Drip Portfolio Report
Tuesday, September 23, 1997
by Randy Befumo (TMF [email protected])

ALEXANDRIA, VA (Sept. 23, 1997) -- Yesterday we learned how to calculate revenues, operating earnings, and earnings before interest, taxes, depreciation and amortization (EBITDA) using a mix of annual and quarterly statements for a subsidiary of a corporation. Did you follow through all of the work there? Well, pat yourself on the back. You have done something that many investors who considered themselves seasoned veterans have problems with all of the time.

Before we start to use these numbers today, I want to stress that "sum of the parts" valuations, or valuations that look at individual parts of a company and try to value them as separate entities, are among the most difficult but most rewarding exercises possible. The way "sum of the parts" valuations work is that you value one subsidiary, back it out of the whole, move on to the next, back it out of the whole and continue the process until you are left with money (meaning the company is overvalued) or you have a very negative sum (meaning the company is undervalued).

Next Monday, when I wrest the Drip Portfolio report back from Jeff, we will be using EBITDA as one of the main ways to value Kansas City Southern Railroad (KCSR). Today we will spend most of the report explaining why. The reason we are looking at EBITDA, also known as cash flow, instead of just ordinary earnings is that unlike a traditional manufacturing company, railroads require a lot of fixed assets to continue running. Now, for accounting purposes, does it make sense for these companies to book the full cost of assets like engines and railcars when they buy them, even though they have expected lives of anywhere from five to twenty-five years? Certainly not. If you did it this way, you would have very high earnings punctuated by occasional large purposes, which would make it difficult to see the real underlying earnings being generated by the company.

To account for this, financial whizzes invented something called depreciation. Depreciation is a way for companies to recognize the costs over a number of years instead of just one. Will that $50,000 locomotive last ten years? Why not account for $5,000 of the price per year over ten years instead of doing it all in one lump sum? Even though on a cash basis the locomotive would be bought and paid for in year one (assuming the company was not financing the purchase), on a Generally Accepted Accounting Principles (GAAP) basis the cost would be spread out over ten years. As a consequence, EBITDA (cash flow) diverges from the accounting earnings.

Although the accounting earnings are an approximation of the cash a company generates, for a company like a railroad the depreciation it has is normally well in excess of any new fixed costs it has to bear. As a result, investors look at a "non-cash" charge like depreciation as a confusing item and put it back into the results. Amortization, the cousin of depreciation, basically does the same thing except that it is used to spread the cost of cash acquisitions over a number of years. As railroads have been an acquisitive bunch over the past ten years in the search of the transcontinental railroad, throwing out the "non-cash" amortization expenses associated with a merger to understand better what the underlying cash flow of the company is also makes sense.

Called "non-cash" charges because they don't actually drain cash from the company, when looking at companies with large fixed assets that depreciate faster than their useful life, looking at cash flow instead of earnings makes a lot of sense. Just like you would with earnings, you relate the cash flow to the going value of the company. Cash flow "multiples," ratios of the cash flow to the market price, are the way to do this. Because many railroads are highly leveraged, meaning they have a lot of debt, the EBITDA is normally compared to the "enterprise value," or the value of the outstanding equity, preferred stock, convertible debt, and long-term debt the company has outstanding. In the case of KCSR, because we are just trying to assess what it is worth on an absolute basis, this will not initially be necessary.

Now, for your homework.

As a north-south railroad, we need to find other north-south railroads to compare to KCSR in order to find out what valuation to place on it. What is this company (or companies)? What are its trailing revenues, operating earnings, and EBITDA? If we placed the same valuation on KCSR, how much would it be worth. Just so you have the numbers, for KCSR we have the following as of yesterday:

Revenues = $506.1 million
Operating Income = $75.3 million
EBITDA = $132.2 million

See you next week, and anyone who gets very far on the homework should post in the Drip Investing message folder and also e-mail me the same post at TMF [email protected].