly half the earnings growth came from:
"Excluding a five cent per share benefit from lower goodwill amortization, diluted EPS before charges grew 16%."
Lest you think that I'm the sort that focuses on the income statement impact of goodwill amortization, let me just say I'm not. For the purposes of analyzing a company, I add back the amortization to the income statement because it has no pertinence, in and of itself, to current earnings. You can't just waltz though life deducting the goodwill amortization from expenses without taking into account what that action has on the balance sheet, though. If you constantly add back goodwill amortization to reported earnings and don't add it back to the balance sheet, the company with zero growth in cash earnings will show an ever-increasing return on capital result, which is plainly nonsense from the standpoint of analyzing the company.
What the presence of goodwill on the balance sheet does is help investors understand the effectiveness with which management has deployed capital, which in turn helps in trying to figure out how well the company will allocate capital in the future, which ultimately helps the investor figure out the intrinsic value of the company. The reason why Fortune Brands has traded at a discount to the market and at a low multiple to earnings, however you want to define those earnings, is that the company shows a return on capital result that is nowhere near as good as other branded consumer goods companies.
In fiscal 1998, for instance, the company's ending invested capital base would have been $857 million higher and the beginning invested capital base would have been $748 million higher, adding back cumulative goodwill amortization. Major invested capital components would have looked more like this, then:
Ending invested capital, FY 1998:
Shareholders' equity: $4,955 million
LT Debt, ST Debt, Notes, Credit lines: $1,486 million
Posretirement, other liabilities: $386 million
Deferred income tax liabilities: $50 million
Total: $6,877 million
Working from left to right on the balance sheet, that's the same thing as total assets (including cumulative amortization) less noninterest-bearing current liabilities.
Beginning invested capital, FY 1998:
Shareholders' equity: $4,765 million
LT Debt, ST Debt, Notes, Credit lines: $1,144 million
Posretirement, other liabilities: $379 million
Deferred income tax liabilities: $38 million
Average invested capital: $6,602 million
To get a sense of the company's cash-on-cash return on capital, you then want to look at what net income would be before taking into account the cost of capital employed to create that cash flow. That means you look at net operating profit after tax, which is basically operating profit plus goodwill amortization less taxes. For 1998, the company reported operating profits of $619.6 million. Add back to that goodwill amortization of $108.2 million, tax that sum (I'm using a 36% tax rate), and you get net operating profit after tax of $466 million.
The exercise here is to try and figure out how productively the company is making use of all the capital at its disposal. Without even adding back to the balance sheet the amount of shareholders' equity and assets that have been reduced by prior restructuring charges (and these are plentiful), the company's 7% return on capital is poor. It's unacceptably small, in fact, and explains why the company doesn't sell at much of a premium to invested capital. Just like debt, equity has a cost. It's not an explicit cost, it's an implicit cost, equal to the opportunity cost of equity, which is the return one should expect from equity in general. All of the equity above costs something and it doesn't take a complex analysis of this company's weighted average cost of capital to see that it isn't meeting its cost of capital. With this being the case, the market is being entirely rational bidding down the equity. It's not productive equity.
Fortune Brands wants you to think so, however, so they wrote off $1.1 billion of it this year, with this incredible explanation:
Effective April 1, 1999, the Company elected to change its method for assessing recoverability of goodwill from one based on undiscounted cash flows to one based on discounted cash flows. The Company determined that using a discounted cash flow methodology was a preferable policy.
Wow. That just blew my mind when I read it. You get flunked in Finance 101 if you figure out the value of the company using undiscounted cash flows. If this means the company used accretion/dilution analysis in figuring out whether an acquisition will add value, then nothing has changed, as it still discusses accretion/dilution in its acquisition press releases.
The Barron's article takes the tack that incoming CEO Glen Wesley is doing the right thing with the goodwill writeoff: "So the goodwill writedown -- in part representing past acquisitions for which Fortune far overpaid -- wipes away some of the non-cash items that had obscured the cash-generating power of the company...." How many times have we seen this one? Blame it on old management, take the restructuring, and move forward with huge growth in EBABS (earnings before all the bad stuff)? The writeoffs are spun as "non-cash charges" today, but make no mistake about it, they represent the frittering away of capital.
So the market is now supposed to believe it's morning again at Fortune Brands, where no dumb acquisitions will be done and "brand power" will deliver results. In my book, if there's no pricing advantage or no market share advantage that allows you to generate superior cash-on-cash returns, you either don't have a brand (in the true sense of the word, before it became this catch-all investing buzzword) or you're overpaying for your brands.
Barron's article also goes on to state that free cash flow is running at an annualized rate of $200 million, which will help share buybacks. Boy, they're getting all the "value investing" buzzwords in here. I don't know how they're treating working capital requirements in their calculation of cash flow, but the cash conversion cycle characteristics of this company aren't too good-looking. As of mid-year, the company had 32 days in payables offsetting a whopping 196 days in receivables and inventory. Now, I understand the spirits business is a low-turns, high-margin business, but if you want to look at cash flow, you can't just add up all the positives on the cash flow statement and not recognize the cash demands of the operating business.
I see 1998 net cash from operations less net capital expenditures equaling $159 million. Annualizing the first half of 1999, I see net cash from operations less net capital expenditures equaling $111 million. Even if I'm missing some seasonality in that annualization, I don't see the share buybacks being financed by free cash flow. If free cash flow IS running at $200 million for the year, almost three-quarters of that is going to go for dividends. So let's just be straightforward with the share repurchase talk. It's being financed by debt, not by free cash flow (I'm not saying the company asserted any free cash flow figure, by the way. I think it's the assertion of the article's writer). Through six months of 1999, the company generated $140 million in net cash from operations and used net cash of $74.5 million in investing activities. That covered 87% of the company's dividend payout for the first half. The share repurchase was financed by a cash inflow of $72.4 million from the exercise of stock options and net debt issuance of $227 million.
If the company's return on capital is of any analytical use going forward, then the market is not going to award Fortune Brands any premium to the capital invested in it, and I would have to think it will trade at a discount to invested capital if the pace of acquisitions persists. Further, I don't see this as a cash flow monster capable of continuing a robust repurchase of shares unless cash keeps flowing in from the exercise of options or from the issuance of debt. In the meantime, I think it's farcical to write off the carrying value of past deals while still counting all the good stuff from those past deals in your income statement and cash flow. It's sort of like the oil and gas business's "successful attempts" accounting, as G. Bennett Stewart III likes to point out.
To answer the Barron's article, it's not a conglomerate discount that exists here. The market is smart enough to figure it out over the long run. It's just not that great a business, and if it is, it's not a well-run business, in my opinion.