Beating the Street (26 page)

Lately, General Host had divested itself of the pretzels, the salt, the TV dinners, the farm stores, and the frozen fish in order to concentrate on 280 Frank's Nursery outlets located in 17 states. What impressed me from the outset was the fact that the company had a long-term program to buy back its own shares. Recently, it had bought some back for $10 per share, which tells you that in the company's own expert opinion General Host must be worth more than $10 per share—otherwise, why would it waste all this money on itself?

When a company buys back shares that once paid a dividend and borrows the money to do it, it enjoys a double advantage. The
interest on the loan is tax-deductible, and the company is reducing its outlay for dividend checks, which it had to pay in after-tax dollars. A few years ago, Exxon's stock was so depressed that it was yielding 8–9 percent. At the time, Exxon was able to borrow money at 8–9 percent to buy back millions of these dividend-paying shares. Since the interest on the loan was tax-deductible, Exxon was really paying only about 5 percent to save 8–9 percent on dividends. This simple maneuver increased the company's earnings without its having to refine an extra drop of oil.

I was impressed by the fact that General Host's stock price had fallen far below the price at which the company had recently bought back shares. When you or I can buy part of a company for less than the company itself has paid, it's a deal worth examining. It's also a good sign when the “insiders,” executives and so forth, have paid more than the current price. Insiders are hardly infallible (those at numerous Texas and New England banks were madly acquiring more shares all the way down) but there are smart people in business who often know what they're doing and aren't inclined to squander money on a fool's errand. They are also willing to work extra hard to make their own investments pay off. This leads us to Peter's Principle #15:

When insiders are buying, it's a good sign—unless they happen to be New England bankers.

So in reviewing the latest proxy statement for General Host, I took it as a good sign that Harris J. Ashton, the CEO and owner of a million shares, had not parted with a single one of them during the recent price drop. Another tempting detail was that the book value of General Host was $9 a share, which exceeded the price of this $7 stock. In other words, the buyer of the stock was getting $9 worth of assets for $7. This was my idea of money well spent.

Whenever book value comes up, I ask myself the same question we all ask about the movies: is this based on a true story or is it fictional? The book value of any company can be one or the other. To find out which, I turn to the balance sheet.

Let's take a closer look at General Host's balance sheet, to illustrate my three-minute balance sheet drill. Normally, there's a right side and a left side to a balance sheet. The right side shows the company's liabilities (that is, how much money it owes), and the left
side the assets (that is, what it owns). Here, we've printed a portion of the left side on page 171 and the right on page 172. The difference between the two sides, all the assets minus all the liabilities, is what belongs to the shareholders. This is called the shareholders' equity. Shareholders' equity is shown as $148 million. Was this a reliable number?

Of the equity, $65 million was cash, so that part certainly was reliable. Cash is cash. Whether the remaining $83 million in equity was a reliable number depended on the nature of the assets.

The left side of a balance sheet, which lists the assets, can be a murky proposition. It includes such things as real estate, machinery and other equipment, and inventory, which may or may not be worth what the company claims. A steel plant might be listed at $40 million, but if the equipment is outdated, it might fetch zero in a garage sale. Or the real estate, carried on the books at the original purchase price, may have declined in value—although the reverse is more likely.

With a retailer, the merchandise is also counted as an asset, and the reliability of this number depends on the kind of merchandise that it sells. It could be miniskirts that have gone out of style and are now worthless, or it could be white socks that can always attract a buyer. General Host's inventory consisted of trees, flowers, and shrubs, which I assumed had a decent resale value.

A company's acquisitions of other companies are reflected in the category marked “Goodwill” (or, in this case, “Intangibles”), shown here as $22.9 million. The goodwill is the amount that has been paid for an acquisition above and beyond the book value of the actual assets. Coca-Cola, for instance, is worth far more than the value of the bottling plants, the trucks, and the syrup. If General Host bought Coca-Cola, it would have to pay billions for the Coca-Cola name, the trademark, and other intangibles. This part of the purchase price would appear on the balance sheet as goodwill.

Of course, General Host is too small to buy Coca-Cola, but I'm just using this as an example. The balance sheet indicates it has acquired other businesses in the past. Whether it can ever recover these goodwill expenditures is open to speculation, and in the meantime it gradually has to write off the goodwill with part of its earnings.

Table 9-1. CONSOLIDATED BALANCE SHEET—GENERAL HOST CORPORATION

I can't be certain that General Host's $22.9 million in goodwill is really worth that much. If half of General Host's total assets consisted of goodwill, I would have no confidence in its book value or in its shareholders' equity. As it turns out, $22.9 million in goodwill out of $148 million in total assets is not a troublesome percentage.

We can assume, then, that General Host's book value did approximate the $9 per share that was claimed.

Turning to the other side of the balance sheet, the liabilities, we see that the company had $167 million in debt to go along with the $148 million in equity. This
was
troublesome. What you want to see on a balance sheet is at least twice as much equity as debt, and the more equity and the less debt the better.

A high debt ratio like this would in some cases be enough to cause me to take the company off the buy list, but there was a mitigating factor: much of this debt was not due for several years, and it was not owed to banks. In a highly leveraged company, bank debt is dangerous, because if the company runs into problems the bank will ask for its money back. This can turn a manageable situation into a potentially fatal one.

Back on the left side, I circled merchandise inventory, which is always something to worry about with retailers. You don't want a company to have too much inventory. If it does, it may mean that management is deferring losses by not marking down the unsold items and getting rid of them quickly. When inventories are allowed to build, this overstates a company's earnings. General Host's inventories had decreased from previous levels, as shown in
table 9-1
.

A hefty accounts payable is OK. It shows that General Host was paying its bills slowly and keeping the cash working in its favor until the last minute.

In the text of its annual report, General Host described how it was engaged in a vigorous campaign to cut costs in order to become more competitive and more profitable—like everybody else in America. Although most companies make such claims, the proof is in the S, G, and A category (selling, general, and administrative expenses) on the income statement (see Table 9-2). You'll note here that General Host's S, G, and A expenses were declining, a trend that continued into 1991.

It turns out that General Host was taking several steps—both on earth and in outer space—to improve its fortunes. On the terrestrial level, the company was adding new scanning devices to automate its checkout system. The record of each transaction would then be beamed up to a satellite and then down to a central computer. This satellite system, when put into place, was expected to keep track of all the sales in all the nurseries, to help management know when to restock the poinsettias and whether to transfer, say, some hibiscus bushes from the Fort Lauderdale branch to the Jacksonville branch.

In addition, credit card authorizations were being speeded up from 25 seconds per sale to about 3 seconds, to make the lines at the cash register move faster and add to customer satisfaction.

Following the same course as Sunbelt Nursery, General Host was planning to enclose a section of each of its Frank's Nursery outlets to extend the selling season. In addition, it was installing Christmas kiosks in shopping malls during the holidays. This wasn't just a harebrained scheme—General Host had experience in the kiosk business from having deployed more than 1,000 of them to sell its Hickory Farm products.

This is a cheap way for a retailer to add selling space. Already, General Host had installed more than 100 Frank's Nursery kiosks—stocked with gift wrapping, Christmas trees, wreaths, and boughs—in shopping malls in 1991, and the company planned to increase the number to 150 kiosks by Christmas 1992. It was also taking steps to enclose the kiosks and make them more permanent.

Meanwhile, General Host was opening new Frank's Nursery outlets at a steady and careful pace. The goal was to create 150 new Frank's by 1995, bringing the total to 430. The company also launched a new private-label line of fertilizers and seeds.

Every company in existence likes to tell its shareholders that business is going to get better, but what made General Host's assertion believable was that management had a plan. The company wasn't waiting for begonia sales to improve, it was taking concrete steps (the kiosks, the remodeled nurseries, the satellite system) to boost its earnings. When a business as old-fashioned as Frank's is modernizing on all fronts and expanding at the same time, there are several chances for the earnings to improve.

A final reassuring detail was the Calloway's transaction. In 1991, General Host had sold off the Calloway's nursery chain in Texas, and it used the proceeds to reduce its debt, thus strengthening its balance sheet.

Since General Host was now confined to the nursery business, the same as Calloway's, the Calloway's sale gives us another chance to compare two similar enterprises. Once again, I took out my most sophisticated investment tool, a 15-year-old hand-held calculator, to do the following math:

Calloway's, with 13 stores, was valued at $40 million—or roughly $3 million per store. General Host owned 280 Frank's Nursery outlets, or 21 times as many stores as Calloway's. The Frank's outlets were older, smaller, and less profitable than the Calloway's stores, but even if we assume they were half as valuable ($1.5 million per store), the 280 Frank's stores ought to have been worth $420 million.

So General Host had a $420 million asset here. Subtracting the company's $167 million in debt leaves you with an enterprise worth $253 million.

With 17.9 million shares outstanding, this means that General Host's shares ought to be selling for $14, or twice the price at the time I made the calculation. Clearly, the company was undervalued.