Yeah right, the cheque is in the mail


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(

Barbie needs some cash




Looking at Mega Brands most recent audited financial statements (December 31, 2012), in many ways they look financially stable.  Their current ratio (current assets/current liabilities) is in decent shape, their debt:equity ratio (total liabilities/total equity) is improving year over year, they had positive earnings for the past two years, and they have a positive cash balance.  So the transaction I’m about to describe wasn’t done in a panic, it was done to take a reasonably healthy company and make it stronger.  Imagine for a second that you are the CEO or CFO of Mega Brands.  You don’t like paying 10% interest since that requires more cash than you feel is really deserved for debt repayment.  You need your other cash resources for day-to-day operations, and you don’t have excess assets that you can sell to generate cash.  What do you do?

Well, you look closely at your balance sheet and you remember that in 2010 Mega Brands issues a whole bunch of warrants.  Warrants are just like a stock option.  It is a financial instrument that gives the investor the right to purchase a common share of the company at a set price.  For general background on options and warrants, see this.  The investors originally paid to get the warrants ($0.50/warrant) and then have to pay again if they exercise their option to purchase the common share (called the strike price, $9.94/share in this case).  Obviously no investor would exercise their warrant if the common share was trading at a price below the strike price.  These particular warrants expire about two years from now and in most cases, finance theory suggests that a holding strategy is optimal.

Mega Brands wanted to raise some cash and had ~240,000,000 warrants still outstanding.  If they could convince all those warrant holders to exercise their warrants, pay the exercise price Mega Brands would receive ~$115 Million.  That essentially enough to cover all the long term debt which would then wipe out the debt with the 10% interest payment.  Early news releases don’t suggest any modified terms, rather Mega Brands executives just had some friendly chats with the major holders of the warrants (i.e. institutional investors) and explained the situation.  The warrants were already in the money since the common shares were trading above $13.  Remember that a warrant holder receives a common share (market value ~$13/share) by paying $9.94/share.  That’s a good deal.  Further, the executives explained that the cash they raised would be used to repay that expensive 10% debt thereby reducing the interest cost and increasing cash available for expansion and dividends.  Win-win for the company and the warrant holders.  No surprise then that approximately 1/2 of the warrant holders have agreed to early exercise.

What will be the impact on the financial statements?  Let’s do this on a single share basis, but in reality closer to 600,000 shares will be issued.  First Mega Brands receives the exercise price from the warrant holders (Dr Cash $9.94) removes the warrant value from equity since the warrants no longer exist (remove at the initial value Dr Warrants (equity) $10) and recognize the new common share being issued in exchange (Cr Share capital $19.94).  Then Mega Brands will turn around and use that cash to reduce their debt, Cr Cash XX, Dr Long term debt XX.  So when the next financial statements get released we should see an increase in equity and an equal decrease in liabilities.

Warrants and options are very common financial instruments.  Mega Brands move to tap into them as a way to raise cash is interesting and a little unusual but quite admirable.


The full financial statements are here.  I encourage you to look at the balance sheet (page 5), and Notes 15 and 16 in particular (pages 33-35).

Note: this blog was originally posted on my site hosted by Pearson Education(

The apple never falls far from the tree

The last six months have not been kind to Apple.  Their share price has fallen about 30%.  They briefly held the record for the all-time highest market capitalization of any firm.  They released their first products since Steve Jobs passed away, to mixed acclaim.  I should admit up front that I’m writing this post on an Apple computer with at least four other Apple products within 3 meters.  I’ll try to remain neutral.

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Despite the stumbles over the past six months, Apple has been an astounding success for the past decade.  If you had sunk $1,000 into Apple stock (AAPL) 10 years ago, you’d have roughly $60,000 now.  No matter how pessimistic you are or how much you dislike Apple products, that is an incredible return.  Beyond that amazing return, what makes Apple interesting?  Or at least from an accounting perspective?

Apple is sitting on a ton, a TON, of cash.  In their latest annual financial statements (September 29, 2012) they report $10.7 Billion in cash.  Scroll through the attached annual report to find the balance sheet on page 44.  That $10.7 Billion in cash is in addition to $18.4 Billion in short term investments and another $92.1 Billion in other liquid investments.  Why does Apple need approximately $120 Billion in cash and investments?  They don’t.  Most companies operate with very little cash on hand, barely scrapping enough cash together to pay the electricity bill or pay employees.  Apple is on the complete other end of the spectrum.


A humourous article points out that Apple’s cash reserves are enough to purchase 100% ownership in Starbucks, Facebook and Yahoo.  Yes all three together.  Corporate finance theories suggest that cash management is very important for a business to succeed.  A business needs to have enough cash on hand, but not be wasteful.  Once a business gets to a stable point, they generally start repaying shareholders via dividends.  Remember that dividends are NOT an expense, they are a return of earnings and therefore reduce retained earnings.  Apple refused to pay dividends for years, arguing that it needed its massive cash resources for company purchases and to fund its large research and development costs.  Finally a year ago, Apple decided that it had more cash than it could ever use so it began paying dividends.  The third such dividend was just paid out last week, $2.65/share or about $2.5 Billion in total.  As dividends go that’s fairly large, but you need to think of the dividend as a proportion of the cost of purchasing the share.  That’s referred to as the dividend yield and for Apple is a paltry 2.4%.

Apple is currently involved in a complex lawsuit regarding the dividend payout.  It is important to note that with the current dividend rate, Apple is “only” paying dividends of $10 Billion per year and there are plenty of projections out there that suggest Apple will generate substantially more net cash from operations every year so their cash reserves could in fact be growing.  Apple is an interesting case study – they were almost bankrupt 25 years ago and some experts suggest that their cash hoarding is the result of a “depression era” mentality – they are so petrified of being near bankruptcy again that they play a very conservative game.  The other issue is that Apple is notorious for leaving significant (almost $100 Billion) cash overseas in other countries.  That overseas cash and profit was generated from legitimate sales of their products and services worldwide.  In most cases Apple has paid the domestic (i.e. local country) income taxes as required by the local jurisdiction.  Apple has taken advantage of a few low-tax countries, that’s not nefarious, its solid business planning.  The problem is that the US makes it very difficult to repatriate overseas earnings, that is, bring the money back into the US.

There are three good lessons to learn here:

  1. Cash is important which means that a company’s dividend policy is also important.  If it’s too high then the company will run out of cash.  If it’s too low, investors will be less happy.
  2. International taxation and cash management is complex.
  3. Psychology and history impacts business decisions.  We need to understand the past before we can understand current decisions.

 Note: this blog was originally posted on my site hosted by Pearson Education(

Cash: where does it go? Where does it come from?

A recent Globe and Mail article on Thompson Creek Metals Co (TCM) caught my eye.  TCM just finished raising some debt in the market to help fund their operations.  That by itself is not really that interesting – businesses raise debt financing every day of the week.  What I found interesting was the rate of interest that TCM had to offer investors to make this debt marketable – about 14%!  Let’s put this in context: bank mortgage rates are hovering between 3% and 4%.  Credit card debt is somewhere around 20%.

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Interest rates are a pretty good measure of risk.  Mortgages are generally low rate because they are secured by a substantial asset (your house) and the approval process is usually pretty thorough (ignoring the housing disaster in the US in the past five years).  Credit card debt is unsecured and pretty much anyone breathing can get a credit card these days.  So TCM’s projected interest rate of 14% is somewhere in the middle – why do I think its interesting?  Just 18 months ago (May 2011), TCM also went to the debt market and raised $350M.  That debt was initially issued to yield ~7.3%.  So why has TCM’s cost of capital (think “interest rate”) jumped so much in 18 months?  Two key factors: (1) their main product is not selling well and (2) they are bleeding cash.  It turns out that financial statements demonstrate this very well, primarily the Statement of Cash Flows.


The Statement of Cash Flows is the “ugly duckling” of financial statements and generally plays second or third fiddle to the Balance Sheet and the Income Statement.  The purpose of the Statement of Cash Flows (SCF) is to tell the reader where cash has come from and where it is being used.  There are three main categories of items on the SCF: operations, investing, and financing.  Operations is the day-to-day business portion; proceeds from selling product and services less the cash required to pay all the business costs like purchasing inventory and paying for wages.  Investing activities are generally related to expanding the business’ assets (new mines, new dump trucks) or replacing those items.  Financing activities relate to raising new money from debt or from issuing shares or repaying debt or shareholders.  The table below summarizes TCM’s SCF (in millions US$) for the past three years:

  2011 2010 2009
Operations 202.7 157.4 105.9
Investing (716.4) (242.6) (412.6)
Financing 495.9 236.0 200.7

The SCF tells a pretty clear story – TCM is in a rapid expansion period.  They have spent over $1.3 Billion on new projects and new expansion in the past three years.  Since their current operations have only generated cash flow of $466 Million, they are scrambling to raise the remainder of the required cash.  In 2009 they issued new shares for $200 million.  In 2010 they raised $236 million mainly from an arrangement to sell future gold production (the “Gold Stream Arrangement”).  In 2011 they raised the majority of the total financing of $495 million from the issuance of the debt mentioned above, $350 M at ~ 7%.  

The picture painted by the SCF is a common story for start-up businesses.  They generally don’t produce much (or any) cash from operations, they require substantial amounts of new assets (negative cash flow from investing activities), so they end up raising new financing from debt or equity investors.  At some point though the business needs to reach a sustainable point where the cash flow from operations is sufficient to fund the required investing activities and start to repay financing activities.  As the story around TCM indicates, investors and management hope to reach that sustainable point before all sources of financing dry up.

I am a firm believer that the Statement of Cash Flows should not be the “ugly duck” and in fact should be the first financial statement that readers turn to.  Rare is the case that the SCF doesn’t tell a very accurate story of the firm simply by looking at the subtotals for the three main sections.  I encourage you to find a set of financial statements for a company you are interested in and create a table like the one above.  There are some common patterns for successful businesses, for new businesses, and for businesses that are a breathe away from bankruptcy.  What does the data from the SCF say about the company you were interested in?

Note: this blog was originally posted on my site hosted by Pearson Education(

Lighting Up: The Cash Flow Machine

Recently, many Canadian provinces have initiated lawsuits against the large tobacco companies, apparently to recover healthcare costs that the provinces must pay to treat individuals with smoking-related illnesses at hospitals. There is little scientific doubt that smoking is not good for our health, yet many people still choose to smoke (or are addicted to smoking). This is relevant to accounting in two ways. First, since smoking is a tough habit to break, once the tobacco companies get you hooked they have a solid source of cash. Second, those tobacco/health lawsuits should have an impact on tobacco companies’ financial statements.


Whether you choose to smoke is not the point of this blog post. Rather, we should consider the business model behind tobacco companies. Take Phillip Morris International (PMI) as an example. From 2009 to 2011, PMI generated over $22B of net income and almost $28B of cash flow from operations. PMI has a gross profit ratio of over 25%, meaning that for every $1 of sales, the cigarettes cost PMI less than 75 cents. In fact, its overall profit margin is 11%. This means that every time someone pays $10 for a package of cigarettes (excluding taxes), $1.10 is pure profit for PMI.

What does PMI do with all this excess cash and net income that it generates? A quick look at its statement of cash flows suggests that virtually all of it gets returned to shareholders as dividends or share repurchases. In the past three years, nearly $30B has been returned to shareholders. No wonder some analysts are so keen on tobacco companies! Most mature, stable companies have similar cash flow patterns—positive cash flow from operations, negative cash flow for investing activities (as the company reinvests in its capital assets, etc.), and negative cash flow for financing (as it repays loans and pays dividends). The unusual thing about PMI is the scale of the cash flow and the fact that there is very little capital project investment, so the cash flow can all be returned to shareholders.

As Alberta, Quebec, and others have jumped on the litigation bandwagon to sue tobacco companies, I would have expected the financial statements of PMI to show substantial liabilities and provisions for potential payouts in case they lose the lawsuits. Given that many of the lawsuits are over $50 billion each, they are not immaterial. Surprisingly, virtually no lawsuit provision is shown on PMI’s balance sheet. There is plenty of disclosure in Note 21, but no actual liability has been recognized. Remembering that Note 21 is drafted by management and may be slightly biased, it explains clearly that PMI is confident that it will win virtually all the lawsuits out there based on its past performance. For the few it may lose, management claims that it is unable to estimate the amount of potential payment and therefore has not recorded anything. This article provides a quick summary of recent tobacco-related settlements. As you can see, some of the past settlements have been very significant—upwards of $100 billion. PMI did not have much equity at the end of 2011: merely $551 million. It wouldn’t take many unsuccessful (from PMI’s perspective) settlements to chip away at that equity very quickly.

Conclusion? While the machine is up and running, tobacco companies will likely generate a ton of cash and return it to their shareholders. When the gig is up and they start to lose their lawsuits, they won’t have any cash on hand anyway since they handed it all back to their shareholders. If you think that they’ve got a while before the gig is up and you can stomach owning tobacco stock, then you may do very well. I suspect that a tidal wave of unsuccessful settlements (from PMI’s perspective) is around the corner. Once it settles one suit, the tidal wave will break and the cash machine will collapse. It will be interesting to see if and when tobacco companies begin to record these likely settlements and how they disclose them in their financial statement notes. Let’s revisit this a year from now.


Note: this blog was originally posted on my site hosted by Pearson Education (