Motley Fool Money - 6 Companies, 4 Strong Balance Sheets

Episode Date: April 23, 2022

What separates a strong balance sheet from a weak one? Motley Fool senior analysts John Rotonti and Bill Mann discuss: - Assets, liabilities, and when more liabilities can actually be a good thing - A surprising way one retailer generates cash from its balance sheet - Companies holding the most formidable cash piles in the world Stocks: COST, GOOG, GOOGL, LOW, F, NCLH, RAD Host: John Rotonti Guest: Bill Mann Producer: Ricky Mulvey Engineers: Rick Engdahl, Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

If you're a small business owner, you already know what it takes to keep everything moving. You're juggling customers, invoices, and about 100 decisions every day. Thankfully, taxes don't have to be one more thing on that list. With Intuit TurboTax, you can get your business taxes done for you with a full service expert. TurboTax matches you with your dedicated tax expert who knows your industry understands your business write-offs and gives you the personalized advice your business deserves. upload your documents right in the app, hand everything off, and still feel like you're in the loop the whole way through. You can even get real-time updates on your expert's progress right in the

app, which makes it so much easier to stay on track. And you can get unlimited expert help at no extra cost, even on nights and weekends during tax season. Visit turbotax.com to get matched with an expert today, only available with TurboTax full service experts. But because they have so much scale and so much negotiating leverage, they don't pay their vendors for four or six weeks. So they're selling it in four or six days. They don't pay their vendors for four or six weeks. They have six weeks of free financing from their vendors. Their vendors are financing the organic growth of the business.

It's truly fantastic. I'm Chris Hill, and that was Motley Fool's senior analyst, John Ron. Rotante. On this Saturday classroom, he talks with fellow analyst Bill Mann about a retailer using its balance sheet to generate extra cash for shareholders. Together, John and Bill are separating the formidable from the week and giving you some ideas for companies with a sneaky strong composition. Hi, fools. I'm John Rotati, and I'm joined by my buddy Bill Mann. Hello, my friend. We're getting the band back together. How are you, brother? I'm doing great. Nothing I enjoy more than doing some video or audio with you. So Fools, today we're talking about the balance sheet again.

We did a prior Motley Fool Money episode on the balance sheet discussing what is a balance sheet, how to interpret and analyze a balance sheet, and how the balance sheet connects to the other primary financial statements. But the balance sheet is so important. So we wanted to do a follow-up episode where we give you some examples of companies that we think have a strong balance sheet, a sneaky strong balance sheet and a less strong or possibly even weak balance sheet. The reason the balance sheet is so important, fools, is because the balance sheet is where the search for a resilient business really starts and ends. If the business doesn't pass this first filter, then personally, my research stops and I move on.

Why? Because the balance sheet is the structural foundation of a business. And history shows that a sustainable and resilient business cannot be built atop a weak foundation. Think of a house, a building, or any other physical structure. The future survival and sustainability of that structure is at risk if it is built on top of a weak foundation. So with that, Bill, let's start off with an example of a company that you think has a strong balance sheet. What you got? One of the most fortress-like balance sheets that I know of is Costco. Costco currently has about

$11 billion in cash and in short-term investments. They have incredible working capital characteristics. It is a company that carries a fair amount of debt, about $6 billion in debt, primarily because they use their cash flows to buy the land for the, you know, that most of the, you know, that most of their warehouses are built upon. So, it's a company that is not without debt. I think a lot of people, when we talk about strong balance sheets, they think immediately like, oh, I want a balance sheet that has zero debt on it. And that is a way of making a balance sheet bulletproof, if you will. But Costco has an adequately levered balance sheet. I agree completely. I think we both own Costco. And the point that I really want to

down on is you said that it has this amazing working capital management. Costco actually makes money off its balance sheet because it has a negative cash conversion cycle. It has negative working capital because what happens is, as you know, they buy merchandise, they buy inventory from their suppliers, they put that inventory on the shelves in the store, and then they sell that inventory within five or six days. But because they have so much scale and so much negotiating leverage, they don't pay their vendors for four or six weeks. So they're selling it in four or six days. They don't pay their vendors for four or six weeks. They have six weeks of free financing from their vendors. Their vendors are financed in the organic growth of the business. It's truly fantastic.

And a vendor would do that in a second with a company, a lot of the business. Costco because they know very well that Costco is going to pay its bills, because once again, the reflexivity of that balance sheet, they know full well that Costco's financial structure is such that they do not have to worry about receiving that money. And because Costco tends to go and buy such huge amounts from their suppliers, they become a structurally important company for those suppliers. So the supply, buyers, you don't want to say that they're happy to wait? I mean, all of us would rather have our money paid today than 60 days from now, but they are completely satisfied with that

model with Costco. So, Costco is actually making money with its balance sheet. It's a very rare company that is in that position. It is. It is very rare. So for my strong balance sheet example, I'm going to go with the obvious, which is Alphabet. I think Alphabet has a lot of has possibly one of the, if not the, strongest balance changes in the world. And here's why. So Alphabet has 139.6 billion dollars in cash, and only 28.5 billion in total debt.

That includes all their leases. And so it has net cash of 111 billion. It gets better. It's a lot. It's a lot. Net cash. Net cash fools just means more cash than debt. It has 111 billion more in cash.

than debt. It has $359 billion in total assets on its balance sheet. So its net cash makes up 31% of its total assets. So this is a super cash rich balance sheet. Its market cap, market capitalization or market value, is $1.72 trillion. So its net cash makes up about 6.5% of its market value. To quickly put Alphabet's balance sheet into perspective, Apple also has a massively cash-rich balance sheet. But Apple is working very hard, actually, believe it or not, to get down to net cash neutral. So Apple has $80 billion in net cash against $381 billion in total assets. So Apple's net cash as a percent of total assets is 21%.

That is still very, very strong. But remember, Alphabet's net cash as a percent of total assets. is 31%. Now, when you see a company, I'm going to say something as if there are several of these, but there really are very few, but when you see a company like Alphabet with $11 billion of cash on its balance sheet, obviously that is some kind of security blanket. And it allows them in some ways, and this will seem a little counterintuitive, to make mistakes, to go out and take risks that do not put their core business or shareholders at great risk at all. But when you see that much cash on the balance sheet, do you not think in some ways that that is a sign of

insecurity for the company? It could be. There's two. So I love this question. So yes, I think that a net cash of $111 billion allows the company to have a security blanket like you talked about, which is, you know, it allows it to play defense. And then a large net cash position like this also provides optionality and allows a company to play offense by, you know, investing heavily in down markets when asset prices are distressed. In Alphabet's case, it spends so much money on long-term investments in the form of CAPEX and R&D that,

I don't in Alphabet's case, I don't think it's a sign of insecurities. I just think it's a sign that they're generating more free cash flow than they possibly know what to do with. So just to put some numbers around that. So Alphabet, in 2021, Alphabet spent $31.6 billion in research and development, in one year, 31.6 billion in research and development. Alphabet spent in 2021, 24.6 billion in CAPX. So, I mean, in one year, it's spending 30, 40, 50, almost $60 billion between R&D and and CAPX in one year. Which is a weapon that they have that few companies have ever had. And what you're talking about here, John, is something that we as analysts call the sources and uses of capital.

One of the incredible things about Alphabet is that they have gotten, their source of capital is the single greatest source you can have. They haven't gone out and raised equity. It's their cash flows that they're generating that cash from. and that's what they're using to fund any number of research development arms, any type of their capital expenditures. It's all generally funded from cash from operations. That's exactly right. And so I said $60 billion in total investments.

It's $56 billion in total investment. So you're exaggerating a little. That's fine. That's great. Yeah. So $56 billion in one. year, Bill, in one year, $56 billion in long-term investments, yet they generated in cash flow from operations $91.6 billion in cash flow from operations. So if you take $91.6 billion and subtract that

from $56,000, do that with your fingers and toes for me, Bill. That's $35.6 billion in free cash flow in one year, $35.6 billion. So, yeah. And then the last thing I'll say about Alphabet is their interest coverage ratio, which is their operating income or EBIT as the numerator, divided by interest expense, is 227. Which means that one year of Alphabet's operating income could pay 227 years worth of its annual interest expense. And so that's why I picked Alphabet from my strong balance sheet category. What do you have, Bill, for your sneaky strong back? I have a company that has as of its last annual report, $236 billion in total liabilities. Let me wrap my head around that.

$236 billion in total liabilities. Which means that if you were the only shareholder of Ford, you would have $236 billion in liabilities. Wow. Wow. Remember, Fools, liabilities are on the balance sheet. Remember, the balance sheet assets equals liabilities plus shareholders equity. Yeah, which is barely more or less that it's $267 billion in net assets at this point. So this is Ford is an incredibly levered looking company. It looks incredibly levered. But the really important thing to note about Ford is that an extraordinary component of its liabilities come in the form of Ford credit. It's the credit that they both provide an owe on for financing Ford vehicles through dealerships.

around the country and around the world. In a lot of ways, it is a pass-through for them and a profit center for them. But they still do have to carry that. They still do have to carry those liabilities on their balance sheet, and they look massive. It's so weird with banks. I love that you brought up Ford. Because with banks, which is what we're talking about here, this is their It is. That's right. It's so great you made that point, because Ford is a bank that also happens to sell. Right. Right. I mean, this is their finance. And so with banks, debt, right? Debt is like it's like inventory.

Right. Right. It's because you use the debt to give out loans, which are assets. And so it's weird. You really have to sort of bend your mind to think about debt at a bank. You can't think about debt at a bank in the same way that you think about debt at an industrial company or something like that. Right.

Which is exactly why when you think about, when you think about four, Or you can think about any company that has a large financing arm. And Ford's financing arm is indeed massive. You really need to flip that switch and think of it as being a bank that also happens to do other things. I love that. You know, Charlie Munger says invert, always invert. And so, you know, think about it in that way. Yeah.

So my sneaky strong balance sheet is Lowe's, the second largest home improvement retailer in the world. So Lowe's has a market value or market cap of $134 billion, but it only has $1.5 billion in cash against roughly $29.4 billion in total debt. That includes leases. So that's a large net debt position of nearly $28 billion. So at first glance, it looks like a less strong balance sheet. But then you dig beneath the surface bill, and you see that it has zero variable rate. debt and zero bank debt. So it's all corporate debt. It has zero commercial paper outstanding,

and it has not yet tapped its revolving credit facility. So that's completely untapped. As far as maturities on its debt, less than 3% of its debt and leases mature in the next year, and 84% of its debt is not due for five years out or longer. It has a triple B plus credit rating from S&P Glover, which is an investment grade rating. Also, its interest coverage, remember we define that as EBIT in the numerator or operating income in the numerator divided by interest expense. Its interest coverage is 14 times, which means one year of its operating income, can pay 14 years worth of annual interest expense.

But here's where it gets better. Its EBIT to interest expense of 14 is the highest. it has been since 2009. So its interest coverage is the highest it has been in 13 years. So things are definitely trending up at Lowe's. And then finally, Lowe's sells products and services that are relevant and in demand and that serve a crucial economic need. So the business is fairly reliable.

its cash flows are fairly reliable and predictable, and it generates really high returns on invested capital and free cash flow, and it uses that free cash flow to service that debt. I don't have the number right in front of me, but there is something that's really important about balance sheets, particularly with companies that do have debt and do have leasehold and do have leasehold obligations. Lowe's maybe fits this really well. Almost, none of Lowe's business is in the form of really large single customers. Oh, right. Yeah, it's split between, you know, a bunch of mom and pops and then Plenty of wholesale. They do plenty of wholesale.

25% of its business is professional contractors. Yeah. But of that 20%, there are no, there are no super professional contractors that that make up. 15% of it so they don't have some sneaky obligation or some sneaky risk because although it is, although it feels great for companies to have huge customers, you don't necessarily want that in conjunction with debt and leasehold expenses. Exactly. 100%. 100%. So our third category, fools, less strong balance sheet. Borderline week, what you got for us. We're going to talk about a hot mess. What you got? Right aid.

Oof. Haven't looked at that one, but it doesn't sound like a strong balance sheet. Yeah. Wrong aid, first aid, right aid. So, right aid is a company that went bankrupt and had to be reorganized a number of different times in the 1990s and 2000s. I want to say that they're on, you know, chapter 11 times three or four. So chapter 44 maybe at this point. A lot of chapters.

A lot of chapters. A lot of chapters in the write-ed bankruptcy book. But they made a choice a number of years ago to again try and grow their business. And so they borrowed heavily. And so they've got about $3.4 billion, excuse me, $3.2 billion in total debt. And they have to service that debt. And you service that debt through cash. Not through earnings, through cash. must actually pay in hard coal dollars. And their expansion has not gone very well. And so over the next year, they have to pay something on the order of $300 million to service their debt. And they may not come, they may not hit that amount in terms of a number that we make fun of a little bit. But it is, you know, it is a good number. Their earnings before appreciation, their abet does.

number, they may not have enough cash to service that debt. So, Rite Aid has painted itself into a corner, and it really has to operate. Otherwise, we may be adding 11 chapters to its bankruptcy book. Yeah, and so what does it do? If it can't come up with the EBITDA, then it either has to, like you said, borrow more. Borrow more debt. And what terms are they going to get for that, John? Yeah, those are going to be usury, right? Those are not going to be good terms. Or, you know, maybe they go into some sort of distress down the road again. So, yeah, Rite Aid does not sound like a particularly strong balance sheet.

Thanks for bringing that one. I'll close it out with my less strong balance sheet idea. I'm going with Norwegian Cruise Line. Oh. This balance sheet is just too risky for me, personally. I understand that mask mandates are being removed and people are shifting their spending towards experiences and travel after sheltering for the last two years. So its finances should actually improve going forward. I understand all that.

But Norwegian has 1.75 billion in cash against 13 billion in total debt. So its net debt is 11.4 billion. But get this. So it has net debt. It has 11.4 billion more in debt than it has in cash. But its market cap is only 9.3 billion. So this company, Norwegian Cruise Lines, has $2 billion more in debt than it has in market value. I can't give you it.

It's interest coverage, its ebit divided by interest expense, because it currently does not generate any EBIT. So, yeah. It's not that you don't have the number. It's non-meaningful. It comes up as non-meaningful. Oh, it's meaningful. Right, right, right, right. So even before COVID, though, if we go back before COVID and before lockdowns, its interest coverage was somewhere between four and, you,

know, 4.8, so less than five. Its interest coverage was less than five, even before COVID. The Altman Z score is a metric that predicts the likelihood of bankruptcy. It's an amalgamation of several different financial health ratios and leverage ratios and coverage ratios and coverage ratios, and it adds them all up, and it comes up with the score. It's called the Altman Z score, and it predicts the likelihood of financial distress down the road. And the rating system for the Altman Z score, anything below 1.8 is considered as risky territory. Well, Norwegians Altman Z score is currently negative, 0.44. Because remember, it's not currently generating any earnings or free cash flow.

It doesn't even generate operating cash. Right now, it's operating cash flow is negative. So it doesn't have any means to service that debt. Now, some of that, John, is a little bit, some of that is a little bit tricky because obviously, and you started with us, so this is fair, cruise ships, cruise liners were deeply impacted by the pandemic. Deeply. Deeply. But here's where, and I want to make sure that people understand what you are saying, because you are not saying Norwegian cruise lines is doomed. No. What you are saying is that they have had to make some real, really hard financial decisions to get to where they are now.

So you can look, for example, at the cash flow statement, and you can see that their capital expenditures dropped by about half between 2019 to 2021. So some of the things that they have done were to put off things like maintenance, to put off some of the capital expenditures that they need. need to continually spend to keep a good cruise line up and running. They've issued a lot of capital stock, a lot of dilution, and all of this flows back to the balance sheet for a company that does not have the E at this point in time. They did what they had to do to survive. I mean, that's fair, right? It's fair. They were in survival mode, and there are investors. Great investors. For example, Bill Miller is currently invested in the cruise lines. I don't know if he's in Norwegian, but he has talked about how he thinks the cruise lines could be a great turnaround story. There are great investors that see opportunity here. Great investors. But how I started this segment, I said, Norwegian is too risky for me. For my blood, this is just not the type of investment I personally feel comfortable making. I do think that their finances, and the outlook for the business will improve going forward.

But thousands of companies out there, and this is just not one that you are. For me. Fair enough. This is what makes a market. Two weak is too weak for me. So there you have it, fools. Bill Mann and myself, we just did. We just gave you six companies, two that we think have a strong balance sheet,

two that we think have a sneaky strong balance sheet. So that's four strong balance sheets. That's four. I'm adding up. Yeah. And then two that have lesser strong balance sheet, borderline week. Bill, we should do this more often. Anytime you want, my friend.

Great to spend this time with you. As always, people on the program may have interest in the stocks they talk about. The Motley Fool may have formal recommendations for or against. So don't buy yourself stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.