17. Four Extremely Instructive Case Histories
The word "extremely" in the chapter title is intended as a pun, because the companies that follow represents extremes of various sorts that have at times been evident in the market in general - and as such, they serve as instructions and grave warnings for investors.
The four histories to be considered here are:
- Penn Central - An extreme example of the consequences of ignoring the most basic warning signals of financial weakness. An insanely high price for the stock of a tottering giant.
- Ling-Temco-Vaught - An extreme example of fast and unsound "empire building" with an utter collapse that was practically guaranteed, forestalled only by indiscriminate lending.
- NVF Corporation - An extreme example of a corporate acquisition in which a small company attempted to devour another seven times it size.
- AAA Enterprises - An extreme example of public stock financing of a small company whose value was based on its business concept and incredibly naive expectations of its potential for profit.
Case Study: Penn Central
Penn Central was the country's largest railroad in assets and gross revenues, whose 1970 bankruptcy "shocked the financial world": the firm defaulted on its bond issues and its stock fell from 86.5 to 5.5 in less than two years, and were wiped out entirely by its reorganization.
Meanwhile, even the "simplest standards of sound investment" would have provided clear warning.
Primarily, Penn paid no income taxes for 11 years. The fact that Penn required such an unusual accommodation to remain in business is itself a strong warning - the company was not earning enough to pay its tax bill - that made its performance seem better, or at least significantly less horrible.
For bonds, the author recommends a minimum "times interest earned" of 5, and Penn was at less than 2. These are before-tax figures. The stock traded at 24 times earnings, but given that the firm was exempted from income taxes, its reported earnings were highly suspect.
The earnings of the firm would have been negative if not for accounting adjustments to "smooth" earnings in light of the costs of reorganizing its operations - so while the firm announced "profits" of $6.80 per share, this figure ignored "special costs and losses" of $12 per share.
Given that other methods of transportation (trucks, busses, and planes) had sapped the firm of both passenger and cargo business for two decades prior to its bankruptcy, there is some question as to whether better management could have saved the firm, given its crippling financial performance.
The lesson to be learned here is that investors should never neglect the task of basic financial analysis, regardless of the market's seeming confidence in a given firm.
Case Study: Ling-Temco-Vought Inc.
The story of Ling-Temco-Vaught is one of a firm that expanded its operations rapidly, and incurred debt even more rapidly. As usual a "young genius" was chiefly responsible for the creation and downfall of the empire, but those who trusted in his vision and condoned his methods cannot escape their portion of the blame.
Over the course of twelve years, LTV exploded, from a modest firm with sales of $7 million to an enormous conglomerate with $3.75 billion - and whose earnings per share went from 0.17 to a deficit of 173.18 per share as the company struggled to service the massive debt it had amassed to expand rapidly.
At the onset, the firm used creative accounting practices to pile all its debt into a single year - the "big bath" gimmick that is used to make a company appear to have one bad year, and then emerge to an extended period of prosperity by virtue of the losses already having been taken. This makes the firm seem more appealing to investors and creditors than its operations merit.
The company's net tangible assets per share rose from $7.66 per share to about $77 per share, but this did not account for the convertible securities the firm had issued and also listed the discount of bonds below their par value as an asset. When these factors were taken into consideration, the assets had actually fallen to about $3 per share.
The debt of the firm rose rapidly to nearly $3 billion, on assets of less than $400 million - it is unfathomable how commercial bankers could have been persuaded to lend such huge amounts of money to a firm with so little collateral to back them.
The lesson to be learned: rapid growth of a firm signals a need for extreme caution for creditors and investors.
Case Study: NVF Takeover of Sharon Steel
The NVF Company was a modest-sized manufacture of vulcanized fiber and plastics, the management of this firm decided to take over Sharon Steel Corporation, a much larger firm. The management of Sharon Steel was naturally against this takeover attempt, but to no avail, and the outcome was disastrous.
By way of comparison, the firms before the takeover compared as follows:
Among all the takeovers effected in 1969, this was clearly the most extreme in terms of financial disproportions. Not only was NVF a much smaller firm, but it was itself financially troubled - but again, creative accounting did much to disguise this fact, both before and after the takeover.
NVF issued a massive amount of bonds to finance the takeover, floating 25-year bonds with a 5% rate, each of which could be converted to 1.5 shares of the company, as well selling an enormous amount of options to buy the stock of the firm for $12 per share, threatening to dilute the issue considerably if the combination provide successful.
The problem of warrants was compounded by its continued use of them as a method of finance. Because its bonds were selling at 40 cents on the dollar, it continued to issue warrants to raise capital - and speculators continued to purchase them. The firm also put in effect a plan that provided warrants to its employees - which was curious in that it gave them "options to buy options," a notion that the author finds entirely ludicrous.
As a result of creative accounting, the firm reached a point where its price-to-earnings ration was 2, the lowest of any company among the 4500 in the S&P stock guide. This should have been a clear sign that the firm was grossly misrepresenting its finances, but Wall Street regarded this as "important if true."
Case Study: AAA Enterprises
A mobile-home salesman named Jackie Williams latched on the idea of franchising, using a mobile home as an office for temporary businesses, such as income-tax preparation, and formed a subsidiary company called "Mr. Tax of America," and started selling franchises to others to use the idea and name.
He found an investment banker willing to incorporate him to raise revenue to start the firm, based on little more than the idea, and launched the corporation in 1969 by selling 500,000 shares at $13, 60% of which went to Williams (instantly making a multi-millionaire of a struggling young businessman) and the remainder to fund the company.
The was clearly a bad move even for the investors who got in on the ground floor - who essentially pooled their resources to start a firm, but gave away more than half of their combined resources to a young man who had a bright idea.
Nonetheless, the stock quickly doubled, to a value of $84 million for a company with a book value of around $4 million and reported earnings of $690,000 - a book value of less than 5% the price of its stock, whose price was 115 times earnings per share. On what merits, one could only imagine.
In addition to financing the "Mr. Tax" franchise, the initial resources were invested in a chain of retail carpet stores and a plant that manufactures mobile homes, and the stock managed to earn $690,000 , or 22c per share - but the following year, the firm lost $4.3 million, or $1.49 per share.
This reduced the company to merely $242,000 in capital assets, or about 8c per share. Meanwhile, the stocks traded at 8.125, a plain demonstration of the complete heedlessness of market prices to firm valuation, as the company was clearly insolvent and beyond hope.
The company was propped up for a time by lands in the amount of $2.5 million to cover operating expenses, but by the end of the year, the firm filed a petition for bankruptcy. When the company closed its doors, it was well underwater, with a negative book value ... and even then, the stock was valued at 50 cents per share - a market capitalization of $1.5 million for a company that represented an bundle of debt of more than twice that amount.
The moral to the story is that speculators are utterly incorrigible: they will buy anything at any price if there seems to be some action in progress, regardless of whether the shares represent any real value, or the firm they represent is actually in business at all.
In commentary on the chapter, it is remarked that little was learned from this case study, as evident by the Internet "bubble" of the late twentieth century, where virtually the same pattern was followed: investors sunk millions of dollars into the "bright ideas" of young men, losing a fortune on reckless endeavors while meanwhile making millionaires of those who had swindled them.