Sunday, April 16, 2017

The Golden arches epitomize Intangible Business at its best!

The Golden arches - logo of the fast food giant McDonalds Corporation - has become the omnipresent logo that jostles both urban and rural landscapes alike, all over the world.
Whether you are driving to work in your car, taking the subway, travelling across state borders on an interstate highway, taking a flight or even just leisure shopping in your neighborhood mall, you cannot escape the presence of this ubiquitous symbol, tempting you to step in and enjoy one of its lip smacking meals once again, an experience that you have come to enjoy so much while growing up through your teens. The menu changes just a little once in a while, but the experience never ever changes. Rarely if ever, will you have the opportunity to be dissatisfied with the food or the service, whether you are dining in-house or picking up from the drive-through window. Product and Service Quality is maintained to the dot and regardless of employee turnover, there is no deterioration in either one.

Yet, the operational smoothness at the ordering counter betrays the ongoing upheaval in
the financial structure of the company. The fact is that McDonalds management has been on a stock buy-back spree for a while now. The chart alongside shows how the outstanding shares of the company is decreasing steadily over the past two years. This is because McDonalds is lapping up its own shares from the stock market using the money from its Share Capital account. Ordinarily, a share buy-back is a welcome sign because it is an indication from management that the current share price is much below its intrinsic value. While McDonalds stock has moved up about 30% in response to this move in the past two years itself, clearly the Management is not relenting and wants the stock to do much more.

As a proof of this, take a look at the NetWorth of the Company in the alongside chart over the past two years. It shows that NetWorth is declining steadily, to the extent that it is now actually negative and in the red. This implies that the Company has exhausted all its share capital in the buy-back process and is in fact now using debt to finance the share buy-back. This is an extreme step. It indicates the strong conviction of the management in its own business model, to the extent that it is relying on debt not only to finance ongoing operations but also to finance the share buy-back. Keep in mind that a negative Networth implies that the book value of the share is negative. If the company were to shut down tomorrow for any reason, the shareholders of the company would theoretically get nothing back!

It is perhaps with this thought in mind that Management has resisted the urge to stop
paying dividends during this entire buy-back process. The chart alongside shows that dividend payout is consistent, and is in fact increasing over time. This means that profits from existing operations are being returned to investors partly in the form of dividends, and the rest together with additional debt is being used to fund existing operations, capital expenditures and the share buy-back process.

How bold a move is this? I have to admit it is very bold. The conviction required to make a share buy-back just once is high enough – but to sustain it consistently quarter after quarter, to the extent that NetWorth becomes negative and increase dividend payout simultaneously - requires conviction of a higher order. The management of the company believes that they have a winning formula in their business model that is unbeatable. This formula extends from the deepest link in their supply chain all the way to the ordering counter in each restaurant. Customers are assured of not only a quality meal at a reasonable price, but of a dining experience that is consistent in any McDonalds restaurant, anywhere in the world. Achieving this level of operational excellence requires time no doubt, but more importantly it requires the continuous and arduous cultivation of intangible assets - all the things that you cannot touch and feel but know for sure are the keys to your success and to your competitive advantage in the marketplace.

What does all this mean for the stock? Well for one, it has nowhere to go but up in the near and medium term. Secondly, once management feels that the stock price has reached acceptable levels, they may start re-issuing the stock to the market at a higher price. In doing so, they would have then invested in their own business with their own (and some borrowed) money and made handsome returns for the business and for each investor in the process!

So the next time you are in a McDonalds restaurant, think about this strategy at play, while you are enjoying your next happy meal along with your family!

p.s. At the time of writing this article, McDonalds stock was trading $130.76, which means the stock is up 7.4% in the first three and half months of calendar year 2017!

Monday, January 23, 2017

Capital Markets know the value of Intellectual Capital

Intellectual Capital of a business is defined simply, in theory, as the value of the intangible assets of the business. As far as theory goes, this definition is entirely correct. But it is in practice where this definition falls woefully short.  The latest accounting standards (read IFRS compliance) require every business to report the value of its intangible assets in its balance sheet. What gets reported however is the value of the intangible assets as is recognized under the accounting standards. And this is the reason why there remains a wide gap between the actual value of intangible assets in the 
business and what is reported in the balance sheet. IFRS accounting standards are conservative by nature and define strict criteria for what can and cannot be considered as an intangible asset in the first place. 
  • The two acid tests in this regard are 
  • The intangible asset should be identifiable

The economic benefits arising from the intangible asset should be reliably measurable
It is due to this strictness that businesses act ultra conservative when reporting the value of their intangible assets. Let’s take an example to understand this better and its impact on investor’s assessment of the business.

Union Pacific Corporation (NYSE: UNP) is the largest railroad operator in the United States. Incorporated in 1969, the company operates 8500 locomotives over more than 32,000 km of railroads employing more than 42,000 people. The company hauls commodity freight such as agricultural products, chemicals and coal as well as automotive and industrial products across the length and breadth of the United States. It competes with other railroad operators as well as road and waterways based freight haulers. The company runs its operations profitably and despite the vagaries of economic cycles, it has not reported a single quarter of loss in the past 13 years that icTracker has been tracking it. This includes that period during the 2008 crisis when every other company appeared to be going down under in a hurry. We would therefore have to assume that the company has developed a deep understanding of its Customers business over a long period of time to the extent that it can forecast demand for its freight services well ahead of time. This in turn enables it to plan availability of locomotives, freight cars, rail routes and staff ahead of time. Operations personnel know the types of train configurations that are required by different type of Customers and freight. They know the routes that will deliver the freight for their Customers in the shortest possible time. They know how to configure a freight train. They know the numbers and types of locomotives that are required for the train. They know the people who can drive such a train. They know how to manage the complex process of storing and sorting wagons in freight yards. They also know how to haul the empty wagons from their destination back to the freight yard as quickly as possible in order to minimize idling of revenue generating assets. All this and other valuable knowledge is ingrained into the operations of the company that leads it to turning a healthy profit quarter after quarter. As an investor, you would naturally expect the balance sheet of the company to reflect the value of this and other intangible assets. Would it surprise you to know therefore that in the 13 years that icTracker has been tracking Union Pacific - the company has never ever reported any intangible assets in its Balance Sheet? In other words, the company believes that it has zero Intangible assets. The balance sheet of the company would have you believe that Customers pay the company purely for renting its physical assets such as its locomotives, freight cars and rail tracks.  

But investors surely know better. The balance sheet mentions the Company’s Net Worth as approximately $20bn. An icTracker valuation of its intangible assets reveals another $23bn of Intellectual Capital, pushing its Intrinsic worth to $43bn. Yet, at the time of writing this article the capital markets are valuing Union Pacific at nearly $85bn i.e. more than four times the reported book value and nearly twice its intrinsic worth. Clearly investors seem to know a hell lot more about the value of the company’s intangible assets than what is revealed in the balance sheet – which is zero.