Footlocker, the Amazon Effect, Twitter’s Profitability and Accounting Manipulations.

Footlocker (NYSE:FL) is a lean mean machine.

Total Debt to Equity less than 42% and cash at bank covers 95% of total debts. In every year since 2000, has Footlocker produced consistent growing positive free cash flow!

And in Footlockers  2016 annual report, Footlocker spent $266m in capital expenditures to generate $664m in net income and $550m in free cash flow.

Or think of it this way, for every 28 cents spent on capital expenditures Footlocker generated $1 dollar in sales revenues.

But how does it stack up against the checklist and the so called ‘the Amazon effect’?

Hey Bro, can I borrow your checklist?

Yes I said that, it’s quite embarrassing to admit it.

Starting out, I remember reading about how important it is to use a checklist, from people like Charlie Munger, Warren Buffett, and Mohnish Pabrai. I was like, yeah great idea, I started writing out bullet points in word, then a month would passed, and I never did look at it again.

But 6 months later I was thinking about creating a checklist again. But this time I thought I’d just download one from another investment site, so googled it, and downloaded 5 and picked the one I liked. I still haven’t used it or bothered to look at it again.

But why? What was going on here?

It wasn’t until a year later that I realised that the problem wasn’t the checklist, it was the fact that I hadn’t really learnt the fundamental principles of investing. Because right now I could write close to 5 pages of questions related to the most critical aspects of investing in stocks.

Before coming to this insight, I would start to do what all new beginners investors do I’d start writing out subjective questions that everyone on the internet suggests, like ‘can you describe the company to a 6 year?’, ‘Does the company have a moat?’ – Which is meaningless unless you understand the basic elements of a moat – What about this question ‘Is it a business that even a dummy could make money in?’ this question requires a fair bit of experience to answer.

Don’t get me wrong I’m sure they are well intentioned, but the most effective checklists are built around your current experience and personal unique intrinsic characteristics.

Why? Let’s take a look why developing your own checklist from the start is essential.

At the start you will instantly realise, as I did, what the size of your own circle of competence is. That is, your level of investment knowledge. You have to be honest with yourself, we all overestimate our own abilities – I certainly did – but I warn you because this exercise is usually emotionally painful.

People will either do two things depending upon your belief system.

The first, which is unfortunately the most common is, people will reject the fact that a gap in knowledge exists and continue to plough ahead. These people blame others for their own misfortunes.

The second type of person, while still feels the pain, will see it as an opportunity to grow. They ask better questions, than the first type of person, questions like ‘What do I need to do to close this knowledge gap?’ and ‘what better habit should I learn?’ and ‘What bad habit should I try to quit?’

Carol Dweck wrote about these two different characteristics in her book the ‘Mindset and referred to our first example as a ‘fixed mindset’ where the person believes that intelligence is based on some innate ability but the second is referred to as a ‘growth mindset’,  where the person believes their success is based on hard work, learning, training and doggedness.

But the moment you get real with yourself, adopting the growth mindset you recognise that gap between the knowledge you have and the knowledge you need, you can than begin gaining knowledge and experience that supercharges your results.  

Not knowing how to create a basic checklist was my wakeup call, knowing that I had to fill the gap in knowledge of those fundamentals of investing. What are those fundamentals of investing? Let take a look.

Prioritize cash flows over accounting earnings.

Twitter (NYSE:TWTR), I would have written it off if I had not understand the basic distinction between accrual basis of accounting (practices) and the cash basis of accounting (practices).

Twitter has been producing positive free cash flows for over the past two years, and while I expect it will post a smaller negative earnings this year, that’s ok. Amazon in the early 2000s taught us that positive operating cash flows are more important.

Why?

Because a company can report earnings that have not yet been earned or just manufactured, but they cannot report cash flows until a real transaction has occurred.

Take the recent Noble Group Ltd case, the team at Iceberg Research  has done a great job of reporting the accounting manipulations by Noble’s management. Noble Group Ltd is a large commodity trader listed in Singapore, ranked number 76 in the 2014 Fortune Global 500 with revenue of $98b, market cap of $6b, and rated investment grade (BBB-/Baa3).

Here are a few findings from their second report in 2015.

  • The divergence between Noble’s net profit and operating cash flows (“OCF”) is striking given its
    status as an investment grade company. Noble has recorded a combined $2.7b net profit since
    2009. However, its operations have lost $485m in cash in the same period. OCF have continued to
    deteriorate since 2011, e.g. ($620m) outflows in 9M 2014.
  • The reason for the divergence between the paper profit and the OCF is the remarkable increase in
    the fair values of unrealised commodities contracts (or “mark-to-market”). These contracts surged
    from near zero in 2009 to an unprecedented net $3.8b ($5.8b assets and $2b liabilities).
  • The level of Noble’s fair values has become incredible. They now dwarf all of their competitors
    (e.g. Glencore). They are 3.5 times the level of Enron’s contracts at its peak, eleven months prior
    to filing for bankruptcy.
  •  Similar to Enron, Noble recognises the entire profit for long maturity contracts the same day these
    contracts are signed.

And from the latest Iceberg Research latest report; 

Noble is sinking in a perfect storm. The company is walking toward bankruptcy and liquidation. 

Noble expects a massive loss of US$1.8b in its second quarter. The loss is mostly due to the impairment of the commodity contracts (around $1.2b). Our main argument against Noble was that this company fabricated profit by inflating the value of these contracts by billions. Noble had already impaired these contracts by $1.1b in its 2015 results. So the total is now $2.3b, and it’s not over. Noble will also record a $500m operating loss due to wrong speculative positions. In the past, Noble would have fabricated contracts fair values to hide these losses, and nobody would have known. This option is not available to Noble anymore. Source

People have lost a lot of money and credibility by not knowing that difference, drinking the kool-aid that management supplied, especially when they emphasize earnings in EBIDTA terms. 

Moving on…

Take a look at Footlockers past performance since 2000.

 

What Amazon effect?  (The Amazon Effect is the impact the digital marketplace has on the traditional business model regarding consumer expectations and the new competitive landscape.)

Sensational headlines are attention grabbing and here is a few common headlines that are constantly used by the media.

‘The Amazon effect on retail’,

‘The Amazon effect is striking again’

‘Here’s how the Amazon effect is hitting the apparel industry.’

All three headlines were from three major financial news websites.

It is well known in the discipline of psychology that the more a message is read the more likely we are to accept it as a truth.

Why is that so? Let’s take a look.

Familiarity has resulted in millions of dollars in sales for a number of businesses. Robert Zajonc wrote in a paper called ‘The Attitudinal Effects of Mere Exposure’, that the more a person is exposed to an item, the more attractive it is.

And, in 2009, Dr Robert Cialdini wrote about the effects of familiarity on liking, in his book, ‘Influnce: The Psychology of Persuasion’.

Dr Caildini wrote; “Often we don’t realize that our attitude toward something has been influenced by the number of times we have been exposed to it in the past. For example, in one experiment, the faces of several individuals were flashed on a screen so quickly that, later on, the subjects who were exposed to the faces in this manner couldn’t recall having seen any of them before. Yet, the more frequently a person’s face was flashed on the screen, the more these subjects came to like that person when they met in a subsequent interaction. And because greater liking leads to greater social influence, these subjects were also more persuaded by the opinion statements of the individuals whose faces had appeared on the screen most frequently (Bornstein, Leone, 8{Galley, 1987). A similar effect occurred in a study of online advertising. Banner ads for a camera were flashed five times, twenty times, or not at all at the top of an article participants read. The more frequently the ad appeared, the more the participants came to like the camera, even though they were not aware of seeing the ads for it (Fang, 2007).”  

As you can see we must stand guard at the door to our mind.

As individual investors we need to challenge our own perceptions and also other people’s assumptions. We need to think like Arthur Conan Doyle fictional character Sherlock Holmes.

But how?

By applying the methods of deduction.

All the headlines are premises based upon assumptions. They say what should occur based upon a generalized premise.

For instance and I’m simplifying here; Amazon has caused large retail  bricks and mortar companies, like bookstores, to go broke. Therefore, Amazon will cause the majority bricks and mortar businesses to go broke once it enters their industry.

Whereas logical deduction, enables some prediction(s) to be made about the way things will be. If the prediction is sufficiently accurate when tested against observations of reality, then the story is regarded as having provided an explanation of why things are as they are.

Their success in explaining or predicting particular phenomena will then typically be assessed based on observation—that is, observing how the theory’s predictions corresponded with the observed facts.

Footlocker is a retailer of sports apparel, and it is widely assumed that Amazon would have highly destructive effects on Footlockers ability to compete on price inferring that sales and profitability should have decrease sharply, since Amazon began selling sports apparel online.

Applying deductive reasoning, we first look at the facts. From the tables provided above we see that footlocker has slowly been increasing its ability to produce growing free cash flows. According to the headlines this should not be happening.

And we see more evidence in the form of high returns on equity, which means that Footlocker is able to maintain high levels of profitability while maintaining a low level of debt. 

From these facts we can start explore several lines of reasoning as to how this is possible that Footlocker can maintain and even grow these high levels of profitability while competing against Amazon. 

What I mean by exploring several lines of reasoning is this, you start to think of all the ways that it is possible for Footlocker to achieve these high levels of profitability and compete with Amazon.

For instance, one line of reasoning could be, Footlocker operates with greater economies of scale and captive customers. Then you begin to look for facts that both support or oppose our line of reasoning. You eliminate one by one your lines of reasoning until you one is left.

 

“Once you eliminate the impossible, whatever remains, no matter how improbable, must be the truth.”

Arthur Conan Doyle

 

Footlocker is currently trading at 8 times earnings, which indicates an earning yield of 12.5% (1 divided by 8) [at 26/9.2017]. In the current environment of low interest rates and low yields on Government bonds 12.5% looks very attractive.

It does pay to ask ‘what if’ in challenging common held assumptions applied in a logical process.

Yours in investing

Adam C. Parris

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