Monday, October 13, 2008

From the Mailbag: Liquor Stores Income Fund: Part 2

As I wrote about previously, Liquor Stores Income Fund (TSE:LIQ.UN) operates retail liquor stores in Alberta and British Columbia. From a book value perspective, there is a great degree of variation in the resulting price to book ratio depending on whether you accept the full $260M of goodwill as realizable or not. One way to approach the issue of goodwill is to accept the book value only if the earnings value of the company exceeds its asset value.

Another way to look at goodwill is to first determine if the company is earning its weighted average cost of capital (WACC). If a company's return on invested capital exceeds the WACC, it's an indication that the company has healthy business economics working it its favor and makes a strong case for supporting the goodwill value on the books. In this case, you need to have a well researched opinion on whether the company can continue earning its WACC on operating assets in the future!

A few problems in calculating future earnings for LIQ include 1) assessing the impact of Bill-C52 which initiates the new Canadian tax law on business trusts commencing Jan 1, 2011 and 2) what applicable growth rates to use (if any) in valuing the company.

Under my own conservative valuation assumptions used on LIQ, I have found that the company is not earning its WACC on invested capital and that the earnings value of the company is less than its asset value. Under those conditions, I prefer to write down the goodwill and adjust the price to book ratio accordingly.

Since inception in 2004, LIQ has grown revenues 10 fold, primarily via acquisitions, and these acquisition have resulted in the substantial goodwill on the balance sheet. I believe the major risk in accurately valuing LIQ, is how to account for their future growth and whether you believe that growth is creating value or destroying it for shareholders. My approach in valuing LIQ's goodwill asset was very conservative, perhaps too conservative, but I would rather err on the side of caution, especially when the goodwill value is such a large percentage of the total asset base.

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