When accountants look at the operating financials, they assume that the company will continue to operate in the future. By definition, The IFRS reassures them that an asset is "a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise."
Yet at times, what the investor may look for in a company's financials is the exact opposite; that is, what the financial condition and value of a company will be should it cease to operate. To look at a company that way, one must look at its liquidation value.
To explain liquidation value, I will use the operating financials of an Oklahoma-based chemical manufacturer. In 2017, the management of LSB Industries (LXU) reported on $1.2 billion in tangible assets and on $576 million in liabilities. The equity balance - at first glance - was $438 million or $14 per share.
In 2017, revenue was $427 million but it reported a loss of over $70 million; In 2016, revenue was $374 million but again management reported on a loss of over $120 million; And in 2015, revenue was $438 million but the net loss was over $30 million.
Let's take a quick detour and discuss the liquidation value strategy. We will return to LSB Industries in four paragraphs.
The Liquidation Value Strategy
The thesis is simple: because a company has been losing money, management is likely to either sell assets in the future so that the company will (1) continue to service its debt, or that frustrated shareholders, tired of management earning a salary at their expense, will (2) require management to get rid of all the company’s assets; i.e. liquidate the firm.
Anticipating this scenario is an investor that believes that after management sells its assets and pays off its lenders, there will be an ample amount of capital left.
Some of the great investors practiced liquidation value strategy. In The Intelligent Investor, Benjamin Graham mentions that between 1926 and 1956, liquidation strategy was a major part of his investment operations. He eloquently defined liquidation as the "the purchase of shares that received one or more cash payments in liquidation of the company's assets."
Another investor, Bruce Berkowitz, famously known to purchase a majority interest in Sears. He began to acquire position in the company in 2005. And told his investors that the company at the time did not reflect any of the value of Sears real estate holdings.
From discount to premium
As LXU trades at about $5, it appears to be a mouth-watering, cheap stock price relative to the book value. Like purchasing a $100,000 home for $36,000. But capital markets had reason to discount LXU’s book value since management reported losses for over three consecutive years.
Excited about the steep discount to book value, I read the latest 10-K report. On page 63, you can read that $1.01 billion of the $1.2 in assets is related to property, plant and equipment, net of depreciation. And if you flip to page 80, you will read that this book entry is related solely to machinery and equipment (buildings and land are less than 5%). And management reports the value based on the cost of the equipment and not the market value.
But what is value of the equipment?
In liquidation, the equipment - or any other assets, except for cash - is often sold anywhere between 70% to 50% of its cost. Let's put the last sentence in numbers. If LXU were to sell its equipment at a 70% discount of the reported cost, the equity per share would be $112 million tangible net worth or $3.23 net worth per share.
If LXU were to sell its equipment at a 50% discount of the reported cost, the equity per share would be negative. Read: at a 50% discount, the common shareholder interest in LXU would be completely wiped (the deficit would be about $90 million, or a loss of $3 per share).
For the accounting enthusiastic reader, here is how I calculated the book value per share. I removed intangible assets such as goodwill. In the case of LXU, that amounted to $11.4 million of intangibles. I also added to the liabilities the liquidation preference of the preferred shares. Since LXU issued 140 thousand of cumulative, redeemable preferred shares, with a liquidation preference of $185 million. (What this means is that, in the case the company liquidates, lenders would be paid $576 million, and then preferred shareholders would be paid $185 million.)
The story of LXU teaches us three lessons. First, stock investing requires more than a quick glance at financial ratios. Unless you had carefully read the 10-K report, the $185 million in liquidation preference would be hidden. That is to say, in the case of liquidation, there were 32% more liabilities than reported by the accountants.
Second, accounting statements are the starting point for analysis but are not the final word. In the case of LXU, because of three years of consecutive operating losses, the possibility exists that the management will decide to sell the company’s assets, so the investor must ask: how much capital will remain – if any - after a sale?
Third, while the purpose of the liquidation value strategy is to find stocks, its real value at time lies in telling us which stocks to avoid.