The Investment Checklist

by Michael Shearn

  Fuel and oil—Fixed Costs in Short-Term and Variable Costs in Long-Term: Southwest states that fuel and oil expense decreased 18 percent as the available seat miles decreased by 13.6 percent. Most of this decrease was due to a decrease in the prices of jet fuel. The majority of fuel and oil expenses are fixed in the short term and variable in the long term. They are fixed in the short term because it would take time for Southwest to adjust its flights to a decrease in demand.

  Maintenance materials and repairs—Mainly Variable Costs: “The majority of the increase in engine costs related to the Company’s 737–700 aircraft, which for the second half of 2008 and all of 2009 were accounted for under an agreement with GE Engines Services, Inc. (GE Engines) that provides for engine repairs to be done on a rate per flight hour basis. Under this engine agreement, which is similar to the ‘power-by-the-hour’ agreement with GE Engines the Company has in place for its 737–300 and 737–500 fleet, payments are primarily based on a rate per flight hour basis.” In other words, Southwest Airlines has outsourced its maintenance materials and repairs to General Electric, and Southwest pays General Electric based on the number of air miles flown: Therefore, this is a variable expense.

  Aircraft rentals—Fixed Costs: “Aircraft rentals expense per ASM increased 26.7 percent and, on a dollar basis, increased $32 million.” Furthermore, in the Notes to the financial statements, you’ll see that total rental expense for operating leases, both aircraft and other, charged to operations in 2009, 2008, and 2007 was $596 million, $527 million, and $469 million, respectively. In other words, aircraft rentals are fixed expenses because they represent multi-year contractual obligations.

  Landing fees—Fixed Costs: “Landing fees and other rentals increased $56 million on a dollar basis and increased 14.1 percent on a per-ASM basis, compared to 2008. The majority of both the dollar increase and per-ASM increase was due to higher space rentals in airports as a result of higher rates charged by those airports for gate and terminal space.” Landing fees can be thought of as an operating lease. Southwest will pay the same fee for the gate whether the plane is full or not. Assuming a stable flight schedule, these costs can be considered fixed.

  Other operating expenses—Fixed Costs: Other operating expenses include interest expense, capitalized interest, interest income, and other gains and losses. Most of these are long-term contractual expenses and therefore are fixed.

  Conclusion: Southwest Airlines Has High Operating Leverage

  To summarize, here are the fixed expenses for Southwest Airlines (in millions):

  Salaries, wages, and benefits where 82 percent of the workforce is unionized and has a contract ($3,468).

  Aircraft rentals as well as landing fees and other gate leases ($718 + $186).

  Other operating expenses mainly representing contractual obligations ($1,337).

  Depreciation and amortization ($616).

  Total fixed expenses are approximately $6,325.

  Here are the variable expenses for Southwest Airlines (in millions):

  Fuel and oil are mainly variable expenses ($3,044).

  Maintenance, materials, and repair are variable expenses which vary by the number of miles flown ($719).

  Total variable expenses are $3,763.

  Therefore the percentage of fixed expenses is 63 percent, and variable expenses approximate 37 percent. Many of these variable expenses are fixed in the short run because Southwest Airlines would need to adjust its flights to meet lower demand. Therefore, approximately two thirds of Southwest Airlines’ costs are fixed and one third are variable, which means if sales were to drop, this would have a disproportionate effect on the earnings of the business compared to a business that has largely variable costs. In other words, if sales dropped 10 percent, then earnings could easily drop by more than 40 percent. You would need to pay a lower price for this business because its earnings are less stable. Now let’s take a look at Choice Hotels’ income statement and see how that compares to Southwest Airlines.

  Reviewing the Income Statement of Choice Hotels to Identify Fixed and Variable Costs

  Choice Hotels is a franchisor that licenses hotel brand names such as Comfort Inn, Comfort Suites, Econo Lodge, and Clarion. As of December 31, 2009, the Company had franchise agreements representing 6,021 open hotels and 843 hotels under construction. Table 6.5 shows a breakdown of the total operating expenses (in thousands) found in the fiscal year 2009 Choice Hotels 10-K, with excerpts below (again in quotation marks).

  Table 6.5 2009 Operating Expenses of Choice Hotels

  Total Operating Expense Breakdown Amount (in thousands)

  Selling, general, and administrative $99,237

  Depreciation and amortization $8,336

  Marketing and reservation $305,379

  Hotel operations $3,153

  Total operating expenses $416,105

  Selling, general and administrative—Mainly Fixed Costs: “The cost to operate the franchising business is reflected in SG&A expenses on the consolidated statements of income. SG&A expenses were $99.2 million for 2009, a decrease of $19.8 million from the 2008 total of $119.0 million. The decline in adjusted SG&A costs for the year ended December 31, 2009, was primarily due to cost containment initiatives as well as lower variable franchise sales compensation.” Also, in the Notes to the financial statements, there is a section titled Contractual obligations, which breaks out the debt and lease expenses of the business: Operating lease obligations total $14 million. Advertising expense was $81.3 million in 2009 representing 82 percent of SG&A. Advertising is a variable cost but you should probably consider it to be a fixed cost as advertising is necessary to maintain high brand awareness. Leases are $6 million in 2009, which are a fixed cost because they are contractual obligations. Although Choice Hotels’ SG&A has some variable components, you can conclude that the majority of expenses are fixed costs.

  Marketing and reservation—No income or loss from these expenses, so they break even: “The Company’s franchise agreements require the payment of franchise fees, which include marketing and reservation system fees. The fees, which are based on a percentage of the franchisees’ gross room revenues, are used exclusively by the Company for expenses associated with providing franchise services such as central reservation systems, national marketing, and media advertising. The Company is contractually obligated to expend the marketing and reservation fees it collects from franchisees in accordance with the franchise agreements; as such, no income or loss to the Company is generated.” These marketing and reservation expenses are passed on to the franchisees. These break-even expenses (meaning Choice Hotels does not make a profit or a loss on them) should be considered neither fixed nor variable.

  Conclusion: Choice Hotels Has Low Operating Leverage

  Fixed costs are close to $108 million, out of a total of $416 million, but $305 million of those expenses represent areas where Choice does not earn a profit or breaks even. Therefore, the business needs to generate revenue in excess of $108 million in order to break even. In 2009, excluding the $305 million in revenue it earned from marketing and reservations, Choice Hotels generated close to $250 million in revenue, which can easily cover these fixed expenses. If revenues were to drop by 55 percent in one year, Choice Hotels would break even. Because Choice Hotels has a low level of operating leverage, an investor takes less risk that the earnings will fluctuate widely when revenues decline.

  As a result, investing in businesses with low operating leverage results in less risk than investing in one with high operating leverage. The reason for this is that businesses that have a large percentage of variable expenses are able to decrease their expenses quickly if sales change. Those that have a high fixed-cost structure are unable to react quickly to a drop in sales. Therefore the earnings of a business with high operating leverage can change quickly, which makes it difficult to forecast earnings. You should always pay a lower price for a business that has high operating leverage to give yourself a sufficient margin of safety to account fo
r these large fluctuations in earnings.

  31. How does working capital impact the cash flows of the business?

  Working capital is the cash a business uses to fund its day-to-day operations. For example, a business uses cash in order to buy inventory, which it needs to operate. A business then gets paid by customers after it sells this inventory and then uses that money to pay its suppliers. By understanding working capital, you will be able to assess whether a business can grow by using its own capital, rather than having to depend on its customers and suppliers to finance the business. The faster a business can turn its inventory and collect its receivables and the longer it can stretch out its payables, the higher the operating cash flow.

  If it is difficult for you to understand the working-capital needs of a business, then it will be difficult for you to forecast the cash flows of a business. To account for this risk, you must pay a lower price for the stock.

  Calculating Net Working Capital

  Working capital is calculated by subtracting current assets from current liabilities. Current assets are balance-sheet items such as accounts receivable and inventory. These are assets that can be turned into cash in less than one year. Current liabilities are balance-sheet items such as accounts payable and short-term debt. These are liabilities that are due within one year.

  Increases in working capital are considered a cash outflow even though the capital does not leave the business. For example, an increase in inventory consumes cash, even though the business still holds the inventory. The business does not have access to the cash it has invested in the inventory until it sells that inventory. As a result, the business cannot use the cash for other investments. You can think of working capital in terms of opportunity cost where the business foregoes the ability to use cash whenever it has to hold inventory or if customers delay payment. By better managing working capital, doing such things as selling inventory more quickly, a business is able to free up cash that would otherwise be tied up in inventory.

  Amount of Working Capital Needed by a Business

  The amount of working capital a business needs depends on the capital intensity and the speed at which a business can turn its inventory into cash. The shorter the commitment or cycle, the less cash is tied up and the more a business can use the cash for other internal purposes.

  For example, most restaurants need to retain very little cash on hand because their inventories are turned into cash very quickly. Service businesses typically require little or no inventory and are paid in cash by customers before providing the service. On the other hand, airplane manufacturer Boeing takes much longer to turn a pile of sheet steel and a bunch of electronics into an airplane; therefore, Boeing needs a lot of cash on hand to cover necessary cash disbursements.

  Calculating a Company’s Ability to Generate Working Capital: Using the Cash Conversion Cycle (CCC)

  The primary tool you can use to measure how quickly a business is able to convert its inventory and receivables into cash and pay its short-term obligations is the Cash Conversion Cycle (CCC). The CCC calculates the number of days that cash is invested in inventory and accounts receivable, and the extent to which the cash outflow is covered by accounts payable. The faster a business can turn over its inventory and collect its receivables and the longer it can stretch out its payables, the higher the operating cash flow. Here’s the formula:

  Inventory conversion period (Days Inventory Outstanding): Average Inventory/(Total Cost of Goods Sold/365)

  Receivables conversion period (Days Sales Outstanding): Average Accounts Receivable/(Total Revenue/365)

  Payables conversion period (Days Payables Outstanding): Average Accounts Payable/(Cost of Goods Sold/365)

  If you add DIO (days to sell inventory) to DSO (days to collect receivables), that will tell you the total conversion period of inventories. Let’s say it takes 50 days to sell inventory and 30 days to collect receivables. Therefore, you can conclude that it would normally take 80 days (50 + 30) to sell inventory on credit and to collect the receivables.

  Then, you would subtract the time that it takes to pay back suppliers. For example, if the days payables outstanding (DPO) is 20 days, you would subtract this from 80 days to arrive at the total time it takes to convert inventories into cash, or 60 days.

  A business can improve its CCC in several ways:

  By selling its products as fast as possible (high inventory turns)

  By collecting payments from customers as fast as possible (high receivables turns)

  By paying suppliers as slowly as possible (low payable turns)

  Table 6.6 lists some examples of businesses with different cash-conversion cycles. They range from negative CCC (which means that suppliers are funding the business) to high CCC, such as homebuilder Toll Brothers, which is required to keep a lot of land in inventory in order to operate.

  Table 6.6 Cash Conversion Cycle of Different Businesses FY2009

  Source: Standard & Poor’s Capital IQ.

  Company No. of Days

  Apple –48 days

  Southwest Airlines –15.4 days

  Whole Foods Market 14 days

  Verizon Communications 25 days

  Energizer Holdings 151 days

  Amgen 340 days

  Tiffany 437 days

  Toll Brothers 847 days

  Calculate the CCC for at least a five-year period for the business you are analyzing. You want to understand why the CCC is changing over time. You can do this by examining each of the components that makes up the CCC—that is, the DIO, DPO, and DSO.

  For example, Hughes Communications (a broadband satellite business) improved its cash conversion cycle from 62 days in 2008 to 39 days in 2009. It did this by encouraging customers to use credit cards to pay their bills, which speeded up its collection of receivables. This had the effect of reducing DSO from 70 days to 65 days. In addition, Hughes also increased the time it paid its suppliers from 48 days in 2008 to 67 days in 2009, which further helped Hughes free up more cash flow. During 2008, the stock price of Hughes dropped from more than $50 per share, to as low as $9 per share at the beginning of 2009. As Hughes’s management improved cash flows, this helped the stock price recover to $26 per share on December 31, 2009.9

  Determine Whether Changes in Working Capital Are Sustainable

  Next, you want to determine if the improvements or deterioration in the CCC are sustainable or temporary. For example, during the recession that began in 2007, many businesses improved their working capital because they were forced to find additional cash to finance their operations. In the past, they were less disciplined in managing their working capital because they did not face financial constraints. However, many of these improvements are temporary rather than sustainable.

  If the improvements in working capital are sustainable, then every dollar of freed-up working capital will boost cash flows. However, if improvements are temporary, you need to adjust cash flows in order to normalize them for these temporary improvements. For example, most businesses can get away with delaying payments to suppliers. If the company has increased its DPO (days payable outstanding) from 40 days to 45 days, and you believe that improvement isn’t sustainable, then you should use 40 days when calculating that company’s CCC. At some point, suppliers may demand stricter payment terms, so the delay may be only temporary.

  Negative Working Capital

  When a business has more current liabilities than current assets, it has negative working capital. This means the customers and suppliers are financing the business, which is a less expensive way of funding growth. For example, let’s say you own a retail business and you invest $1 million in inventory, and it costs $1 million to build a store. Now let’s say you can finance 50 percent of your inventory by paying suppliers 90 days later. The upfront capital investment would then be $1.5 million instead of $2 million. Your suppliers are allowing you to delay payments for your investments and giving you a ready supply of cash.

  A common attribute of bus
inesses that benefit from negative working capital is that cash flow from operations exceeds net income. Here are two examples, from 2009:

  At online retailer Amazon.com, cash flow from operations exceeded net income by $2.4 billion.

  At online travel website Expedia, cash flow from operations exceeded net income by $377 million.

  This means these businesses were able to generate more cash flow from operations than net income. Many times the excess free-cash flows are invested in short-term investments, such as cash, which generate interest income that drops straight to the bottom line. These businesses thus generate a safer cash-flow stream.

  Negative Working Capital Only Works in Your Favor When Sales Are Growing

  You cannot rely on negative working capital being a consistent, meaningful source of cash flow, especially if growth isn’t strong. If the business experiences a significant downturn, either due to a secular decline, demand shocks, or market-share losses, then the business may face a liquidity strain. When the business stops growing, it is unable to push out liabilities further into the future, and the positive effects of negative working capital will reverse and decrease the cash flows of the business. Instead of continuing to pay suppliers out of growing cash flow, if growth slows down, the business will have to pay the suppliers out of its existing cash balance.

  For instance, in the third quarter of 2008, Dell generated negative cash flow from operations, which it has done only two times since 1993.10 At the beginning of the third quarter, demand for products was stable and Dell was ordering supplies on a normal basis, when midway through the quarter, customers stopped placing orders due to the financial crisis that was taking place. This meant Dell could no longer keep pushing out its accounts payable balance, and it had to use more of its cash to pay its payables. In the fourth quarter of 2008, this situation reversed itself as demand stabilized and Dell’s customers returned to a more consistent ordering pattern. Luckily, Dell had a sizable amount of cash on its balance sheet so it was able to fund the shortfall. If a negative working capital business does not have enough cash on the balance sheet, then the business will run into short-term liquidity problems and potentially face bankruptcy. If you foresee that happening, that company is obviously not a good investment at that time!