A cheque in the mail is better than a tweet?

After my post a month ago bemoaning the potential death spiral facing Canada Post, I thought I would provide some balance by discussing the merits of Royal Mail, England’s original version of Canada Post.

In the world of old mail and new mail, there are two key stories right now: the initial public offering (IPO) of Royal Mail and the IPO of Twitter. Perhaps on the outset these two companies don’t seem to have much in common, but at their core they are both in the business of sharing information. Royal Mail delivers traditional letters and packages (a lot of packages these days due to online shopping). Twitter delivers breaking news stories from around the world and LOL cats.

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Image Source: http://www.lolcats.com/

With most traditional IPOs, security regulators require substantial disclosure, including audited financial information months prior to the actual IPO date. Twitter is using a special IPO procedure, the Jumpstart Our Business Startups (JOBS) Act, which allows for substantially less disclosure than a normal IPO. In order to qualify for the JOBS Act IPO, Twitter must have less than $1 billion in revenue. This is about all the financial information we currently know about Twitter. The Globe and Mail had an interesting piece in which the writer stated that they preferred the Royal Mail IPO to the Twitter IPO. Shocking, perhaps, particularly after my post about Canada Post. Royal Mail might seem like a dusty old horse compared to Twitter’s 500 horsepower shiny red convertible. But the G&M article has some excellent points that are worth raising for all accounting students.

Basically, don’t let flash and sparkle distract you from a company’s underlying business model. One thing that financial statements generally do not tell a reader is what the future profitability of the company will be. Financial statements, by design, are historical—they reflect the past. The past is a decent predictor of the future… until it’s not.

What do I mean by that? Well, consider Royal Mail’s history. It has been in the delivery business for over 100 years. It has infrastructure (trucks and buildings) in place and some consistent market demand. Clearly the mail delivery business has changed over the past 100 years and Royal Mail will need to continue to adapt as the market continues to change. But until people stop sending letters and birthday packages, and until people stop buying goods on the Internet and having them delivered, Royal Mail has a stable or slightly declining market. Now lets consider Twitter. Tweeting is free (you get what you pay for in my opinion), so it doesn’t cost Suzi or Tom anything to tweet about their meal or their clothes or some celebrity gossip. Twitter earns revenue through advertising. Companies pay to have their tweets pushed to your twitter account. This can be annoying and I, for one, rarely (if ever) click on those ads. So how effective are those ads? We don’t know—we need to wait to see Twitter’s financial statements.

Now consider the barriers to entry for Royal Mail and Twitter. If you want to compete with Royal Mail, the barriers to entry are high. You need to build a network of collection and delivery locations and you need trucks, buildings, and delivery people. If you want to compete with Twitter, you need a few computer science gurus, some servers, and some late night pizza. The next Twitter could be right around the corner. Instagram, Tumblr, and their like could very well trump Twitter. Then what happens to its advertising revenue? Cue descending slide-whistle sound effect.

Perhaps you remember one of Aesop’s most famous fables, “The Tortoise and the Hare.” Slow and steady may win the race, so choose your investment wisely.

The Tortoise and the Hare, by Arthur Rackham

Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

 

Interest Can Fly Under the Radar

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Image source: http://www.bombardier.com/en/home.html

Bombardier is one of Canada’s larger manufacturers and has frequently made the news recently as the production of its new C-Series commercial jet gets tantalizingly close. The C-Series jet is apparently key to Porter Air’s expansion plans out of the Toronto Island Airport (YTZ), and it is obviously very important to the future success of Bombardier.

Bombardier (BBD.B) already has 177 firm orders in place with hopes of another 150 orders a year or two from now. The development costs of this new jet are close to $4 billion. When Bombardier sells a C-Series jet to Porter (or any other airline), the price of the aircraft must include a portion of these development costs in addition to the direct labour and materials involved in building the plane itself. As the development costs creep higher, Bombardier really only has two options: (1) charge more for each jet once they start selling, or (2) give up any hope of recovering the development costs. Under IFRS (IAS 38), it is important to distinguish research costs from development costs. The distinction is important: development costs can be capitalized as an asset while research costs much be expensed. IAS 38.57 defines the development phase of a project to be when six criteria are met:

  • technical feasibility can be demonstrated
  • there is intention to complete the project for use or for sale
  • there is ability to use or sell the asset
  • there is existence of a market for the output (sale)
  • there are adequate resources ($$) to complete the project
  • the expenditures for the project can be accurately tracked

Obviously the C-Series jet is in the development phase. Bombardier also has other aircraft in the development phase but does not provide a breakdown of development costs by jet-type. The chart below shows how much the development cost asset has grown over the past three years. We will assume the bulk of this growth is due to the C-Series.

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These development costs include the costs of the prototypes, scientists’ salaries as they figure out aerodynamics, retooling costs, building and tweaking engines, testing prototypes, etc. All of these costs are capitalized up to the time that Bombardier starts actually selling C-Series jets. Then, Bombardier must start amortizing its development cost asset, in this case on a per-unit basis calculated on a best-guess for the number of jets to be sold.

If you’re in introductory financial accounting, or you are like 90% of the population and just dabble (or less) in accounting, I suspect this idea of capitalizing development costs may seem strange. Recall that an asset is a cost that has been incurred that has future benefit. A very common asset is a company’s property, plant, and equipment (PPE). We allow companies to capitalize PPE (i.e., set it up as an asset) because the PPE will hopefully generate a future stream of cash flow through product sales or service sales. Development costs aren’t all that much different, except they are intangible. The development costs related to a new jet allow the company to sell a new product and keep current with technology. Without spending money on development, Bombardier would find itself using outdated technology while trying to compete with other plane manufacturers that have new technology. This is unlikely to be a successful strategy.

Now that we have a decent understanding of development costs, we can explore Bombardier’s costs a bit more. According to the September 17, 2013 Globe and Mail article, Bombardier doesn’t seem to clearly understand how much it has actually spent on developing the C-Series. This is not really true; some accountant inside Bombardier knows exactly how much the company has spent. The issue here is whether Bombardier should be including the interest cost in its development costs. This is covered in IAS 23 (Borrowing Costs) and is an intermediate to advanced topic. The basic idea is that if Bombardier borrowed money to fund development costs, then the interest related to the borrowed money should be included in the capitalized development costs, hence increasing the development costs. There are only a few instances where interest costs are not immediately expensed, so if capitalizing interest seems odd to you, you’re not alone.

Another example of when interest can be capitalized is building a new factory. Assume for a second that you are building a new factory and borrow $1 million to fund the construction costs. Interest related to your loan should be capitalized during construction and is hence considered part of the overall cost of the factory. That cost will be amortized over the useful life of the factory. Interest incurred on the construction loan after the factory is put into use would be immediately expensed. The same is true for Bombardier’s development costs. So in the Globe and Mail article, the confusion stems from one Bombardier executive speaking about direct costs related to development while another, likely with more accounting experience, included interest costs related to the development. The second person is technically correct.

So what is the quick synopsis for us?  First, development costs, when they meet the definition, can be capitalized. Second, interest costs can also be capitalized in certain circumstances. And third, planes are bloody expensive!!

Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

Yeah right, the cheque is in the mail

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When was the last time you mailed something?  I mean, really mailed it?  Stamp, envelope, dropping it off in a red box?  Alternative forms of communication have clearly replaced traditional letter mail and Canada Post is suffering as a result.  Badly.  If you take a moment to think about the business model of Canada Post, you realize that a large portion of their costs must be the delivery process which is primarily done by individuals walking through neighbourhoods, hand delivering … flyers, packages from Amazon, and the odd letter from Grandma.  We used to complain about our mail boxes being full of bills but even those are being delivered electronically now.  The graph below summarizes the basic problem with Canada Post’s business model – shrinkage:

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But even that doesn’t tell the whole story.  The other side of the problem is the increasing number of houses/addresses that require some delivery:

 

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So we’ve got a business with a delivery system that needs to expand, but shrinking revenues.  No surprise then that Canada Post is losing money,

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But wait.  Maybe its not losing money.  Fo the year ended December 31, 2012 they had net income of $94 million, that looks pretty good.  Yes, except that net income is inflated by $152 million due to a one-time, non-cash pension correction.  If you look at the second line under “Cost of operations” you will notice that the employee benefits are about $130 million less than the prior year.  Essentially Canada Post squeezed the union in their latest round of of negotiations and was able to reduce some of the pension and benefits.  That reduction shows up as a one-time gain in 2012.  I’ll admit that Canada Post is very upfront about that adjustment in their annual report.  I would argue that they are more transparent about their true loss than most for-profit businesses that I have seen.

The most latest quarterly report (June 2013) isn’t any more favourable, showing losses for the first two quarters of 2013:

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There is one more view of this that I want to point out – the Statement of Cash Flows.  Remember that the statement of cash flows summarizes how the business got cash and where it spent cash.  That summary is broken down into three main categories: Operations (the main business activities), Investing activities, and Financing activities.  I’ve written about the importance of analyzing the statement of cash flows before, you may want to read that post as well. 

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What do we see here?  On a first glance it looks OK.  Canada Post is obviously a mature business so we should expect the operating activities to be generating sufficient cash to support the investing activities and the financing activities.  In 2012, it looks like it does.  Let’s ignore the financing activities for a moment since (a) the total financing activity cash flows are very small and (b) its a non-traditional business that is owned by the Government.  Now focus on the investing activities and pick out just the capital asset expenditures.  This is for items like new delivery trucks and sorting machines.  In each of the last two years, the capital expenditures have been pretty constant, about $1/2 a billion per year.  Now compare the operating cash flows to the capital expenditures required and you will see the rest of the problem.  Canada Post is struggling to earn enough money to replace its necessary capital assets.  Without those capital assets for delivery, Canada Post has no business model.  No cash, no assets.  No assets, no business.  No business, no cash.  And the death cycle begins.

Canada Post has one massive financial problem that I haven’t mentioned yet – pensions.  I won’t go into that here since I talked about that in the last post.

The Globe and Mail had a terrific story about the issues that Canada Post is facing and included some potential solutions such as less-frequent delivery or not doing door-to-door delivery.  Neither of those likely affect you or I since we get very few traditional letters.  I am sure that the older generations are more frequent users/receivers of traditional mail and I suspect they’re not going to be very happy with any reduction in service.  Perhaps its our job to explain the dilemma that Canada Post finds itself in?  One weekend when you visit your parents, friends’ parents or grandparents I encourage you to ask them what they think about Canada Post, explain the financial issues, and see what solutions you can come up with.  Then submit your ideas to Canada Post, they’re actively soliciting them on the the homepage.  You might as well put your financial acumen to work and help solve this problem.

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Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)