Reading a company’s financial statements used to be simple.
Assets were stated at their acquisition costs, so you knew what had gone into the business. There were no derivatives, so the income statement more or less reflected the business’s true operations.
Of course, corporate managements tried to game the system – the late 1960s were full of accounting scams of one sort or another. But once the rules had been tightened up after the 1970s bust, what you saw was what you got.
Today, that’s no longer the case… and this change has created wonderful opportunities for anyone, including the income investor, who’s able to make sense of our complex world.
The Mark-to-Market Nightmare
The most damaging change in accounting rules is mark-to-market accounting, by which assets are revalued at the end of each year according to market price rather than held in the books at cost.
Mark-to-market accounting was originally devised as a way to keep brokerage houses honest, so they couldn’t fiddle the books at the end of the year to pay higher bonuses. But it spread to banks on both sides of the balance sheet, with absurd results. For example, the big banks showed large profits in 2008 as their credit quality declined, because their liabilities were worth less.
Today, mark-to-market accounting has spread even further to the fixed assets of industrial companies. In the third quarter of 2014, for example, the iron- and coal-mining company Cliffs Natural Resources (CLF) was forced to take a $5.7-billion charge, net of tax ($7.7 billion gross) on its coal and iron ore fixed assets because the price of both commodities had declined. It had nothing to do with any long-term change in the coal and iron ore businesses.
On an operating basis, the price decline didn’t result in heavy losses that might have threatened Cliff’s survival; on the contrary, the company recorded a modest operating profit in the quarter.
Yet as a result of the accountants’ markdown, Cliffs’ equity was reduced from a comfortable $6.9 billion (against which $3 billion of long-term debt looks manageable) to a ridiculous negative $177 million. On a book accounting basis, therefore, the company is balance-sheet insolvent.
Beware the Corporate Raiders
But in the real world, this makes no sense at all. Fixed assets, which were valued at $11.1 billion before September – presumably their approximate historic cost – aren’t suddenly worth $3.2 billion. To replace them today would probably cost considerably more than $11 billion, not less.
On top of that, these assets are expected to earn income over a life span of decades, and that income can reasonably be expected to fluctuate depending on mineral prices. Thus, periods of low earnings will be balanced by periods of bountiful profit and cash flow, such as 2010 to 2011 – but only for those who already had such assets in place and in full operation.
The real danger for Cliffs’ shareholders is that the false value imposed on their assets by the accountants weakens their bargaining power against a corporate raider.
Normally, a takeover offer of, say, $15 per share would look ludicrous compared to Cliffs’ pre-September book value of close to $40 per share. It’s even unreasonable compared to Cliffs’ “true” net asset value in today’s depressed markets of perhaps $30. Yet, a $15 offer might, given the company’s negative $1.20-per-share book value, tempt the more foolish speculators to sell out.
Ultimately, the ones being ripped off are stable, long-term Cliffs shareholders.
A Bonding Moment
Nevertheless, Cliffs remains an interesting play for income investors right now.
You see, even though the new U.S. environmental regulations on coal-fired power stations are a long-term threat to the domestic coal business, the impact should be curtailed by the recent GOP takeover in the Senate. (In any case, many of Cliffs’ coal assets are in Australia and are dependent on burgeoning Chinese power station demand.)
Additionally, Cliffs made a profit in its third quarter, excluding the write-off, and it had an EBITDA of $233 million – ample for debt service. With a yield of 5.6%, the shares are somewhat attractive. However, they remain dangerous for income investors because another difficult quarter or two might result in a dividend cut.
On the other hand, Cliffs’ bonds are a very interesting opportunity for an income portfolio.
Although Cliffs’ balance sheet currently shows negative equity, its debt is still rated BB-plus by Morningstar, one grade below investment level. Standard and Poor’s is slightly less optimistic, rating the bonds BB-minus, but either way, Cliffs’ yield is higher than the current average BB corporate debt yield of 4.68%.
The 4.875% bonds of April 2021, of which there are $700 million outstanding, are currently trading around 75% of par. That gives a running yield of 6.5% and a yield to maturity of 10.3%, and it means income investors can score a higher and safer yield than the shares offer.
Plus, investors should also benefit from a capital uplift – either when the bonds are repaid at 100% in April 2021, or beforehand, if iron ore and coal prices rise and lift the bond price.