A Not-So-Hidden Clue…

Wednesday, 24th February, 2016
Melbourne, Australia
By Kris Sayce

  • Secrets of the balance sheet
  • Looks like it’s going lower
  • Conference 2016

In a short while (about three or four paragraphs from now), the vast majority of readers who opened this email will immediately close it.

It won’t be because I’ve offended them.

It won’t be because I’ve made an obvious attempt to get them to click on a link for one of our long promotional letters.

And it won’t be because I’ve gone off into a rant about nothing in particular (although that does happen quite often).

The reason they’ll close this email is down to this statement: in today’s Port Phillip Insider, I’m going to show you how to read an income statement and balance sheet.

I can hear the mouse clicks already.

They’re closing this email and moving on to the next.

That’s fine. As I always say, our relationship with our readers is purely voluntary. We don’t force anyone to read or buy anything if they don’t want to.

In my view, that’s the best kind of business relationship, and it’s the relationship we’ll always have with our readers.

But what’s the big deal about income statements and balance sheets?

Why do I need to teach you anything about that?

Isn’t the reason you buy an investment newsletter so you don’t have to read about such boring things?

There’s some truth to that.

But the lesson I’ll teach you today won’t be a typical class on financial statements. This lesson will focus on no more than half a dozen key lines that you’ll find in almost any company’s financial statements.

And it’s these few lines that will help show you the real impact, in the real economy, of record low interest rates.

If that interests you, keep reading more after this…

Markets

After what felt like days of non-stop bullishness, the US market took a beating overnight.

The Dow Jones Industrial Average fell 188 points, or 1.1%.

The S&P 500 fell 24 points, or 1.3%.

In Europe, the markets headed south at the end of the day. The FTSE 100 closed down 1.3%, while Germany’s DAX index ended 1.6% lower.

Locally, as I write, the Aussie S&P/ASX 200 index is down 109 points, or 2.2%. Hong Kong’s Hang Seng index is down 311 points, or 1.6%.

As for commodities, crude oil is currently trading at US$31.33 per barrel, and gold is US$1,222 per ounce.

Of course, considering what we see happening in the markets in the months ahead, today’s gold price could turn out to be a bargain a year from now.

That brings us back to the topic of today’s letter…

Secrets of the balance sheet

To give you some background and context, let’s first look at a report that cropped up in Bloomberg today:

Community Health Systems Inc. operates 195 hospitals in 29 states and is the U.S.’s second-biggest for-profit U.S. hospital chain. This month, it revised its fourth-quarter 2015 provision for bad debt up by $169 million — and said that 40 percent, or about $68 million of that amount, was from patients being unable to pay deductibles and co-payments. Patient bankruptcies also contributed, the company said…

“I’m surprised it’s not bigger,” Sheryl Skolnick, an analyst with Mizuho Securities USA who rates the stock underperform, said of Community’s bad-debt figure. “They need to fill the beds and collect the cash.”

At this point, many folks will decry the state of the US healthcare system. They’ll use it as proof that capitalism can’t be trusted to run healthcare.

Naturally, we’ll tell those folks not to be so foolish. The US healthcare system is about as far from ‘free market’ as the Aussie system is.

But that’s a topic for another day.

Yes, today’s essay will cast a critical stone speedily, and hard, in the direction of the government, but for different reasons — and we’ll cast a second stone, just as speedily, and just as hard, in the direction of the central bank.

There’s a reasonable chance that you’ve never heard of Community Health Systems [NYSE:CYH]. I was unaware of its existence until today.

The company is relatively small in terms of market capitalisation, valued at just US$1.65 billion (AU$2.3 billion).

But, while the company itself may be small, its potential problems aren’t. The report from Bloomberg suggests that US president Obama’s Affordable Care Act (Obamacare) is to blame.

No doubt it deserves some of the blame. But it’s not the only place for blame.

I billed today’s Port Phillip Insider as a lesson in learning how to read certain parts of a company’s financial statements. It can be a very dry subject. It can be complicated too, figuring out the various accounting principles.

But, if you know what you’re looking for, it can also be incredibly enlightening. So when you find what you’re looking for, it can lead to that ‘Aha’ moment.

That’s when you can finally connect the dots. That’s what happened to us today. After reading the story on Community Health Systems, and taking just a few minutes to flick through the income statement and balance sheet, it was easy to see how everything fits together.

Folks in the mainstream and on the business TV channels, sometimes talk about the ‘financial economy’ and the ‘real economy’. It’s the idea that one has become disconnected from the other.

That’s why — they claim — low interest rates and money printing haven’t had a bigger impact on businesses.

However, they can only say that if they haven’t looked at the financial statements of a company like Community Health Systems.

So, why don’t we do just that?

First, let’s remember a few key points:

  • Community Health Systems has a market cap of US$1.65 billion;
  • Provision for bad debts are up US$169 million;
  • The company owns 195 hospitals in 29 states.

Oh, and check out this news story from Marketrealist.com:

Community Health Systems acquires two to four hospitals each year as a part of its growth strategy. The company acquired HMA in 2013 for $7.6 billion.

Even before I saw that news report I knew that Community Health Systems had been on a buying spree. In fact, it was because of what I saw in the company’s balance sheet that raised my suspicions that this could be the case.

What did I see? This:

Source: Bloomberg

The line in focus is ‘Goodwill’. You can see that ‘goodwill’ has increased from US$4.2 billion in 2011 to US$8.9 billion in 2015.

When you see that happen, it usually tells you a company has carried out a bunch of takeovers. But why is this important?

The simplest way to think about ‘goodwill’ is that the business doing the takeover has paid a higher price than the acquired business is currently worth.

The difference between the current real value and the price paid is ‘goodwill’. Companies will pay more than a business is really worth for a number of reasons.

Most often, it’s because the acquiring company believes it can make more out of the company’s resources than the existing management. That could be due to higher productivity, or the classic term used in takeovers, ‘synergies’.

But that’s not the only place to look. Scroll down the balance sheet further, and you’ll find that other giveaway of a takeover frenzy, ‘LT Borrowings’, or ‘long term borrowings’.

Here you can see how Community Health Systems’ long term borrowings have grown over the past five years:

Source: Bloomberg

In 2011, the company’s long term borrowings were US$8.7 billion. Today, it’s US$16.6 billion.

But we can go back further. In 2001, the company’s long term borrowings were just US$980 million.

From there it began to grow. The company’s debt hit US$9 billion in 2007, before plateauing, and growing again to the current level of US$16.8 billion.

Remember that interest rates were at rock bottom in the early to mid-2000s too. The US Federal Reserve finally began rising rates, only for the US and world economies to collapse after peaking in 2007.

There are other signs of trouble on the balance sheet. The number of shares outstanding has grown from 92.7 million in 2010 to 112.8 million today.

That tells you that not only is the company leveraging up its balance sheet by borrowing more, but it’s diluting current shareholders by issuing more shares to partly fund the acquisitions.

After all, the company’s goal is to make between two and four takeovers a year. How else will it fund those takeovers?

It certainly can’t do it from free cash flow. The company’s interest expense alone last year was US$988 million. Once all the expenses were taken into account, the company booked a profit of US$158 million.

Not enough to pay a dividend. And not enough to keep shareholders happy. The stock price is down 69% over the past year…and is now closing in on the 2008 low.

The point to all this is: do you think any of Community Health Systems’ takeovers would have been possible if it wasn’t for record low interest rates?

Would this now relatively small company have been able to secure over US$16 billion-worth of debt if it wasn’t for low interest rates and money printing?

That’s the impact of the ‘financial world’ on the ‘real world’. It’s a mistake to think that what has happened at the Fed, the Reserve Bank of Australia, or the European Central Bank hasn’t had an impact on the markets.

It has. The financial statements of Community Health Systems is a perfect example of that. The stock price is down, and the company has a bundle of debt it needs to refinance in the years ahead.

That’s the impact of low interest rates.

Looks like it’s going lower

Check this out:

Source: Bloomberg

It’s the yield for Community Health Systems’ 5.125% bonds, due to mature in August 2018.

Over the past year, the yield on these bonds has gone from below 4%, to above 5%.

The bonds have a rating of BB by Standard and Poor’s. A BB rating is a non-investment grade bond. In other words, a junk bond.

The way we see it, ‘junk’ is just about the right word. This bond issue alone has an amount of US$1.6 billion outstanding. The 8% bonds due November 2019 have an even lower rating of B- from S&P.

That bond issue has US$2 billion outstanding.

Quite how it will refinance and pay for these bonds if interest rates rise any further is anyone’s guess. Remember, its interest bill last year was US$988 million, leaving a profit for shareholders of just US$158 million.

If we were gamblers, we’d say the stock price has further to fall, even after a 69% drop. As for the bonds, with our gambling hats on, we may be tempted to short sell those too.

Conference 2016

This morning, all the bigwigs here at Port Phillip Publishing HQ in Albert Park held a meeting to discuss our 2016 investment conference.

We’ve gotten into a habit of holding the event every two years. The first conference was in 2012 in Sydney, titled ‘After America’.

Our second conference was in Melbourne in 2014, titled ‘World War D’.

Our third conference will be in…

You’ll have to wait and see. We’re about a week or two away from finalising the venue and date…and months away from finalising the guest speaker list!

We’ll keep you posted.

Cheers,

Kris


End of day market data

If you have any ideas about what you would like us to include in our end of day market data drop us a line at letters@portphillipinsider.com.au, and type ‘Market data’ in the subject line.

52-week highs: 32 stocks, including CIMIC Group Ltd [ASX:CIM], Jumbo Interactive Ltd [ASX:JIN], Macquarie Telecom Ltd [ASX:MAQ], St Barbara Ltd [ASX:SBM], Service Stream Ltd [ASX:SSM], and The Reject Shop Ltd [ASX:TRS].

52-week lows: 32 stocks, including Bendigo & Adelaide Bank Ltd [ASX:BEN], Computershare Ltd [ASX:CPU], Pepper Group Ltd [ASX:PEP], SMS Management & Technology Ltd [ASX:SMX], and Vectus Biosystems Ltd [ASX:VBS].

Note: The stocks listed above are stocks that hit an intra-day 52-week high during today’s trading. The stocks didn’t necessarily close at the 52-week high.