Motley Fool Hidden Gems Investing - How to Analyze a Balance Sheet

Episode Date: September 1, 2024

“If you thought we were in the weeds, now we’re about to start tunneling.” Jim Gillies joins Ricky Mulvey for an in-depth look at how investors can understand a company’s balance sheet. And a heads up, this show gets to some more advanced concepts than our usual fare. They discuss: - The basics of balance sheets.  - If lululemon has an inventory problem. - A cautionary tale from a mattress seller.  - Companies with strong balance sheets, (besides Berkshire Hathaway). Companies discussed: OTC: KSIOF, WING, LULU, SNBR, CATO, CHGG, EBAY, COST, SFM, ASO, MEDP, WINA  Host: Ricky Mulvey Guest: Jim Gillies Engineer: Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

Want to fast-forward your career? Discover the Chang School of Continuing Education at Toronto Metropolitan University. Our programs are the perfect way to boost your success. Visit the Chang School online today. A balance sheet, Ricky, is just a moment in time, right? It is what is the financial position at this moment in time. I think from a more comprehensive analysis of the balance sheet, you should have multiple balance sheets. you should be looking across quarters, you should be looking across years and see how things have changed. I'm Ricky Mulvey, and that's Motley Fool Canada's Jim Gillies. He joins me on today's show for a class on balance sheets, or how investors can understand what a company is keeping on its books. We've also got an in-depth look at Lululemon and some stories about the company beyond its

surface numbers. And at the end, we've got some under the radar companies with strong balance sheets. A few notes before we get started. One, I want to let you know this show gets to some more advanced concepts than our normal stuff. You also might notice that Jim's audio clips a bit. And we're also off on Monday for Labor Day. Hope you're having a good long weekend and we'll be back on Tuesday. Jim, balance sheet day has finally arrived. I think we've promised this on, what is at like two or three weekend shows now, but we're finally here. No more stories about Nortel networks. We're going straight. We're going straight to the balance sheet. I think a good place to start for this is just to kind of walk through your process when you're maybe checking

out a company for, you know, when it's going through your process, what are the balance sheet checks that you're doing? Sure. There's a number and a lot of them are actually the financial statements work together, right? You really can't focus on one because you got to bring things in. So while you are looking at a balance sheet, you'd be looking at the amount of debt a company's got, the amount of cash a company has got. You can check the different individual accounts. But you start getting into things like leverage ratios. That's starting to mix the balance sheet with the income statement. You're comparing debt, the total debt, to a profitability metric like EBITDA. And if you're selling physical goods, even if you're not,

but it's easier there, you want to look at things like turnover ratios. These pull in things from the income statement like sales or cost of goods sold. It's a means of heading towards a very balance sheet heavy metric called the cash and conversion cycle, which we can get into a little bit, that talks about things like days sales outstanding, days inventory outstanding, days payables outstanding, which are all basically working together as a metric or I guess metrics for the efficiency of a company. I also like to go through the balance sheet. I look at, you've got your two sides, your assets and your liabilities plus equity on the right side. On the left side with assets, I always like to go through the assets and try to answer for myself,

how real is this asset? How dubious is this asset? Assets are organized on the left-hand side of the balance sheet according to their ease, at least allegedly, according to their ease of conversion into cash. That's why you see cash at the very, very top. That's generally why you see things like goodwill or deferred tax assets or company-specific intangible assets near the bottom of the balance sheet, because they likely have very little, if not zero value to anyone besides the company in question. And maybe not even then, considering the history of writing off goodwill several years after you paid for it is not short. So I came here with a bit of a case study. It's a company called Neat.com. It's a Canadian company, KSI and the Toronto Stock

Exchange, I think. Really not important, but this is a company that does software for basically data management in the pharma industry. The company looks free cash flow positive. Maybe they have cash flow negative for the longest time, but when you factor that they are capitalizing just the vast majority of cash they generate as their own personal intangible asset. In the most recent balance sheet, I think they had about $87 million in total assets, but close to $32 million of that is just the company-generated intangible asset. Now, they can't sell that to anyone. They can't monetize that. The only way they're ever going to get any value out of that, any cash value from that is if the entire company gets taken out. So you always got to ask yourself, how real are

these assets? Mainly because in the event of a solvency crisis or a liquidity crisis, availability of cash is really, really important. And you don't need it until you need it, if you catch my meaning. I heard Ohio State finance class, Professor Sheridan, liquidity is oxygen. You don't realize you need it until you really need it. Yes. Real quick on that. I don't understand the capitalizing on an intangible asset and how that affects the free cash flow. So the money has spent out. Okay. And so, since we're going down, we're supposed to be in the balance sheet today, but we're going to go

to the cash flow statement. I'm sorry. They all connect. I got to title the show somehow. There you go. Okay. So we're on the operating... I'm sorry, we're on the cash flow statement. There are three sections to the cash flow statement, the operating cash flows, investing cash flows, financing cash flows. The funny thing is financing cash flows are largely prescribed. You're raising of capital, you're paying off of debt, you're buying back stock, preferred stock if you want is in there as well, but it's fairly fixed and narrow. Investing cash flows are fairly fixed and narrow. It's capital expenditures, but maybe you sold some assets so you get some cash back from selling some PP&E,

recognize spending on intangibles and what have you. Everything else lands in the operating section. It's the dumping ground of the cash flow statement, which is funny because when we talk about free cash flow, the simplest definition is operating cash flow, what I've just called the dumping ground. Operating cash flow, less CapEx. This company here that I'm talking about right now, Neat.com, they really don't have any CapEx. Their CapEx budget is very, very low. But all of that money is being spent on the intangible assets. So a free cash flow, a very simplistic or someone who's just running a screen, doing operating cash flow as CapEx, they're going to think this company is far more profitable than it actually is,

or far more cash generative, I should say, than it actually is because they are ignoring the spending on intangibles. In this case, you have to understand the type of company you're looking at. That is what they're doing for CapEx effectively. They are spending on this self-generated data management asset that, again, might have a little dubious value to anyone but them. If they can sell the company for more than it's worth today, great, when and if they ever choose to sell it. But as valuing it on an ongoing free cash flow basis, you'll be very, very disappointed because the cash flow is not actually – free cash flow is allegedly the amount of cash available for you to deploy in one of the classic capital allocation ways, dividends, buybacks, payoff debt,

invest for growth, acquire other companies kind of thing. This company doesn't have it, but a quick look, a quick cursory look might suggest they have it. Anyway, that's the quick answer. Back over on the balance sheet, just the last thing I wanted to talk about before we move along in our conversation is assets can have dubious value like I talk about, so you want to be aware of that. Funny thing is liabilities are typically worth a dollar for a dollar. People like to get paid back and they don't tend to want to take a haircut. If they have to take a haircut, they're probably going to make your life pretty miserable. Let's break this down because I know we're not doing the growth versus value investor thing.

But when we're looking at a young company with a lot of sales growth, inching its way towards profitability, maybe, what should I be looking for in the balance sheet? In this case, is a quick ratio meaningful? How much cash it can pay folks? Yeah. I'm not a big fan of the inching towards profitability. In that case, profitability is an accounting construct. Cash flow is a more real construct, at least the way I look at things. So I would tend to say, if inching towards profitability, let's just loop it inching towards cash generation as well. Just marry the two concepts. In that case, I want to know how much cash they have. I want to know how much unencumbered cash they have.

A quick ratio, for those who don't know, the quick ratio is basically the very readily or at least theoretically readily monetizable assets on the asset side. Again, organized top to bottom for ease of cash conversion to the worst. You're taking your cash, you're taking your short-term investments, you're taking your accounts receivable. You might be haircutting your accounts receivable, maybe say $0.75 on the dollar, but you add those three things together and divide by all current liabilities. And the various places you want to read your finance textbooks and whatever will say,

oh, you want to have this at least 0.75. You want to at least because you want to know, like you're not going to have to pay all your current liabilities immediately, but you want to be able to at least know you can hit 75. Above one is better, above one and a half better still. But I did come with a case study, but it's not inching towards profitability.

It's actually a really – it's a pretty impressive company. It's a Wingstop. High-growth company, yeah. Well, I listen to the high-growth part of things, but not so much the inching towards profitability. But at Wingstop, so Wingstop, five-year revenue growth, 25.5% annualized. The last year of revenue growth, 32%. Profitability is more than fine.

If you wanted a nitpick on Wingstop, it'd be the valuation. This is an expensive wing joint. But their quick ratio, just taking cash plus short-term investments. they don't have any, but just non-restricted cash plus the net receivables, they've got a quick ratio of about 1.33. However, as part of their deal, they take cash flows from all their stores and it goes into an advertising fund. It's about $31 million, I think, in the last balance sheet I looked up. It's about $31 million. It's both a restricted asset account, that is money that is earmarked to be spent on advertising, but they've also got a corresponding

equal amount liability. That liability pops up in our calculation or it's included in our denominator calculation for the quick ratio, but I've excluded it from the numerator calculation. I would argue, based on looking at balance sheet, that this is fair to exclude that from current liabilities. We're already adjusting the current ratio. Because as they spend for the required advertising fund that makes up the liability, they will absolutely be spending out of the restricted asset that they've gathered for to offset that liability. I would say it's actually fair to throw them both out. At that point, the quick ratio jumps from 1.3 to about 2.14, which is then even again, it shows that in the immediate need for cash here is probably

not high. They're more than capable of turning it over quickly. What I do get more interested in as a balance sheet, I've already mentioned it, but it's the cash conversion cycle. It's actually been slightly negative at Wingstop for the last five years. Last year, I think they were slightly positive it's not a big deal this is a very the takeaway because always you know we can all look at numbers we can all calculate numbers it's what is the takeaway what is the implication of the numbers and i look at the cash conversion cycle at wing stop and i see how low it's been and i say this is a very efficient business which is probably good because their inventory of course is overwhelmingly raw chicken wings which don't exactly keep that long unless you freeze them

Gotcha. Let's do cash conversion cycle while we've mentioned it a couple of times. Why is this meaningful to you? What does it tell investors? So it's an efficiency metric. And so you want to start with... It basically takes the major working capital accounts, accounts receivable, inventory accounts payable. You might want to bring accruals in, but from the balance sheet. And then it also brings in some select sales-related accounts from the income statement. You start with what are called turnover ratios. How fast do we turn over the balance on the balance sheet? Accounts receivable turnovers is sales divided by your average for the period, the average accounts receivable. Inventory

turnover is the cost of goods sold from the income statement divided by the average inventory during our accounting period. The account payables turnover is purchases. Now, we don't have an account for purchases on the income statement. But all purchases is the cost of goods sold from the accounting period plus the ending inventory minus the starting inventory. Divide that by the average payables for the period. Then to go from the days outstanding for each of those turnover ratios, we just divide 365 by the respective turnover. Day sales outstanding is 365 divided by account receivable turnover. Days in inventory is 365, number of days of the year, 365 divided by inventory turnover, days and payables, 365 divided by the accounts payable

turnover. And then the cash conversion cycle, I'm sorry for those trying to write all this down, trust me, Wikipedia has got an entry. The cash conversion cycle is day sales outstanding, which is tied to receivables, or it's tied to sales and receivables, plus days in inventory, which is tied to cost of goods sold and inventory, minus days payables outstanding. So that is the basic number. And you want to see how things have moved over time. Different businesses, different companies will have a different kind of a base level cash conversion cycle. And as I've already mentioned, Wingstop, because their inventory is chicken wings, they're going to want to move those in and out as fast as possible. You don't want to have chicken wings on ice for the next six months kind of thing. You're going to see the day's inventory low if it's a well-run, efficient company. You're going to see day's sales outstanding very low because you're paying instantly. You hand your credit card over and you get your wings. Then payables is how quickly do they pay their payables. So, the fact that it is slightly negative to be maybe one day or less positive over the last five years should not be surprising. Where I would be concerned, and again, a balance sheet, Ricky, is just a moment in time, right? It is, what is the financial position at this moment in time? I think from a more comprehensive analysis of the balance sheet, you should have multiple balance sheets. You should be looking across quarters. You should be looking across years and see how things have changed for better, for worse over those time periods.

What would be a... So on the cash conversion thing, and I promise we'll go to Lululemon in a sec. So then when would the cash conversion cycle number be sort of a warning flag for you? if it has well i was gonna say once we get to lulu i'm gonna give you a yellow flag let's do lulu because i can tell you there's a yellow flag that i would think about with lulu lemon look at that we're doing a we're doing a tease middle of the show we're recording this before lulu lemon reports i so i'm going to use the previous quarter's numbers i think their balance sheet has some like just some weird things going on with it and i don't know if it's it's good or bad. But for example, one thing, it's building up its cash base. It has nothing in short-term investments. And right now, if you're a CFO of a company, you can get an easy... What

is it? 4% or 5% by getting some treasuries. That's what the Berkshire people are doing. So I'm thinking like, why are you doing that? You're giving me a shrug emoji. Yeah. You have to ask the CFO. I would agree. They're probably not... They're not making as much interest income as they probably could beyond that. But maybe they figure they just want to be more conservative and have that nearly $2 billion in cash. They've got $1.9 billion, I guess. They want to have it available as quickly as possible. I don't know. All right. And here's one that I do not understand. Lululemon spends $0 on interest expense. It's also got $250 million in short-term debt, $1.5 billion in long-term debt. I thought

those things came with interest. I do not understand how this is possible. And here I'm going to apologize to the listeners. If you thought we were already in the weeds, we were about to start tunneling. They actually have zero debt. What they have, I know this is, it's not debt per se. What they have is operating leases. And operating leases, so in other words, they rent their stores. They're paying rent every month to their stores or wherever their storefronts are. And this stuff used to be leases, operating leases used to be carried off balance sheet. So they weren't on the balance sheet. They would just, you know, have a rent expense that would flow through the income statement every accounting period.

And then a few bright wags said, well, you know, an operating lease is contractual payments over a certain period of time. Boy, that sounds like debt. Operating leases probably should be thought of as debt equivalent. Hey, we're going to require you to capitalize all your operating leases and stuff them on the balance sheet. So what you end up doing is you have, and they changed the accounting rules to require this. I will say this doesn't change the cash flows of company at all, by the way, but okay. So now you have to have the present value of lease payments as a liability, operating lease, present value, kind of equivalent to debt, perception of debt.

And you have offsetting what's called a right of use asset on the asset side of things, which is just the store that you're leasing. And this can be a topic for a bit of debate. The Godfather of Valuation, Professor Aswath Damodaran, will shake his head disapprovingly in my direction, and that's fine. I disagree with operating leases as debt equivalent because, again, these are rent payments. Are you going to staff those stores, Ricky? Are you going to have people working in those stores to service people? Yeah, unless you got the self-checkout thing going on where you're just staffing people overseas to have you watch you on cameras. Maybe. Are you going to pay those people? Hope so. Oh, cool. Why aren't we capitalizing those operating costs? Why are we capitalizing rent, but not employee wages and benefits?

You got me. Well, I just like... And also too, take a 10-year lease into a bankruptcy court and see how many months they give you credit for. Hint, it will not be 10 years. Hint, you might be lucky to get one. Okay. Anyway. So what you're seeing in Capital IQ on that debt is actually just the present value of operating leases. And, you know, operating leases, actually, when you capitalize operating leases, you end up and then the rent payment that you're making ends up basically splitting into two components, there is a depreciation or amortization of that pseudo asset you've got, you know, or the of the value of you're going to be taking it down. And then there's a component

that you will call implied interest. But again, it's a little dodgy. And you can work this out. I did put an example in our notes, but I'm not going to go through that because it's a pain in the neck. But essentially, if you wanted to evaluate a company with a lot of leases, the end result is you've got to add back the implied interest expense to operating income or EBITDA to get a better amount. And then you've got to change the amount of debt. But I'm sorry. I understand the logic behind capitalizing operating leases and treating them as debt equivalent. I just don't agree with it. Let's go on to the inventory because this is one where I'm a Lululemon shareholder. It's something

that I'm taking a look at. Last year, Lululemon leadership saying... Lululemon leadership. There you go. Basically saying, hey, we're going to get inventory under control. We're not going to use a bunch of discounting to get rid of it. This is also at a time where sales growth, particularly in North America, is slowing down. They got $1.4 billion in inventory. And I know how much you like numbers in isolation. But to me, it's a sign as I see that continuing to rise from 2022 to today, that they're struggling to get that under control. Is that a yellow flag to you? That is the yellow flag I was preferring to when I was talking about the cash conversion cycle. Yeah, because a number in isolation is just that, a number in isolation. It doesn't tell us anything.

However, again, think about the business that we're working through here. They get their cash almost immediately. Again, cash conversion cycles, day sales outstanding plus days inventory outstanding, less days in payables. What you've seen here, day sales outstanding is actually very small because they get remittance from the credit card companies almost immediately. Day sales and inventory is very little number. The big numbers can be how many days are in inventory or how quickly, if you, again, go back to the precursor ratio, that would be inventory turnover, how fast they turn over all of the inventory that flows through the business in an accounting period, typically a year. I can tell you, Lululemon, a decade ago, was turning their inventory about

four and a bit times a year. About once a quarter, the entirety of the inventory balance is flushed through the whole company. Today, they're below three. When we look and we crack the numbers for the cash conversion cycle at Lululemon, we find that from 2013 through 2019, it was clipping along in the 80s. There's some variation. That's okay, fine. It was going from 80 to 85 to 82 to 84 to 83. It was clipping along in the same era. Okay, cool. 2020 and 2021 starts to bubble up to the low 90s. Lower is better, fools. Lower indicates more efficiency. 2022, it went to 107 days. 2023 goes to 106 days. This is definitely trending in the wrong direction. And then you break out, again, the three components, days sales outstanding,

days inventory outstanding, days payable outstanding. The payable is the offset. You're adding the first two and deducting the third. Days payable outstanding over the last decade we've talked about, it was in the low to mid single digits. So they were paying their payables pretty quickly. The last four years, it's averaged about 24 days. So they're pushing on their vendors a little bit, not paying them as quickly as they previously were. And that can be okay. I mean, if you're Lululemon, you're kind of the big dog running around in athletic wear, you could maybe lean on your suppliers a little bit. There's nothing wrong with that if you can get away with it. But I'm going to point out that payables going from four

to 24 days, roughly, in the past five years. That's an offset to the day's sales plus days in inventory. Again, throw out the day's sales because it's very little here. That's masking some of the problems with the inventory. That day's payable rising is masking some of the problems of inventory rising faster. The day's inventory was, a decade ago, 85 days. Today, it's about 126 days. One way to reframe that and think about that, because again, what is the takeaway? Whenever we talk about numbers, it's the numbers are the numbers, right? What is the implication? What is the takeaway? I'm going to suggest that what this number says, days in inventory going from 85 to 126, and really the last couple of years is really

pushed up. The efficiency of the business, the efficiency at which Lulu moves inventory through its system has fallen by about a third. So it's fine for you to tell me you're not going to discount anything. God bless. This number says you might have to discount something if you want to start moving this stuff. But if you are seen to be discounting and moving, you then run the risk of impacting your premium branding. So it's potentially complicated. Yeah. Another part of the balance sheet that is interesting to me, this is a company with $24 million in Goodwill, zero bucks in intangible assets. I mean, they got a pretty strong brand. That's got to be more... The Lululemon brand has to be worth more than zero or $24 million.

There's another one. Don't understand it. Well, that's because they're lying to you, Ricky. Oh, cool. Cool. Okay. Good. Okay. Let me make my case. So first off, you don't just get to pick an asset value for your brand on the books. You don't just get to go make up a thoroughly reasonable – I would agree with you. The value of the Lululemon brand is substantially worth more than zero. It's probably in the billions, to be honest with you. What would someone else pay for that? I'm going to suggest they're going to pay more than zero and probably significantly more than zero if you wanted to buy.

And of course, if someone did buy Lulu the company, Lulu Lemon the company, they would, as part of that acquisition, allocate the purchase price across the various assets, both tangible and intangible. They would allocate the price among those assets. And that would include the brand names acquired. So if someone were to buy them, Nike comes out of nowhere and buys Lulu Lemon, Nike will then put a value for their purchase price on the Lulu brand. But because Lulu has grown its brand since inception, and given the inherent conservativeness of accounting, at least the supposed inherent conservativeness of accounting, that's a whole other show, you don't just get to make up a value and stick it on the books. And also, too, as the company grows and gets better or worse, do you take gains or losses

and flow them through the income statement? It's not cash anyway. So that is, I think, a little bit distracting. However, here is why I say Lulu is lying to you. And I'm doing a little deliberately provocative. Because you are right. They have $24 million in goodwill and zero in intangibles. But I was there when Lululemon bought Mirror for $500 million in June of 2020. I remember seeing it. And that acquisition... Go ahead. I was just going to set it up. So mirror was basically, I'll say a pandemic story. It was literally a mirror you put in your house and then personal trainers and workout classes would come to you. And then you would work out in the comfort of your home with basically a big TV slash mirror on the wall. Yeah, it's kind of – what if Peloton had a baby with the Mirror of Erised from the Harry Potter universe? It was kind of – no one else is ever going to make that one. Yeah, it was a really weird acquisition, but they paid half a billion dollars for it. And of that half a billion dollars, $85 million was allocated to intangible assets, recognizable intangible assets, and $362.5 million was allocated to Goodwill. And yet, you've just told me the balance sheet, and I have confirmed this, the balance sheet has only $24 million in Goodwill, and we do not amortize Goodwill any longer, and zero intangibles. what has happened with the mirror acquisition? The answer is, they amortized about a third

of the intangibles they initially allocated to the mirror acquisition and wrote off the other two-thirds. In 2022, they wrote off 100% the entirety of the goodwill that arose from the acquisition. So I've not seen a more efficient way of setting half a billion dollars on fire, but Lululemon managed to do it. All that said, I don't get terribly worked up when I see goodwill on the balance sheet. That's a starting point. I then go back and look and see what did that goodwill arise from? And if it is something like this, and I will give full disclosure, In June 2020, when Lululemon bought Mirror, I thought it was a bad deal at the time. And I believe I said on Motley Fool Live, this is a goodwill impairment write-off waiting to happen.

I thought it was a really bad acquisition. But you want to go back and see what acquisitions caused the goodwill and see how things have progressed since then. because of course, in the first couple of annual reports after they acquired Mirror, if you dug into the notes to the balance sheet and the financial statements, they're like, oh yeah, everything's fine. We don't need to do any impairments. And then magically, write the whole thing off, call it a day. I will assume that if you are at this point in the podcast, you're one of the hardcore investing nerds. So we're going to finish it off with two things. One is a balance sheet story. And then the second we're going to do

is maybe some companies with some sneakily strong balance sheets one we've talked about a lot in pre-interviews but i don't think we've done it on the show is sleep number the magic retailer yeah this is a company that has two million dollars and i know we don't do numbers in isolation okay it has two million dollars in cash and 106 million dollars in accounts payable that seems bad jim it's worse than you've made it out to be actually oh really okay yep yep so sleep number formerly known as select comfort is uh yes ricky is correct we have talked about this but yeah i don't think we've done it in the show so let's do it they are one of my favorite cautionary tales because this is actually a rerun they already did this once they blew up their own

balance sheet via buying back their own stock apparently someone in their corporate finance department, read a simplistic headline that probably wrote out as buybacks is returning cash to shareholders and never read past the headline. So going back, I'm going to go back about two decades from 2002 through 2006 when they were still known as Select Comfort. They made a ton of cash, piled on their balance sheet, on their debt-free balance sheet, I will put it that way, Ricky. And then around 2005, they started buying back their own stock because don't you know, buying stocks, returning cash to shareholders. And they accelerated through. If my sarcasm is not coming through, I can amp it up a little bit more. And they accelerated.

They accelerated in 2007. They blew the entirety of their cash balance. They'd taken years to build up on buybacks. And then they kept going anyway. And they put additional buybacks on their credit line. And then the world turned and growth slowed. And they had what's called a negative working capital cycle, or sorry, a negative cash conversion cycle, that means the inventory is sold before you actually pay for it. It's a wonderful balance sheet trick if sales are growing. A Dell computer back in the day was famous for this. You would make the order and pay for it online. They would have your cash and then they would order the parts to assemble your computer and ship it to you. And they would push off their payables by 30 or 60 days.

So what it effectively amounted to was a 30 to 60-day interest-free short-term cash loan that they would finance their business with. And select comfort was like that, or sleep number bed if you prefer. And so unfortunately, in 2008, when the world was ending, of course, and credit crisis and la, la, la, and these guys sell beds, I'm sure it's not tied to housing starts or anything, their sales rolled over, their negative working capital became an anchor rather than a boon to them. And basically, the company turned free cash flow negative. And remember how they blew all their cash. Kind of sounds like right now with $2 million in cash, don't it? They blew all their cash on buying back their own stock and went into debt to buy back more of their stock. And now

their stock has rolled over. And long story short, free cash flow negative, more debt on the balance sheet than cash. Stock falls 90 plus percent. They had to sell a bunch of shares in a vulture financing move at like 80% to 90% off of what they had paid for them. Just brilliant capital allocation. You think that would scar them a little bit, but nope, not our plucky heroes at Sleep Number. They decided to do this again and do it bigger. From 2012, I know I'm just bringing a nasty letter from them, but from 2012 through 2022, 11 years, they spent $1.6 billion on buybacks. But they only produced, I say only, they only produced about a cumulative billion dollars in free cash flow during those years. How'd they square that circle? Well, of course,

they put the rest of it on debt. They did it again. And then free cash flow, stop me if you've heard this before, right? Free cash flow turned negative. They've just barely turned cash flow positive in the first half of 2024 to the tune of about $9 million. Trying to throw that against debt now. Big deal. Because in addition to the $106 million in payables you mentioned, you got $540 million on a credit line that matures in about two and a half years on which they're paying 8.4%. This was easy to see coming. The company had their own history as a warning case study, and they blew it up again anyway. Ironically, they still have a negative cash conversion cycle. So they should be able to make some progress if and only if airbed sales rebound

and they put some of that cash to work. But wouldn't it be a lot better to be buying back stock today at $14 rather than $114 they were paying a couple of years ago? The solution here is I expect what they're going to have to do is they're going to have to do what they did last time. They're going to have to sell a whack of stock at a far, far, far lower price than they and then they were buying it back just to fill this hole. The entire finance team involved in this should lose their jobs, frankly, and throw the CEO too. This is appalling management.

I mean, if you're going to get a mean letter, you might as well just go all the way on it, Jim. I'm just saying, how did you do this a second time? We're not ending the show there. We've talked about a pharmaceutical software company with some weird free cash flow stuff. We've talked about Lululemon and maybe how they're getting... Not maybe. We talked about how Lululemon is getting less efficient and we've got a cautionary

case study. All of that's kind of negative, but it's more interesting to do that than just say, that company has a great balance sheet. That company has a great balance sheet. But I think that's where we should end it. The payoff. If you've been listening this long, you should get some companies to look at with strong balance sheets, not just cautionary case studies. And when we think of bulletproof balance sheets, Berkshire Hathaway is the one that comes to mind immediately. Basically, $280 billion I'm rounding in cash and equivalents, enough to buy the vast majority of the S&P 500. We're going to set that aside. That one's known. So to finish off, what are some companies that you follow maybe with a sneaky strong balance sheet?

Sneaky strong. And sneaky strong doesn't necessarily translate to good shareholder returns, although sometimes it does. So, I'll give you the negative one first just so we can finish on Happier. So, for example, Cato, which is a retailer mainly in the American Southeast, has more cash on their books, have zero debt, have more cash on their books than the company's market cap. Sounds good. Yeah. It's literally the business, if you strip out the cash. They've also got some hidden assets. They've got some owned land they bought at a bankruptcy. So, the value of the land that's on the books is very, very low, but they've hived off a couple of pieces of it over the years and sold it for considerably higher than the percentage that they would have

recognized in the bankruptcy purchase. The problem is the CEO slash controlling shareholder seems at best disinterested, frankly, and so the stock is down two-thirds in value over the past couple of years. Boy, it'd be nice if John Cato decided to actually focus on his business, but that one's kind of a backhanded compliment here's an interesting one and it's not gonna a lot of people are gonna say that uh you know probably throw this one out but we'll i'm kind of going up from the bottom of my notes here we're gonna finish with the super strong ones but this is kind of the interesting one um chegg the uh online um basically student outcomes you know tutoring service a lot of people think it's going to get killed by ai they're trying to bring ai

into their business it's imploded in the last few years and that their balance sheet they've got more cash than debt on their balance sheet. They've been buying their own debt back at a substantial discount, not in the most recent quarter or two, but before that. They got more cash than debt, and they've guided that they will have, quote unquote, at least $100 million in free cash flow in 2025. If they do that, and that might be a big if, but if they do that, the stock is presently trading at two times free cash flow. Seems cheap to me. A couple that I really like, They've kind of been long-term, excellent compounding stories that have more cash than debt, very cash generative. Names you've heard of, eBay. Yes, I'm serious, eBay. The second

largest non-Chinese e-commerce portal even today. No points if you can figure out who the largest one is. Some river in South America. Costco. Costco has a fantastic balance sheet, more cash than debt and a great many other things that should make you love Costco. Sprouts Farmers Market, the next Whole Foods, if you will. They just eliminated their last remaining true debt. They do have some leases like we've talked about, but those are not debt equivalent in my book because you've got to lease a space to have your store. They make a lot of cash. They've got a really rock-solid balance sheet. Academy Sports and Outdoor, same drill, slightly more debt, but lots of cash. And then it wouldn't be a show with me on it if I didn't mention

Winmark and MedPace. So you can throw them into MedPace. MedPace did the anti-sleep number. When their stock got cheap, they went out and bought back 13% or 14% of the company, including exhausting all of their cash hoard and going into debt. Except they did this really unique thing, which once the stock price went up, they stopped buying back their own stock and paid off all their debts. So they're back to being a debt-free balance sheet with half a billion dollars in cash on it. It's funny how that works out. There you go. Some companies to learn from, some stocks for your radar. Love it. Jim Gillies, thanks for the class. I'll call it a masterclass. Appreciate your time and your insight. Thanks

for being here. Thanks, Ricky. If you've got any feedback on today's show, or maybe you've got an investing class you'd like to hear, shoot us an email at podcastsatfool.com. That is podcasts with an S at fool.com. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Ricky Mulvey. Thanks for listening. We're off on Labor Day. We'll see you on Tuesday. Thank you.