Strategy To Tactics: Pilgrim's Pride And Balance Sheets 101
Feb. 11, 2015 7:49 AM • ppc
- Everyone should know how to read a balance sheet.
- Those with small portfolios should learn to glean as much information as they can as quickly as they can.
- Balance Sheets tell a story about a company's health and structure that even beginners can see when they know how.
- Pilgrim's Pride balance sheets provide useful practice reading balance sheets and provide us an opportunity to evaluate a potentially under valued company.
As part of a series I'm doing on the very basics of fundamental investing (particularly for small investment portfolios), I recently wrote an article surveying the income statement of Pilgrim's Pride Corporation (NASDAQ:PPC ). The overall goal of that article was to establish baseline knowledge on what is commonly on an income statement. In addition, I hoped to start the reader down the road of teasing information out of the income statement and interpreting whether a company is growing its profitability in a sustainable fashion.
This article continues the process with the Balance Sheet. In my opinion, a strong understanding of the balance sheet is crucial to fundamental analysis. If, (strangely) I could only look at one financial statement on a company, I would choose the balance sheet.
From the growth of assets and shrinking of liabilities, an investor can infer how profitable a company may be, how it is structured, whether it is likely to go bankrupt, and whether there are signs of aggressive accounting or shenanigans.
What is the Balance Sheet?
The Balance Sheet very simply gives the investor a snapshot of what the company owns, owes, and what is left over for shareholders at a given point of time. The balance sheet holds true to the fundamental building block of accounting; that assets= liabilities + equity. This is common sense, if we think about it. We, as equity owners, can only own our share of assets left over after debts are paid off.
It seems so simple. We need only look at a balance sheet, look at how much equity is left over, and determine a price we are willing to pay for that equity. Of course, as always, the devil's in the details. We need to look at the specifics of the balance sheet, and how the different categories of assets, liabilities, and equity change over time in relation to each other, to get a feel of how the company is performing. This gives us a truer sense of what a fair asking price for that equity might be.
Since we started the analysis with Pilgrim's Pride Corporation (PPC ), we will continue with PPC. Without further ado, here is PPC's Balance Sheet.
Just as we saw in the previous article, the balance sheet represents three years. We could also choose quarterly balance sheets as well. The income statement showed activities throughout the year, but the balance sheet shows the state of affairs at a particular moment. For instance, on December 29, 2013 PPC had $508,206,000 in cash. We don't know what they had on Dec 28, or what they had on Dec 30, and we don't care. We can get a good enough idea of the structure of the company using quarterly and annual time periods.
As I said before, the balance sheet is broken down into assets, liabilities, and equity, and we'll break the conversation into the same categories.
Current assets are fairly liquid assets that the company expects to sell or use up within a year. The company should be valuing its current assets conservatively. For instance, short term investments should be recorded at the lesser value of either the current market value or the price the company paid. PPC's current assets are broken down into the following categories: cash and cash equivalents, short term investments, net receivables, inventory, and other current assets. These are pretty standard categories, though you may see some variations.
We can see from the total current asset row that assets are increasing over the past three years. More importantly, the current assets that we care about most are increasing. Not surprisingly, this should please us.
Cash and cash equivalents
Cash and cash equivalents are the name implies; assets that are cash or are just as liquid as cash. Obviously, we want to see this increasing. Since cash is the most liquid asset, it provides the greatest moat when dealing with liabilities, and it provides the greatest flexibility when taking advantage of short term opportunities. When company's hoard cash, some investors will view the stock negatively. The idea is that the company should be pursuing more opportunities, and is too conservative to keep up with its competitors in the long run. As with everything, there are excesses, and you will need to balance pros and cons between safety and return.
PPC's cash is increasing very rapidly (at least from 2012-2013). Since we don't see current debt skyrocket, and we don't see other slightly less liquid assets drop of the scale, we can conclude most of this cash comes from profits. We can look at the income statement, and later the cash flow statement to confirm this.
Short term investments :
Short term investments include T-bills and other investments that can be converted into cash. Along with cash, PPC's short term investments grew from 2012 2013. This combination is comforting as an investor. Not only is PPC clearly becoming profitable, but they are building a substantial moat which should help them avoid falling into bankruptcy again without some warning signs to investors.
Net receivables are short term payments owed to the company by other customers (individuals or other companies) for purchases of the company's products or its services.
Net receivables can be a double edged sword. We can see PPC's net receivables creeping up over the years, growing 2.72% from 2011 to 2012 and then 1.13% from 2012 to 2013. This is not phenomenal growth, but slow growth like this is positive. Particularly, since we see a greater growth in cash over the same time periods, and we do not see a growth in debt taken on.
Were we to see rapid growth in accounts receivable, but smaller growths in cash, or losses in cash, we would have some concerns. Our major concern would be that PPC's credit terms were too generous, and could cause cash flow problems over time. Selling products on generous credit terms is nice, but ultimately, bills have to be paid, and the money from sold products has to be collected to do that.
In addition, accounts receivable is a handy place for companies who engage in account shenanigans to shift assets back and forth. AR accounts that grow or shrink suddenly or are out of proportion of sales, cash, growth rates bear watching. I will talk about this more in later articles.
Inventory includes finished goods ready for sale, but also the raw materials and works in progress that will become finished goods. This is one asset that we do NOT want to see build up significantly over time. Relatively stable inventories show that the company is forecasting sales properly. Rapidly decreasing inventories could indicate unexpected sales, or problems on the production side. Rapidly increasing inventories could indicate an unexpected drop in sales or poor production management. Both situations bear investigation. Look to the annual reports, as well as sales or revenue columns on the income statement. If the annual report does not spell things out for you, you should be able to infer what's going on from the company's revenue performance.
Fortunately for us, PPC to have relatively stable inventory numbers. It's worth noting that inventory for PPC consists of live chickens, feed, slaughtered chickens etc. It's important to note where costs can easily fluctuate. In this case, the price of feed drives inventory prices, and ultimately cost of goods sold. We can move on in our investigation.
Other current assets
Other current assets are non-cash assets which are due within a year, such as prepaid expenses. If other current assets constitute a large percentage of the company's current assets, you are going to want to do a word search for "other current assets" in the company's annual report and determine what the assets are. For most cursory investigations, researching the details is not worth the effort. As your investments get larger however, these are the details you are going to want to take the time finding out.
Long term investments are those investments with a greater than a year time horizon. These can be minority stakes in other companies, or commodity hedges to lessen the impact of raw material cost changes.
Unless they constitute a large portion of the asset column, long term investments should not concern us greatly. In this particular case, PPC does not have any long term investments listed (as of 2013).
Property, Plant and equipment
Sometimes Property, Plant and Equipment (PP&E) is simply referred to as fixed assets. PP&E is the estimated value of business property, buildings, and large scale equipment. PP&E changes over time as property values increase, and as buildings and equipment depreciate. Appropriate levels are dependent on what type of business the company is. Consequently, PP&E is more useful when compared either to similar companies, or across several time periods.
PP&E growth or shrinkage can tell you many things. Dramatic reduction in PP&E accounts may indicate that the company will need to use assets up soon to invest in new equipment or buildings. Dramatic rises in PP&E can explain away drops in cash as necessary and less detrimental, than other cash drops.
PP&E give us an idea of how fast a company can adapt to new innovations or trends shaking up its industry. Companies with very large investments in PP&E compared to their book value may have more difficulties in adapting and retooling than smaller more nimble competitors.
Pilgrim's Pride has a relatively steady PP&E account, hovering around 1.2 Billion dollars. But values are decreasing, and we must anticipate sometime down the road, Pilgrim's Pride will have to invest money into fixed assets to continue operations. Since the numbers are relatively stable, small investments should be adequate. Were we to see numbers drop precipitously, we would anticipate large investments, barring very unusual circumstances.
When a company purchases another company, they often pay more than tangible value. Anything paid over the tangible value is added to the goodwill column. Another way of looking at it, is that goodwill is the value of all intangible assets gained from acquisitions.
I don't look at goodwill much during my analysis, but large and growing pools of goodwill make me nervous. Goodwill can be distorted to raise asset values. Later, goodwill can be written off, resulting in a "surprise" drop in overall book value.
Furthermore, Goodwill is an indication that the company paid premium on tangible assets to gain supposedly "valuable" intangible assets. But if goodwill is growing as a proportion of total assets over time, it is clear management is not as good at acquiring intangible assets as it thinks it is.
Pilgrim's Pride lists nothing under goodwill for the years we are examining.
Intangible Assets lists the estimated value of the company's trade secrets, patents, and other intellectual property. Intangible assets can be strong revenue providers for companies and are an important part of business, but at this level of analysis, they do not bear strong importance.
Accumulated Amortization is not a common entry. It is the total amount of all amortization that has been levied against the intangible assets account, and is intended to account for the gradual reduction in value that even intangible assets will have over time. As intangible assets lose value, we can expect to see numbers increase in this column.
Other assets is a catch all for miscellaneous long term assets that do not fit in any other category. Again, we are forced to refer to the annual report to determine what these assets are. Unfortunately, PPC does not directly spell out the contents of their (long term) other asset account, but lists many miscellaneous and unusual assets that are placed in several different accounts. Many assets come from an agreement made with the Swift Pork Company to sell real estate, tractors, inventory, livestock and other assets. These assets could be placed in both short and long term other assets as well as A/R, inventory and other accounts based on GAAP specific rules. At this level of analysis, it's difficult to parse out where things went exactly. Fortunately, these assets constitute less than 2% of total assets (1.2% in 2013) and are shrinking by about .4% per year. For a surface evaluation of PPC, they are practically irrelevant.
Deferred Long term asset charges
This is not a particularly important section of the balance sheet, and should never be a significant portion of the asset column. Similar to prepaid expenses, deferred long term asset charges are expenses that the company has paid, but has not accounted for in the asset column. In PPC's case, the differed asset charges are less than 1% of total assets and falling rapidly.
Much like current assets, current liabilities are debts due or expected to be paid off within one year. This time we want to see current liabilities decreasing, or at least growing at a slower pace than current assets. In addition, we want to see current assets at a greater level than current liabilities. A company without enough liquid assets to pay its immediate debts is going to weather any headwinds poorly.
In our case, PPC current assets do indeed exceed current liabilities for all displayed time periods. In addition, current assets rose almost 5.4% from 2011-2012, while current liabilities only rose 1.8%.
However, the next year, current assets only rose 25% while current liabilities rose 48.37%. If this situation persists, PPC is going to find it
harder to meet its yearly obligations. Since this is a company emerging out of bankruptcy
Accounts Payable is money the company owes for purchases made on credit. Think of it as the inverse of accounts receivable. As conservative investors, we want to see it decreasing over time, though some accounts payable balance is acceptable. If other vendors offer our company favorable credit terms, there is no harm taking advantage of it.
In PPC's case, we see accounts payable gradually shrinking. This is a positive sign, and we will look for this to continue.
Short/Current Long Term Debt
Portions of long term debt that are due within the upcoming year. As long as we see a corresponding drop in long term debt AND current assets still exceed current liabilities, fluctuations in this account should not concern us. Once you have begun to analyze companies at a deeper level, you will probably want to dig into the annual report and chart out when large payments will come due for heavily leveraged companies. For now, it's sufficient to glance at this column and ensure the company is not taking on debt to pay for its debt as it comes due.
Other Current Liabilities
Other current liabilities is a hodgepodge of short term liabilities not fitting into accounts payable, or short/current long term debt, forcing us again to consult the mighty annual report. PPC lists nothing under other current liabilities.
Long Term Debt
Debt, such as issued bonds, leases, or other types of financing that come due over a year from the date measured on the balance sheet are deemed Long Term debt.
Debt has its place in corporate structure. A company can fund projects through issuing debt, selling equity, or paying with cash directly from operations. Cash is the least costly option, but most opportunities are likely to cost most companies far more money than they have on hand. Selling equity (issuing shares) is more appealing when share prices are very high vs. "fair value", but since calculating fair value is a bit of a guess, there's plenty of room for managers to make suboptimal decisions about when to sell stock. Besides, the market whims move up and down without regard to company funding needs.
Debt, however, is always available (at greater or lesser costs), and comes with the handy side benefit of providing a tax shelter (debt costs are subtracted before taxes are calculated). Consequently, we don't mind seeing debt, we just like to see it at manageable levels. That way, the cost of debt, which tends to go up as debt levels go up, doesn't restrict the company's ability to do business. In addition, the less debt the company has, the more room it has to issue debt in the future if profitable ventures present themselves.
We can measure a company's structure by dividing debt by equity, called the debt/equity ratio. Unfortunately, there are many different ways of calculating this number, so you may want to find an appropriate methodology and calculate the number yourself. That way you know, as you compare debt/equity from one company to another, that you are using an apples to apples comparison.
Personally, I take long term debt (plus current portion of long term debt) and divide it by total stockholder equity.
In Pilgrim's Pride's case, Long Term debt/equity ratios have fallen from 256.22% to 61.2% in three years. If we were only to look at the long term debt total at the end of 2013 ($500 Mil), we might conclude that the company has substantial debt and chalk it up as bad news. In reality, the company is emerging from bankruptcy and is improving its debt levels rapidly. Debt levels at the end of 2013 are still a little higher than I would like. I prefer debt levels at 50% or lower. However, value is rarely found in perfectly healthy companies. It is entirely possible that the market has not fully valued the decline in debt. Although this information is publicly available, market reactions for smaller and less exciting companies can lag and present value. If so, discount free cash flow analysis, common sense, and finding these patterns of improvement in the financial statements can reveal value that others are momentarily ignoring.
Other liabilities is another catch all, this time for miscellaneous long term liabilities.
Deferred Long Term Liability Charges
If the company enters a long term contract to purchase product, or exchange currency at a future date, it may know it is obligated to pay a certain amount upon delivery of product. The company wants the cost of goods to match possession of the product, so it accounts for the obligation under deferred long term liability charges. Later the account will be moved to accounts payable, and finally subtracted from cash when paid out.
Like many of the other ambiguous charges, you can research details on deferred long term liability charges by reading footnotes in the annual reports. As long as these figures stay relatively constant from year to year, I would not put much emphasis on this entry (in a cursory investigation). If the figure rises significantly, it's worth investing more time to determine whether the company is not engaging in shady accounting.
Minority Interest is the value of the equity a company (as a minority shareholder) owns in its subsidiaries. So, as an imaginary example, if PPC bought up Dirty Tom's turkey & pigeon "sanctuary", they could record all the assets as their own. However, if PPC only bought 90% of DTT&PS, they could only record 90% of the assets as their own. 10% of those assets still belong to Dirty Tom and his extended family, and that 10% should be recorded under minority interest.
In what's becoming a theme, PPC does not spell out its share of its subsidiaries. It is difficult for me, at a glance, to break out what companies PPC holds interest in. Furthermore, the last annual reports I could find on their website are from 2012. The lack of transparency is a red flag in my mind.
This seems counter intuitive at first, but negative goodwill is recorded when a company purchases another company for less than its tangible book value, often from a distressed seller. The difference between the purchase price and tangible value is considered negative good will.
In PPC's case, there is no negative goodwill recorded. If there was, I would view it with cautious optimism. Cautious because assets gained from distressed companies can come with their own baggage (lawsuits, liens etc). But I like a company that is healthy enough and hungry enough to find bargain assets and pick them up below book value.
Miscellaneous Stocks Options Warrants
Stock warrants are issued by the company, and when exercised result in the production of new shares. While stock warrants may be a good deal for those acquiring them (they are often cheaper than options, and they typically don't expire for years), they should prompt caution from us as we pursue the balance sheet. If there are significant outstanding warrants (depicted in dollar amounts), we can expect noticeable stock dilution down the road as they are exercised. In Pilgrim Pride's case, there are no outstanding stock warrants.
Of course companies typically issue equity rather than warrants to raise money. Usually, they issue direct shares of the company profit, we call "stock". There are two main categories of stock shares. Preferred stock is the bigger brother of the two, with first access to the company's assets right after debt holders.
Common stock is the other category of shares, and probably what you are familiar with. There are a few things to note about common stock. First, shares of common stock are not "guaranteed" dividends in the way preferred stocks are. If dividends get cut, the company is not going to pay the missed dividends down the road. Next, common shares are the bottom of the food chain in a liquidation. Whatever is left after debt holders and preferred stock holders get their share is handed out to common shareholders (there won't be anything).
More to the point, we care about how common share totals are trending. Are they increasing over time? Than the company is selling shares. This isn't necessarily bad, but is worth noting. If you are holding shares, the company is diluting them with its sales. You had better be confident the company is using the money they are raising in a way that will ultimately result in more money per share. The inverse is also true. A decreasing total implies the company is buying back shares. If shares are underpriced, this can be a good thing. Or the company could be spending money on shares because it is too lazy or incapable of finding useful places to invest that money otherwise.
In Pilgrim Pride's case, outstanding stock rose by 20% from 2011 to 2012, but then remained constant following that. A diligent investor should remain cautious for continuing dilution because the company may try to hide some of its funding woes with further stock sales, rather than take on additional debt.
Retained earnings are the company's cumulative net earnings after dividends are paid. You can think of them as the company's savings account. We want to see this number increase over time, although the company will take big hits to retained earnings when it makes big investments, not just when they turn a loss instead of a profit.
Pilgrim's Pride increased their retained earnings by $174 Million from 2011 to 2012, and another $550 Million from 2012 to 2013. They are well on their way from bankruptcy to positive holdings in Retained Earnings, and I can't view this as anything but positive news.
These are shares in the company that are NOT outstanding. The company has retained these shares, or bought them back. Either way, no dividends are paid on these shares and we can mostly ignore them.
This is equity that cannot be categorized as retained earnings or outstanding stock. Normally, capital surplus results when a company issues shares at a "par value", but sells the shares for more than par value. The additional money is considered capital surplus. For now, you can ignore this amount in your analysis.
Other Stockholder Equity
Other Stockholder Equity is where an assortment of gains and losses that do not belong on the income statement are annotated. Unrealized gains and losses on securities, derivatives, hedges and conversions of foreign subsidiaries can be recorded here. If this is a substantial number, you will have to visit the annual report for clarification. I would steer clear of any company where the majority of the equity listed is under "Other Stockholder Equity". It indicates that the company is extremely leveraged, and possibly manipulating numbers to disguise some of their leverage.
While Pilgrim Pride's other stockholder equity account was not enormous, it was consistently negative, and not insignificant dollar amounts (averaging around 50 million). As was all too common in my research, Pilgrim's Pride was vague about what constituted "Other Stockholder Equity". The information is undoubtedly buried in their report, but I could not find it with a search that was intended to be quick and dirty, but ended up being more thorough than I intended.
What story does the balance sheet tell us about Pilgrim's Pride?
We can visually see the company emerging from bankruptcy, and so far it looks successful. Current assets are rapidly rising and long term assets are slowly rising. In the last installation, we noted that interest expense was falling on the income statement. Here we can directly see long term debt falling rapidly. Furthermore it appears that Pilgrim's Pride is improving their financials through legitimate profits, as accounts payable are decreasing and there is no dilution through stock sales after 2011. In addition, PP &E have not depreciated significantly, so the company doesn't appear to be funding growth by abandoning investments in necessary capital assets. Furthermore, despite significant debt payoff, we see retained earnings growing, and the next annual statement should show retained earnings in positive territory.
We also noted that there are many "misc" and "other" accounts that could use in depth research. However, as long as these accounts remain very small percentages, and, as they do in many cases, continue to decline, we do not need to assign too much weight to them. If these misc accounts were to grow suddenly we would need to devote much more time researching them.
Bottom line… On bottom:
Just like the income statement, the balance sheet tells a story. The balance sheet can tell us much of what the income statement tells us, but indirectly. We can assume profitability by seeing how assets and liabilities change over time. But the balance sheet tells us something the income statement can't. It gives us insight into management strategy. From the balance sheet we can see whether the company funds its growth through debt or equity, whether they are paying down debt, or hoarding cash, or how liquid or illiquid the company's assets are. Finally, changes in balance sheet totals hold clues as to whether the company is playing accounting games to hide earnings or revenue weaknesses.
With both the balance sheet and income statement analysis completed we could move on to determine valuation. However, my next article will finish evaluating PPC with the last financial statement, the cash flow statement. Future articles will examine discount free cash flow analysis and other valuation techniques, as well as vertical and horizontal financial statement analysis.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.