Porter shares a classic investment lesson taught to him by one of his mentors 20 years ago. Is the stock you’re buying too expensive, a great value, or priced fairly? Porter teaches you how to find all the information you need to determine what a business is really worth from the ground up.
Male:Broadcasting from Baltimore, Maryland and New York City, you're listening to the Stansberry Investor Hour.
Male:Tune in each Thursday on iTunes for the latest episode of the Stansberry Investor Hour. Sign up for the free show archive at investorhour.com. Here are the hosts of your show, Buck Sexton and Porter Stansberry.
Buck Sexton:Hey, everybody. It's Buck Sexton with the Stansberry Investor Hour. I'd like to wish you all a happy and freedom-filled July 4th week. So happy belated 4th of July to all of you. We hope you're listening to this podcast as you're, I don't know, up on the beach or manning the barbeque grill or perhaps back in the office because I guess you can't take off the entire week unless you happen to be our fearless leader, Porter, who can take off whenever he wants.
But with that said, guess what? We've got a very special show for you today because one of the smartest guys we know, Porter, well, he's back. At least his voice is back with us. We put together one of Porter's classic investment lessons first taught on the old Stansberry radio program, Stansberry Radio 1.0. If you've ever wondered exactly how Porter examines a company and values their stock, you're in for a real treat. He's going to go into great detail for you in just a few minutes.
The investment lesson from Porter today is timeless and a very important part of understanding if the company you're buying is cheap or expensive. These are the vital financial tools taught by Warren Buffett and Benjamin Graham. The best minds in investing all use what Porter is about to tell you. You see, most people forget what they own when they buy shares of stock. Most of the world buys a stock and expects the share price to rise in a few months so they can turn a short-term profit.
But they completely forget – or maybe they don't realize at all – that what they're actually doing is buying a piece of a business. That is at the center of what Porter is going to show you. You can bet that if someone invests in a private business in his local town, he would be far less concerned about what other people think the business is worth, right? And more importantly, that person would demand the business turn regular profits and management return a reasonable share of those profits to its owners.
But for some reason, most investors don't treat their investments in publicly-listed companies the same way. So Porter is going to take you step-by-step through the stock valuation process taught to him by one of his mentors 20 years ago. He's going to show you how to find all the information an intelligent investor would need to determine whether or not a business is sound and more importantly what it's really worth.
There's also a follow-up video to this podcast that shows all of the screenshots from Yahoo Finance and the other sources that Porter is using. You can get a link to the video for free by going to investorhour.com and entering your e-mail. Okay. Just a couple more quick things before we get started with the man himself with Porter here, if you haven't already, please subscribe to the Stansberry Investor Hour in iTunes or Google Play or even SoundCloud. Leave us a comment there as well. That will tell people this is a good, worthwhile podcast that they should check out, too, and of course the podcast is free so they've got nothing to lose and so much to gain. We'd really appreciate that from our Stansberry friends and family.
Speaking of grateful, we are thrilled that so many of you are tuning into the broadcast each week. You're helping us to climb the rankings and get more of our brand of investment research and political journalism to the people that matter, and that's you. So keep tuning in and we'll keep the news you can use coming your way. Next week, we'll have P. J. O'Rourke back as a special guest host. It's always great to have P. J.'s whit and humor to enlighten us, keep us grounded in the free markets and reality. And in this time of political insanity, P.J. is going to be dropping some truth bombs I am sure.
I believe we're also trying to line up a Blockchain and cryptocurrency expert to come in. Recent movements in the market are making it more and more apparent that digital currencies and the Blockchain technology, they're here to stay. In fact, just last week, the IMF urged banks to invest in cryptocurrencies. IBM scored a massive Blockchain deal with seven major banks, and there's just an incredible and noteworthy amount of money being raised and invested in the Blockchain space.
Looking deeper into July, we've got a very special show coming up with my old boss, my main man in fact, Glenn Beck. He is somebody who's always been fascinated by long-term financial trends, by the Fed, by the government's sometimes disastrous when it comes to its involvement in the markets. So Glenn Beck will be joining us for Episode 9, which is broadcast on Thursday, July 20th. Get excited about that. It's going to be fun. It'll be like young Skywalker interviewing Obi-Wan. I guess that makes me Skywalker.
Porter is also scheduled to be back at the end of the month. So I know you're all looking forward to his return, the chief himself, Mr. Porter Stansberry. We miss the big guy, but we're glad that he's having some fun. In August, we'll be welcoming the dean of high-yield debt, Marty Fridson and Agora Publishing Founder Bill Bonner.
Okay. Let's get on with the important stuff so we can provide you with some value, dear listener. Here's Porter Stansberry to tell you everything you ever wanted to know about how to value a stock before you buy it.
Porter Stansberry:I'd like to do something for you that one of my mentors in business did for me almost 15 year ago now. What he did was he taught me how to find a good business in the stock market. The stock market has a lot of disadvantages, but one of the great things about the stock market, about the public equity markets, is that companies are forced to disclose all the information that an intelligent investor would need to determine whether or not they were a great business or a terrible business.
The interesting thing is that even though all that information is out there, very, very few people actually know how to use it. And one of the things he taught me was you didn't even need to know the name of the company to be able to determine whether or not it's a great business. So I'd like to do the same thing with you today. I'd like to teach you exactly how I look at companies when I'm doing an analysis to find a stock to recommend in my newsletter. And I'd like to show you by using a real case study, real stocks that I profiled. Let's see, one of them was nine years ago and one of them was six years ago. And we'll be able to see how they each turned out over the long-term based on – purely based on the numbers I had available to me at the time.
So the great thing is I'm not going to even let you know the names of these businesses. We're just going to look at the numbers. And we'll be able to decide whether or not this is the kind of company we'd like to own or not. And to help us along, we have as always my co-host, Aaron Brown.
Aaron Brown:Yeah. I'm not sure what help I'm going to be able to provide to you because I am in the learning seat as well.
Porter Stansberry:So Aaron is going to be here to ask hopefully the kind of questions that you'll be thinking of while we go through this. The first thing I would just like you to do is to look at this chart. Now we've blurred out the name of the company here so you can't see what business this is. But what you can see is that the stock holders here have done very well. If you'll notice, even in the bad markets of 1987, even in the bad markets of 2001, 2002, and even in the bad markets of 2007 and 2008, this stock did okay.
Now there is one big correction here from, what, about '65 and early 2005 to the bottom in 2008. So the stock did correct here about 50 percent. That's a pretty big drawdown. But you'll notice that that doesn't correspond with the other big corrections in the market. So something must have been going on inside this company at the time. If you look at the years of the big corrections, like look at '87, look at '01, this stock actually tends to be countercyclical. It tends to go up with the rest of the stock market is going down. That's a good thing in general.
But the most important thing is just to look at how gentle this increase in equity price is over time. It goes from the lower left of the chart to the upper right. And even though there are some significant drawdowns, you can see the trend is clearly to higher and higher equity prices.
Now let me show you – this, by the way, of course, is the good company. This is the company you'd like to figure out before it goes from the bottom-left to the upper-right which one it is. The bad company, the company that you would never want to buy, is right here. So this is, again, this is the kind of company you wouldn't want to own. And, Aaron, why would you not want to own a stock like this?
Aaron Brown:It looks like you'd have to time it perfectly. It's all over the place.
Porter Stansberry:In fact, over this 20-year period, the stock goes absolutely nowhere. It starts a little bit above 20 and ends up a little bit below 20. And in the middle, you've got a lot of volatility. But you don't have any real increase in wealth.
Aaron Brown:Not at all.
Porter Stansberry:Okay. So I'd like to show you how we dealt with both of these stocks in our newsletter. The first one, the good company, we described as our best no-risk opportunity ever. And we said so because this company is incredibly capital-efficient. And what that means is very simple. They're able to increase the size of their revenues, their sales, and their earnings while not spending much or any additional money on investing in their own business. So they're able to pass along their profits to their shareholders.
The second company we looked at, the one that had the chart that went nowhere for 20 years, we called the worst business in the world. In fact, we said it's so bad it could only serve as a bad example. So let's take a look at what these two companies do and how they make money. Let's start with the balance sheet of the bad company. We're going to do the bad company first, and I want – you'll see there's a method to my madness. When you start to look at numbers for stocks, I strongly suggest you start with the balance sheet.
Aaron Brown:Why would you start with the balance sheet, Porter?
Porter Stansberry:You want to start with the balance sheet because when you buy a company, what you're mostly buying are assets. And if you don't understand what the assets are, how could you possibly buy them? So there are a couple of main category of assets. Let's take a look at these.
The first group is very easy to understand. They're called current assets. And that means that's assets that can be turned to cash in less than 12 months.
Porter Stansberry:So you've got cash. That's cash in the bank. You've got short-term investments. That could be Treasury bills or T-Bills or things that would mature in less than a year for cash. Net receivables, that's how much money other people owe this company that they expect to be paid in the next 12 months. And you've got inventory that they expect to be sold in the next 12 months and other current assets. And we don't really know what other current assets are because it's not that specific. But it doesn't matter because the numbers are very, very small. So it's inconsequential to the analysis.
Aaron Brown:Let me ask you a quick question here. Now looking across, we've got 2012, 2011, and 2010, are you looking for any trends or anything like that when you're looking at the – any of these numbers up here as far as consistency wise? Do you want to see it trending up, down?
Porter Stansberry:Yes. But let's get to that in a second.
Porter Stansberry:Let's just understand first what these assets are. So, Aaron, are there any assets there that you don't really understand? Do you know what all these things are?
Aaron Brown:Yes, they make sense.
Porter Stansberry:Right. They're cash, they're – they don't have any short-term investments, but those would be things like cash, notes, CDs.
Aaron Brown:Right. They've got their inventories. They've got their receivables.
Porter Stansberry:Receivables are money that they're owed. Inventory is whatever their product is. It's just stuff sitting in boxes.
Porter Stansberry:Right. And other current assets. We don't know what that is but it doesn't matter because it's a very small number. Now one of the things that jumps out at me is that this is a very big business because they have total current assets of almost $5.5 billion. See, all the numbers here are in thousands.
Aaron Brown:In thousands, right.
Porter Stansberry:And that's – that's $5.3 million. So $5.3 million thousand is $5.3 billion. That's a lot of cash.
Aaron Brown:Yeah, that's a lot.
Porter Stansberry:And we happen to know because we know what the company is. We're cheating. You don't. But that's okay. You're learning. We know that this company is currently valued by the stock market at only around $2.5 billion. So something very strange is happening here because this company controls $5.5 billion in cash essentially but it's only valued by the stock market at $2.5 billion. So that – that means that there is either – either the stock market is radically mispricing this company, which would be a great opportunity.
Porter Stansberry:Or there's something significantly wrong with these assets so that the stock market is discounting their value so substantially.
Porter Stansberry:Okay. So let's try to figure out what could be wrong with this business. Now we know – we understand what they have in terms of cash. Let's look at it in terms of assets. What else do they own besides cash? So we know they've got $5.5 billion in cash. What else do they have? They have $600 million in something called long-term investments. Now, what could that be?
Aaron Brown:I don't know.
Porter Stansberry:It almost certainly is going to be the excess value of the company's pension program. It could be other cash management tools like Treasury bonds for example. So things that are like cash but are longer in duration than one year.
Porter Stansberry:Property, plant, and equipment, self-explanatory isn't it?
Porter Stansberry:These are the machines and the real estate and the stuff that the company owns. This is a big company. It has $6.5 billion worth of property, plant, and equipment. Now red flag. Anytime you see a company that has that much assets in terms of property, plant, and equipment, you have to be very certain what it is and what the actual value of that is because you can imagine that if this company were to enter a period of stress or perhaps even go into bankruptcy then they would have to auction off all that stuff. And when you auction off that much stuff, you don't get much for it.
Aaron Brown:Now I understand that these are the assets. But my question would be so let's take the property, plant, and equipment. Do we know that – are there any loans on any of these? Or are these strictly assets?
Porter Stansberry:We're going to get to liabilities in a moment. The first thing you do is look at the assets. Then we're going to look at the liabilities.
Porter Stansberry:But just the key to understanding these numbers, we don't yet know what the property, plant, and equipment is. And we don't need to know to do this analysis. What we need to remember is that any time you have a company that has so much property, plant, and equipment it's likely to be overvalued on the balance sheet. And that is a real problem because if you're doing a value analysis and you're trying to figure out what the real book value should be, you'd have to discount this property, plant, and equipment. All I want you to know for now though is that this company has a ton of property, plant, and equipment. And that makes us cautious.
Porter Stansberry:Okay. Next thing you have is goodwill. Now goodwill is the hardest thing on the balance sheet for people to understand, but it is actually incredibly easy to understand. I don't know why people's brains have such a hard time with this concept but it's really very, very simple. And here's the best way I can explain it to you. Your balance sheet is supposed to tell investors the actual market value of the things that you own. All right. Now, of course, it's impossible to get very accurate with that because the value of everything changes all the time and mostly decreases. So we'll look at the – there's something called depreciation, which we'll look at, which is a charge against these assets as they go down in value.
However, Aaron, what would happen today – let me explain goodwill this way. What would happen today if you went out and bought a new car?
Aaron Brown:I would be screwed as soon as I drove off the lot.
Porter Stansberry:That's right. And how much would the – let's say you bought a car for $100,000.00. What's it worth the day after you drive it off the lot?
Aaron Brown:I would say I would lose probably 20 to 25 percent value.
Porter Stansberry:Let's say $75,000.00 just to keep the numbers easy, okay. And with an expensive car like that you do lose a lot of money as soon as you drive it off the lot. Unfortunately, I know this. [Laughs] Okay. So if you're doing this on your own personal balance sheet, Aaron's balance sheet, and you just bought $100,000.00 car, you couldn't put $100,000.00 in property, plant, and equipment because that car is not worth $100,000.00. It's only worth $75,000.00.
Porter Stansberry:On the other hand, the cash that you spent on it didn't just disappear. It went somewhere. Where does it go?
Porter Stansberry:Goodwill. So goodwill represent the excess capital that was spent to acquire anything else. It could be software. It could be property, plant, and equipment. It could be another business. It could be anything. Mostly you find goodwill when companies are buying other companies and they have to do something with the difference between the company's book value and the share price of it. So if you buy a company at two times book value, well, then half of the value of that acquisition goes into goodwill and half of it goes into other spots on your balance sheet. That's it.
It's just the excess value of what the company has bought over time. Now why is it important? Well, it's important because oftentimes unlike automobiles, when you buy an operating business, you're going to get more value than the value of the assets. And so if you see a lot of goodwill on the balance sheet, it could mean this is a very good company that has very high quality assets that are worth more than their current net value. Okay.
Porter Stansberry:So we don't want to spend too much time on this. But when you see a company like this that you know is deeply undervalued by the stock market. We told you the market cap here is only $2.5 billion. It's got $5.5 billion in cash. It's got $6 billion in property, plant, and equipment. That's $11 billion in assets right there and the market's trading them for $2.5 billion. You can know straight away that this company, something's wrong because the market value of these assets is way off in the stock market itself.
So I'm going to tell you that that probably means the goodwill value there is inflated.
Porter Stansberry:I'm going to tell you it probably means that this company spent too much on acquisitions. And that almost $2 billion in goodwill asset will probably have to be written off.
Aaron Brown:So for people looking at this, goodwill is kind of a red flag in a way sometimes?
Porter Stansberry:A large number in goodwill is a red flag.
Porter Stansberry:A large number in goodwill is a red flag, just like a large number in property, plant, and equipment is a red flag. It doesn't necessarily mean it's not a good investment. It just means you have to think about it for a while and use your judgment to decide whether or not it's worth buying. Okay. Now the other numbers we're going to ignore because they're extremely small relative to the size of this business. It really doesn't make any difference. The only thing you'd kind of want to look at carefully here is any large number in intangible assets because goodwill and intangible assets are very similar in nature. Goodwill comes from corporate acquisitions and intangible assets comes from everything else. You don't have much intangible assets here. There's nothing to worry about.
So let's get down to the total asset number. Now this is where you have to use your judgment. And this is a very important process. Aaron, we've talked about what the company has on its books and we've talked about the areas of the balance sheet we believe are suspect. At first glance, at first blush, what would you do with that total asset number? Would you say that that total asset number undervalues the real earnings capacity of these assets or would you say the total asset number probably overstates the real earnings value of these assets?
Aaron Brown:I would say it probably overstates.
Porter Stansberry:It probably overstates because there's almost $8 billion on these assets that are in property and goodwill. And it can be very difficult to make a lot of money with property and it can be impossible to make money with goodwill. So out of the $15 billion, almost half of it in my mind is suspect.
Porter Stansberry:So first thing I'm going to do mentally is I'm going to write that number off by at least 25 percent. I think the property, plant, and equipment in an auction at this business is probably going to be worth about $2.5 billion. I'm making the number up. I just – I want to discount that number heavily because I don't believe it has all that much utility. Likewise, I'm going to completely erase all the value given to goodwill. So that means I'm going to end up here with actually, well, look at the numbers. I said $2.5 billion and $5.5 billion. That ends up being $8 billion. So I'm writing off those total assets in my mind by almost 50 percent.
Porter Stansberry:Okay. Now I don't have proof of that yet. But I'm going to assume I'm right until I am proven otherwise because I have a lot of experience at this. But what I'm telling you to do is anytime there's a big number in property, plant, and equipment and anytime there's a big number in goodwill, and a big number for a stock with a $2 billion market cap, a big number is anything over $1 billion. Now if this was a $10 billion market cap stock it'd be a different matter. Or if they had total current assets of $10 billion, it'd be a different matter.
But what you see here is a company that has most of their assets tied up in goodwill and in property, plant, and equipment. And that is a very risky business.
Porter Stansberry:So if I assume that the real value of their total assets is only $8 billion then we're going to have a problem here. Do you know why?
Aaron Brown:Well, you cut the assets in half so that's a problem.
Porter Stansberry:Yeah, and look down the chart there in the balance sheet.
Aaron Brown:And the liabilities are now going to exceed what you've projected to be their true assets.
Porter Stansberry:That's right. So, again, my evaluation of their real asset value is completely made up. I just made it up out of whole cloth by looking at the numbers and thinking about what they may be worth in a distressed situation because sooner or later every company is going to come under stress. And if you have high quality assets then you can hold those an investor and you don't have to worry about the share price. In fact, it's an opportunity to buy more. But if you've got low quality assets like a lot of old property, plant, and equipment, you have a big problem.
The big problem here is that this company is way overleveraged given its profitability. And we'll see that in a second. But let me show you what we've got here. Let's go through the liabilities. Now so I told you that current assets are things that are like cash or cash that can be exchanged for cash in less than 12 months. What do you think current labilities mean?
Aaron Brown:Same thing, 12-month time period.
Porter Stansberry:Twelve months. These are things you've got to pay in the next 12 months. So they've got to pay accounts payable of $3 billion in the next 12 months. That's a lot of money.
Aaron Brown:It seems like a lot.
Porter Stansberry:That's a lot of money, okay. So even though they've got $5.5 billion in current assets, they really don't own it. They're just holding onto it for the moment. It's kind of like float in insurance companies. It's not really there because they're going to have to pay it soon. So that's – so in other words, that $5.5 billion in cash is a little bit of a mirage.
Aaron Brown:Oh absolutely.
Porter Stansberry:What's interesting is if you just look at current liabilities and you subtract it from current assets, what you end up with is essentially the market cap of the stock today.
Aaron Brown:Okay, that makes sense. So you were saying $2.5 billion roughly was the market cap of the stock?
Porter Stansberry:Yeah. And so what you're seeing in this company is that the stock market is actually trading it based on the value of that float, on the value of the difference between its current liabilities and its current assets because the stock market is essentially saying all the other assets it owns have been mortgaged. And they don't count towards the company's value. And they're not productive because they're not making any money as we'll see in a second. So we're not going to assign any value to them.
So let's go down. So current liabilities are roughly $3 billion, $2.9 billion. What about long-term debt? What's that mean?
Aaron Brown:Anything over 12 months I'm guessing.
Porter Stansberry:Exactly. So these are other obligations the company has over 12 months.
Aaron Brown:It looks like a pretty big number there.
Porter Stansberry:It's a pretty big number. And then what are other liabilities? That's a huge number, $4.5 billion almost.
Aaron Brown:Yeah, I have no idea what the other liabilities would be. I have no idea.
Porter Stansberry:A company like this that has lots of property, plant, and equipment, you think it has a lot of people that have to take care of all that property, plant, and equipment?
Aaron Brown:Lots of maintenance.
Porter Stansberry:Lots of maintenance. And what do all maintenance men require? Back surgery. [Laughs]
Aaron Brown:Yeah. Okay. [Laughs]
Porter Stansberry:Other liabilities are going to be pension obligations or medical obligations to the employees. And you'd have to get into the 10(K) and discover what they all are and what it really means. But I'll just tell you straight out, it's a bad number. That is a very, very dangerous number, especially in the current age. We talk about this all the time. The war between the people who've been promised things and the people that have to pay for them.
Aaron Brown:Plus, as the Baby Boomers age, I mean, lots of pension problems.
Porter Stansberry:Yeah. So this is a big, big red flag.
Aaron Brown:Big red flag.
Porter Stansberry:So when we look at this balance sheet, we come up with on – just in the black-and-white, we come up with $15 billion assets and $11 billion in liabilities. But when we look into it a little bit further, we think the assets here are maybe only $8 billion because we're going to discount property, plant, and equipment and we're going to discount goodwill. And on the other hand, when we look at liabilities, just at first blush is says almost $12 billion. So we're about $4 billion in the hole. But guess what?
We know from experience that these other kind of liabilities, they always balloon in cost. So I think the liabilities here are probably understated and the assets are probably overstated.
Aaron Brown:That doesn't sound like it's a good start to this company's balance sheet.
Porter Stansberry:Not at all. So what we would want to – if we were considering this as a deep value play because for only $2.5 billion we can buy $15 billion worth of assets, at least on paper, right. If we were considering this as a deep value play, the thing that we would have to see, we would absolutely have to see, is some significant change in the operations of this company that lead us to believe it's going to be significantly more profitable in the future, significantly. So let's go to the income statement next, which is where we record sales and profits.
Now this is the income statement of the same company. And the income statement is very simple. It's how much money comes in the door and the costs of earning all that money, and what's left over, of course, is profit. It's simple. So going down on the left column here, total revenue, what do you think that means?
Aaron Brown:That's just all the money from their sales.
Porter Stansberry:All the money they made they collected from customers. What's the cost of revenue?
Aaron Brown:The cost of doing business.
Porter Stansberry:It's the cost of whatever it was required to make that individual product. So their operating costs, okay. So they did $19 billion in sales, but it cost them $17 billion to produce it. Does that sound like a good business to you?
Aaron Brown:I mean, it sounds like it's a risky business to me.
Porter Stansberry:So one thing I encourage people to do because these numbers are big, and that makes it harder for people to understand. Just get rid of all the other numbers. Just think of it as 19 and 17. It doesn't matter whether it's $19.00 or $19 billion. In this case, it's $19 billion. But the percentages are always the same. So think to yourself, think like this. What if you had a bake sale in your front yard and you were selling brownies that cost you $17.00 to make and you were only selling them for $19.00. Does that sound like a very profitable enterprise?
Porter Stansberry:No. Okay. So we said at the beginning that we wouldn't want to buy this company unless we had seen some kind of massive change to its operations. What do we see here? We see sales going from three years ago from going from $17 billion to going to $19 billion. Is that a massive change?
Aaron Brown:Not at all.
Porter Stansberry:We see them decreasing in that last year going from $19 billion to $19.3 billion.
Aaron Brown:Doesn't seem like a good sign.
Porter Stansberry:Sorry, $19.8 billion to $19.3 billion. And what about gross profit? Anything change?
Aaron Brown:Very little.
Porter Stansberry:It has.
Aaron Brown:I mean, these are billions so we're talking about here, so that is a big number.
Porter Stansberry:I would say percentage wise going from $1.1 billion to $1.6 billion is a very significant change. So they have found a way to reduce their costs of revenue, their cost of whatever it is that they're making, which is great. But it's still not a very good margin, right?
Aaron Brown:Yeah. It seems like our competitor could possibly come in and squeeze them.
Porter Stansberry:So three years ago, they were selling their brownies for $17.00 and it cost them $16.00 to make them. That's a really tiny margin. And the margin's got a little bit better. It's gone from $16.00 to $17.00 to $18.00 to $19.00 to now $17.00 to $19.00. But it's still not very good.
Aaron Brown:They've become more efficient but it's still a pretty scary thin margin.
Porter Stansberry:They've become slightly more efficient and they've grown revenues. But they haven't dramatically changed anything here. This is still not a very profitable business. Okay. Now let's look and see if there's anything else that seems unusual. Okay. We know what research and development is. They don't have any. Hmm.
Aaron Brown:So that's actually good because this would be real heavy if it was a tech company. That would be a big number I'm imagining.
Porter Stansberry:So we know that whatever this is, it's not very high tech, okay. Next, selling, general, and administrative. Do you know what that means?
Aaron Brown:I would guess that that would be their sales team and the sales support team.
Porter Stansberry:That's right. And the – this is also where you'll find – where options grants are now expensed in this line. So you can see that in terms of their sales, they don't have to spend very much on their employees really. So they've got $19 billion in sales and they're only spending $500 million in comp. So they're not spending a lot on their employees.
Aaron Brown:That's a good thing.
Porter Stansberry:That's a good thing. But it costs so much to make whatever it is that they're making that it's still not a good business.
Aaron Brown:I agree with that.
Porter Stansberry:All right. Now this next line here is others.
Porter Stansberry:We don't know what that is, and it's a big number. It's more than they spend on all of their employees. So we have to figure out what that is. Now my first guess is that's probably the options expense. They probably have it segmented out. But we don't know and we wouldn't want to buy this company until we could figure it out.
Porter Stansberry:Now there's two ways to figure it out. You can go into the SEC filings. You can look at the notes at the bottom. And you can usually figure it out. If you can't do that – when I say go to the SEC filings, I mean go to the annual report which called Form 10(K) and read all the way through it until you can find that number and figure out what it is. The other way is to call the company and ask them.
Porter Stansberry:It's that simple. And usually they're happy to help. Usually. If they're not that's a big red flag. [Laughs
Aaron Brown:That's a real big red flag. I got you.
Porter Stansberry:Okay. So you can see here that this company is very marginally profitable, very marginally profitable. They do $19 billion in sales. They only make quarter billion in profit. That's pitiful.
Aaron Brown:Yeah. It's not looking good.
Porter Stansberry:So I would much prefer to see profits of at least, at least – sorry, operating profits of at least 10 percent; at least. That's bare minimum. So what you should see here is profits almost 10 times larger than they are.
Porter Stansberry:That's no good.
Aaron Brown:No. That's not good at all.
Porter Stansberry:Okay. Also, do they sometimes not make any money?
Aaron Brown:Yes, they do sometimes not make money.
Porter Stansberry:Even on an operating basis –
Aaron Brown:Like in 2010.
Porter Stansberry:Yeah. That's scary.
Aaron Brown:That's really bad.
Porter Stansberry:And I'm going to show you why that's so scary. This company is so thinly profitable that if they can routinely have losses on an operating basis, there's going to be a big problem, big, big problem. You just can't be involved as a passive common stock investor in a business that has routine operating losses. Can't afford that risk. Okay. So the rest of this is pretty simple. So here, this line item is what they call, again, other expenses, which we don't know what it is. But it's not an operating expense. So it's got to be something else. It's probably some kind of an impairment charge or depreciation. We don't know.
Aaron Brown:It's a huge number compared to the previous two years.
Porter Stansberry:It's a huge number. So it looks like they must've written something off –
Aaron Brown:Like a one-time write-off possibly?
Porter Stansberry:Well, could be. Could be. They might've decommissioned a plant, something like that. We don't know. But it's a big number.
Aaron Brown:Something to pay attention to.
Porter Stansberry:Yeah. We'd want to find out what that number means just like we'd want to find out what this number means. So those are two numbers you'd have to highlight and do some work on.
Porter Stansberry:But you know what I'm thinking is I'm not even going to bother with it because nothing is looking right here.
Aaron Brown:Nothing's looking good at all.
Porter Stansberry:So I'm not going to spend a lot of time on a company when nothing – when all I find is red flags. There's nothing here I want to be a part of. So I'm not going to really worry about it.
Porter Stansberry:Okay. So that leaves you with your earnings before interest and taxes. Okay. So you can see here in two of the last three years, they've lost money on an operating basis. That's terrible.
Aaron Brown:That's terrible.
Porter Stansberry:Okay. And then look at – here's a big number. This is a very important number to understand. This is interest expense. Here's my tip of the day for you, Aaron. When your company has an interest expense that is close to or exceeds the operating earnings, you've got bankruptcy.
Aaron Brown:Yeah, because they're – yeah. I mean, they can't even pay their interest basically on their earnings.
Porter Stansberry:No. So if your earnings were a loss of $110 million, how did you pay for your interest expense?
Porter Stansberry:Yeah, exactly. And where does that get you if you do it enough years?
Aaron Brown:It's going to be bad. Your interest rates are going to go up and you're not going to be able to renew that debt.
Porter Stansberry:So we talked about buying the car as an example in real life. So what happens if – imagine you have – imagine you have a student loan outstanding, okay. And imagine that the minimum payment for that student loan is whatever it is each year, $5,000.00. But imagine that after your mortgage payments, after your child support payments especially if you're a former NFL player, after your car payments, after your grocery bills, after everything you pay, right, you come to the end of the year and you have zero or les than zero. How do you pay that student loan?
Aaron Brown:You don't.
Porter Stansberry:Credit card.
Aaron Brown:Yeah, that's it.
Porter Stansberry:And if you start getting that kind of debt onto a corporate balance sheet, you've got big, gigantic problems. Big problems. Okay. So the real income here before taxes is a loss of $300-plus million, a loss in the year before, and a big loss in the year before that. A company you want to own?
Aaron Brown:Not at all.
Porter Stansberry:No, no. All right. And they had some income tax expenses they had to pay, income taxes, which is interesting because they don't – they're not making any money. So I can't imagine why they're paying income taxes. But they are. And then – or sorry, we're going to see in a minute that they're not really paying income taxes.
Porter Stansberry:But they have to charge for it as though they are until they become so impaired that they say, "We're probably going to go out of business." And then they get all that on paper back. But that's a detail we probably don't need for now. The point is all you need to know is the income before tax is negative the last three years. It's a very, very slimly profitable business. And it's got lots of weird charges that we can't understand easily. Red flag, red flag, red flag, red flag, red flag.
Aaron Brown:I'm saying absolutely no way buy this stock.
Porter Stansberry:Okay. Now let's go and look at cash flow because this is very important. We can already rule this business out because of – we think the balance sheet is already upside down in realty and we can see the income statement that the company is not profitable enough to afford its debts. You can see that just by looking at these two things. So we know they've got $11 billion in total liabilities. We know their interest expense is large and seems to be growing. And if we look at their balance sheet, we can see that their debts while stable are still very substantial. So we've got a problem here because that – their debts aren't growing but their interest expense is. And what's that tell you?
Aaron Brown:The company's not earning any money and it's going down.
Porter Stansberry:When your interest expense is going up and your debt balances are flat, it means you're having to pay more to borrow money. And that is a very scary process because once your interest rates start ratcheting up you become the subprime NINJA borrower and you blow up. Okay. So let's go to cash flow now.
So cash flows, we said this company was not profitable. Remember? We said two of the last three – three of the last three years it didn't actually make money, right. Okay, but when we look at the cash flow statement we see something totally different. It turns out they made a lot of money in cash last year and some money the year before. So what is the difference? What's going on here?
Well, you remember the $600 million charge from the income statement?
Porter Stansberry:This one right here, "Others". Okay.
Aaron Brown:Is that the one that you thought – suspected could be options or something like that.
Porter Stansberry:Could be options. Something –
Aaron Brown:Something you have to investigate in the 10(K).
Porter Stansberry:Right. It turns out what that is is that's where they've put their depreciation charge. So they have all this property, plant, and equipment, and every year it gets older and a little bit less valuable. Okay. And that's a real charge, but it's not a cash charge. It's not something they have to pay this year in cash.
Porter Stansberry:So in reality, even though that depreciation is real, the company still has the cash to work with. Okay. Now this is important. This is very important. The cash flow statement is what matters if you're looking at an ongoing business that is stable and profitable. On the other hand, if you're looking at a company in distress then the income statement becomes more important because what's dragging that company down is going to be found in those depreciation charges.
Aaron Brown:So basically what you're saying is we wouldn't have even gone to the cash flow statement in this example.
Porter Stansberry:We wouldn't even be here now.
Aaron Brown:It would – we would've stopped a while ago.
Porter Stansberry:Yeah. We wouldn't even be here now. But it's important that you understand the difference.
Aaron Brown:I got you. I understand.
Porter Stansberry:What is important is to understand the difference between the cash flow statement and the income statement is mostly about depreciation charges. Okay. There were some other expenses that were non-cash. So let's look at the major differences. The first difference is the depreciation charge. The second difference is a change to accounts and receivables. So what's that mean? It means that this company was able to increase the size of that float by quarter billion. In other words, there was a change in the timing of when it paid things and when it received payments. And as you can see, this number is large but variable. It doesn't – it's not always positive. Money's flowing and money's flowing out and that was the actual difference. These are immaterial numbers.
Porter Stansberry:These are all immaterial numbers except for this one. That's the big number. And I say they're immaterial because they're just – it's just cash floushing in and out, changes in inventory. Sometimes inventory grows. Sometimes inventory falls. And the cash involved in the managing of inventories goes in and out. But it's immaterial. There's nothing here that matters except for that number. That number matters a great deal because that number means the company is actually profitable on a cash basis most of the time, in two of the last three years. And so that's how they're affording to run a business that is not ultimately profitable because they have the cash to keep them going at least for now.
Porter Stansberry:Okay. Now here's another big problem. If your property and your plant is depreciating by $600 million a year, $661 million a year, how much, Aaron, do you think you should be spending on capital investments to upgrade your plant to keep it going?
Aaron Brown:More than you're writing off.
Porter Stansberry:More than you're writing off. So you see that they are still doing that. Their capital expenditures for the last year was over $700 million, over $800 million, over $600 million. But here – so when I tell you that the cash flow matters to good companies but is irrelevant to bad companies, the reason why I say that is because it's great that they actually held onto $600 million in cash that they didn't get credit for in their profits. But they had to pay it all back.
Porter Stansberry:So if you're only making $160 million in cash but your capital requirements every year for your company are $600 million, $700 million, $800 million, what are you really doing?
Aaron Brown:You're upside down.
Porter Stansberry:You're upside down. And we saw that when we looked at the income statement. The income statement told us the real facts in this company. There's a lot of ongoing depreciation. There's a lot of very expensive property to maintain. And it's a very low-margin business. And all of the money the company makes and more ends up being reinvested back into the company. So you can see over the last three years they have spent $1.4 billion, so a little over $2 billion investing in their own company but they've only made less than $1 billion in cash. So somewhere along the line in the last three years they had to borrow an extra $1 billion just to keep breaking even.
Aaron Brown:I don't want to work for that company.
Porter Stansberry:Uh-uh. No, sir. Now here's another great little tool we can use. I don't pay much attention to the rest of the items on this – on investing activities because this is just cash flow management stuff. They're selling bonds and buying bonds. It's just money in the door, money out the door. It's irrelevant. It's not material. The big number is here. The big number is here.
Aaron Brown:Now one quick question. So from the income statement to the cash flow statement, it happened that the $661 million showed up in depreciation but that's not always the case I'm guessing, correct?
Porter Stansberry:Sometimes you'll see depreciation as a line item. Usually you do. For some reason, they have it here as others. They should say depreciation.
Porter Stansberry:That's all. It's just a – it's I don't want to name the online database we're using but it's an error in the online database.
Aaron Brown:Okay, I got you.
Porter Stansberry:And you see it because you know it's here.
Aaron Brown:Right, it matched up.
Porter Stansberry:Right. Okay.
Aaron Brown:But that's not always the case.
Porter Stansberry:So what – but what I want you guys to remember, and I hope you'll write this down, is that the critical difference between net income and cash flow is depreciation. That's the critical difference. And where you see a lot of deprecation you're very likely to see a lot of capital expenditures. As an investor, capital expenditures are sort of your enemy. Now they're not an enemy of yours if the business is high margin and growing and profitable because you would invest more in it if you could, too.
But what happens mostly is that companies get old. Their property deteriorates and they end up sending all their profits, all their cash, on their own business. And that leaves nothing for investors. So –
Aaron Brown:And just kind of a quick macro question here. So right now, we're in a near zero interest rate environment.
Aaron Brown:So I'm going to make an assumption here, and correct me if I'm wrong, that if you're looking at a lot of capital expenditures and you're assuming that those are loans, you have to assume over time the interest rates are going to skyrocket at some point and it's going to put a heavier load on this CapEx, is that right?
Porter Stansberry:That's right. You would feel very insecure about investing in a company where when interest rates are at the lowest they've been ever in the United States and their interest costs have gone up. That's a very, very bad sign.
Porter Stansberry:And, of course, look what their interest is compared to their operating income. Their operating income is little or nothing but their interest is always growing.
Aaron Brown:Bad sign.
Porter Stansberry:This is a very bad sign, okay. So then if you understand that the difference between the income statement and the cash flow statement is mostly depreciation then what you have to look for is to figure out, and this is the critical number, Aaron, what are the real owner's earnings here. This is what we're – this is the whole point of looking at the income statement and the cash flow statement. If the income statement approximates what the profits should be to an owner and the cash flow statement shows you what they actually were.
So the actual profit here to owners was $30 million. That's the amount that was paid in dividends and I would include buybacks of stock. The company actually was issuing small amounts of stock. That's I'm sure related to stock options. And you can see that their borrowings are growing as we knew they must. Their borrowings are up $0.5 billion over the last three years. So they're borrowing money and they're paying very little to their owners –
Aaron Brown:They're not purchasing any stock back.
Aaron Brown:Which is not a good sign.
Porter Stansberry:And they're investing enormously in their future business. But why would you invest enormously in a future business that isn't profitable?
Aaron Brown:The only thing I can guess is projecting to grow for some outside factor and/or an extreme high barrier to entry that they feel like they might be able to turn things around.
Porter Stansberry:So as you'll recall, I called this the worst business in the world. The reason why this is the worst business in the world is because you will never, ever make enough money ever in this business to cover your capital expenditures and your interest. These guys are spending close to $1 billion a year on capital investments and interest. They can't make $1 billion a year because their business is so low margin. The result is there are no real owners' earnings at all. The dividends are not increasing and they're not buying back stock. And the amount of money they're returning to dividends, $30 million a year on $20 billion in sales, is laughable.
This is a business, if you just looked at the numbers, you would never, ever, ever buy. Ever.
Porter Stansberry:Never once.
Aaron Brown:It's so blatantly clear for the first time ever by looking at these three statements that it would be absurd for somebody to actually put the ticker symbol in and buy it.
Porter Stansberry:And yet you can see that Wall Street ran the stock up from 2003 to 2007 tremendously, all right. I shorted it right about there. [Laughs] Now it made me look like a fool for a while, but I was eventually dead right. Now what business was this? Well, you can read all about it in 2004 issue of my newsletter. This is – what date is this – September 2004. And this was U. S. Steel is the name of the company. And the reason why it had that huge run-up in price.
Aaron Brown:Yeah, you mentioned that Wall Street helped run it up. I'd like to know what that means.
Porter Stansberry:So you might recall we had a president whose name was George W. Bush.
Aaron Brown:I remember that guy.
Porter Stansberry:And he, as you'll recall, he ran on the premise that America needed a smaller government.
Aaron Brown:That's right.
Porter Stansberry:And that we needed to free the markets and we needed to stop nation building and mind our own business.
Porter Stansberry:Okay. Well, actually, of course, he led a war –
Aaron Brown:He did the complete opposite, yeah.
Porter Stansberry:of conquest in Iraq.
Aaron Brown:Trillions of dollars.
Porter Stansberry:And tried to create a state there. And he also, of course, abandoned all of his free market principles and he pushed through steel tariffs to aid his friend in the steel industry, mostly Wilbur Ross. This is the impact of the steel tariffs. Wall Street became convinced that if only the U. S. Steel had the protection of the government tax on imports they would be able to increase their margins.
Aaron Brown:Didn't work.
Porter Stansberry:Didn't work, won't work. Steel making is a ridiculously difficult business, and as long as we have union work rules we'll never have a profitable steel industry in the United States. Sorry. Those are the facts. Okay. Now as opposed to the worst business in the world, you'll recall I also wrote another newsletter in the past called Our Best No-Risk Opportunity Ever. And in this issue I talk about the secret of capital efficiency. So let me show you what a really well-run business looks like. Let's, again, start with the balance sheet.
Aaron, we know what these things are now.
Porter Stansberry:We've got cash, you've got receivables, you've got inventory, and you've got things that could be converted to cash in the next 12 months, $2.5 billion. All right. Now remember we saw the first company, U. S. Steel. It was a terrible company. It had over $5 billion in current assets and a market cap of only $2.5 billion.
Aaron Brown:Right. What's the market cap on this one?
Porter Stansberry:Market cap on this one is over $10 billion.
Porter Stansberry:Now it doesn't have very much cash for such a big company, does it?
Aaron Brown:Right, right, no, it doesn't.
Porter Stansberry:And why is that? Because it doesn't need very much capital.
Porter Stansberry:And that is a beautiful thing as you will see.
Aaron Brown:And that's the definition of the capital-efficient business.
Porter Stansberry:That's the definition of a capital-efficient business. Okay. So now things you'd want to look out for in a well-run business, you want to make sure that inventories are not growing in a way that's unreasonable.
Aaron Brown:Because that would mean they're not moving their product.
Porter Stansberry:Right. So are inventories – is there a bubble in inventory here?
Aaron Brown:Not at all.
Aaron Brown:It's pretty consistent.
Porter Stansberry:Great. How about same thing with receivables; a lot of times when companies grow really fast they do it by taking on a lot of dodgy clients who can't actually pay them.
Aaron Brown:It looks like their vendors pay just fine.
Porter Stansberry:Well, there is growth here which shows that the business is growing.
Aaron Brown:Right, shows that they –
Porter Stansberry:But there's not a bubble.
Porter Stansberry:The receivables don't go from $500 million to $1.2 billion overnight. Just steady growth here. Okay. Now what else does the company own? Well, they own some property, plant, and equipment.
Aaron Brown:Looks like a pretty big number to me.
Porter Stansberry:It's not that big. It's actually less than the cash they have.
Porter Stansberry:So that's actually a very small amount of property, plant, and equipment, especially for a $10 billion business. All right. So that's good because that means less maintenance workers, less back surgeries.
Aaron Brown:Okay. Good point.
Porter Stansberry:Goodwill, a very small number compared to the others. Okay. Normal. So it doesn't seem like this company does many big acquisitions, don't have to worry about that. Intangible assets, don't know what those are, see that they have increased quite a bit. It's interesting. We might want to figure out what that is. But the number's still so small doesn't really matter.
Porter Stansberry:Ten percent of cash, not a problem. Okay. Total assets, the company says assets are worth around $5 billion. Any reason that we should doubt this?
Aaron Brown:Not that I can see.
Porter Stansberry:No. The assets are half cash and everything else looks pretty normal.
Aaron Brown:Yeah. So far looks sound.
Porter Stansberry:So I would – I rarely do this, but I'd say chances are you might discount the property, plant, and equipment by maybe call it $1 billion instead of $1.6 billion but it's not a big number so it's not going to be hard to unload. So maybe we'll call it $4 billion instead of $4.7 billion but –
Porter Stansberry:I mean, still, high quality assets. You can tell just by looking at the numbers. How can I tell? Well, again, property, plant, and equipment is less than cash. Goodwill is a very small number compared to the market cap of the business or any of the other numbers we see here. It's probably all reasonable. All right. How about liabilities? We know what current liabilities are, right?
Aaron Brown:Mm-hmm, within 12 months.
Porter Stansberry:These are due within 12 months. Now, that's a big number.
Aaron Brown:It's pretty big.
Porter Stansberry:That's a very big number. This company must be a buying a lot of stuff. That's not necessarily bad. That means they're doing a lot of business. Can they afford to pay $1 billion in the next 12 months?
Porter Stansberry:Absolutely. They've got the cash. All right. But what you'll notice is they don't have much spare cash, do they?
Aaron Brown:No, no, no they don't.
Porter Stansberry:They've got about a $500 million cushion.
Aaron Brown:Sounds like a big number but – uh
Porter Stansberry:For a $10 billion business it's a pretty small number.
Aaron Brown:Yeah, it's pretty small.
Porter Stansberry:Huh. That's interesting. I wonder why they don't require very much cash. You know how much cash Apple holds on its balance sheet?
Aaron Brown:What is it, like $87 billion or something ridiculous?
Porter Stansberry:$170 billion.
Aaron Brown:Oh, $170 billion.
Porter Stansberry:Okay. Now why would this company only need $500 million in terms of a cash cushion between what they have in the bank and what they owe this year? Why would they need so little cash?
Aaron Brown:I'm going to guess that they don't have a lot of research and development. They probably have very few competitors. And they have a client base that consistently purchases their product.
Porter Stansberry:Bingo, bingo, bingo. So a lot of investors, they instinctively think, "Oh, I want a company that has a lot of cash so I'm safe." Well, that's not necessarily the case. A company that holds a lot of cash is probably scared.
Aaron Brown:They probably need it.
Porter Stansberry:They probably need it. [Laughs] All right. Let's look here. What other things does this company owe?
Aaron Brown:All right. So we've got the long-term debts, so anything over 12 months.
Porter Stansberry:Yeah. So they –
Aaron Brown:$1.5 billion there.
Porter Stansberry:So this is what people really think of in terms of debt. These are payables, and this is real debt. So they have $1.5 billion in debt. We told you they've got a $10 billion market cap. Is that very much debt?
Porter Stansberry:No. Almost none. Is it very much in terms of their assets?
Aaron Brown:I don't see any problem with it yet.
Porter Stansberry:No. No way, right. We said they have – we say our approximation of their real asset value is $4 billion, and they've got $1.5 billion in debt. That'd be like if you had a $400,000.00 home with $150,000.00 mortgage.
Porter Stansberry:Still not a problem. Okay. Now ooh, a little red flag. Other liabilities. We know what those mean, right?
Aaron Brown:Well, we don't know what they mean, but we assume that they could be options or something like that, right?
Porter Stansberry:It's healthcare for retirees.
Aaron Brown:Right. And we have to assume that that goes up.
Porter Stansberry:That will go up. And that is a big number and that is a problem. Okay. So we've got to be careful about that. Now total liabilities, again, seems very reasonable given the size of the assets.
Aaron Brown:Yeah. Even if you take down the total assets down to $4 billion, you're still okay.
Porter Stansberry:You're still covered. You're still covered. So you see if you look at the difference between the assets and the liabilities, you come up with a relative small number of net tangible assets, only around $200 million. But you have total stockholder equity of $1 billion. So what you have here is a company that operates with very little cash, very little cash.
Porter Stansberry:That's – we already come to that conclusion and we see it at the bottom line.
Aaron Brown:That's right.
Porter Stansberry:All right. So let's go now – so anything here that would make you absolutely not want to buy the stock? Anything in the balance sheet that would show you –
Aaron Brown:Nothing. No. I would certainly go to the next screen.
Porter Stansberry:The thing that occurs to me is there's no real red flags here but how is it that this company can operate with so little cash, so little tangible asset? How does that work? Net tangible asset, how does that work? Let's find out.
All right. So first glance, let's look. Is the company growing revenues?
Porter Stansberry:This, by the way, is the income statement. It's the second stop on our journey through the financial statements. The company is generating cash or sorry –
Aaron Brown:Yes, and it looks good. I mean –
Porter Stansberry:The company is growing revenues.
Aaron Brown:Year-over-year growth is great.
Porter Stansberry:How about their expenses of making those revenues?
Aaron Brown:Slightly more but compared to their gross profit or even to their total revenues no problem.
Porter Stansberry:It seems like their margins are pretty stable.
Aaron Brown:It does.
Porter Stansberry:Right. Okay. So if I had to ask you to guess how much money on a gross basis this company would make in 2013, what would you say?
Aaron Brown:I would say $3 billion.
Porter Stansberry:Exactly, $3 billion. All right. How about their overhead? Seems to have a little bit of growth there. I'm wondering about that. Maybe they bought another company or something because that's kind of a big jump, $300 million.
Porter Stansberry:It's not a deal breaker, but I want to understand what's happening. So their executive overhead popped up. Non-reoccurring expenses are very, very small.
Aaron Brown:Very small.
Porter Stansberry:Irrelevant in our analysis. And their operating income seems to be growing at around $1 billion. So they're bringing in $3 billion in gross profit. They're spending $2 billion on overhead. That leaves them with $1 billion in profits.
Aaron Brown:Looks good.
Porter Stansberry:$1 billion in profits on a $10 billion market cap stock? That's a lot of profit.
Aaron Brown:That's great.
Porter Stansberry:That sounds pretty good. Okay. So their interest expense is under $100 million which is, again, not a big deal. And that leaves them with their income before tax, which as we said is around $1 billion. And then their income tax is high. They pay a lot of taxes.
Aaron Brown:They're a profitable company. That makes sense.
Porter Stansberry:That's America. Welcome to America.
Aaron Brown:Welcome to America.
Porter Stansberry:So that leaves them with their after-tax profit of $660 million. No red flags here.
Aaron Brown:Not at all.
Porter Stansberry:Now, again, would you say this is a high quality business just looking at these numbers? They make a billion on $6 billion in revenue pre-tax?
Aaron Brown:Absolutely. That's huge. I mean, that's awesome.
Porter Stansberry:So what's your margin there? That's going to be about 12.5 percent.
Aaron Brown:That's great.
Porter Stansberry:So over 10 percent. All right. And even after tax, they've still got a 10 percent profit margin.
Aaron Brown:This is a company I'm interested in buying.
Porter Stansberry:All right. Let's take a look. How are the cash flows? Now before you say anything, just tell me – well, I told you earlier, what's the main difference between the income statement and the cash flow?
Aaron Brown:I had to write it down.
Porter Stansberry:Quiz. Quiz.
Porter Stansberry:Depreciation. So the first thing you've got to look for is depreciation. All right. How did we do with deprecation?
Aaron Brown:Looks like it's fine.
Porter Stansberry:$200 million; $200 million in depreciation on $6 billion in sales.
Aaron Brown:That looks like nothing. It's –
Porter Stansberry:A fairly small number.
Aaron Brown:Fairly small.
Porter Stansberry:Now is it related to CapEx, to the investments ongoing in the business?
Aaron Brown:Yes, I would say so.
Porter Stansberry:Yeah, it's related, right. So their depreciation's around $200 million a year and the CapEx ends up being around $2.5 million.
Aaron Brown:That's not bad.
Porter Stansberry:All right. So in other words, there's not huge ongoing investments here in this company. They're just investing enough to cover their depreciation. That's all they're doing. And that means that for this company, their income statement is actually a very good judge of the actual owner earners. And we'll see that in a minute. Okay. So remember, we had $600 million in after-tax profits. Okay.
Capital expenditures are only $2.5 million. Again, we ignore the flows from investing activities because it's just cash management stuff. They're just buying Treasury bonds and then getting them back. It's like a sloshing washing machine. It's irrelevant to the real ongoing profits of the business. This company is very capital efficient in my eyes because it has very low depreciation compared to the size of its sales and very – and therefore, very low capital expenditure requirements. The result is that the company's able to spend large amounts of money on its shareholders.
Aaron Brown:So this is where their cash is going.
Porter Stansberry:Exactly. So how much money do they spend on their shareholders last year?
Aaron Brown:Of what, $600 million.
Porter Stansberry:$600 million. And what exactly was the profit from their net income statement, $660 million.
Aaron Brown:$660 million, yeah.
Porter Stansberry:So a lot of companies the income statement is not very correlated to the owner earnings. This company it is. It's very tightly correlated. And that is a – this is a very important thing for you to think about. So in this case, you can rely on the management statements about its income and its earning because they're real and you know they're real because you can look at the cash flow statement and see it and because it flows through to you, the shareholder.
Now here's what I want to point out to you. The owner earnings here have gone from $350 million to $500 million to $600 million.
Aaron Brown:It's a company that cares about their stockholders.
Porter Stansberry:And every year the company spends way more on its stockholders than it spends on itself.
Porter Stansberry:This is what it spends on itself. This is what it spends on its stockholders. That's the kind of company you want to own. And that progression of constantly earning money, constantly buying back stock, constantly raising the dividend, that is what ends up causing this. Every year, this company makes more and more money, and every year, it pays its shareholders more and more money.
Aaron Brown:That's a great chart.
Porter Stansberry:This company is Hershey. And I recommended it in 2007 about right here.
Aaron Brown:And that was right before the major downturn in the markets but it doesn't look like it blipped hardly at all.
Porter Stansberry:The '08 downturn didn't affect Hershey whatsoever. We didn't even stop out of the stock.
Aaron Brown:That's amazing.
Porter Stansberry:And, of course, it's done very well. I believe this will be the best recommendation that I will ever make in my newsletter. And I say that because I believe that Hershey will continue to grow and continue to compound that growth by buying back stock and that this is one of the few companies that can never be acquired by anybody else because the ownership is such – let me show you the owners here – the Hershey Trust Company is the controlling shareholder. The trust is, of course, the Milton Hershey Trust. And the state law of Pennsylvania says that the trust is never allowed to sell nor are they ever allowed to relinquish control of this company. So it can't be acquired by a private equity firm. It can be stolen from the shareholders in any other way.
So this – if you buy this stock, you and your family will be able to hold it forever. And eventually, that compound return will make it the best investment you could've ever had in your life. I would expect that Hershey will outperform almost any other American business for its shareholders over the next 20, 30, and 40 years.
Aaron Brown:Now question. It sounds like a very unique situation where the state is kind of locking in the trust to hold their shares. Did you find that information in the 10(K)? Is this something that average investors could find?
Porter Stansberry:Yes. You'll find all that information in the 10(K), which is the annual report of the company, and the annual report is published to shareholders. And it's a very unique situation. It's a very, very well-run public company, as we have seen. And it's very capital-efficient. So one way of measuring capital efficiency is you can look at what the gross profit was at the company. In this case, that's $2.8 million. Let's get the calculator out so we can – so the gross profit of this company was $2.8 billion. That's what they actually earned selling their chocolate bars. It cost them $3.7 billion to make the chocolate bars. They got $6.6 billion in exchange for them. So their gross profit was $2.8 billion.
And then we said that they returned roughly $600 billion to shareholders. So $600 billion in the form of dividends and buybacks divided –
Aaron Brown:$600 million.
Porter Stansberry:$600 million, sorry.
Aaron Brown:Got you.
Porter Stansberry:Divided by $2.8 billion gives you 21 percent. So that means that on every dollar of profit they make, $0.20 or $0.21 is going directly to shareholders.
Aaron Brown:That's fantastic.
Porter Stansberry:That is an extremely high rate of capital efficiency. And, again, that includes all the overhead. It includes all the CapEx. It includes all the interest expense. It even includes the taxes. So this is a great capital-efficient business to own and that's why you can see they don't need much – they don't have to hold onto much cash. They can give it back to you.
Aaron Brown:All right. So the $1 million question, would I buy this today?
Porter Stansberry:Well, let's take a look at that. We can go through some of the key statistics here. And here are the key statistics. Oh, geez, the market cap has doubled since [laughs] I last looked at it.
Porter Stansberry:So it's a $20 billion stock now. When I recommended it, it was an $8 billion stock.
Aaron Brown:And the market cap is shares outstanding times the price of the stock, correct?
Porter Stansberry:The market cap is the total value of all the outstanding shares. So we have 225 million shares. And we have a share price of $90.00. And that gets you $19.2 billion.
Porter Stansberry:All right. So what did I say the share price was, $90.00. That can't be right.
Aaron Brown:It was $86.00.
Porter Stansberry:Geez, this has gone up so much. [Laughs] Oh my God.
Aaron Brown:The best stock you ever recommended, Porter. You just said it.
Porter Stansberry:Well, it's not – I mean, it isn't yet the best stock.
Aaron Brown:It will be.
Porter Stansberry:But it will be. So wow. It was a great buy in '07. I personally don't think it's a buy today. Why? Well, I don't like to pay more than 10 times a company's operating earnings for the stock. So if we go and we look at what the real operating earnings were here, and in Hershey's case, we can use the income statement because the income statement is representative of the actual profits as we saw when we looked at the cash flows. So the operating income here is $1 billion. And it's growing, but it's $1 billion. So I would pay 10 times $1 billion, which is $10 billion.
Aaron Brown:$10 billion, right.
Porter Stansberry:Right. And I recommended it just below that level. And now we have it at twice that much.
Aaron Brown:Yeah. It's almost 20.
Porter Stansberry:So I think there's too much risk in the stock price.
Porter Stansberry:There is no risk –
Aaron Brown:The company fundamentals are fantastic.
Porter Stansberry:Look at these fundaments.
Aaron Brown:Yeah, it's the stock price.
Porter Stansberry:Return on assets, return on equity. This is an unbelievably great business. This is just incredibly well-run. This has incredible capital efficiency. It has what Buffett calls economic goodwill because it has a customer base that loves its product. This is a great business. But I'm not buying a company at 30 times earnings. I'm not buying a company at 20 times operating earnings. It's just too expensive.
Aaron Brown:Okay. So once somebody finds a stock that fits your recommendations for the balance sheet, the income statement, and the cash flow, then you need to look at these key statistics and do some simple calculations. Is it that easy?
Porter Stansberry:It is that easy, okay, with this one big provision. Hershey's is an excellent capital-efficient business. For excellent capital-efficient businesses, all you really need to know is what the operating income is because these things down here are all going to be roughly the same for every company. They're all going to pay taxes. They're all going to have interest expense. It's all going to be roughly the same. So if you get to the operating income and if you see that the cash flow and the operating income are roughly the same, that shows you that these are – that this is an honest company that has a good business that's – it's everything is lined up the way it should be. So you want 10 times cash flow or 10 times operating income. They end up being roughly the same number. And you don't want to pay more than that. It's that simple.
Porter Stansberry:But you got to that point only after you looked at the balance sheet and you knew what the assets were, you knew they were fairly valued, there weren't any huge red flags, you knew what the liabilities were, you knew there was positive equity. There's no giant debt problem, there's no huge bubble in property, plant, and equipment or in goodwill. You saw the company was very profitable on a gross basis. You saw that there were no huge bubbles in the inventories or growth – huge growth in the interest expense. And so then you could figure out, wow, this company is really good to its shareholders. It's very capital efficient. It's going to pay me more than it's paying itself. When you have all that stuff lined up then you can go, "Okay, what's the valuation?"
Aaron Brown:Then it comes down to the right price.
Porter Stansberry:And then once you figured out that it is at the right price, it is a capital-efficient business, it is treating its shareholders well, then, of course, you can do the simple thing, which is just ask yourself is this a product that I'd be proud to own.
Porter Stansberry:Is this a product that I think my children or grandchildren or great-grandchildren are likely to use?
Aaron Brown:For sure.
Porter Stansberry:Simple. That's all there is to it.
Aaron Brown:All right. And this is pretty much what your newsletter's all about.
Porter Stansberry:Our newsletter is really about finding companies that for whatever reason are being unappreciated by the market. And we want to stick with the highest quality companies like Hershey. And we want to buy them when they're trading at a great price that will allow us to have large future profits. And what happened here with Hershey is that back in 2007, right around in here, 2006-2007, Wall Street became consumed with the idea that companies should lever up their balance sheets and pay huge special one-time dividends to their shareholders. They're called recapitalizations. And it was all the rage on Wall Street.
And there was no way to do that with Hershey because of the controlling shareholder. And so the capital on Wall Street went to other businesses that would lever up and pay them special dividends. It fled away from Hershey. And that gave us a rare opportunity to buy this incredibly high quality business at such a reasonable price. It's that simple. That's what happened. From time-to-time, Mr. Market, as we call him, or the fad on Wall Street will abandon these companies and you can buy them at a great price. It doesn't happen all the time. I don't know when the next time we'll have the opportunity to buy Hershey for 10 times operating earnings. But I know it'll happen again.
Aaron Brown:That's great. And, Porter, I know that you're going to be hosting a new kind of premium podcast call with your analysts. I'm suspecting that knowing some of these key terms will help out our listeners that participate in that call, is that correct?
Porter Stansberry:Yeah. I think it's very important if you plan to be a buyer of individual stocks or if you plan to be an investor in stocks at all, even if it's through a mutual fund, you should absolutely have the ability to do what we just did, which was to look at the financial statements and to come up with a rough estimate about whether or not this is a business that's good enough for you to own and whether or not it's trading at a price that's safe enough for you to pay. It's that simple.
Buck Sexton:All right, folks. There you have it. I hope today's episode of the Stansberry Investor Hour made you a little bit savvier as an investor and certainly more confident valuing a business before you buy it. remember, there's a follow-up video to this podcast showing all of the screenshots from Yahoo Finance and the other sources Porter used during the lesson. Just go to investorhour.com and sign up to get the video link. We'll also send you access to the show transcript, links to past episodes, and the special content we post for you on the Stansberry Research website.
Send us your questions, thoughts, and feedback. Write to us at [email protected] We love getting your e-mails. Great to hear from the Stansberry friends and family, Stansberry squad, #stansberrysquad. We should start that by the way. Thanks again for listening, everybody. It's always great to have you with us.
We really appreciate it. And until next week, my friends. This is Buck Sexton. Over and out with Stansberry Investor Hour.
Male:Thank you for listening to the Stansberry Investor Hour. To access today's notes and receive notice of upcoming episodes, go to investorhour.com and enter your e-mail. Have a question for Porter and Buck? Send them an e-mail at [email protected] If we use your question on air, we'll send you one of our studio mugs. This broadcast is provided for entertainment purposes only and should not be considered personalized investment advice. Trading stocks and all other financial instruments involves risk. You should not make any investment decision based solely on what you hear. Stansberry Investor Hour is produced by Stansberry Research and is copyrighted by the Stansberry Radio Network.
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