Friday, October 10, 2008

From the Mailbag: Liquor Stores Income Fund

Liquor Stores Income Fund (TSE:LIQ.UN) is a business trust which as of June 30th, 2008, operates 204 liquor stores in the provinces of Alberta and British Columbia. Alberta operates with a fully privatized retail distribution for alcoholic beverages, whereas British Columbia operates with a blend of both private and government run liquor retail stores. LIQ operates with 84% of their stores in Alberta and the remainder in British Columbia. As an income trust they pay .135 cents/share per month, yielding a dividend return of 12.9% based on a share price of $12.51.

After reviewing the business model, a reasonable place to start looking for potentially undervalued companies is on the balance sheet! From a non-current asset perspective, its troubling to see such a high percentage of goodwill (even worse if combined with intangibles), which comprises 59% of the total asset base. In order to understand if this company's assets are undervalued in the public markets, we need to understand if the goodwill is reasonable. The price to book value of the company on first glance appears undervalued at 79%, but if we back out the entire goodwill amount, the price to book ratio balloons to over 700%. Of course, removing all the goodwill may not necessarily be more accurate than leaving the entire amount on the balance sheet, but it does establish the importance of goodwill to this company's P/B ratio!

I will note that both Jarislowsky and Brandes are skeptical regarding goodwill and will back out goodwill in calculating debt/equity and other key ratios involving equity.

Goodwill comes about when assets are acquired for more than their fair value. Paying more than fair value makes sense when those assets provide enough future cash flow to justify the purchase price. While it's true that goodwill is subject to an annual impairment test, management has a high degree of discretion in formulating its value and may act strategically in this regard depending on what incentives exist for them to do so!

Stay tuned, in my next post I will look whether the return on Liquor Stores' assets support the goodwill figure on the balance sheet.

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