<THE BORING PORTFOLIO>
To UAM's Financials
By Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (July 2, 1999) -- On Wednesday, I continued my look at United Asset Management (NYSE: UAM) with a discussion of adjustments to the intangible assets that come along with this company. This discussion could be used as a platform for the treatment of intangibles in general, but it's particularly germane to UAM, given that intangibles account for just under two-thirds of UAM's assets and 345% of shareholders' equity.
I prefer to approach this sort of company in a different way than looking at straight book values, however. If you've read my stuff before, this is going to be somewhat old hat, but I think it's still not mainstream, so it bears repeating for newer readers. First, poolings of interests distort the successor economics of mergers and acquisitions. This is due to the fact that the market value of equity traded for another company is never reflected in the combined account of the resulting entity. The owners of the new entity get to look at a return on capital result that contains the following: 1.) Increased cash flow on; and 2.) A capital base reflecting not their basis of investment in the acquired company, but someone else's. You're getting a mismatch in the cash flows and capital laid out to acquire those cash flows.
In a purchase-treatment acquisition, you're getting much closer to the real economics of a transaction because the difference between the assets handed over (whether that's funded straight out of cash, with cash raised by debt issuance, or through equity issuance or other consideration) and the fair value of the net assets acquired (which is usually in the neighborhood of shareholders' equity) is marked up on the balance sheet as intangibles on the left side of the balance sheet and as a component of equity on the right side. This makes all the sense in the world because you want to see evidence of capital being traded for another entity, which you don't get on the balance sheet of a company engaging in poolings of interests.
Say I acquired via a stock swap another (debt-free) company for $100 and that company had $5 in tangible book value and $4 in free cash flow or earnings. Under the pooling of interests method of accounting, the incremental return on equity for this business would be 80%. If my current return on capital is 20% and I delivered that sort of incremental return to my shareholders, I'd be a genius, right? No.
Say I financed that $100 purchase price with debt costing 6.15% pre-tax. I would be generating $6.15 in operating income (using a 35% tax rate -- 4%/0.65 = 6.15%) but I'd have to come up with $6.15 each year in debt service. There would be no addition or subtraction to EPS (though things might be a little different in an alternative minimum tax world) so there would be no reduction or addition to the value of the company, right? No, especially if the business never grew. The $100 in debt would come right off the top of the company's enterprise value, owing to the interests of those debt holders. The addition to the company's pre-tax income stream would be negated by the increase in debt, leaving no marginal shareholder value left over from that transaction.
Bringing this back to the issue of amortization of goodwill, let's say we mark up $95 in goodwill from the deal and we elect to amortize the goodwill over five years, at $19 per year. If the goodwill expense were not deductible and earnings never advanced past $4, then would the value of that additional business increase over time simply because the book value of the acquired company is decreasing by $19 each year? If you look at the economics of it in the following light, it would, right?:
Book value.....Earnings...ROE(Begin. equity) $100.00.........$4.00................4.00% $81.00...........$4.00...............4.94% $62.00...........$4.00...............6.45% $43.00...........$4.00...............9.30% $24.00...........$4.00..............16.67% $5.00.............$4.00.............80.00%
If you don't amortize the intangibles and leave them on the balance sheet, then the true return on capital characteristics show themselves going forward. If your unleveraged return on capital is 4% in year one and never grows, then it's 4% in year 5. Unless you're a Japanese conglomerate, you're unlikely to be pleased with that return on capital over the long run. If you're financing the deal through equity issuance, this doesn't change. Your unleveraged return on capital isn't any different. Your cost of capital would in most environments be higher, which might be a deal breaker, but your gross return on the investment wouldn't be any different until you've extinguished that capital in some way or the cash flow changes. Moving assets of the balance with a bookkeeping entry doesn't change the company's financial aerodynamics.
This might be boring, I'm sure, but it plays an important part in what I'm trying to determine with the UAM idea. Here's why. When you look at this company's cash flows, you're looking at a stream of cash that has the amortization of acquired contracts netted out. That gross cash stream won't look any different if the absence of intangibles on the balance sheet is the only element of its financials that have changed by year ten. Therefore, any change in return on investment brought about by a bookkeeping alteration to the denominator in return on capital assessments doesn't mean anything. As long as the numerator hasn't changed and there has been no deployment of capital to change the denominator of ROE of ROIC, then ROE and ROIC haven't changed.
It's quite obvious that this company generates a ton of cash. That's sort of a Philip Morris-type of thing. Anybody can see that PM is cheap based on today's cash flow. Figuring out where it's going and figuring out your true return on capital at Philip Morris when you bring the net present value of potential liabilities onto the balance sheet (much like what you would do with an insurer establishing reserves for liabilities that range all the way from being future outflows to expected outflows) is the bigger challenge. Luckily, I'm not dealing with PM, since I still don't know how to model how juries and governments around the world will act and. Even more conveniently with UAM, the necessary balance sheet adjustments are readily available and very straightforward.
To get at return on capital here, you add back both unrecorded goodwill (goodwill that would have been assumed had poolings been structured as purchases) as well as accumulated amortization. Therefore, invested capital at the beginning of the year is more than half a billion dollars higher than book capital and is nearly $600 million higher at the end of the year. All of this of course changes the return characteristics of the business and explains why the company is cheap on cash flow metrics. I'm willing to go on looking at the company because the business model is attractive, I don't believe it falls into the "dangerously cheap" zone, and from everything I can tell, this is a company that doesn't just pay lip service to enhancing shareholder value. They've put significant dollars into their share repurchases over the last couple years, which is a long way from companies that are just doing that to offset stock options dilution or worse, companies that announce repurchase authorizations for the press release value.
I'm attaching a spreadsheet (Excel 95 and 97 format) that shows my base economic model of the company. It's what you see below, but you can work through the cells in the attached. Next week, we'll deal with the significance of the adjustments I've made and modeling the company going forward. The differences in the three cash EPS data are due to adding amortization of intangibles back to reported EPS in the second figure and then in the "alternate data" column taking out the tax deduction the company gets on that. We'll also deal with the tax issues next week and get the present value of the tax shield into the valuation. In the meantime, questions, comments, and lower-intensity flames are welcome on the Boring Port message board.
Have a good Independence Day weekend.
Company: UMA (financials in millions, except per share amounts) UAM Alternate data Price.....21.19 Market Cap.....$1,279.81 Enterprise Value.....$2,131.98 EV/Revenues.....2.27 EV/Invested Capital.....1.14 EV/Assets.....1.55 Price/Book Value.....5.87.....1.57 PSR.....1.36 EPS.....$1.16 Cash EPS.....$3.02.....$2.43 P/E.....18.26 Cash P/E.....7.01.....8.70 EV/Operating.....11.37 EV/Net Income.....30.42 EV/NCFO.....9.49 EV/NOPAT.....11.09 Diluted Sharecount.....60.40 ROIC.....10.22% A/R Days Sales Outstanding.....30.54 Working Capital.....96.90 Inventory Turnover.....0.00 Capital Turnover.....0.50 Days in Inventory.....0.00 Days Sales Outstanding.....61.09 Days in Payables.....155.73 Cash Conversion Cycle.....-94.64 Asset Turnover.....0.66 Assets/Equity.....4.24 Net Margin.....7.47% ROA.....4.91% ROE.....20.80%.....15.82% Cash/Share.....$2.09 Current Ratio.....1.49 Quick Ratio.....1.49 LT Debt/Equity426.87%.....114.02% Begin Invested Capital$1,892.08 End Invested Capital$1,870.23 YOY IC Growth-1.15% Avg. Invested Capital$1,881.15 Invested Capital Turnover0.50 ATOI$116.26 NOPAT.....$192.21 Effective Tax Rate.....43.29% Indicated after-tax NOPAT.....$140.80 Income Statement Trailing Revenues.....$937.73 COGS.....$464.24 Amortization of contracts.....$112.55 Other operating.....$173.43 Operating Earnings.....$187.52 Interest expense.....$57.77 Other amortization.....$6.16 Pre-tax income.....$123.59.....$150.23 Tax expense.....$53.50 Net Income.....$70.08 Gross Margin.....50.49% Operating Margin.....20.00% Net Margin.....7.47% Balance Sheet Cash & Equivalents.....$126.07 Excess cash.....$79.18 Last year excess cash.....$76.10 Receivables.....$156.94 Inventories.....$0.00 Last Yr Inventories.....$0.00 Payables.....$198.07 Current Assets.....$294.97 Current Liabilities.....$198.07 Long-Term Debt.....$931.36 Shareholder's Equity.....$218.18.....$816.80 Last Yr Shareholder's Eq.....$455.56.....$963.65 Total Assets.....$1,377.88 Last Year Assets.....$1,479.03 Avg. Assets.....$1,428.45 Average receivables.....$78.47 Average inventories.....$0.00 Average Assets.....$1,428.45 Average share equity.....$336.87.....890.23 Working Capital Change.....$20.14 Net Op. Cash Ex. WC Change.....$204.54 Net Cash from Operations.....$224.68 NCFO/Reported Earnings.....320.58%
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Stock Change Bid APCC - 3/16 20.06 BRKb +32 2278.00 CSL --- 48.75 GTW +1 7/16 61.50
Day Month Year History BORING +0.63% 1.15% 5.09% 41.11% S&P: +0.74% 1.35% 13.76% 131.67% NASDAQ: +1.29% 2.06% 25.01% 163.32% Rec'd # Security In At Now Change 8/13/96 200 Carlisle C 26.32 48.75 85.19% 4/20/99 460 American P 14.48 20.06 38.59% 12/31/98 12 Berkshire 2276.17 2278.00 0.08% 2/9/99 100 Gateway 20 72.38 61.50 -15.03% Rec'd # Security In At Value Change 8/13/96 200 Carlisle C 5264.99 9750.00 $4485.01 4/20/99 460 American P 6659.25 9228.75 $2569.50 12/31/98 12 Berkshire 27314.00 27336.00 $22.00 2/9/99 100 Gateway 20 7237.50 6150.00 -$1087.50 CASH $18091.65 TOTAL $70556.40
</THE BORING PORTFOLIO>