Wednesday, May 25, 2011

Return on Invested Capital: Part Two – Better Use of Capital = Competitive Advantage

As we saw in the previous installment, a company that can plow its earnings back into the business and continue generating  a high rate of return (as measured by ROIC) is a compounding machine. It will grow its earnings and enrich any shareholder that bought stock at a reasonable price.

This time around, let’s look at a theoretical comparison of two businesses that make the same earnings but with dramatically different invested capital requirements.

Company A is a retailer that needs $165 million of invested capital to generate $15 million in earnings, about 9% ROIC. Most of the capital goes toward inventory with the remainder spread among warehouse space, capitalized technology projects, and equipment.

Company B is a retailer that needs $30 million of invested capital to generate $15 million in earnings, a 50% ROIC.

Assuming a steady ROIC rate, how much does each company need to invest in its business to grow earnings 25% next year?

Let’s start with Company B. At 50% ROIC it must invest $7.5 million of its $15 million earnings to generate a $3.75 million (or 25%) increase in earnings.

Year One
Reinvested Capital
Year Two
Incremental Earnings
Invested Capital
+$7.5M (25%)


+$3.75M (25%)


For Company A, at 9% ROIC it must invest $40 million over the previous year to generate $3.75 million (25%) in increased earnings.

Year One
Reinvested Capital
Year Two
Incremental Earnings
Invested Capital
+$40M (24%)


+$3.75M (25%)


Wow, right? Company B only had to reinvest half of its earning, and it produced a nice bump to incremental earnings. What are its options with the remaining $7.5 million? It can distribute it to shareholders, making them quite pleased. It can reduce its prices to deter competitors from entering its market. It can reinvest that money in marketing or research to create competitive advantages. Or, if possible, it could just reinvest the rest as capital and keep compounding those earnings.

Poor Company A. I hope it has access to debt markets for funding, or that its shareholders are willing to take a dilution as it goes out to raise cash. It certainly can’t cover that $40 million need for additional capital with earnings. Moreover, it’s probably losing ground to more efficiently capitalized competitors that can afford to fund branding initiatives or improve the look of their websites or however else they might use their extra cash.

Surely this is a mythical example, right? It’s meant to create an absurd contrast, right? Company A would be long dead in the real Darwinian world of capitalism, right?

Well, Company A’s invested capital is the same as in a particularly bad state at the end of 2005 (when it also had a $25 million loss). And Company B is…pretty close to at the end of 2010 after redesigning its business model. The reinvestment scenarios are hypotheticals, but I think it makes the point.

Allow me highlight that the stock was trading north of $34/share when the company announced end of year 2005 results. Today it trades around $14/share though, in terms of invested capital needs at least, it’s a much different company.

Next we’ll discuss the dog-eat-dog world of business and why a high-ROIC business must have some sustainable advantage to keep the bigger dogs at bay.

Wednesday, May 18, 2011

Return on Invested Capital: Part One – Compounding Machines (With Appreciating Values)

Here’s a good problem for a company to have. You have more demand for your products than you have inventory to satisfy it or current capacity to build more inventory. You’re a profitable company, so you have net income. What do you do with your earnings?

Easy. Produce more inventory, sell more product, and satisfy the demand, right?

Perhaps, but this requires an investment of capital. Few companies can resist the knee-jerk impulse to grow sales at every opportunity, but growth often diminishes the value of a company.

When a company produces net income, its most basic decision is whether to distribute that income to shareholders or reinvest it back into the company. How should it go about making that choice?

The fundamental issue is whether plowing an additional dollar of earnings back into building more inventory will produce more than a dollar of incremental earnings. This is the ROIC question. If your analysis suggests that the additional investment of earnings will produce $1.20 in incremental earnings, your ROIC is 20% and probably higher than what your shareholders could do with the money if you gave it back in the form of a dividend. At any rate, it’s a fair return, and a CEO would be acting rationally to retain those earnings for business growth.

If the company could produce the same 20% return by reinvesting earnings year after year, shareholders would have a bona fide compounding machine on their hands. Earnings would beget more earnings would beget a higher value for the company.

Discarding short-term distortions and market moods that affect stock price, a company is worth the earnings (or, more precisely, cash) it will produce for investors from now till eternity. Indulge me…

If a company earns a stable $10 per share each year (and you have complete confidence it will continue earning this same amount forever), discounted cash flow theory tells us we value it like a bond. Using a 10% discount rate and 0% growth rate, it is worth $100. (1/(0.10 - 0.0) = 10x current earnings.)

If a company earns $10 per share and you can confidently (and conservatively) say its earnings will increase 5% a year from now till eternity, it is worth $200 using that same 10% discount rate. (1/(.10 – 0.05) = 20x current earnings.)

(Take careful note of the “if” condition used in both of the discounted cash flow examples. No company can guarantee stable earnings forever. Nor can you expect a company to grow its earnings at a set rate forever. That’s not the nature of competitive markets in which companies function. And trees never grow to the sky; everything has a maximum growth capacity and peaks at some point. As a fair rule of thumb, the higher the growth rate the earlier the peak.)

The point is a simple one: the ability to grow earnings is clearly a very, very big deal in determining a company’s value. ROIC can be a powerful metric for demonstrating whether the business is a compounding machine that will grow earnings for owners and increase the value of their shares.  That’s why I pay attention to it.

It is, however, worth making a couple notes of caution when including ROIC in your kit of analytical tools:

Don’t use ROIC as a static measure…Test it over multiple periods.

The ROIC calculation consists of an earnings numerator and invested capital as denominator, both of which can change from year to year for any given company. Some businesses will have wildly fluctuating earnings, swinging from profits to losses and back to profits again. Even if they maintain a low base of invested capital, a nice ROIC today will lose all its luster tomorrow when the losses hit.

Here are two questions to use in tandem: For every increase in invested capital, did the business show a larger increase in earnings? And did this happen consistently over a multi-year period? Of course you capture the gist of this exercise by simply calculating ROIC for each year and seeing whether it stayed even, went up, or went down.

Businesses that are compounding machines will have earnings that grow at a higher rate than their need for incremental invested capital over multiple periods. (Though every company hits bumps in the road from time to time.)

(This leads to an important aside question: what is enough ROIC? I don’t think there’s a single good answer to that question. I once read about Joel Greenblatt telling his business school students that they should just say “good is good.” In other words, whether the business generates 20% or 70% ROIC, both are enough to indicate that the company can compound profits at a satisfactory rate. I would only add that you want to see that a company’s ROIC is equal to or better than competing companies in its industry that should have similar capital requirements.)

ROIC is a quality measurement; it doesn’t tell you what a company is worth.

 Ah, a classic investing conundrum…you find a company consistently producing 50% ROIC and trading at 70x earnings. Do you invest in it? Most likely, no.

There are two guiding principles of long-term investing: 1. Find a high quality company, and 2. Buy it for much less than what it’s worth. ROIC only helps you with the first part of the equation, and a high-ROIC producer can still be so overpriced that no conservative estimate of earnings growth every lets it catch up to its trading price.

Alas, ROIC is no secret metric. You’ll find that most high-ROIC producers have been discovered and are trading at a fair or high price-to-value. But you’ll find two kinds of opportunities present themselves from time to time.

One, a consistent high-ROIC producer is temporarily priced cheap. The market thinks something is wrong with the company, has become bored with it, or whatever. You have to determine whether you agree with the market’s assessment. The market is often right, so I suggest you have compelling logic for why it’s wrong before making an investment.

Two, a company is turning the corner on its business model and either increasing earnings on the same invested capital base or decreasing its capital base while producing the same earnings. Either way, ROIC increases. You have to get out in front, normalizing these elements of the company’s business and taking the risk that your assessment is right and will ultimately be rewarded with a growing stock price.

Some expenses are not so different from invested capital.

Even if accounting standards keep them off the balance sheet, there are several categories of expense that can serve the same purpose as assets. In other words, investments in them are necessary to maintain or grow the business. Examples include: long-term (but uncapitalized) leases, research and development, expensed technology projects, and marketing expenses.

The important point is that a failure to put money into these expenses would directly affect the company’s ability to sell its products or services. For example, Paychex (PAYX) generates an eye-popping ROIC. Its need for capital is minimal compared to its ability to generate impressive earnings. But Paychex operates in a brutally competitive market for small business payroll and HR services where keeping market share is dependent upon expanding its army of salespeople on the street. Make no mistake, sales and marketing expenses are a required investment for the company, akin to sinking working capital into inventory. If it stopped hiring, its sales would drop quickly. Yet sales and marketing will always be categorized as an expense, allowing Paychex to show a higher ROIC and suggesting it needs less investment to maintain its business than it actually does.

It's critical to identify which expenses must expand in order for the business to grow revenue. The savvy investor will treat those expenses much like he would invested capital...checking to make sure he's getting at least $1 back in earnings for every dollar the company plows into these expenses.

Wednesday, May 11, 2011 (OSTK): Part Two – Returns on Invested Capital

More than 80% of Overstock revenue comes at no cost to the company.

How’s that for grabbing your attention?

Here’s how it works: Overstock has roughly 1,600 suppliers of surplus, outdated, or returned merchandise that engage the company as fulfillment partners. In exchange for featuring their products on, the suppliers agree to own and manage the inventory and ship orders to customers using boxes stamped with Overstock’s logo.

Overstock runs the website, promotes the site and brand, provides customer support, and processes the credit card transactions. For those services, the company charges its fulfillment partners a 20%-plus commission (give or take).

After a sale is consummated, Amex or Visa puts dollars into Overstock’s bank account. Overstock hangs onto that money for a week or two before paying the suppliers their take. The difference is essentially no-cost money. Overstock never had to buy this inventory, keeping those dollars free for other purposes. It never had to store these products in a warehouse or increase space to carry more merchandise during holiday season. Again, freeing capital dollars for other purposes. It never took on risk that the products might not sell quickly, have to be marked down, and hurt margins.

Overstock augments the fulfillment partner business with about $28 million in owned inventory. Management says this is to fill gaps in the overall variety of products they offer, helping bring traffic to the site.

In 2010, Overstock did $880 million in revenue with fulfillment partners. That produced a frictionless $167 million in gross margin dollars. Those dollars covered all but about $8 million of Overstock’s total expense structure. Overstock’s direct sales made up the difference plus enough to give the company earnings around $14 million.

This was accomplished on less than $30 million of invested capital.  That’s a ROIC rate of 48% given that Overstock had very little tax to pay (the upside of the preceding 10 years of losses). And here’s the kicker: if it can grow the fulfillment side of its business (and that’s not a foregone conclusion…we’ll tackle the competitive pressures and risks in future installments), Overstock will need very little additional capital to do so. 
You don’t have to pull out your HP 12c calculator to see that the numbers could get high very quickly.

Let’s step away from Overstock for a moment and play with some investing theory. Next installment: what’s the big deal about ROIC anyway? 

Wednesday, May 4, 2011 (OSTK): Part One – An Introduction

All my best ideas were someone else’s ideas first. This gives me no pain. I long ago ceded the thrill of originality to better minds and bigger egos. I’m content to troll through newspapers, screens, blogs, message boards, and the like to collect investing ideas.

But when an interesting idea comes along, I revel in the deep struggle to understand it, handicap its potential, and determine its value. That’s just not work I can (or want to) leave to anyone else.

I found on the “Corner of Berkshire and Fairfax” message board, a Canadian-based homage to uber-investors Warren Buffett and Prem Watsa.  Overstock has been a pet feature of the board moderator since Fairfax made an investment in 2007 and subsequently took a seat as a company director.

It seemed an intriguing gamble by a renowned value investor – taking an equity position in a young company with a track record of losses – so I thought Overstock worthy of a second glance.

As the name lets on, it’s an internet retailer of overstock and surplus items. Patrick Byrne has led the company for ten years. He is the son of Jack Byrne (who has the eternal favor of Warren Buffett for helping lead GEICO through its pre-Berkshire turnaround), and Patrick even worked briefly under the Berkshire umbrella as interim CEO for uniform maker Fechheimer Brothers, Inc. This, plus Watsa’s investment, lends Overstock quite the value investing halo.

I crunch a few numbers and find that Overstock has recently passed the $1 billion mark in sales and produced $14 million in net earnings (only its second full year profit). The market cap is $345 million, giving it a not-so-cheap-looking P/E multiple of 25.

But that’s not what captures my attention. Overstock reached that revenue milestone and produced that profit while maintaining an invested capital base of only $30 million. If you assume it has a normalized tax rate of 23 percent, that’s a return on invested capital (ROIC) of 36 percent. Not bad, especially if earnings are on an uptick.

So, my interest is piqued. I’ve found this company that already has the blessings (and money) of a bona fide value investing legend, it seems like it may have some momentum in revenue and earnings, and it’s building a business on a miniscule amount of capital. Discretion be damned! Let’s invest! A business that can grow without the need for much capital is an investment compounding machine. If…

…Well, “if” the business can continue growing its earnings at a faster rate than its need for additional invested capital. Determining that means taking a hard look into its operations and its competition.

Before we jump into that, however, we’ll use our next installment to ponder the concept of ROIC.