Balance Sheets: The Good Kind of BS | 03/01/2015
DEAR INVESTOR, We know what makes stocks worthwhile, right? Those who took formal classes or read substantive books cite factors such as the present value of expected future cash flows. Those who follow the news would probably think in terms of beating previously-issued earnings or revenue guidance and/or raising guidance for the future. Each camp is convinced it is right and tends to have nasty things to say about those in the other, who supposedly don’t get it. Actually, both camps are correct. Nobel laureate Robert Shiller spoke of stock prices as influenced by total demand for stocks, that being the sum of demand from “smart money” (the present values crowd) and from “ordinary investors” (fans of the guidance game, etc.). As diametrically opposed as both camps seem, have you noticed something incredibly important they have in common? Both are looking, in their own ways, at the income statement (or the statement of cash flows, sometimes dubbed the “other” income statement). Neither talk about the balance sheet. Deep down, folks on both sides know what a balance sheet is and could recite the reasons for its importance if asked to do so. But unless you specifically ask, neither is likely to bring it up on its own. That’s interesting, and may well present opportunities for investors like us.
This starts with my having absolutely no idea where the market is going. Well actually, I have two strong opinions. Problem: They are diametrically opposed. This reminds me of law school and moot court, an exercise where we were given a case and told to research the daylights out of it and argue before a panel of make-believe judges (sometimes guest starring real world judges), but at the outset, we weren’t told which side we’d have to represent. We needed to know how to argue either side of the question. In that spirit, if I want to provide a bullish market forecast, I could deliver a great one that discusses the slow but steady potentially more sustainable levels of economic activity; our track record of incredible problem-solving resiliency that has enabled the market to power forward, even notwithstanding some occasional potholes as we succeed in moving past crisis after crisis; the still-very-modest inflationary pressures; the likelihood that when interest rates rise, the ascent will be very gradual and modest, etc.. If I want to issue a bearish forecast, again no problem: I’d discuss our lack of understanding regarding oil; increasing heat (the worst kind) in the Middle East while Congress seems more concerned with shutting Homeland Security because Barak is being naughty regarding immigration; how seemingly-favorable unemployment stats might be masking a bad underemployment problem; how the Fed is eventually likely to wind up raising interest rates and how we have an entire generation of investors who’ve never lived with this, have no real idea how to address it and have lived for years with models containing nothing but low interest rates in their data samples; not to mention the Ukraine, Greece, and of course the big pending U.S. Supreme Court Obamacare case. What a moot court exercise! Business schools really ought to follow their legal brethren and adopt this.
So in the real world, considering both sides of the argument, on the one hand, I can think of plenty of reasons to want to lighten up on stocks, but on the other hand, I don’t see here-and-now catalysts that compel me to do so. No matter what I do or don’t do, I can’t get comfortable that I’m getting it right. So instead, I’m going to BS you. I’m going to suggest sticking with stocks. (I’m ultimately swayed by the absence of immediate catalysts to bail coupled with stocks’ historic comeback ability even when they do periodically tumble.) But knowing how small and risky our companies tend to be, I’m going to suggest thinking long term about income statements and cash flows (as I usually do). I’m also going to suggest looking for healthy balance sheets. Having one can make the difference between shrugging off bad times and Googling lawyers who specialize in bankruptcy. Investing in a company with or without great balance sheet is like the difference between owning a stock and a call option that expires in the very near future. Both need the investment case to pan out. But the former will be wiped out if that doesn’t happen right now. The latter can afford to wait, and even tolerate some missteps along the way, a big advantage considering how uncertain the real world is. We really can find these financially strong companies. One of the most under-appreciated and under-recognized characteristics of so many companies we look at is their strong balance sheets. That characteristic, rather than confidence in the near term market, earnings estimates, or the flow of economic data, is what gives me the wherewithal to stay all in.
Meanwhile, our Top 40 has had a good stretch but our most recent month was a bit karmic; we experienced some modest underperformance. (The Model Portfolio, which had exhibited greater strength, also had its form of a karmic moment, as it was relatively weaker February.)
[newsletter_anchor]ALL CASH, MINIMAL ACTION[/newsletter_anchor]
Of all the stocks I’ve encountered in the nearly five years since this newsletter launched, Emerson Radio (MSN) may be the most perplexing. For starters, it would be hard, really hard, to ignore a stock that’s priced below the amount of cash and cash equivalents currently on a debt-free balance sheet as MSN is – unless operations were burning cash to an extent that threatens the company’s existence, which is not happening here. And by the way, the present situation, a stock price of $1.34 versus cash and equivalents amounting to $1.46 a share, is after the company paid a special $0.70-a-share dividend in September 2014.
Why, you may ask, should I feel angst about a scenario like this? Instant arbitrage, how good is that! First off, let’s scratch the notion of instant; the last payout before the latest one occurred back in 2010 so if there is going to be a liquidation, it’s not going to occur quickly. (And for the record, MSN is wrangling with the IRS over how much of the 2010 payment should have been withheld in connection with the stake of a major shareholder; MSN’s worst-case exposure amounts to ab0ut $0.18 per share.) The issues here are twofold.
One is operations, which although not crashing and burning do seem on a slow boat to nowhere. MSN is known, so to speak, for low end consumer electronics and household appliances. The merchandise is fine (in my younger days, I had an Emerson clock-radio-tape player on my desk that was as good as anything else then the market) and there still is a place in the world for appliances that don’t cost much. But most of these are sold through two vendors, Wal Mart and Target. Those are two pretty big vendors, but the “concentration” risk here is noteworthy and MSN did recently take a noticeable hit as Wal Mart shifted some microwave business elsewhere. MSN gives no hint as to how it can try to grow this business. What MSN is saying is that it is growing its licensing business. I’m indecisive about how I feel about this. I don’t see the Emerson name as being so hot as to attract eager licensees. But the distribution MSN brings to the table might prove attractive. Operationally, this is where I’m pinning my hopes.
The other concern is the presence of a 56.2% shareholder that is going through a bankruptcy proceeding in Hong Kong. There is a possibility this will wind up in a forced liquidation of the position, but lately, the probabilities have been shifting in the direction of the stake not having to be sold.
So here’s where we are. The stock is in our Master, Cash-Rich, Growth, Under $5, and Value lists. A recommendation here has been open since 11/1/13 and, adjusted for the special dividend, we’re up 12.6%, versus 9.9% for the Russell 2000. We can afford to keep holding. Our main risk is time value of money; an arbitrage play that materializes in a month is a lot more valuable than one that takes 20 years. Our opportunity here is that someone on the inside, possibly the 56.2% shareholder that seems like it may regain voting control after conclusion of its bankruptcy proceeding, gets more impatient and becomes a catalyst for faster cash distribution and/or more operational energy.
[newsletter_anchor]A GREAT THIRD IMPRESSION[/newsletter_anchor]
My first impression of Vonage (VG) was pretty bad. That was from 2006, when many at Reuters, where I worked at the time, were buzzing about the upcoming IPO and I tried hard to dissuade a software developer who was anxious to pick up a big chunk of share. He should have listened to me. That offering was every bit the dud I thought it would be. And others I knew found the then-newfangled internet phone service hard to set up. My second impression, formulated as this newsletter launched in mid-2010 was better and I profiled VG in the debut issue. Operations had become cleaner and the company, recognizing how incredibly competitive phone service, even internet phone service, gradually moved toward what struck me as a sensible niche strategy; very low-end plans (Basic Talk) sold through big partners like Wal Mart, and low-cost international calling plans targeted toward particular immigrant communities in the U.S. Helping, too, were mobile apps that enhanced the usability of these services. This wasn’t the sexiest strategy around, but it pushed VG well into the black with enough cash generation to even start trimming debt and buying back shares. I articulated my third impression a year ago, shortly after VG acquired Vocalocity and renamed it Vonage Business Solutions (VBS). The idea here is to sell cloud-based phone services to the SMB, small- and medium-sized business (up to 1,000 employees), market; mainly to the smaller end of that market, firms with up to 20 employees. I liked this business from day one (early in this newsletter, I recommended and profitably sold a different entrant in this field). Communications is getting more powerful and complex given messaging, employee mobility, etc. but complexity is getting brutal (on-premises equipment) making the cloud a great solution to a growing problem. We can debate how natural an extension this was of VG’s low-end specialty consumer focus, but the reality is that it worked wonderfully in year one. Revenues for that business grew 50% and VG invested heavily in the platform and the sales infrastructure.
Going forward, it looks like VG is taking another big step forward. It recently enhanced VBS through the purchase of Telesphere, a Unified Communications-as-a-Service (UCaaS) company that extends VBS’ capabilities toward larger SMB firms, particularly those with dispersed work forces. Revenue is slated to decline in the consumer business as VG seeks to emphasize quality of customer (to keep churn low). This is, however, a nice cash cow that’s helping to feed VBS.
As to the stock, yes, I despised the IPO. But we have been averaging in well below that ridiculous mid-teens level. The present price, around $4.60, is profitable for us. The valuation metrics nowadays look run of the mill: PEG, price/sales and price/book ratios of 1.77, 1.12 and 2.84 versus industry medians of 1.77, 1.34, and 2.26. But the stock, currently in our Master, Under $5 and Value lists, seems more a growth play.
When it comes to sorting out an investment case regarding Synergetics (SURG), it seems as if we need to think of two aspects. One, the larger more established one, is a company that produces products for ophthalmic and neuro surgery, mainly disposables. It also produces related capital equipment but this, the bigger-ticket side of the business, can be volatile from quarter to quarter (more in a positive way lately but we have to allow for the possibility of episodes of less-favorable volatility going forward) is likely to receive less focus in the future than the more stable disposables business. Like anything medical, this is a case of good demographic underpinnings to demand, enhanced lately by wider health care coverage, offset periodically by brutal pricing pressures due to competition and insurance reimbursement practices. When we first looked at SURG back in the summer of 2010, the second aspect of the investment case was the windfall from a litigation win, something we were able to ride for a 154% gain (versus 36% for the Russell 2000). Today, Aspect One is as it was, but aspect two is different. The latter involves VersaVIT, equipment (and kits) recently introduced by SURG for vitreoretinal surgery involving the back of the eye, a delicate procedure that addresses problems arising from trauma, diabetic complications, macular degeneration, etc. Again, there’s the demographic angle: The aging population and increases in the incidence of diabetes are likely to boost needs for such procedures. There’s also SURG’s competitive edge: VersaVIT is highly portable and moderately priced, thus facilitating its use in ambulatory surgery centers or even in-office procedures, both of which are gaining favor relative to hospitals (even out-patient departments) with their higher costs and greater bureaucracies. Aspect Two figures to be enhanced by the introduction of VersaVIT 2.0, with most customers of 1.0 upgrading. We tuned into Aspect Two in the 1/1/14 Issue and so far are up 24% with this position, versus 6% for the Russell 2000.
On the whole, it looks like VersaVIT is off to a good start. SURG estimates that in the quarter ended 10/31/a year ago, customers were using VersaVIT in 20% of their cases while in the most recent period, usage is estimated to be up to around 75%. To get a sense of the potential here, SURG cites a study by Market Scope LLC to the effect that in early 2012, there were about 2,000 practicing retinal specialists in the U.S. and another 7,600 in other countries, and that about 327,000 vitrectomies would be performed in the U.S. in 2014 and a total of 1.295 million worldwide. As of SURG’s latest reporting date (12/10/15), a total of 12,185 vitrectomies had been performed (including evaluations). It’s hard to say how much of this market SURG will eventually get – although given the small footprint of VersaVIT relative to rivals, there is reason for optimism – but it does seem likely SURG can get more than enough to make a significant impact for a company with annual sales of about $66 million and market cap a shade below $115 million. The stock presently appears in our Master, Cash-Rich, Under $5 and Value Lists. Its PEG, Price/Sales and Price/Book ratios are 1.37, 1.73 and 1.76 versus industry medians of 1.80, 4.32 and 3.94. SURG is debt free and liquid leaving it well able to afford “strategic acquisitions,” a recent one, Sterimedix, enhancing the larger core business with disposables for ophthalmic and aesthetic surgery markets.
[newsletter_anchor]B2C => B2B[/newsletter_anchor]
Prepare for a possible hit to the ego. Thinking of yourself as a consumer (i.e., when you’re not on the job), do you realize that many companies that sell goods and services to you probably wish they didn’t have to do that? Ever since the acronyms B2C (business-to-consumer) and B2B (business-to-business) were invented, I’ve lost count of how any times I heard companies discuss how their future prospects were tied to success in migrating from B2C to B2B. Now think of yourself in your professional context. Can you blame them? B2B transactions tend to be larger in scale, which means that although you may spend more to acquire and serve a single customer, you get a much bigger bang for the buck in terms of revenue. And you may stand a much better chance of seeing recurring revenue, rather than a once-off transaction, and you probably have a better opportunity to sell additional products to that same business customer than to the consumer, who, in contrast to seeing you as a relationship partner may or may not remember where they got the thing you sold them ages ago. The catch is that it’s hard to successfully migrate from B2C to B2B.
GlobalSCAPE (GSB) is an example of a company that is succeeding in this transition. It took a while to get going: We had a disappointing 2010-12 run with this stock (down 24% versus a 28% Russell 2000 gain). But it’s taken hold more recently, helping a new position we opened 1/1/14 to rise 36% versus a 6% Russell 2000 advance. As to the company’s B2C roots, perhaps you remember CuteFTP (I do – and still have it on my pc). It was a terrific little inexpensive piece of software, marketed a lot via shareware, that easily allowed for secure file transfer between one’s computer and a web site to which the user had authorized access. That was GSB’s initial flagship product. For me, it was great. I used it for personal web sites. And I was able to use it to maintain professional web content for which I was responsible at while at Market Guide, Multex and for a while, even at Reuters. But that, for GSB, was a problem. I got a ton of incredibly valuable and long-lasting use out of CuteFTP, despite having paid only a one-shot fee ($35 I think) back in the 1990s. And until I first found GSB on a screen created for this newsletter, I had never heard of the company; I had assumed CuteFTP was created and sold by a guy working from his basement, or something like that. That’s why even though I’m just as much a C as a B, I can easily understand why companies want to rise “above” B2C.
In 2014, EFT (Enhanced File Transfer) which is much more suitable for B2B, accounted for 80% of revenues. Indeed, when it comes to enterprise transfer, there really is a lot of need for properly-secured solutions. The need for security is obvious. We’ve seen in the news stories of high-profile breaches in which companies report that hackers got access to important customer data. If a company is willing to cede control of its most valuable content, it can get easy to combine secure storage, remote access, sharing, and so forth. I collaborate professionally using Google drive and related applications. Frankly, though, I hate the idea that my work product is stored on Google. This is an example of the sort of B2B challenges GSB meets nowadays; giving customers wide ranges of choices that let them decide where files go, who can use them, where they reside (a firm can choose to have GSB host content, but that’s not mandatory) and how their increasingly dispersed and mobile work forces can access and work with them (now, it’s not just pcs and laptops that may be located anywhere; it’s also about phones and tablets that may be on a corporate network, an employee’s home network, or even Starbucks WiFi or the employees own phone data plan when Starbucks network goes on the fritz). Leveraging its old-time CuteFTP-based skill set, GSB is comfortably profitable, in the early stages of what could be a nice growth curve, and generating healthy level of surplus cash flow, enough to induce the company to institute a regular dividend policy; the yield (1.9%) is respectable, but not a big deal; what’s noteworthy is that a tech company as small as GSB is (annual revenue: $27 million) in a position to do it. The stock is in our Master, Growth, Momentum and Under $5 lists. Its price/sales and price/book ratios, 2.35 and 3.03, are not lean, but they are below those of generally high industry medians (3.80 and 4.36 respectively).
[newsletter_anchor]CASH AS A SURVIVAL TOOL[/newsletter_anchor]
There are multiple reasons why being cash rich can be a boon for a company and its shareholders. On Wall Street, uttering “buy back shares” or “dividends” in response to the words “excess cash” is about as standard as Pavolv’s dogs salivating in response to the ringing of a bell. But there are other important potential uses; acquisitions, investment in internal growth ventures, get through a touch business cycle, or live to fight another day even after having made complete mess of things. bebe Stores (BEBE), in our Cash Rich list, is an example of the latter.
This is a mall-based chain of apparel stores for young women (it has other kinds of stores, such as outlets, but for the most part, it’s a mall-based retailer) who favored a hip sort of edgy look. Once upon a time (late 1990s-early 2000s) the company was hot. It carried little or no debt yet consistently generated returns on equity north of 30%. Growth was sizzling and by 2005, the stock, which had been at single digit levels for a while as it took the market a while to recognize upstart BEBE, finally peaked around $30. Fast forwarding to the present, we’re able to look at the stock because it trades below $10 (and toward the lower end of our single-digit range). Trailing 12 month revenues were $423.7 million, down from a $628.7 million 2008 peak, and the bottom line has fallen deep into the red. There have been some unusual charges, as there often are, but that’s not the main thing. Operating cash flow has also been significantly negative in 2013 and 2014. If still-debt-free BEBE didn’t have the cash hoard it does thanks to the good old days ($1.20 a share worth), survival would likely be in doubt. That may yet come to pass if the next few years look like the last two. But there are indications that BEBE may, in fact, be in the early stages of a turnaround.
For one thing, there’s a new CEO, a 40-year retailing veteran who joined BEBE in 2014. (While I don’t typically like to base investment decisions on easy-to-crave but hard-to-really-get personal assessments of executives, I have to confess that seeing a fresh voice seems right after the corporate wheels came off as badly as they did here.) And in the latest quarter, comparable store sales rose 8% year-to-year, versus the last quarter of 2013, when comps fell 2.6%. So it seems customers are now seeing something very different, and better. That doesn’t by any means confirm that BEBE is out of the woods. But it’s an important preliminary signal and one that suggests we can give credence to the sort of things BEBE says its doing.
Store closures are part of the package, lots of them, more of these than openings. That comes as no surprise. Retailers that mess up often wind up having expanded too aggressively. Store remodelings are also occurring and as hoped for, are outperforming non-remodeled stores. Again, this is not a surprise. A fresh look can help even a successful retailer. Another item of standard fare for recovering retailers is BEBE’s talk of more focused merchandising efforts. This playbook is so standard, it almost makes me wonder why so many retailers get into trouble in the first place. These factors, together with the strong recent comp and the time BEBE buys thanks to its cash position, could, for many, justify a green light on BEBE stock as a speculative turnaround play. Typically, though, I also like to see something unique to the specific company. I think with BEBE, that may turn out to be in the kinds of messages it delivers to its target customers. Early on, BEBE delivered a consistent, on-point brand message that emphasized sultry sophistication. But in the late-200s, the messages changed, which is not necessarily the end of the world (brands can evolve), but they were all over the place, and that’s a big no-no. Sometimes BEBE talked in terms of merchants. Other times it was about collections. Then it was junior. Next, it was very junior. Sometimes it was about being cheap. And then, super sexy. BEBE is tossing all that out and converging now on a clear-cut statement: “Be more you,” which in fashion terms, translates to confidently wearing bright, bold looks worn with visible confidence. Is it a winner? It’s too early to say. But it’s not too early to suggest it seems to mesh with the look of its merchandise and perhaps more important, with what I recall from when I had occasion to profile BEBE several times during its heyday. Meanwhile, here’s what’s great about a youthful target audience. Many probably were not focused on BEBE during the times when its messages were at their messiest. So in a sense, BEBE gets new chances to make a first impression. Helping too is a positive carryover from the recent past; BEBE is still mainly in the better more productive malls.
Make no mistake about it. This is a speculation on the company’s ability to get back to, or at least make progress moving toward, its glory days. It’s not cigar-butt valuation play, probably thanks to the cash: the P/S and P/B ratios are 0.68 and 1.69 versus 1.69 and 2.92 industry medians. (I didn’t subtract the cash and recalculate the ratios because as long as BEBE is losing money the way it is, I do not consider the cash to be surplus.)
Gaiam (GAIA), which was introduced 7/15/13 and in which we’re up 39% (versus 19% for the Russell 2000), is not the only investment play in LOHAS (lifestyle of health and sustainability) but it’s still very attractively priced relative to some other big names in the area. The best-known giants in the field are Whole Foods Markets (WFM) and Lululemon (LULU), which trade respectively at 1.40 and 5.56 times trailing 12 months sales. Both ratios are substantially above the respective industry medians (0.46 and 1.39). GAIA trades at 0.99 times sales versus a median of 1.41 for its industry.
WFM and LULU are known for top-quality products, yoga apparel in the case on LULU and food in the case of WFM. But offerings of both tend to priced for a generally well-heeled target customer bases. So besides having to make assumptions about the merits of LOHAS, shareholders in those companies must also address the pros and cons of selling primarily to upscale customers, which is often great early on but does raise issues of how far the business can expand before having to choose between slowing growth or dilution of the brand through downscale drift.
GAIA is not completely free of this. After some business fine-tuning, we can now look at the company in two parts: branded products (mainly yoga apparel, in competition with LULU, yoga mats, blocks, and other yoga accessories, restorative products such as foam rollers and massage sticks, balance balls and rubber resistance products, and its SPRI line of fitness products including the high-intensity training market) and media. The latter has traditionally sold wellness-oriented DVDs (yoga, exercise, healthy eating, personal development, spirituality and so forth) much of it through big-name brick-and-mortar and e-commerce retailers. Don’t focus, though, on DVDs; GAIA media has been evolving along with its world as it has digitized its content and now tends to sell through its subscription GAIAM TV channel and through streaming over all the usual array of devices (one thing interesting GAIA does is allowing subscribers to download its programs and play off-line so long as the subscription remains active).
The first impression is that GAIA serves pretty-much the same affluent customer group as does WFM and LULU. No doubt there is a lot of commonality. But don’t assume everybody interested in LOHAS is as affluent as those who shop at WFM and LULU. The market is much broader than that: hence GAIA’s success selling through retailers like Amazon and Wal Mart. And hence its ability to get approximately 15,000 brick-and-mortar store-within-store arrangements, a roster that’s still growing thanks to recently-announced arrangements with Kohl’s. Presently, the company is staking a new direction in yoga; yoga for athletes which is launching with two videos featuring well-known athletes (NBA star Kevin Love and retired NFL star Eddie George) working with Kent Katich, founder of All Sport Yoga. The idea, here, is to attract more consumers. Athletic yoga accessories are debuting with a 100-store test at Dick’s Sporting Goods. The key here is that GAIA can address and is addressing a broad market without angst over what it means for its brand. Its brand is sufficiently wide ranging.
There’s one more noteworthy aspect to GAIA. Media and product sales are very different businesses and GAIA plans to split into two publicly traded companies along these lines through a planned tax-free spinoff to occur after the completion of the annual audit of 2014 results. Split-ups like this have a generally good history of enhancing overall shareholder wealth and that could be particularly so with GAIA, as it gives investors better visibility of financial performance of each business, something that seems especially important given that GAIA has one business in which black ink is eventually expected and another (media) for which investors tend to be much more tolerant of net losses as reported under standard accounting rules.
[newsletter_anchor]EXCITING AND IRRITATING[/newsletter_anchor]
Destination XL Group (DXLG), formerly Casual Male Retail Group, first recommended on 8/15/10 and reviewed again on 5/1/14 may be simultaneously one of the most exciting opportunities we have and one of the most irritating. (The stock is up 75% since the first write-up, versus 104% for the Russell 2000; and down 7%, versus a 10% market gain since the later review.)
The great thing here is a strong position in an under-served but large and important niche; men’s apparel in big-and-tall sizes (i.e. waist sizes above 42). If you’re in this category, you know how difficult it can be to find decent selections at regular department stores and specialty apparel stores. And often the better quality the store is, the less likely it is to serve big-and-tall customers effectively, if at all. That would be fine if the U.S. population is getting smaller. But contrary to what the fashion industry thinks but consistent with what the rest of us know, the opposite is occurring. Yet resistance to big sizes remains intense. (In a recent episode of ABC’s Shark Tank, I was flabbergasted at the pushback encountered by an entrepreneur seeking investment in her plus-size woman’s high-fashion apparel business as even the generally forward-thinking panel, including one fashion expert, had an incredibly difficult time believing there was a meaningful customer base for this sort of thing.) It’s not as if many others couldn’t compete with DXLG. They just don’t want to. So in a sense, investing in DXLG is like betting at a racetrack knowing ahead of time that all jockeys except one plan to forfeit the race and not even take their horses onto the track.
So why, then, aren’t we light years ahead of the market in our DXLG position? Well, going back to the horse race analogy, even a bet on the one horse that’s out there can’t pay off unless and until the lone jockey can figure out how to locate and get the horse across the finish line.
For DXLG, the finish line is a single retail concept, Destination XL, a store concept that relative to the company’s other chains (Casual Male XL and the more upscale Rochester Big & Tall), has more square footage, wider aisles, large changing rooms, more attractive décor, a comprehensive selection of products for all price points, better-trained sales associates, and on-site tailoring. In a perfect world, the world at which DXLG aimed, all Casual Male XL and Rochester Big & Tall stores would vanish, all customers would migrate to Destination XL, and the better Destination XL chain would completely new more customers and even expand the customer base by serving what the company refers to as end-of-rack customers, those with waist sizes 38 to 42, a particularly large group that’s better able to shop at other stores but would still be much, much better served at Destination XL. I like the idea. You can make cases for both multi-brand and single-brand business models, but when a company is small as is DXLG, single-brand is probably the path of least resistance, particularly a single brand that’s better positioned to attract end-of-rack customers.
The irritation comes from the reality that getting to the finish line has proven easier said than done. For one thing, there are many markets that aren’t quite big enough to justify a full-scale Destination XL store. So DXLG has introduced a smaller-footprint version of the chain. But I think the bigger drag on results and on the stock has come from the migration of the business. It’s easy to close a store. It’s not as easy to get all those customers to switch to different stores with different looks at different locations. And some new Destination XL units have been taking longer than expected to get up and running due to construction, permitting, etc., delays, the usual things that bedevil any new enterprise. DXLG is working on all these issues. But they have caused quite a few hiccups in sales/earnings trends and DXLG is finding it necessary to slow the progress, which is now scheduled to be completed at the end of 2017.
Early indications are that the finish line is worth reaching, even if it takes longer than anticipated to get there. In the latest quarter, comparable store sales growth at Destination XL stores open 13 months or more was up 12.8%, on top of an 11.3% year-over-year comp-store sales gain in the year-earlier quarter. Of course I wish DXLG would be able to reach the finish line as per its original timetable. But this is real life, not a scripted television show. Considering DXLG trades at just 0.59 times trailing 12 month sales (versus a 0.72 industry median) combined with what I believe to be better-than-average growth prospects, I’ll tolerate the irritations thrown our way by reality and stick with the stock.
[newsletter_anchor]APPLYING KREMLINOLOGY TO GROUPON[/newsletter_anchor][/newsletter_anchor]
Are you old enough to remember Kremlinology? For the uninitiated, this was a branch of Cold War Western diplomacy that involved extensive study and analysis of seemingly trivial utterances and actins on the part of the Soviet (Russia during the Communist era) government with the aim of discerning what the heck those folks were thinking and planning. This was vital given how meagre the flow of information through regular channels was. Sometimes, given restrictions on public company disclosures and the fact that many executives like to play their cards close to their vests, we occasionally need to do likewise when we analyze stocks. Groupon (GRPN), the presumably now well-known company that got famous (so far, rich is debatable) marketing promotional deals offered by merchants, may be a case in point. It’s an easy company to sneer at, given sometimes uninspiring experiences consumers have had using their “Groupons” and the insanely exorbitant level at which the company’s late-2011 IPO was priced. But the stock is now at a level that can be more rationally connected to company performance and contrary to the beliefs of early skeptics (including me), the business has been and is still growing, and I think, may just be getting started. And by the way, it comes to our attention via our Cash-Rich list; so much for flash in the pan.
So here’s where Kremlinology comes in. As much as I like the prospects for GRPN’s core business, I see clues here and there that lead me to wonder if management really understands what its core business really is. I think for the most part they get it and that they’ll be fine. But risks remain. Here’s the red flag: In the second sentence of the Business Description form the 10-K filed about a year ago, management stated: “Our vision is to become the starting point for mobile commerce, with the world’s largest marketplace of unbeatable deals. We want Groupon to be the destination that our customers check first when they are out and about; the place they start when they are looking to buy just about anything, anywhere, anytime.” Earth to GRPN: Cool your jets. That’s not going to happen. Have you ever heard of Amazon, Yelp, eBay, Trip Advisor, Priceline, etc.? GRPN’s then-stated mission brings to mind the time in the 1990s when I covered the hot new restaurant stock, Boston Chicken. Lines at the restaurants were humongous and the stock was flying. But management’s sincere and aggressive spin at a standing-room-only analyst meeting was: We’re home meal replacement, NOT fast food! And as time passed, they stuck to their guns; they were absolutely positively not fast food. Eventually, they became an absolute mess and the chain is now a miniscule imitation of what it once seemed destined to become. I’m sure you can find you own examples of companies whose dreams are inconsistent with their capabilities and opportunities. It usually ends badly.
I’m much more encouraged by the latest 10-K filed just a couple of weeks ago. Now, GRPN says “its vision is to connect local commerce, increasing consumer buying power while driving more business to merchants through price and discovery. We want Groupon to be the destination that our customers check first when they are out and about; the place they start when they are looking to buy just about anything, anywhere, anytime. By leveraging our global relationships and scale, we offer consumers deals on things to eat, see, do and buy in 47 countries” (emphasis supplied). There is some language repeated from the year earlier, but now, the tone is different – and it’s now on point. The internet has unleashed a revolution in the way advertisers and marketers reach prospective customers and much if it is vastly improved over the past. One thing, however, that seems to have been left behind is local business. It’s great to have a “worldwide” web, but not when you’re trying to find goods or services, or customers or clients, within walking distance or a short drive. GRPN brings something special to the table here (and although others have said anybody can do what GRPN does, nobody seems to be doing it on GRPN’s scale; actually GRPN’s business is much more infrastructure intense than many realize). And by the way, GRPN is fully aware of bad experiences on the part of consumers and is working to address them. A big thing is getting businesses to maintain continuous presences, to combat deal expirations before consumers get chances to use them. GRPN is improving its e-mail targeting and now doing much more business via “pull” where consumers search for what they want rather than “push” where GRPN tells you out of the blue what’s available. Increasing adoption of the GRPN mobile app is a big plus here. I think GRPN is very early in tapping its full opportunity, and that it will have a long and solid growth curve as it fills out its categories and as merchants and consumers become increasingly habituated to this form of marketing.
Frankly, though, I’m perplexed at why GRPN is also in “goods,” where it sees itself as a place consumers can go to buy stuff. If I looked at this operation and nothing else, I might be intrigued – they offer nice merchandise at good prices. But in terms of total ecommerce, GRPN is like a pimple on an elephants you-know-what. And for as much criticism as Amazon takes (not always justifiably) on its margins, GRPN’s gross margins are significantly lower. I don’t get it. I’m not sure why GRPN feels it needs to hold inventory, do physical distribution, etc. If this serves as a loss-leader to drive consumers to the main local-deals business, I can live with that. But if GRPN thinks it’s going to threaten Amazon, Ebay, etc. al. (as a blogger recently suggested), ouch. The change in the 10-K vision (supported by a recent investor PowerPoint) statement serves as Kremlinology suggesting opinion inside GRPN may be moving to where I’d like to see it go. (I can go either way on GRPN’s fledgling endeavor to adapt GRPN-type deals to travel.) Given the company’s strong balance sheet (meaning it can well afford to pursue its bona fide opportunities and even hit some potholes along the way), reasonable if not low valuation metrics (1.73 price/sales versus 1.42 industry median), the more hopefully result of the latest Kremlinology exercise, and the huge growth opportunity ahead, I think GRPN is a worthwhile speculation for those who understand the risks.
Hospital Profits Soar As Obamacare Prescribes More Paying Patients | 03/01/2015
Hospital operators continue to see profits and revenue not seen in a decade thanks to the Affordable Care Act and related efforts to sign up uninsured patients to coverage so facilities can reduce unpaid medical bills.
Large hospital operators HCA Holdings (HCA), Tenet Healthcare (THC) and Community Health Systems (CYH) in the last month issued robust 2014 earnings, revenues and large declines in uncompensated care costs, a key measure of expenses.
“We reported Tenet’s strongest quarterly EBITDA in more than 10 years,” Tenet chief executive officer Trevor Fetter boasted last week of a key earnings acronym in the hospital chain’s 2014 fourth quarter.
Hospitals have been working to enroll uninsured patients. Tenet said its “Path to Health program” launched in 2013 continued to enroll more patients in this year’s second open enrollment period through the use of financial counselors, direct mail marketing and community events.
“We held nearly 800 outreach and enrollment events, reaching tens of thousands of people in our priority markets,” Fetter said. “Our daily enrollments have increased by more than 60% during this enrollment period and we estimate that we will exceed the number of exchange enrollments that we achieved last year.”
Hospital operators are reporting more paying patients and fewer uninsured, which means far fewer unpaid medical bills. “For the last four quarters, the decline in self-pay admits and adjusted admits and the increase in Medicaid in expansion states have grown quarter over quarter,” Community Health CFO Larry Cash said.
HCA reported a decline of nearly 9 percent in “same facility self-pay and charity admissions,’ executives said on its fourth quarter earnings call. “These represent 7.2% of our total admissions compared to 8.3% last year and has continued to turn favorable for the company,” HCA chief financial officer William Rutherford told analysts.
Forget The Singles Bar... Stay In With The Arcam Solo Bar | 03/01/2015
Flat screen tvs are one of the great advancements of modern civilisation. Fewer than ten years ago we were all watching movies on huge glass tubes that distorted images, gobbled up energy and deteriorated or shifted colour over time. Now we watch massive screens with pencil-thin bezels and superbly even LED illumination. Things have definitely changed for the better… except in one respect: sound reproduction. The average flat-screen tv may have umpteen bells and whistles but usually the sound coming out of the screen isn’t anything like as big or as impressive as the screen. Of course there are always surround sound systems for the really serious movie buffs but for the rest of us there’s the thorny issue of wires and speakers trailing all over the house. And for people like us there are soundbars. They’re definitely a step up in audio quality and power from a built-in tv speaker, but some of the cheaper soundbars are a bit disappointing and about as subtle as being hit in the teeth with a house brick when it comes to bass.
So if you want a soundbar with a decent output you may have to look a bit further up-market. With this in mind I recently stumbled across the Arcam Solo Bar. No it’s not a pick-up joint; it’s a soundbar and all-round music system that can fit neatly on the wall beneath your tv screen while beefing up the sound on your favourite tv programmes, it also doubles as an audio streaming device or amplifier for almost any sound source. You can connect the Arcam Solo Bar to a tv using either a coaxial connector, an optical SPDIF lead or by using one of four HDMI inputs. The Solo can make use of ARC (Audio Return Channel) so you only need one HDMI cable and you can control the Solo’s volume using your tv’s remote. ARC is a relatively new standard so not all screens can accommodate the feature so be sure to check first. Now, because the sound has to be processed from the tv there is occasionally a chance that the audio can be out of sync with the picture so there’s a setting for that if necessary that can introduce a delay. For the vast majority of broadcast programmes it isn’t a problem but occasionally things do go awry.
The Solo Bar also is compatible with Bluetooth aptX so you can stream music from your phone or tablet. There’s also a Bluetooth transmitter on board to send signals to Bluetooth headphones. Arcam has also developed an app for the Solo that runs on Android and iOS devices. The app mimics the controls on the front of the soundbar although the Solo also has its own remote control if that’s what you prefer to use. Arcam has designed the Solo Bar to work with 4K video sources and it can handle most high-resolution audio formats available from music download services. The Solo can work with most other sound sources such as game consoles or you could use your tablet or phone to stream Internet radio. There are six drive units behind the Solo’s grille with 100 watts of power. If you fancy beefing up the sound further there’s an optional Solo Sub with a 300-watt amplifier with a 10-inch driver. This can connect to the soundbar either wirelessly or via a wired connection. I gave the Arcam Solo Bar a lengthy audition while I was at the Sound & Vision Show, held in Bristol at the end of February, and I have to say that the sound quality was very impressive. It sits well alongside the Naim Muso but takes up less space. At £800 ($1,235/€1,100) it isn’t the cheapest soundbar on the market but I’d probably wager it’s probably the best. It doesn’t offer surround sound so if you really do want the full immersive experience with AV receiver and a Dolby 5.1 setup with multiple speakers then you might want to spend a bit more on a full home cinema. For my money I’d say the Arcam Solo was a really good companion to a large tv and although it sounds stunning on its own, it’s even better with the Solo sub alongside for an extra £500 ($770/€690).
More info from www.arcam.com.uk
Prices and currency conversions correct as of March 2, 2015.
Arcam Solo Bar Amplifier 100W, Driver units 4 x 4″ + 2 x 1″, Dimensions W1000 x H130 x D110mm, Weight 6.4kg
Arcam Solo Sub Amplifier 300W, Driver units 1 x 10″, Dimensions W310 x H430 x D310mm, Weight 12.4kg
Nemtsov Rally Should Worry Russia's Leaders | 03/01/2015
Sunday’s planned anti-war rally in Moscow turned into a memorial for slain opposition leader Boris Nemtsov, murdered on a stroll home from Red Square’s GUM mall on Friday night. Some 7,000 people turned out, according to official numbers. Social media put it at two times that. And while the protest went off without a hitch — no police crackdowns, no reported violence — the rally should worry Vladimir Putin and his United Russia party.
If the opposition has an ounce of fearlessness, they could use Nemtsov’s death as a call for change in the Kremlin. The problem is, this will not go over easy with the powers that be, namely President Vladimir Putin.
For investors, a fragile Putin means a fragile Russia.
Nemtsov was murdered while walking home with Anna Duritskaya, a 23 year old Ukrainian woman who’s been dating the 55 year old since she was about 19. His death has turned up the volume on Russia’s political risk. Once investors just had to consider oil and the Ukraine mess in their investment decisions. Nemtsov made it local. Whether you’re ExxonMobil with a $723 million joint venture on hold because of sanctions, or a day trader gambling on the Market Vectors Russia (RSX) fund, Friday night’s homicide in Moscow is a reminder that Russia’s in trouble.
Russian equities, as tracked by RSX, are up 21.8% year-to-date, beating the MSCI All Country World Index. It’s definitely not trading on the fundamentals. RSX is Russian roulette.
“Investor sentiment has been so bad since the Russian invasion of Ukraine last year it’s hard to imagine it could get worse. But this brazen act of political terrorism is probably the one thing to make it worse,” William Browder, CEO of Hermitage Capital told me in an email exchange from London on Sunday.
Browder, an American born investor who lived in Russia and fell onto Putin’s hit list, lost his Hermitage investments in Russia. He was kicked out of the country in November 2005. At the time, he had $4.5 billion invested in Russia and the former Soviet states. His lawyer, Sergei Magnitsky, died in a Russian prison four years later. The Russian government claims Hermitage was committing various financial crimes.
See: Lessons from the Death of Nemtsov, Putin Rival – Reuters Op-Ed
How To Write Your First Pain Letter | 03/01/2015
A Pain Letter is a new-millennium alternative to a cover letter. It’s a letter. It has black or blue ink on a white page, but that’s about all that a Pain Letter has in common with a cover letter.
When you send a cover letter with a resume into some kind of faceless Black Hole recruiting pit, you know your odds of hearing back from the employer range from slim to none. Here is a horrifying story we heard from a job-seeker who was told by a company recruiter that she doesn’t even look at the resumes coming in through the firm’s Applicant Tracking System. She ignores those resumes and finds her own candidates via LinkedIn!
When you send a Pain Letter, you don’t pitch it into a Black Hole career portal to die. You send it to directly to your hiring manager at his or her desk. I think I know what you’re thinking: how do I find my hiring manager? Here’s how to do that!
I was a corporate HR leader for ages. I saw the recruiting process degrading and becoming more zombified every year. I saw how that degradation of the recruiting process was hurting job-seekers and employers. Nobody wins — only a technology vendor wins when technology takes over what should be a warm and vibrant human process. Recruiting is a human activity, not a technological one.
When everybody figures out that the way to get your resume through the keyword searching algorithm is to cram keywords into your resume or your application, the sorting technology becomes useless. That is the biggest “Duh!” in the world, but when we fall into our business brain we can lose the ability to think clearly.
We invented Pain Letters to give job-seekers a more powerful and immediate way to tell their story to hiring managers. If you want to write a Pain Letter and skip the obnoxious online-application chore, here are the steps to follow.
Research the Employer
A Pain Letter is not generic. Every Pain Letter is unique. If you don’t want to take the time to research the employer before you write a Pain Letter, don’t even bother writing it.
Start your research at the organization’s own website. Read about its business. What do they make or sell? Who are their clients? What sorts of issues do you imagine that the organization is dealing with?
Figure Out The Pain You Solve
Everybody solves some kind of pain in their work. When you say “I’m a Payroll Coordinator,” it means that you solve several different kinds of pain that employers experience when the payroll system doesn’t run properly. You have to pay people correctly or you’ll violate the law. There are wage and hour laws, and other things like wage garnishment and tax changes that make payroll a critical business function. Here are some of the types of Business Pain a Payroll Coordinator can solve:
- I solve the pain associated with employees getting paid the wrong amount or not getting paid on time.
- I solve the pain that comes with improper tax deductions and reporting mistakes.
- I solve the pain that comes about when employees’ payroll deductions for insurance and other benefits are miscalculated.
- I solve the pain that hits employers when nobody in Payroll can help them answer their pay-related questions.
This is just the tip of the iceberg. Good Payroll people like you solve another two or three dozen kinds of Business Pain! If you want to send Pain Letters and generally to step into the new-millennium workplace with confidence, stop focusing on your skills, and tell us instead about the kinds of pain you relieve!
Who Has That Pain?
Which employers are likely to be experiencing the kind of Business Pain you solve? If you’re a Payroll Pain Relief Specialist, that might be employers who are growing fast and adding staff. You can find out who’s growing in your area by reading your local business publication (online for free) and looking for its annual list of fast-growing employers.
Now You Need a Name
You will send your Pain Letter directly to your hiring manager. In the case of a Payroll Coordinator, that might be the CFO or the Director of HR. Don’t send your Pain Letter to the CEO of the company unless you’re pursuing an executive job or unless the employer is really small. CEOs are famous for having very diligent administrators who are likely to send your carefully-written Pain Letter right back into the same Black Hole abyss you were trying to avoid.
Samsung Unveils Galaxy S6 And Galaxy S6 Edge With Curved Screen | 03/01/2015
Samsung has taken the wraps off its big attempt to lead the market again, with two new smartphones for its Galaxy range including the unique Galaxy S6 Edge with an AMOLED screen that curves over both sides of the phone. Samsung launched both the S6, a device which looks and feels similar to the S5 but boasts higher specs, and the curved, S6 Edge.
Samsung CEO JK Shin said the company had built both phones “from the ground up,” calling the Edge “the most beautiful smartphone in Samsung’s history and the most advanced smartphone in the world.”
The phones will go on sale on April 10 in 20 countries.
The names of the phones and overall specs fell in line with recent rumours and leaks, but Samsung laid down some impressive specs for the devices on Sunday. In an event that included a fog machine, strobe lights and powerful soundtrack with booming bass, Samsung said both devices included a 5.1 inch quad HD super AMOLED screen packing in 577 pixels per inch.
The new Galaxy S6 features 77% more pixels than the S5, while the Edge has a super AMOLED screen wrapped around both edges of the device.
The battery for both phones lasts up to 12 hours on Wifi and charges “faster than any other smartphone in the industry,” according to Samsung. It takes 10 minutes to charge the S6 for four hours of battery life, and roughly half the time of the iPhone 6 to charge it to 100%.
Samsung has also changed its stance by putting in a built in battery, rather than a replaceable battery.
The phone’s camera features a 16-megapixel sensor and an F1.9 lens for the front and back camera that — thanks to its lower aperture – takes better photos and videos in low light than then iPhone 6 Plus, Samsung claimed, showing videos and photos side by side on a big screen.
The camera is also relatively quick to launch, taking 0.7 seconds to open by double tapping the home button.
Samsung is under great pressure to make up for recent, sluggish sales of its flagship Galaxy S5 smartphone. The S6 isn’t quite a Hail Mary Pass, but a significant attempt to lift it out of the doldrums and lead the market once again. In two years its global market share has slid from a third to 25%.
Part of the problem is Apple. The company recently announced a blowout quarter thanks to strong sales of its iPhone 6, and that represented a big payoff from from cheekily taking a leaf out of Samsung’s book by making a phone with a much larger screen. Samsung was once derided for being among the first of the big OEMs to bring so-called phablets to market with the Galaxy Note, and now the concept is being aped everywhere else.
The company has recently trimmed marketing costs to help make up for the shortfall, but the bigger, long term problem may be the gradual commoditization of making smartphone handsets.
Vendors like Samsung and HTC have tried to innovate on top of the Android operating system by offering tantalizing new features, but the more fundamental way Samsung can compete is on hardware, price and design.
Samsung also announced a new version of its Gear VR virtual reality headset that syncs with the Galaxy phones, with greater processing power and increased pixel density.
Why Federal Reserve Monetary Tightening Is Still A Distant Event | 03/01/2015
Since the Federal Reserve began easing monetary policy to combat the 2008-09 global financial crisis, most Fed forecasters have been consistently early in predicting for a normalization in the fed funds rate, i.e. for the Fed to begin a new round of policy rate hikes. For example, the March 2008 Blue Chip Economic Indicators survey of America’s top economists predicted the fed funds rate to rebound to 4.0% by the summer of 2010. Subsequent forecasts were similarly early.
Current consensus suggests that the Fed will hike the fed funds rate by 0.25% during the mid-June to mid-September timeframe. In a recent post on why gold is looking more bullish, I asserted that with most of the world’s major central banks still in easing mode, the Federal Reserve will find it difficult to begin a new rate hike cycle without upsetting the global financial markets. For example, the People’s Bank of China just announced a 0.25% policy rate reduction in order to counter a slowing Chinese economy. A more hawkish Fed policy will result in the U.S. dollar strengthening further, putting more downward pressure on emerging market economies that are either suffering from a shortage of U.S. dollar reserves or are dependent on commodity exports. Countries such as Brazil, Colombia, Chile, and Turkey fall into this category.
In addition, there are three other reasons why the Federal Reserve will not begin a new rate hike cycle this year. I believe the Fed will hike by 0.25% at the most, most likely during the October 27-28 FOMC meeting, with another rate hike not likely until 2016. Here’s why.
1. The Federal Reserve is still haunted by its policy mistakes during the 1930s
In 2009, former Fed Chairman Ben Bernanke repeatedly defended the Fed’s unconventional monetary policies by invoking the lessons of the Great Depression, stating: “I was not going to be the Federal Reserve chairman who presided over the second Great Depression.” Bernanke long argued that the Fed worsened the economic effects of the Great Depression by not easing aggressively enough. In particular, he attributed the worst of the slump to a fatal Fed policy mistake in September 1931, when the Fed hiked its discount rate by a full 1% in an effort to stem the outflows of gold from the U.S. after the Bank of England exited the gold standard. The Dow Jones Industrial Average subsequently declined 30% while the number of U.S. bank failures tripled.
While the worst of the 2008-09 global financial crisis has passed, the global economy remains in a precarious state. The Janet Yellen-led Fed is no doubt struggling with the specter of initiating a new rate hike cycle in the background of such a sensitive global economic environment.
2. U.S. inflationary pressures are still subdued
Despite the recent pick-up in housing activity and an improving job market, there seems to be no rising inflationary pressures. The U.S. Consumer Price Index (CPI)—even excluding energy and food prices—has continued to decline over the past several months. For example, the 12-month change in the U.S. CPI (excluding energy and food) declined from 1.9% last July to 1.6% in January. Meanwhile, the Fed’s preferred measure of inflation, the price index for Personal Consumption Expenditures (PCE), has remained subdued as well. The 12-month change in the PCE price index (excluding energy and food) declined from 1.5% last July to just 1.3% in January, its lowest reading since March 2014. With the trade-weighted U.S. dollar index rising to a six-year high just last Friday, it is likely that U.S. inflation will remain subdued—thus negating any need for an imminent rate hike or the beginning of a rate hike cycle.
3. Interest rates need to stay low in order for the U.S. government to service its increasing debt levels
According to a recent McKinsey study, all of the world’s major economies have taken on higher levels of debt relative to their GDP since 2007. Over the last seven years, global debt (debt owed by governments, households, and non-financial corporations) rose by $57 trillion to $199 trillion, or 17% of global GDP. The global debt-to-GDP ratio is 286% as of 2Q 2014, a record high.
The U.S. has not been immune to this trend. While U.S. households and corporations have deleveraged over the last seven years, the U.S. government has taken on higher levels of debt in order to fund the 2009 fiscal stimulus package and increased social welfare spending. As of 2Q 2014, the U.S. debt-to-GDP ratio is 233%, or about $40 trillion.
The Congressional Budget Office (CBO) projects the U.S. federal government debt-to-GDP ratio to keep growing over the next decade due to increasing social security outlays, higher healthcare spending, and increasing interest payments due to rising government debt levels. In fact, the CBO emphatically states that “the large and increasing amount of federal debt would have serious negative consequences” if interest rates were to rise from current levels. This is another reason why the Fed will keep rates near current levels for the foreseeable future.
Bottom line: The combination of a precarious global financial system, muted inflationary pressures, and a significant U.S. debt overhang means the Fed will be accommodative for the foreseeable future. Look for the Fed to hike by only 0.25% this year, with one more 0.25% hike in the first half of 2016.
C-Corps Have Limited Use For Tax Savings | 03/01/2015
Increasingly, upper-income folks and their tax professionals are considering a corporate structure in tax planning in order to avoid Obama-era tax hikes. Starting in 2013, Congress raised the top tax bracket for individuals to 39.6%, effectively 41% after factoring in the Pease itemized-deduction limitation. When the 3.8% Net Investment Tax on unearned income is factored in, the combined individual top rate is a hefty 45%. Upper-income taxpayers are rewarded with an 11% or more tax savings when they can shift income from their individual to corporate tax returns. Plus, Congress is discussing corporate tax reform and they may reduce corporate rates, widening the gap with individual rates.
Active traders who don’t qualify for trader tax status (business treatment) wonder if a corporate structure allows trading expense deductions considering that Section 212 investment expenses are restricted on individual tax returns. Corporations cannot deduct Section 212 investment expenses, therefore they don’t provide tax relief when a trader does not qualify for trader tax status.
A pass-through-entity trading business – like an LLC or S-Corp – qualifying for trader tax status has business expense treatment. Administration fees paid to a management company organized as a corporation are a business deduction on the pass-through entity. The receiving corporation has business income and expense treatment. Business treatment on both the pass-through entity and corporation translates to tax efficiency.
Investors cannot efficiently shift income to a corporation
A pass-through-entity investment company has Section 212 investment expense treatment on the individual owner’s level for administration fees paid to a management company organized as a corporation.
That’s not tax efficient since investment expenses face significant limitations on individual tax returns, including the 2% AGI threshold for miscellaneous itemized deductions and the Pease itemized deduction limitation. Miscellaneous itemized deductions are not deductible for AMT tax.
If the investment company allocates a share of trading gains to the management company corporation in lieu of paying fees, the corporation doesn’t have business purpose. Plus, the corporation could be deemed a personal holding company (PHC) subject to a PHC surtax of 20% on undistributed PHC income. A corporation may not deduct non-business expenses including Section 212 investment expenses, which only individuals may deduct.
Corporations deduct business expenses, not investment expenses
Corporations with business activities may deduct Section 162 trade or business expenses. Corporations aren’t permitted to deduct non-business expenses including Section 212 investment expenses for individuals. When a corporation with established trade or business has ancillary investment expenses related to their business activities — like investing working capital — those expenses are deemed Section 162 business expenses and not Section 212 investment expense. Pure investment companies structured as a corporation may not deduct investment expenses. Pass-through entities with investor tax status report investment expenses on Schedule K-1 issued to individual owners.
It’s clear Section 212 is for individuals only, and corporations need business purpose to deduct Section 162 business expenses. Corporations cannot deduct non-business expenses. I spoke with an IRS official on this matter and his informal advice was to agree with the position stated in this blog.
Warning to traders not qualifying for trader tax status
Traders not qualifying for trader tax status should not use a corporation since they don’t have business purpose and corporations can’t deduct non-business expenses. While a corporation starts off with presumption of business purpose, that alone doesn’t achieve business purpose. The corporation must qualify for a trade or business. For a trader that means qualification for trader tax status. A corporation is not a remedy for not qualifying for trader tax status.
Corporate tax rates lower than individual rates
The corporate tax rate starts at 15% on the first $50,000 of income, 25% on the next $25,000 and it settles in at 34% thereafter. Personal service companies don’t qualify for the lower rates under 34%. Taxpayers generally try to take advantage of the lower bracket rates so if the corporation pays them qualified dividends years later there’s still meaningful cumulative tax savings.
Unlike pass-through entities including S-corps, LLCs and partnerships, a corporation (C-Corp) pays entity-level taxes. (Note: LLCs can also elect C-Corp tax-filing status.) An individual owner pays taxes on qualified dividends paid by the corporation up to a 20% (long-term capital gains) rate. Plus a 3.8% NIT is applied on unearned income if you’re over the AGI threshold. Paying taxes on the entity and individual levels is commonly referred to as “double taxation.” Corporations avoid double taxation by paying compensation to owners and officers. Most states also tax corporations, so double taxation can defeat the purpose of using a corporation in high tax states. (State taxation for corporations is beyond the scope of this blog post; see more information in Green’s 2015 Trader Tax Guide.)
A corporation needs business purpose
Before you jump into reorganization as a corporation, it’s important to understand the pros, cons and potential pitfalls. My bailiwick is investors, traders and investment managers. In a nutshell, adding a corporation as a second entity makes sense for a business trader or investment manager to reduce Obama-era tax hikes on individuals. But using a C-Corp structure for an investment company does not work. Corporations need a business purpose; therefore, investors won’t find salvation using a corporate structure.
A successful strategy for a trading business
Suppose you have a successful trading company LLC that qualifies for trader tax status and files as either a S-Corp or partnership. Consider adding a corporation as a second entity to provide administration services or to hold intellectual property and charge royalties to the trading company LLC. That has the effect of shifting income from your individual tax return to a corporate tax return. Either the S-Corp trading company or C-Corp management company can unlock employee-benefit plan deductions including health insurance and retirement plans. (Investment companies can’t generate compensation or earned income by arranging employee-benefit plan deductions.)
A failed strategy for an investor
Suppose you have an investment activity that doesn’t qualify for business treatment. (Read How to Qualify.) You also don’t offer investment management services to clients, so you don’t have any business purpose.
A tax salesman approaches you and promises tax deductions using a corporation. These promoters find their prey on the trading education and seminar circuit. The promoter says you can dump your education expenses and other startup expenses into a corporation going 18 months back and generate a net operating loss (NOL) in the corporation to carryover to subsequent tax years. The promoter also suggests a second LLC entity for trading.
If that LLC doesn’t qualify for trader tax status and pays the corporation management or administration fees, it will have investment expense treatment. That defeats the purpose and you’re right back at the beginning of the problem with investment expense limitations on your individual tax return. Seminars and pre-business education are generally not deductible as investment expenses pursuant to Section 274(h)(7).
Conversely, the LLC can wait to achieve trader tax status at a later date and pay the corporation fees then, which will be business deductions for the LLC trading business. The promoters argue the corporation can utilize its NOL to offset the income from the trading business LLC. But, that doesn’t work in my view, as the corporation can’t deduct those expenses in the first place without business purpose from its inception. Dumping expenses that lack deductibility into a corporation for later use does not have legal authority.
At best, the corporation is entitled to capitalize Section 195 startup business expenses for a reasonable amount over a reasonable period if it has business purpose in the works. It’s simple for an IRS agent to determine whether a corporation has trader tax status or business revenue and, therefore, to determine whether any expenses are legitimate Section 162 corporate deductions.
Personal holding company taxes
Corporate structures are intended for trade or business, not investment companies. Personal holding company (PHC) law charges additional taxes on corporations straying into non-business activities. There are exceptions from PHC rules for financial institutions including banks and insurance companies, but that list doesn’t include trading companies.
The PHC tax is 20% of undistributed personal holding company income. PHC income (Section 543) includes dividends, interest, royalties (with exceptions), annuities, rents, personal service contracts (with exceptions) and more. Exceptions from PHC income include active business computer software royalties, active business copyright royalties in many fact patterns and personal service contracts when a specific person (talent) isn’t named in the contract (consult a tax expert). PHC income also does not include capital gains on trading, which is the main source of income in a trading company. PHCs are corporations with five or fewer owners and more than 60% of their income is from PHC income. The definition of PHC Section 542 discusses business deductions and it clearly leaves out Section 212 investment expenses (which are for individuals not corporations).
Green NFH CPA Darren Neuschwander and tax attorney Roger Lorence contributed to this blog.
Berkshire's Shareholders Say: Create Value, Don't Extract It | 03/01/2015
At a time when the activist hedge funds’ agenda of extracting value from corporations by cost-cutting, share buybacks and financial engineering has also become the default boardroom agenda, it is heartening to read in Warren Buffett’s 50th annual letter to Berkshire Hathaway’s shareholders that its management and shareholders almost unanimously rejected that agenda.
Buffett reported that at last year’s annual meeting, Berkshire’s shareholders were offered a proxy resolution:
RESOLVED: Whereas the corporation has more money than it needs and since the owners unlike Warren are not multi billionaires, the board shall consider paying a meaningful annual dividend on the shares.
Apparently the sponsoring shareholder of the resolution didn’t come to the meeting. As a result, the motion was not officially put forward.
Nevertheless, Berkshire tallied the proxy votes and they were, as Buffett notes, “enlightening.”
Berkshire’s directors had recommended a “no” vote, as did almost all the A shares – owned by Berkshire insiders, by a margin of 89 to 1. This was hardly surprising.
What was striking was that the hundreds of thousands of B shareholders also voted a resounding “no,” with 660,759,855 “no” and 13,927,026 “yes.” That makes a ratio of about 47 to 1 against.
Thus Buffett concludes: “98% of the shares voting said, in effect, ‘Don’t send us a dividend but instead reinvest all of the earnings.’ To have our fellow owners – large and small – be so in sync with our managerial philosophy is both remarkable and rewarding. I am a lucky fellow to have you as partners. “
A radical idea: invest for the long term
Dennis K. Berman lamented recently in the Wall Street Journal that other companies are not so fortunate. They are subject to a vast campaign from activist hedge funds that is striking “for its sheer scale and ferocity, with some $119 billion placed in their hands. Last year, they pursued 343 companies, up 27% from the year before.”
The sameness of their value extraction agenda is also striking for its short-term focus—“raise the dividend, buy back shares, cut these costs, spin off that division, sell the company.”
Activists are short-term tourists with little interest in the long-term health of the firm. According to FactSet, which tracks activist activity, 84% of activists hold their shares for less than two years. Activists so rarely call for greater long-term investment in innovation that FactSet’s database doesn’t even have a category for it.
Perhaps the most worrisome thing about activist hedge funds is that they have succeeded in getting managements and boards to think in the same unproductive way. A survey last month confirmed that US firms give low priority to innovation programs. As Gautam Mukunda points out in his HBR article, now many corporations don’t need to be forced to cut back on innovation. Now they want to do what the activists want.
A movement for long-term investing
Yet Berman also reports that there is “a burgeoning movement across asset managers to push more long-term investing in the markets. They are, in fact, forming a new coalition called Focusing Capital on the Long-Term, and will meet in New York in March to press their agenda. The group includes fund manager BlackRock [BLK], insurer AXA [Euronext: CS], and Singapore’s sovereign wealth fund GIC.”
Berman half-jokingly suggests that activists might differentiate themselves by offering funds supporting long-term investing and even offers the pitch in proper Wall Street-ese:
“A fund that identifies and aggressively advocates for new approaches in companies suffering from chronic underinvestment and short-term management focus. Designed for patient investors who want to build real, sustainable value.”
Of course, such a fund already exists: it’s called Berkshire Hathaway.
The track record of this approach is available and it appears to be rather profitable. “Over the last 50 years (that is, since present management took over),” Buffett reports, “per-share book value has grown from $19 to $146,186, a rate of 19.4% compounded annually.”
Why don’t more corporations and activists follow it?
And read also:
The Seven Deadly Sins of Activist Shareholders
Salesforce CEO slams ‘the world’s dumbest idea
How hedge funds transfer wealth from investors to managers
When pension funds become vampires
Berkshire: Rats In The Granary
The five biggest surprises of radical management
Follow Steve Denning on Twitter at @stevedenning
The 5 Star Approach To Turning A Customer Experience Around | 03/01/2015
No matter who you are, every entrepreneur has had an unhappy customer or follower, at least now and then.
Today I invite you to meet Jonathan Sprinkles, communicator, keynote speaker, author, and self-described “Connection Coach” (and yet another of the great individuals I’ve met through entrepreneurial friend Garrett Gunderson, whose summit I’ll be attending later this week.) It’s the Connections part of Jonathan’s expertise I will address today and in two additional columns he and I will pen together within the coming few weeks. I like him that well, as I hear what he has to say about our increasingly reputation-driven entrepreneurial world.
As Sprinkles shared with a filled room of dental and chiropractic businesses last week, in the reputation economy we now live in, bad customer experiences can carry astonishing power. Whether or not we ask, our customers speak to us in one of three ways: They may say “thanks,” they like their service, and leave. Or perhaps they don’t like the service, and they say or post something against you. Or, most deadly of all, the biggest group (in the middle of the bell curve) will say nothing at all. When they leave your business you have no idea where their opinions may stand.
Think on this: traditionally, if a customer has liked your service they’ll tell three people. But if they don’t, they’ll tell 11. This is understood, but these are old numbers. In the world of Internet, that “11” may become 11,000. Or 11 million. More than 75% of buying decisions are based on reviews.
“An opinion becomes ‘valid’ just because it is posted,” says Sprinkles. “It doesn’t have to be ‘right’. So little ol’ me with my opinion and keyboard has the ability to affect your income. I can possibly affect you losing your license. I can even influence when you get to retire.”
All thanks to the glory and infamy of the Internet and the reputation economy’s power. As entrepreneurs, then, Sprinkles recommends we learn to love customer feedback. In fact we should welcome and crave everything our customers have to say.
“People only complain about what they care about,” he explains. “If they’re telling you about it, it’s important to them. In that respect, negative feedback is a gift, as the individual is giving you the chance to know about their experience, to take it somewhere, and to fix it.”