Propeller Skies

Since even the mainstream media has figured out the world in general is suffering from a gnarly credit crunch, now is a great time to discuss the debt to equity ratio. The primary use of the debt to equity ratio is to determine the solvency of a company.

Debt is not necessarily bad - if a company can borrow at 5 percent and generate a return of 10 percent, the difference benefits the company. However, too much debt leaves companies at risk during recessions. If the return drops below the interest rate on the debt, a company begins losing money. After they lose enough, they default on the loans and lenders can force them into bankruptcy. Shareholders end up with a fat fucking zero at the conclusion of bankruptcy proceedings.

To calculate the debt to equity ratio, divide long term debt by shareholders’ equity. This is easy, as both inputs are found on the consolidated balance sheets. While total liabilities can be used instead of long term debt, I prefer using long term debt because short term debt is already captured in other metrics I calculate. [UPDATE: For more on the many faces of debt, see Michael Brush on buried debt - Ed.]

Acceptable debt to equity ratios vary by industry. Capital intensive businesses, such as railroads, generally have higher debt to equity ratios. In contrast, businesses with low capital investments, like software companies, have lower debt to equity ratios. As such, the debt to equity ratio is best used to compare companies within an industry, with lower numbers being more desirable.

As shown in the above table, all railroads improved year over year and managed to beat their five year average. While this is certainly positive, shareholder equity increased in all six railroads from 2005 to 2006, necessitating a look at the debt side of the equation. Long term debt increased at Burlington Northern (BNI), Canadian National (CNI), and CSX. Should this trend continue, it will become an issue at all three companies. However, because CSX is toward the bottom of the heap with regard to several profitability measures, the year over year increase in debt is cause for concern.

To mitigate the inevitable complaints, it’s Melissa time:

See also: Cash King Margin, the previous post in the series, and Railroad Performance Measures: Operating Ratio at the beginning.

While poking around the internet researching the Foolish Flow Ratio, I came across another useful measure from The Motley Fool - the Cash King Margin. The Cash King Margin is basically a measure of net profitability. However, since it uses free cash flow* instead of earnings, which are bullshit, I find it a superior indicator of profitability, or lack therof.

To calculate the Cash King Margin, divide the free cash flow by sales. If the result is 10 percent or greater, excellent. If not, then the company is doing a shit job of getting cash from sales to the bottom line and not worth paying a premium for. In general, a higher Cash King Margin is more desirable. And now, the ever popular table:

Only two railroads, Canadian National (CNI) and Norfolk Southern (NSC) managed a Cash King Margin of over 10 percent. Additionally, CNI is the only railroad with a five year average Cash King Margin over 10 percent. In contrast, CSX and Union Pacific (UNP) are bringing up the rear. While both were profitable in 2006, CSX had the distinction of being the only railroad with a negative margin in 2005. However, CSX did improve its Cash King Margin by the most points year over year.

For further reading, the next post in the series is: Debt to Equity Ratio, the previous post is Foolish Flow Ratio, and the first post is: Railroad Performance Measures: Operating Ratio

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* Which alert Prizzo Skeezy readers will recall measures actual cash

The Foolish Flow Ratio is one of the most useful performance measures dreamed up by The Motley Fool. The Foolish Flow Ratio quantifies how well a company is managing their working capital. This measure appeals to my contrarian nature, because it treats inventories* and accounts receivable, traditionally considered assets, as liabilities. Conversely, accounts payable, generally considered a liability, is treated as an asset. This contrarian thinking is justified, because accounts receivable are really interest free loans to customers, while accounts payable are interest free loans from suppliers.

Watch out for exploding accounts payable while receivables remain steady - this means management is shafting suppliers to make their numbers look good. Management often gets away with this because equities traders are dumbasses and almost never look beyond net income and earnings per share.

To determine the Foolish Flow Ratio, subtract cash from current assets and then divide by current liabilities minus short term debt. This a fairly easy measure to calculate, because all the necessary inputs are found on the consolidated balance sheets.

The whole point of being in business is to have more loot coming in the front door than going out the back door. This is why the Foolish Flow Ratio gives the thinking investor an edge - it provides a way to measure this. According to The Motley Fool, a ratio below 1.25 is acceptable, while 1.00 or less is preferred. A ratio below 1.00 means a company has more cash coming in than going out.

Railroads are a bad example, as they almost always ace this measure. This is because they have almost no inventory fucking up their flow. However, I have the spreadsheet made for railroads, so here is the table:

Both Norfolk Southern (NSC) and CSX are well above the industry average. Remember, lower is better for the Foolish Flow Ratio. This is not particularly surprising in the case of CSX, as alert Propeller Skies readers have likely figured out CSX sucks wind like hookers on Ponce suck dicks. While NSC is above both the industry average and its own five year average, the year over year trend is headed down, which is the correct direction. In contrast, CSX’s Foolish Flow Ratio is above its five year average and increasing year over year.

Union Pacific (UNP) is another surprise. Usually vying with CSX for first place in the piss poor management hall of shame, UNP managed to pull off the best Foolish Flow Ratio in the industry two years in a row. However, the year over year trend is up, which is the wrong direction, so I am not about to call a turnaround. Also, UNP’s current Foolish Flow Ratio is only slightly lower than their five year average - another argument against improving management.

See also: Cash King Margin, the next post in the series, Quick Ratio, the previous post in the series, and Railroad Performance Measures: Operating Ratio at the beginning.

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* Alert Prizzo Skeezy readers will recall the quick ratio considers inventories worthless, a similar treatment.

With the term “liquidity crisis” currently flying around like shit in a pigpen, now is a good time to discuss the quick ratio, which is a strong test of liquidity. As such, the quick ratio provides insight to the short term financial health of a company. I like the quick ratio because it is more conservative than Rush Limbaugh - the formula assumes inventories are worthless and subtracts their value from current assets. Thus, liquidity of firms that have a hard time unloading inventory* is not positively distorted like it can be with the current ratio, a similar performance measure.

To calculate the quick ratio, subtract inventories from current assets and then divide by current liabilities. In general, a quick ratio greater than 1.0 shows that a company is liquid. In practice, the railroads I am using as examples rarely have a quick ratio over one and acceptable quick ratios vary by industry. If the quick ratio falls significantly from year to year, it is a warning sign of potential future liquidity problems.

Calculating the quick ratio is easy, because all the inputs are found in one place - the consolidated balance sheets. Inventories are found on the balance sheet under assets. In the case of the railroads, inventories are often labeled as materials and supplies - since they do not manufacture anything they do not have traditional inventory like widgets, half built widgets and raw materials laying around. They do, however, need to keep fuel on hand along with oil and spare parts. Current liabilities are also found on the consolidated balance sheets and are labeled as such.

CSX and Norfolk Southern (NSC) currently have the highest liquidity of all the railroads, based on the quick ratio. BNSF (BNI), Canadian National (CNI), and Union Pacific (UNP) are all below the industry average. CNI and UNP both have quick ratios below their respective five year averages, as well.

Besides being inherently useful, the quick ratio is one component of Harry Domash’s Impending Bankruptcy Indicator, a very useful tool.

For further reading, see the next post in the series: Foolish Flow Ratio, the previous post in the series: Enterprise Value to Free Cash Flow, or the first post in the series: Railroad Performance Measures: Operating Ratio.

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* Like homebuilders during the biggest housing downturn since the Great Depression.

I like to call enterprise value to free cash flow the thinking man’s price to earnings (PE) ratio*. Because the PE ratio relies on market capitalization, companies with higher debt loads can look cheaper or more attractive than competitors with less debt. Using enterprise value to free cash flow eliminates this potential distortion.

Investors are essentially purchasing future cash flows, also referred to as profits (or losses in the case of negative cash flows), so a higher enterprise value to free cash flow ratio means investors are paying more for future profits. Conversely, a lower value means investors are paying less and potentially getting a bargain. Enterprise value to free cash flow is best used to compare companies in the same industry or a company to its historical value.

Alert Propeller Skies readers will recall that enterprise value and free cash flow have been calculated already. So, without further ado, behold the 2006 enterprise value to free cash flow of six, count ‘em, six, North American Class I Railroads:

Strangely, CSX and Union Pacific (UNP) are trading at a premium to the industry average, despite generally poor operations. CSX also has the honor of being the only railroad with a negative enterprise value to free cash flow in 2005 and over the last five years, caused by negative free cash flow** in four out of five of those years. All the railroads except CSX and UNP currently have an enterprise value to free cash flow ratio above their five year average. Based on the enterprise value to free cash flow, railroads do not appear to be trading at a discount.

Also see the next post, Quick Ratio, the prior post Enterprise Value, or start at the beginning of the series with Railroad Performance Measures: Operating Ratio

notes:

* The price to earnings ratio is a company’s stock price divided by their earnings. While this gives a rough measure of value, accounting ninjas can produce bogus earnings quite easily.

** While operating cash flow was positive at CSX each year from 2001 to 2005, capital expenditures exceeded operating cash flows. Because railroads are a capital intensive business this is not the end of the world. However, I would like to see some improvement in operating performance measures after these massive capital outlays. Alert Prizzo Skeezy readers will recall that CSX’s operating ratio has been improving, but average train speed - which should benefit from capital improvements like more sidings and double tracking - is obviously not. Because of the lack of clear and broad based improvements in operating performance measures, CSX certainly does not , in my opinion, deserve a premium valuation.

Enterprise value is how much a company would cost to buy outright. Enterprise value is important for comparing companies against each other, because it accounts for debt and equity. While market capitalization is often referred to as how much a company is worth, this is a shortcut and ignores debt and cash on the books. Debt is a liability and cash is an asset. For example, if I sold my Acura on Craig’s List for $1,000 plus the remaining debt, the actual cost to the buyer would be $17,000 because he would have to pay off the remainder of the loan. In comparison, if I sold a file cabinet on Craig’s List for eighty dollars and the purchaser discovered a twenty dollar bill in the drawer, he would have effectively paid only sixty dollars.

The first step is to calculate the market capitalization, which is the share price times the number of shares out. Simple enough, right? Share price is highly variable, so I arbitrarily use the fourth quarter high for consistency when comparing companies within an industry and year over year. Generally, the high and low closing prices by quarter are in the 10-K somewhere, but some companies, such as Canadian National (CNI), are very unhelpful and refuse to publish this. Fucking Canadians. For number of shares out, I use diluted shares, found on the consolidated statements of income.

The second step is to add long term debt to the market capitalization. This is also known as debt due after one year and is found on the consolidated balance sheets. Alert Propeller Skies readers playing along at home can also add short term debt. I personally do not bother, but I do pay attention to trends in short term debt to suss out anomalies.

Finally, subtract the cash money. Cash and cash equivalents are found on the consolidated balance sheets.

Enterprise value by itself is not particularly useful. Stay tuned to find out how to combine enterprise value with other performance metrics to create informative measures. We might get nuts and leverage a few synergies up in this bitch, as well.

For further reading, see the next post in the series: Enterprise Value to Free Cash Flow, the previous post in the series: Free Cash Flow, or start at the beginning with Railroad Performance Measures: Operating Ratio.

Prior to requiring an irritating registration, the Motley Fool provided plenty of useful articles discussing tools for analyzing companies. One of these tools is free cash flow. While net income and earnings can be fudged easily, free cash flow is important because it is more difficult to manipulate. Free cash flow is actual cash money that a company can give back to investors (think dividends or share repurchases) or use to expand the business.

At its simplest, Free cash flow is cash from operating activities minus capital expenditures. The free cash flow calculation can be complicated endlessly by backing things out of operating expenditures that have nothing to do with operations, like the cost of stock option grants. I am lazy, but alert Prizzo Skeezy readers might Google “motley fool free cash flow” for more information. Cash from operating activities can be found on the consolidated statement of cash flows, as can capital expenditures. Sometimes cash from operating activities is labeled as net cash provided by operating activities, cash provided by operating activities, or something similar. Capital expenditures show up as total capital expenditures, property additions, capital investments, or similar.

Increasing free cash flow over time is desirable, while declining free cash flow is bad news. When comparing two companies in the same industry, the company with consistently higher free cash flow has an advantage. In the case of capital intensive industries, like railroads, a trend to watch for is declining capital expenditures. Because railroads require large capital investments in locomotives, freight cars, and rails to increase revenues, declining capital expenditures over a period of time is a red flag, even though free cash flow may be improving. While railroads are highlighted in this analysis and the following table free cash flow is a performance measure applicable to all companies.

All six railroads managed to increase free cash flow year over year and over their five year averages in 2006. As per usual, CSX (CSX) and Union Pacific (UNP) are getting smoked like it ain’t no thang by the other railroads. Canadian Pacific (CP) is also getting its ass handed to it. In contrast, Canadian National (CNI) is clearly kicking ass and taking names, while BNSF (BNI) and Norfolk Southern (NSC) are also doing quite well.

As free cash flow is dreadfully dull, it is time for more inspiration:

For more information on railroad specific performance measures, see previous posts in the series - Railroad Performance Measures: Average Train Speed and Railroad Performance Measures: Operating Ratio at the beginning.

Another railroad performance measure I follow is average train speed. This measure, speed, is a pain in my fucking ass. Because financial disclosure regulations do not require it, railroads report speed whenever the fuck they feel like it or, in the case of Canadian National (CNI), almost never. However, reporting has improved recently and railroad performance measures are updated weekly except for CNI.

Despite the lack of reporting, average train speed is a very useful performance measure to track. Basically, faster trains allow railroads to haul more shit with less cars and fewer locomotives. Since freight cars and locomotives cost a fuckton of money, and hauling stuff is how railroads generate revenue, less capital equipment plus more stuff delivered equals higher profits.

The first conclusion that can be drawn from the above table is only half the major North American railroads provide average velocity on a regular basis. From the limited data available, all three railroads managed a year over year improvement in average train speed. However, only Canadian Pacific (CP) had an average speed above the five year average. CSX and Union Pacific (UNP) both had slower average train velocities in 2006 compared to their 2001 - 2005 average. Alert readers will recall that CSX and UNP also had the highest operating ratios during 2006.

Speaking of alert readers, if anyone out there on the internet could hook a cracka up with sources of historical speed data for the missing railroads, I would be most appreciative. Average dwell time would be nice, too.

Average train velocity is merely one performance measure. See the next post in this series: Free Cash Flow or previous posts in the series - Railroad Performance Measures: Yield and Railroad Performance Measures: Operating Ratio at the beginning.

notes:

Useful links regarding performance measures:

• Canadian Pacific AAR Reports
• Union Pacific AAR and STB Reports
• Railroad Performance Measures - does not include CNI.

Yield, or revenue per car is another railroad performance measure I calculate. Because the capital and operating costs of rail are similar no matter if they are filled with raw sewage or gold, railroads with a higher yield are in a better position to put mad cash in their shareholders’ pockets. Keep in mind, since I am measuring revenue per car and not profit per car, management can fuck up and lose money while hauling gold. Conversely, a well managed railroad can make a nice profit hauling raw sewage.

So, if management will probably find ways to waste money anyway, why look for a high yield? Railroads with high yields and improving profitability may be turnaround plays. To calculate the yield, simply divide total revenue by the number of cars hauled. Cars hauled can generally be found under: volumes, volume and revenue, revenue table, revenues, or similar table headings. Searching for carloads or cars hauled also works nicely. Because I am lazy, I do not bother to subtract out non-freight revenue when calculating the yield. While this may be technically incorrect, revenues from operations other than moving shit around are generally a small percentage of the total and are therefore insignificant.

Now, for fun, I will draw a few conclusions from the above table. First, all of the railroads are clearly enjoying pricing power. This is obvious because yield has increased year over year for each of the railroads and current yields are all above the five year average. Second, Norfolk Southern (NSC) is far below the average industry yield for 2005, 2006, and the 2001 - 2005 average. However, alert readers will recall from railroad operating ratios that NSC has a better than average operating ratio that has improved dramatically over the 2001 - 2005 average.

To show how yield and operating ratio work together to determine profit, I subtracted the Operating Ratio from 100 and multiplied by the Yield for both NSC and CSX, its closest rival. Using this measure of profitability, NSC makes $324 in profit per car, or roughly 21 percent less than CSX, which makes $412 per car. If NSC were to increase its yield to the same level as CSX, say by reducing the amount of raw sewage hauled and replacing it with gold, they would make $502 per car in profit, or 18 percent more than CSX.

Yield is simply one performance measure. See also Railroad Performance Measures: Average Train Speed, the next article in the series, or Railroad Performance Measures: Operating Ratio at the beginning of this series.

I like railroads as an investment for the following reasons:

• Simple to understand - railroads move heavy shit from point to point;
• Macro-economic effects on railroads are easy to figure out - when the economy is good, people are shipping stuff, when it crashes, volume goes down;
• Efficiency, railroads use substantially less fuel to transport goods than trucks;
• Not affected by increasing traffic congestion; and
• There are only six Class I railroads in North America, making it simple to compare them.

Operating ratio is a key metric of railroad performance. It is basically a measure of profitability and shows the percentage of revenue used to operate the railroad. A lower operating ratio is better, as more revenue is falling to the bottom line or available to reinvest in the business. Over time, if the operating ratio is decreasing, the railroad is increasing profits. Railroads with lower operating ratios have more cash to reinvest in the business or return to shareholders in the form of dividends and buy backs. They also earn more for each additional dollar in revenue.

Despite being such an important measure, the operating ratio is easy to calculate. The operating ratio is simply operating expenses divided by revenue. Both items can be found in the annual report under the Consolidated Statement of Income, Consolidated Income Statements, or similar. This is generally at the back of the report to discourage investors from actually reading it.

A few conclusions can be drawn from the above table. First, Canadian National (CNI) has the lowest operating ratio, which is a sign of effective management. Second, Norfolk Southern (NSC) shows the most improvement over the five year average, a decrease of 11.9 points. This implies management has been successful at controlling costs and increasing efficiency. Additionally, NSC has the second best operating ratio of the railroads compared. Union Pacific (UNP) has the highest operating ratio, a sign of poor management. Their operating ratio, while improving on a year over year basis, is also above the five year average. This means management is getting worse over time. While CSX currently has the second worst operating ratio, they have the second highest decrease over the five year average at 10.1 points. For the industry as a whole, operating ratios declined from 2005 to 2006 and were well below the 2001 - 2005 average.

While important, the operating ratio is not the only measure of railroad performance. Several more will be posted in the future. Check out the next article in the series, Railroad Performance Measures: Yield.

Since this shit is boring, a little inspiration is in order:

notes:

Annual reports are available at the following web addresses:

• BNSF Annual Reports
• Canadian National Annual Reports
• Canadian Pacific Annual Reports
• CSX Annual Reports
• Norfolk Southern Annual Reports
• Union Pacific Annual Reports