Tuesday, November 18, 2008

Mickey Mouse Accounting

When we discussed operating leases we saw that as per current accounting rules, the debt shown on a company's balance sheet does not adequately present a company's true debt level. Unfortunately, off-balance sheet debt doesn't stop at operating leases. Consider The Walt Disney Company (DIS), which operates theme parks, owns a movie studio, and has an extensive media network (e.g. television stations).

Disney has strong, well-recognized brands, has great margins, and has a P/E under 10. Its stock has dropped from about $35 just a few months ago to its current price under $20! As a result, it has undoubtedly popped up on the radar screen for a few value investors with long-term outlooks.

A quick look at its balance sheet reveals equity of $32 billion and debt of $15 billion. Since nobody knows how long this (or any) downturn will last, a conservative capital structure is essential. In the near-term, people will cut down on their trips to Disneyland, and businesses will cut their advertising budgets for Disney's television stations. As such, it's of utmost importance that a company have manageable debt loads if it is to qualify as a long-term investment.

Digging a little deeper, however, reveals that Disney has agreed to purchase various non-cancelable broadcasting rights in order to bring its viewers action from the NFL, NBA, NASCAR and other sporting events. Capitalizing these obligations results in more than doubling the debt of $15 billion on the balance sheet to $37 billion! The D/E ratio changes from 46% to 115%!

But is this really how we should be treating these broadcast agreements, the same as how we treat debt? Absolutely. If Disney had "bought" these rights upfront, they would qualify as assets, and whatever they borrowed to pay for these would qualify as debt on the balance sheet. Just because the various sports leagues have agreed to effectively fully finance these rights does not change economic reality.

Furthermore, the debt we've just added on represents very real risk. If viewership goes down, or advertisers cut their spend, Disney would not make as much off of those games, but they would still owe every part of that debt. This is akin to a company buying a hard asset financed with debt, and not being able to generate the returns off that asset to cover the debts.

That's not to say Disney should be discarded. So far this year it has shown an ability to weather the storm. Furthermore, last recession it also managed to stay profitable. It is diversified across many segments and has strong margins which shows it owns differentiated products. However, investors must recognize that for all companies they consider, it is essential that they recognize all of a company's debts before proceeding with an investment.

1 comment:

John said...

Very interesting and well done. It shows you cannot simply rely on the ratios from a finance web site, must dig a little deeper. Thanks.

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