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Discontinued Operations Removed from Invested Capital – Invested Capital Adjustment

Tuesday, July 9th, 2013

This report is one of a series on the adjustments we make to convert GAAP data to economic earnings. This report focuses on an adjustment we make to convert the reported balance sheet assets into invested capital.

Reported assets don’t tell the whole story of the capital invested in a business. Accounting rules provide numerous loopholes that companies can exploit to hide balance sheet issues and obscure the true amount of capital invested in a business.

Converting GAAP data into economic earnings should be part of every investor’s diligence process. Performing detailed analysis of footnotes and the MD&A is part of fulfilling fiduciary responsibilities.

We’ve performed unrivalled due diligence on 5,500 10-Ks every year for the past decade.

Assets from discontinued operations are assets that are held for sale by a company. These discontinued operations assets are disclosed as a separate line item on the balance sheet. While invested capital usually includes all capital invested in a business over its lifetime, we remove these discontinued operations assets from invested capital for a more accurate picture of how much operating capital a business has on hand to generate NOPAT. We also remove the income or loss from discontinued operations, which we detail in a separate report.

Most investors would never know that these discontinued operations distort GAAP numbers by over-stating assets on balance sheets and distorting the picture of a company’s ability to generate a return on that capital.

Goldman Sachs (GS) classified its reinsurance business as held for sale in 2012, with assets of $16.9 billion. Along with a much smaller asset held for sale, GS had nearly $17.1 billion in assets held for sale in 2012, with no material income or loss resulting from these assets according to its financial statements. Without adjusting for these discontinued operations, investors would mistakenly expect GS to have invested capital of $97.2 billion and a return on invested capital of only 8.7%. Removing discontinued operations lowers GS’s invested capital to only $76.1 billion and its ROIC is 11.1%.

Figure 1 shows the five companies with the largest (gross value and as a % of net assets) discontinued operations capital adjusted out of invested capital for 2012.

Figure 1: Companies Most Affected By Discontinued Operations in Invested Capital in 2012 

DiscontinuedOperationsSources: New Constructs, LLC and company filings.

These companies are far from the only ones affected by discontinued operations in invested capital. In the last fiscal year, the removal of discontinued operations from invested capital occurred for 332 different companies for a total adjustment value of $100 billion. Our database contains over 3,281 instances of discontinued operations removed from invested capital for a total adjustment value of $933 billion.

Discontinued operations in invested capital can artificially depress return on invested capital and make a stock look undervalued. Case in point: OneBeacon Insurance from Figure 1. OneBeacon had a total of $2.2 billion in discontinued operations removed from invested capital. Without this $2.2 billion in discontinued operations removed from invested capital, OB would have recorded invested capital of $3.6 billion and a return on invested capital of just 2.5%. Instead, with this adjustment, OB has a total invested capital of $1.4 billion and an ROIC of 6.4%.

Without this adjustment, it would have appeared that OB was unable to generate any meaningful return on the capital invested into its business. With this adjustment however, OB looks to be in much healthier shape, and earns a 4-star, or Attractive rating. Diligence pays.

Sam McBride and André Rouillard contributed to this report

Disclosure: David Trainer, Sam McBride and André Rouillard receive no compensation to write about any specific stock, sector, or theme.

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  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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