A Better Gauge of a Company's Health

11/06/2009 11:13 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

Two companies with very different tales to tell—Ford and Australian mining startup Lynas—show why investors shouldn't rely on easy-to-manipulate earnings reports.

Follow the money.

That's great advice whether you're trying to unravel political skulduggery or separate stock market winners from wannabes.

Too many investors, though, think the money they should be following is earnings, the most familiar, but also most easily manipulated of financial measures. The great financial crisis, which still has the world economy in its grip, should have taught us that companies can continue to generate fabulous earnings growth even as they rot from the inside.

If you want to follow the real money, concentrate on a company's balance sheet, the best single source of information about its health.

Right now, with so many companies still recovering from near-death experiences in the land of debt and leverage, watching balance sheets for the moment when a company goes from intensive care to the recovery room is one of the best ways to look for bargain-priced stocks that are on the mend.

Ford Under the Microscope

Let's take Ford Motor Co (NYSE: F) as an example of what following the balance sheet can tell you about a company and about whether or when you want to buy its shares.

Ford made the front page of business sections across the country November 3 by announcing a startling $1 billion profit for this year's third quarter. The company generated earnings of 29 cents a share, a huge improvement over its loss of seven cents a share, or $161 million, in the third quarter of 2008.

Other earnings numbers were just as impressive. For example, Ford's North American unit generated its first profit from operations—as opposed to rearranging financial deck chairs on the Titanic—in four and a half years. Overall, the company will be solidly profitable in 2011, Ford has told Wall Street analysts.

It's time to buy, right?

Not until you look at Ford's balance sheet.

From that financial report, you'll get a better idea of how much progress Ford has made and how much further it has to go.

Because Ford is the only one of the three major US automakers to avoid bankruptcy, the company still carries the full burden of its debt. And a very full burden it is.

The company's liabilities will come to $38 billion in 2011, according to Barclay's Capital. That compares with just $22.3 billion for General Motors, which has been able to shed substantial debt in its passage through bankruptcy.

Indicative of Ford's newfound relative financial health, rather than drowning in that sea of red ink, the company will be able to refinance much of its debt. Ford has announced that it will raise $3 billion to pay down debt. The cash will come from a $1 billion offering of common stock and the sale of $2 billion in senior notes. The notes can be converted to common stock or cash in 2016.

A Thumbs up from Creditors

What will Ford do with this $3 billion? It will use the money to pay down 25% of its revolving line of credit. That planned reduction, in turn, has enabled the company to persuade other lenders representing $6 billion on its credit line to extend the maturity of that debt from December 2011 to November 2013. In other words, rather than having to find the cash to pay off that $6 billion in a little over two years, Ford has put off the bill on that debt for an additional two years. (The company is negotiating to extend the maturity on the rest of its revolving line of credit, too.)

What do the lenders get in return? A one percentage-point increase in their interest rate margin, an increase in fees, an upfront payment, and a 25% reduction in the amount that Ford can draw down on this line of credit.

All this means that lenders, who have an opportunity to do far more extensive due diligence than do individual investors, have given Ford a balance sheet seal of approval. They believe the company is on the comeback trail, and they've backed up that belief by giving Ford a chance to strengthen its balance sheet. That, in turn, will make the company significantly less vulnerable if sales volume in the auto industry doesn't pick up again as quickly as everyone now expects.


Shares Face Dilution

I'd take that kind of balance sheet improvement over an announcement of a one-quarter gain in earnings as evidence of a turnaround any day.

But this kind of balance sheet analysis also convinces me that I don't want to buy Ford's shares quite yet. The company is going to issue 132 million new shares to raise that $1 billion in its stock offering. After the offering, current investors will own 4.1% less of the company. That degree of ownership will have passed to investors who buy the next shares. Until the stock sale, current shareholders will own all of the 20 cents a share that Standard & Poor's projects Ford will earn in 2010. After the sale, they'll own just 19 cents in earnings per share.

How important is that swing of a penny? Not very. Hardly enough to deter an investor looking to buy at $7.58 a share now.

But the difference does start to become significant if you believe Ford's $1 billion stock offering in 2009 won't be the last time the company has to go to the well. Even if Ford uses all the $3 billion it raises in cash to reduce debt, it will still have $35 billion in liabilities at the end of the process.

So investors who are encouraged by Ford's balance sheet improvement have to ask themselves how many more times will they see their ownership of earnings diluted by 4% or more before Ford's balance sheet is reasonably solid.

A Different Look Down Under

Let's compare the story of Ford's balance sheet with that of a very different company, Lynas (OTC: LYSCY), an Australian mining startup that owns the world's richest deposit of rare earth minerals. (See my September 11 column, " A rare opportunity in mining stocks ," for more on why you might want to own a rare earth mining company.)

Here's a company that's back from the balance sheet dead. In February, Lynas canceled a drawdown of $95 million from a convertible bond offering when the company could not meet its terms. That, in turn, led to the cancellation of a $105 million senior note. And that in turn led to the suspension of work on the company's rare earth mine, with exploratory drilling complete and stockpiles starting to build.

Then along came a Chinese investor, China Non-Ferrous Mining, which offered to put up $252 million (Australian) in exchange for more than 50% of the company. That deal would have put Lynas back in business, but also would have concentrated even more of the global supply of rare earth minerals under Chinese ownership. China already controls 95% to 97% of global rare earth production. The deal fell apart when Australian regulators said no to Chinese majority ownership. (For the complete story of this deal, see this September 25 post .)

Lynas Doubles its Shares Outstanding

But thanks to the recovery in global financial markets and commodity stocks since the start of this rally on March 9, Lynas was able to raise $408 million in a stock offering. The dilution to existing shareholders was huge: Shares outstanding jumped to 1.3 billion November 3 from 655 million June 30. Each shareholder who bought before the November 3 stock offering owns about half as much of the company now as he or she did before.

But what those June 30 investors now own is a smaller part of a company with the cash to complete construction of its concentration plant, so Lynas can begin to ship its rare earth production—instead of just storing it—and can complete its advanced materials plant in Malaysia for the further processing of rare earths.

And new shareholders—anyone who buys in after the new shares were issued November 3 and started trading November 4—don't suffer that dilution. However, future expansion will require raising more capital, which will also certainly result in dilution of existing shareholders of both the June 30 and November 3 variety.

Yet the collapse of the Chinese deal has already given some of that future dilution back to anyone who buys the shares now. The Chinese bid sent the stock into a frenzy that took the price of the company's American depositary receipts to $44.65 on September 23. The collapse of that deal and the near-death experience for Lynas cut the share price in half. Lynas' shares traded for just $22.50 on November 3.

If you buy today, you get twice as big a piece of the company as you would have on September 23. That's some payback for future dilution.

And remember that you are getting a piece of a company with a balance sheet that's strong enough to say that it actually does have a future. And one in which raising $400 million, instead of billions as with Ford, makes a difference between night and day for the shares.

I'm adding this stock to The Jubak's Picks Portfolio with this column. I'll be buying the US ADRs, which trade in the US on the OTC Bulletin Board, rather than the Australian shares, because the former are easier and less expensive for US-based investors to buy.

At the time of publication, Jim Jubak owned shares of the following company mentioned in this column: Lynas.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money . He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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