Barbie needs some cash

NewImage

 

 

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(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

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%.

Screen Shot 2012 11 28 at 5 18 12 AM

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.

NewImage

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(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

Wholesale Dividends: Good or Just Special?

NewImageA number of US companies (including Costco, for example) are rushing to pay out massive dividends before December 31, 2012 to beat the dividend tax hike that is pending. A quick refresher on dividend taxes in the US: Under George W., long-term capital gains and dividends were subject to a temporary tax break resulting in a maximum tax rate of 15% (compared to normal business and employment income subject to a maximum tax rate of 35%). This tax holiday was supposed to have expired December 31, 2010 but was extended for two years by President Obama. Politically, dividend and capital gains tax rates are important. Those with less-than-average wealth generally don’t care about these rates since that set of the population doesn’t usually own investment portfolios that generate capital gains and dividends. However, the wealthy really do care, and they’re the ones who contribute to political coffers. But let’s leave the political aspects aside since they can be all-consuming on their own.

NewImage

NewImage 

If you are a US company and you know the dividend tax holiday is about to expire, you would prefer to give your shareholders cash before December 31, 2012 so they would only pay the 15% tax rate. If you paid the dividend the next day, January 1, 2013, your shareholders would be subject to a maximum 40% tax rate (39.6% to be exact). That’s a big difference. Especially when your dividend payment is $675 million. What? Who gets dividends like that?? Well, the Walton family does. Yes—the founding family and controlling shareholders of Walmart. They own and control 51% of the shares of Walmart and have decided to trigger a one-time, special dividend of roughly $1.3 billion, of which their portion is roughly $675 million. Issuing the dividend by December 31, 2012 results in tax savings of about $166 million for the Walton family alone. That’s a big deal and smart tax planning.

In Costco’s case, the special dividend works out to about $7 per share. This is well above the normal dividend rate of about $0.14 per share and works out to a total of $3 billion. Interestingly enough, the very same day that Costco announced its special dividend, it also announced new debt offerings (meaning it will be borrowing from investors) of $3.5 billion. Do you see any connection between the two? Paying the dividend requires $3 billion in cash, but Costco needs that cash for day-to-day operations, so it borrows more cash.

Should we care? I think so. This is a clear case of tax policy driving economic decisions—maybe even bad economic decisions. In Costco’s case, the US Treasury will collect substantially less tax than if the dividend was paid a month later, and the interest cost on the new debt is tax deductible for Costco, which will decrease its taxable income for years to come. In my opinion, this is a clear case of a wealth transfer to the rich at the expense of the general US tax payer, or at least the expense of the US government. There are some potential arguments to justify such behaviour but I don’t find them compelling. I will chalk this up to a capitalism #fail.

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