March09, great piece of financial analysis. The world needs more forums such as this where investment literacy can be raised througout the broader community so that major wealth destruction, such as the dot-comm bubble and the GFC can be better avoided. (Of course, the corollary is that a fully-literate, fully-informed marketplace would result in fewer mispricings of securities and hence fewer investment opportunities for discerning investors, so I should be careful what I wish for!) The one piece of rebuttal I would make in response to your post on COF is that any balance sheet should be read in conjunction with the other financial accounts, especially the cash flow statement, before meaningful investment conclusions can be drawn, in my view. You're right, COF's balance sheet is indeed asset-light; however, the cash-generating pedigree of the business makes this a less-important deficiency than otherwise would be the case. Specifically, to the extent that the past 5 years included both highs and lows in business conditions and therefore represent a full business cycle for COF, the business generated a total of $90m in Operating Cash Flow over that period. Pre-equity servicing and business expansion, calls on capital (i.e., "stay-in-business" capex) totalled some $30m. So Free Cash Flow before discretionay allocation comes to some $60m (or crudely around $12m pa). Seen from a debt-funder's viewpoint, I think total net interest bearing debt of $95m will be seen to be easily serviceable by this level of sustainable cash flow. The current ratio (current assets/current liabilites) at 1.6x even at the bottom of the business cycle - and despite the company having historically distributed all earnings to shareholders - reinforce impressions of more than adequate solvency, I believe. So you're right the "weak" balance sheet might continue for years, but I'd argue that while, on its own, the balance sheet might look challenged from a tangible asset standpoint, when viewed in conjunction with the cash flow capability of the company, it is not a major investment consideration. Indeed this financial characteristic is typical of "people" businesses (and also distribution businesses, for that matter). As an aside, have a look at AAX, which is often compared to COF (similar industry). AAX's balance sheet is indeed long tangible assets and its retained earnings have risen sixfold over that 5-year period, yet it has not generated any FCF (even pre-equity servicing). Which is probably why the adverse impact on its dividend paying abilities during the downturn was so much greater than COF's. While AAX having a "superior" asset-based balance sheet makes intuitive sense to me from an accounting theory point of view, from an investment point of view I'd far rather own COF than AAX because to balance sheet only matters to the extent that it is supported - or otherwise - by cash flow. Thanks for contributing to the debate. Every well-considered viewpoint shared that raises the level of finanacial literacy is welcome.
COF Price at posting:
$1.07 Sentiment: LT Buy Disclosure: Held
