In Part I of this series on floats, I wrote about how Berkshire Hathaway has been able to create less-than-free float from its insurance operations — a key reason for the company’s stupendous success. I also listed a few “general principles” on floats and showed how high-quality floats can become “unencumbered sources of value.”
In Part II, I expanded the discussion on Buffett’s attraction towards floats in a variety of business situations encountered by him in his long career, ranging from floats enjoyed by American Express and Blue Chip Stamps in his early years, to recent structured derivatives contracts created by him.
In this concluding part, I will shift focus away from Buffett (although I will use his thoughts on the subject) to other businesses that enjoy attractive floats.
Hindustan Unilever (HUL)
Let’s start with HUL. Take a look at the company’s summarised balance sheet as on March 31, 2012.
Take a few moments to observe the above statement. I’ll wait for you.
Notice that HUL is debt free. Why? Let’s try to answer this question by reorganising the company’s balance sheet.
Each side of the HUL’s balance sheet — assets as well as liabilities — totals to Rs 11,407 cr. That’s not a co-incidence by the way. 🙂
Let’s focus on the asset side for now. Of the total assets, let’s segregate financial assets. These would be non-current investments (Rs 70 cr.), current investments (Rs 2,252 cr.), and cash and bank balances (Rs 1,996 cr.). These total to Rs 4,318 cr. So the total breakup of financial assets and operating assets is as under:
Financial Assets: Rs 4,318 cr.
Operating Assets: Rs 7,089 cr. (balancing figure)
Total Assets: Rs 11,407 cr.
Now, let’s look at the liability side of the balance sheet which shows how the total assets are financed. Here’s the breakup:
Equity: Rs 3,680 cr.
Debt: Rs Nil.
Float: Rs 7,727 cr. (balancing figure)
Total Liabilities: Rs 11,407 cr.
“Float?” Yes, float. Other People’s Money (OPM) which carries no interest. Hindustan Lever is debt-free because it has access to free money provided by other people. It does not need to borrow any money to finance its operations. That becomes rather obvious by re-looking at the following two figures:
Operating Assets: Rs 7,089 cr.
Float: Rs 7,727 cr.
Since this float, which is cost-less, is more than operating assets, can we infer that all of the company’s operations are financed with free money? Yes!
How could HUL achieve this feat? Let’s find out by quantifying the main contributor of the company’s float. Of the total float of Rs 7,727 cr., trade payables alone are worth Rs 4,844 cr, an amount which is more than sufficient to finance inventories and receivables aggregating to Rs 3,524 cr. Here’s the breakup:
Inventories: Rs 2,667 cr.
Receivables: Rs 857 cr.
Total: Rs 3,524 cr.
Trade payables: Rs 4,844 cr.
What does this mean? It means that HUL obtains trade credit from its vendors which is more than sufficient to finance its investment in receivables and inventory. That is, HUL operates on negative working capital, which is the key source of the company’s float.
How should we determine the importance of this float to HUL’s stockholders? By doing a thought experiment. Just like the importance of the person is realized when he/she is no longer there, let’s figure out the importance of HUL’s float by imagining that it’s not there. Let’s make the float of Rs 7,727 cr disappear. Poof! It’s gone!
But hang on a second. HUL still needs to have Rs 7,089 cr of operating assets, which need to be financed from somewhere and it’s source of free money — float — just evaporated. So, HUL needs to find alternate financing. There are only two sources: Debt and Equity. If HUL had to employ debt to replace float, then at current interest rates of 10% p.a. it would have to pay about Rs 700 cr. as interest, which if we consider, would have reduced its pretax profits from Rs 3,621 cr in FY12 to Rs 2,921. That’s a reduction of 19% in HUL’s pretax earnings.
Alternately, HUL could replace its float by issuing additional shares. Assuming it did so, at its current stock price of Rs 500, then in order to raise Rs 7,089 cr, HUL would need to issue 14 cr additional shares to its existing 216 cr shares. That’s an addition of 6% to its equity capital which would have resulted in no incremental earnings.
Either way we look at it, we can see that presence of float is quite important for HUL’s stockholders. Float prevents the company from the burden of interest-bearing debt. It also prevents the need to dilute equity.
Now’s lets look at another company — Nesco Limited — about which I had written a few years ago. Take a look at Nesco’s balance sheet as on 31 March 2012.
You’ll notice that just like HUL, Nesco too a debt-free company. Why? To answer that question, let’s reorganise Nesco’s balance sheet — just as we did in HUL’s case.
Each side of the Nesco’s balance sheet — assets as well as liabilities — totals to Rs 381 cr.
Let’s focus on the asset side for now. Of the total assets, let’s segregate financial assets. These would be current investments (Rs 210 cr.) and cash and bank balances (Rs 4 cr.). These total to Rs 217 cr. So the total breakup of financial assets and operating assets is as under:
Financial Assets: Rs 214 cr.
Operating Assets: Rs 167 cr. (balancing figure)
Total Assets: Rs 381 cr.
Now, let’s look at the liability side of the balance sheet which shows how the total assets are financed. Here’s the breakup:
Equity: Rs 290 cr.
Debt: Rs Nil
Float: Rs 91 cr. (balancing figure)
Total Liabilities: Rs 381 cr.
Nesco’s operating assets of Rs 167 cr. are financed to the extent of Rs 91 cr. by OPM, which carries no interest. Was this float not available, Nesco would necessarily have to raise this money from debt and/or equity. Either alternative would have reduced earnings per share, as was the case in HUL discussed earlier.
So, how could Nesco obtain this float? Let’s find out by quantifying its main contributors. Of the total float of Rs 91 cr., advances & security deposits from customers alone are worth Rs 57 cr and trade payables are worth Rs 8 cr. These two items, which total to Rs 65 cr. are more than sufficient to finance inventories and receivables which total to Rs 13 cr. Here’s the breakup:
Inventories: Rs 5 cr.
Receivables: Rs 8 cr.
Total: Rs 13 cr.
Advances & security deposits from customers: Rs 57 cr.
Trade payables: Rs 8 cr.
Total: Rs 65 cr.
Nesco has three businesses each of which use float. Exhibition organizers who book Nesco’s exhibition center pay the company advance money to book space for various exhibitions. They also pay security deposits. Similarly, for occupying its commercial buildings, Nesco’s tenants pay security deposits to the company. Finally, for its manufacturing business, the company enjoys trade credit. Moreover, neither the exhibition business nor the commercial building business has any receivable or inventories, so the aggregate of trade credit and advances & security deposits exceed the aggregate investment in inventories and receivables.
Just like in the case of HUL, Nesco too, then, enjoys a negative working capital which is the key source of the company’s float. The only difference between the two situations is that while in HUL’s case, trade credit provided the float, while in Nesco’s case advances & deposits from customers primarily provide the float.
The Relative Attractiveness of Floats
We’ll come back to a more detailed discussion about trade credit and customer advances & deposits. For the time being let’s recall how Warren Buffett thinks about float as an attractive source of financing. A key lesson from Buffett on this is:
If you get access to an enduring and free (or less-than-free) float — whether it comes from insurance underwriting, derivatives contracts, trading stamps, travelers’ cheques, stored value cards, deferred taxes or any other source — then assets financed with such a float will become “an unencumbered source of value” for your stockholders. This will happen because (1) the assets financed with such a float would still be valued on the basis of their expected future earning power; but (2) the true value of the liability represented by the float will be far lower than its carrying value, provided the float is both costless and long-enduring.
Those two factors — cost and duration — determine how attractive a float it. The lower the cost approaches zero, and the longer the duration approaches eternity, the more the float resembles a perpetual, zero coupon bond which, as I discussed in Part I, will be worth almost nothing as a liability which is really cool because assets financed from the float could be worth a lot, just as happened in the case of Berkshire Hathaway.
Conversely, the higher the cost approaches the cost of alternate financing, and the lower the duration of the float, the less attractive it becomes. Under such circumstances, liabilities which are source of float should be valued fully on the balance sheet of company having access to that float.
Costless and long-enduring floats, then, are a very attractive form of financing — more attractive than debt, and more attractive than additional equity. We saw this in our HUL “thought experiment” above. Buffett agrees with this line of thinking. When asked about the relative attractiveness of low-cost floats vs other forms of financing, he said:
“Our insurance companies have had a terrific experience on cost of float‚ and we’d like to develop it just as fast as we can. Right now we’ve have no interest in issuing a bond because we have more money around than we know what to do with, and it comes from low-cost float. But if a time came when things were very attractive and we’d utilized all the money from our float and retained earnings and we still saw opportunities, we might very well borrow moderate amounts of money in the market. It would cost us more than our float was costing us, but it would still provide us with incremental earnings. But we would try to gain more float under those circumstances, too.”
Float = Leverage
The correct way to think about floats, then, is to think of them, simply as a form of leverage. Leverage, however, is traditionally associated with interest-bearing debt. But a free float is also a form of leverage, isn’t it? After all, it’s OPM and that’s what leverage means. Just like low-cost debt can lever up the return on invested capital, a free, or low-cost float can lever up the return on operating assets and that’s what Buffett meant when he wrote:
Any company’s level of profitability is determined by three items: (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of “leverage” — that is, the degree to which its assets are funded by liabilities rather than by equity.”
“Funded by liabilities rather than equity.” He used the word “liabilities” and not “debt. That’s key. The more of an asset that you can fund with a free float, the less the need to fund it with expensive debt or equity becomes.
Role of Negative Working Capital
Why, then, do businesses ever borrow money to fund their operations? Why don’t they just use free floats? The obvious answer to this question is that most businesses do not operate with a negative working capital. They simply don’t have free floats.
Recall that negative working capital arises when money tied up in inventories and receivables are more than offset by funds provided by customers by way of advances & deposits and also by trade credit. Let’s now return to the discussion of these two important contributors of free floats: Trade credit and advance payments & deposits from customers.
Trade credit is given to a firm by its vendors. Advance payments & deposits are given to a firm by its customers. Why, as was the case with HUL, would a firm enjoy substantial trade credit which more than finances its inventories and receivables? And why, as was the case with Nesco, would a firm get paid in advance by its customers and also receive substantial deposits from them, which, when taken together, more than offset its investment in inventories and receivables?
The answer to both these questions is “Market Power” — the power of a firm over its vendors (who give it large amounts of trade credit) and its customers (who give it large amounts of advance payments & deposits) in quantities large enough to ensure that the firm can operate with negative working capital, as we found in the case of Nesco. The super powerful ones can operate with negative net operating assets (where float exceeds investment in inventories, receivables, and fixed assets), as we found in the case of HUL.
Where does this “market power” come from? It primarily comes from two sources: (1) shortages; and (2) moats.
Shortages Don’t Produce Enduring Floats
We have little interest in floats produced from shortages-derived market power. That’s because such floats are likely to be temporary, fair weather friends. To see how, think of a shipping company during a shipping boom when freight rates are sky high and every shipper is drowning in cash. The freight rates are high because of shortage. This shortage delivers market power to the ship owners, who can demand, and obtain, not only high freight rates, but also advance payments from their customers. These advance payments from customers, will temporarily reduce working capital requirements because receivables will turn into advance payments received.
Alas, such a happy environment is unlikely to last. The entry barriers in shipping are low, even though the gestation period is high. It’s only a matter of time when the supply of new ships will create a glut. Such a glut will have two consequences. One, freight rates will fall. And two, power will shift from shipping companies to their customers, who will now refuse to make advance payments and will insist on very lenient credit terms. For shipping companies, advance payments from customers will disappear, and will be replaced by receivables from customers. There will be dire consequences so far as working capital requirements are concerned: When its float disappears, a shipping company will typically find it hard to stay afloat unless it replaces the free source of finance with debt, or equity. This is happening now in global shipping industry.
This kind of power shift in a value chain is not limited to the shipping industry. You will find it in automobile industry, in textiles, in chemicals — in fact, you’ll find it in any commodity industry having low entry barriers.
In such situations, being impressed with temporary low-cost float during good times, could be a costly mistake. The lesson for long-term investors is clear: Beware of floats derived from shortages in commodity-type industries having low entry barriers. Recall, this lesson is consistent with Buffett’s belief that a float is attractive only if its cheap and enduring and a float produced from temporary shortages is anything but.
Moats & Floats
Let’s now talk about the second source of market power — one which is cheap and enduring, and one which should interest us a lot: Moats.
Buffett uses the metaphor of a “moat” to illustrate a business’s superiority “that make life difficult for its competitors.” A truly great business, says Buffett, must have an enduring moat around its economic castle that protects its excellent returns on invested capital. He writes:
“What we’re trying to find is a business that for one reason or another — because it’s the lost-cost producer in some area, because it has a natural franchise due to its service capabilities, because of its position in the consumer’s mind, because of a technological advantage or any kind of reason at all – has this moat around it. And you throw crocodiles and sharks and piranhas in the moat to make it harder and harder for people to swim across and attack the castle.”
Finally, we have reached the point which I wanted to make at the very beginning of this long series! Professors are rarely known for their brevity 🙂
The point is this: Floats and Moats go together.
Think about it. What kinds of companies can operate with negative working capital (e.g. Nesco) or even negative net operating assets (e.g. HUL)? What power do such companies possess over their customers and suppliers, who happily (or even unhappily) finance their working capital (Nesco), or even the entire capital (HUL) employed by the business?
The answer, of course, is companies which possess enduring moats. While, HUL’s moat is derived from the company’s brands and distribution network, Nesco’s moat in its exhibition center business is derived from scarcity.
How Floats Lever Returns
HUL’s moat is much more powerful than Nesco’s and that’s reflected in its negative net operating assets. All of HUL’s operating assets are financed by its float, while only part of Nesco’s assets are. Nevertheless, float in both cases levers up return on invested capital for both the companies.
To see how floats lever up returns on invested capital, consider that one of the consequences of a solid moat is that it enables a business possessing such a moat to earn excellent returns on its invested capital. Earning excellent returns on invested capital, in fact, is a pre-requisite for spotting a moat, according to Buffett. He writes:
“A good moat should produce good returns on invested capital. Anybody who says that they have a wonderful business that’s earning a lousy return on invested capital has got a different yardstick than we do.”
Notice, he used the term “invested capital” which is the capital provided by investors — debt as well as equity — and does not include funds provided by floats. He did not use the term “total assets” although most great businesses possessing enduring moats will have good returns on assets and on invested capital.
How can a business earn excellent returns on invested capital? There are only two ways to do it: (1) maximise the numerator i.e. returns; and/or (2) minimise the denominator i.e. invested capital.
A moat (whether derived through pricing power or a sustainable low-cost advantage) can help the business achieve (1). A free, or a low-cost float (derived, of course, from an enduring moat) can help it achieve (2). How so? Let’s see how this happens in case of HUL and Nesco.
For FY12, HUL earned pre-tax profits of Rs 3,500 cr. On total assets of Rs 11,407 cr., this translates into a return on assets of 31%, which is fantastic. But, when we recognize that out of total assets of Rs 11,407 cr., float contributed Rs 7,727 cr., leaving only the balance 3,680 cr. to be financed by equity, then the pre-tax profits on equity get levered up to 95%.
Similarly, for FY12, Nesco earned pre-tax profits of Rs 97 cr. On total assets of Rs 381 cr., this translates into a return on assets of 25%. But, when we recognize that out of total assets of Rs 381 cr., float contributed Rs 91 cr., leaving only the balance Rs 290 cr. to be financed by equity, then the pre-tax profits on equity get levered up to 33%.
Think of it this way. A business may employ a large amount of assets, but such a business — because it has an enduring moat may enjoy significant market power over its vendors and customers. The business exercises its power over its vendors by insisting on, and getting away with, very lenient credit terms from them. In addition, power is also exercised over customers by insisting upon, and getting away with, receiving advance payments & deposits from them. The vendors and customers don’t have a choice. They have to adhere to the terms dictated by the business because for them, there is no other alternative. This market power, exercised in the manner described, results in the ability of the business to operate with negative working capital which reduces, or sometimes even eliminates, the need for stock and bond investors to invest anything in the firm’s operating assets. Invested capital (the denominator) is minimised, which results in a jump in return on that capital.
Let me give you another example — this time from USA.
Each side of the Amazon.com’s balance sheet — assets as well as liabilities — totals to $25 billion. The breakup of asset side is as under:
Financial Assets (Cash and cash equivalents and marketable securities): $10 billion
Operating Assets: $15 billion (balancing figure)
Total Assets: $25 billion.
Here’s the breakup of the liability side:
Equity: $8 billion
Debt: $ Nil
Float: $17 billion (balancing figure)
Total Liabilities: $25 Billion.
Amazon.com enjoys a float of $17 billion even though it employs only $15 billion of operating assets! No wonder it’s a debt-free company. But, how does it get so much float?
The main contributor towards Amazon.com’s float is accounts payable of $11 billion, which, when compared with inventories of $5 billion and accounts receivable of $3 billion result in a negative working capital of $3 billion. By keeping inventories low, by ensuring customers pay amazon.com quickly, and by taking longer to pay its vendors, Amazon.com has been able to build a huge float. In addition, the successful Amazon Prime service and sale of gift certificates enables the world’s largest online retailer to collect funds from customers in advance.
In 2011, amazon.com pre-tax earnings were $934 million, which when compared with total assets of $25 billion translate into a return of only 3.7%, but when compared with Equity of $8 billion, gets levered up to 12% ROE. Considering the prevailing low interest rates in USA, that’s not bad at all.
Amazon.com is a wonderful example of a situation where return on assets is mediocre, but return on equity is good, simply because the company has access to large amounts OPM on favourable terms. It’s the float which makes amazon.com profitable and it’s the float that keep the company debt-free. If you were to value amazon.com, you’ll have to think very hard about two questions: (1) How likely is it that amazon.com’s float is truly costless; and (2) How long will it last?
A Pattern and A Few General Principles
if you look carefully at the worlds’s debt-free companies (e.g. look at BHEL, BEL, EIL, Wipro, Infosys, Intuitive Surgical, and Apple) a pattern emerges. Many of these companies will, apart from being debt-free have the following additional characteristics:
- Substantial financial assets;
- Negative working capital, or sometimes even negative net operating assets arising out of large amounts of trade credit and/or advances from customers as compared to to investment in inventories and receivables; and
- An excellent return on invested capital caused by a high return on assets, which gets further levered up by usage of a free float.
In other words, where there are large enduring floats, you will find moats. This makes moat hunting an objective exercise, doesn’t it? Apart from looking for signs of moats indicated by high switching costs, low-cost advantages, intangible assets, and network effects as Pat Dorsey does in his wonderful book “The Little Book that Builds Wealth,” you may also spot an enduring moat by simply looking for the above pattern.
Finally, in your hunt for long-term high-quality businesses, as you witness the proximity between floats and moats, you will also discover that all floats are not the same. In particular, you will discover the following general principles:
- Floats are wonderful if they cost less than nothing. They are also wonderful if they are free or have a very low cost as compared to alternate sources of finance like debt or equity;
- Enduring floats which arise due to market power delivered by strong moats are more valuable than floats arising out of temporary shortages;
- The true value of a liability represented by an attractive float is far lower than its accounting value and that’s why assets financed by such floats become an unencumbered source of value for stockholders;
- Floats may be enduring even though they are classified as current liabilities because what matters is the balance in the account and not the liability towards a given person (e.g. when the security deposit from one customer is replaced by the deposit provided by a new customer);
- As a moat narrows, because of technological obsolescence or any other reason (think Kodak, MTNL, RIM), you will notice a gradual decline in the firm’s market power as measured by diminution of negative working capital and gradual increase in debt and/or equity to finance necessary investment in inventories and receivables;
- Floats in technology firms are less likely to be enduring as compared to floats generated by dominant FMCG companies; and
- Floats provided by millions of small customers (e.g. travellers checks, stored value cards, security deposits for gas connections) are likely to endure for longer than floats provided by a handful of vendors and customers.
Happy Moat Hunting!
Acknowledgements: I’d like to thank Priyank Sanghavi and Ankur Jain with whom I had extensive and very helpful interactions on the subject of floats and moats which helped me formulate my thoughts on the subject.