Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.
Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheets of AT&T (NYSE:T) and Verizon (NYSE:VZ), in order to get some clues as to how well these companies are doing.
I will go through the balance sheets of these companies, reviewing the most important items, and seeing if there are any major differences between the two, making one a better investment than the other. Information that I used on AT&T can be found here, and information on Verizon can be found at this link. Note that this article is not a comprehensive review as to whether either of these two stocks should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.
Note that this is my first article, and it might be a bit too basic for some and too long-winded for others, but I hope that some of you can derive benefit from it.
Cash and Cash Equivalents
The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.
AT&T and Verizon are two such companies. AT&T as of 12/31/2012 had about $4.9B in cash, which is up by $1.8B from where their cash position was a year before. This increase is due mostly to higher earnings. While $4.9B is not a lot of money for a company with a $198B market capitalization, you should keep in mind that this company bought back over $12B in stock over 2012 and paid out over $10B in dividends.
Verizon had $3.6B in cash as of the end of 2012. I should note that in this figure, I also included Verizon's short-term investments, which can be easily converted into cash. This amount is $10.3B lower than the year before, due largely to an $8.5B special distribution from Verizon Wireless to joint venture partners, Verizon Communications and Vodafone (NASDAQ:VOD). For a company with a $127B market cap, $3.6B isn't a lot of money, but they did pay out about $5.2B in dividends over 2012.
Receivables constitute money that is owed to a company for products or services that have already been provided. Of course, the risk with having a lot of receivables is that some of your customers might end up not paying. For this reason, you usually like to see net receivables making up a relatively small percentage of the company's sales.
AT&T had a total of $12.7B in net receivables at the end of 2012, which represents 10% of its 2012 sales of $127B. Verizon had $12.6B in net receivables, amounting to about 11% of its 2012 sales of $116B.
I don't see anything to be alarmed about here, given the business that both of these companies are in.
Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of their operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.
If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.
AT&T's current ratio is 0.71, while Verizon sports a current ratio of 0.79. Both of these are less than ideal, but what are the odds that the entire operations of either of these two companies comes to a grinding halt? It is something to consider, nonetheless, but I would be a lot more concerned if I was dealing with a smaller and younger company with operations that are concentrated in just one or two places.
Property, Plant, and Equipment
One of the problems with the telecom industry in which both AT&T and Verizon operate, is that the business is very capital intensive, requiring constant investments and upgrades in infrastructure. This can be seen in the capital expenditures of both companies, which can be found on the cash-flow statements. For instance, AT&T spent almost $20B in capital expenditures over 2012, while Verizon spent over $16B. You can see this on the balance sheet, where AT&T shows $110B of property, plant, and equipment, while Verizon shows almost $89B after accumulated depreciation. I usually don't like to invest in companies that have to invest this much money in capital expenditures, but that's the nature of the beast in the telecom industry.
With both of these companies, the two biggest intangible assets are goodwill and wireless licenses. Goodwill is simply the price paid for an acquisition that's in excess of the acquired company's book value. The problem with a lot of goodwill on the balance sheet is that if the acquisition doesn't produce the value that was originally expected, then some of that goodwill might come off of the balance sheet, which could, in turn lead to the stock going downhill. Then again, acquisitions have to be judged on a case by case basis, as good companies are rarely purchased at or below book value. AT&T has almost $70B of goodwill on its balance sheet, while Verizon is carrying about $24B. When it comes to licenses, AT&T has over $52B tied up in that area, while Verizon has almost $78B there.
With both AT&T and Verizon, intangible assets account for nearly half of their asset totals. Due to the problems with goodwill that I just spoke about, you generally don't like to see intangibles account for more than 20% of total assets, but the amount of money that's tied up in licenses shows a huge barrier to entry for any other potential competitors, so this can work to the advantage of both of these companies.
Return on Assets
The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher, the better, although lower returns due to large asset totals can serve as effective barriers to entry for would-be competitors.
When calculating this figure for both AT&T and Verizon, it gets kind of tricky, because both companies have significant items in their earnings that are usually ignored because they don't always occur in the normal course of business. For these two companies, these items include damage from Hurricane Sandy and actuarial losses on their pension plans. So, I will use the non-GAAP earnings that exclude these items in this calculation. The formula looks like this:
Return on Assets = (Net Income) / (Total Assets).
For AT&T, the return on assets would be $13.5B in net income, divided by $272B in total assets. This gives a return on assets for 2012 of about 5%. For Verizon, the return on assets is $6.5B in net income, divided by $225B in total assets, producing a return on assets of just under 3%.
While AT&T has the slight edge here, neither of these are inspiring, but with asset totals well in excess of $200B, both of these companies have tremendous barriers to entry for potential competitors who might otherwise threaten their dominant positions in the industry.
Short-Term Debt Versus Long-Term Debt
In general, you don't want to invest in a company that has a large amount of short-term debt when compared to the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.
However, this is not a concern for either AT&T or Verizon, as AT&T carries just $3.5B in short-term debt, while Verizon carries about $4.4B. Unfortunately, these numbers are dwarfed by their long-term debts.
Long-term debt is debt that is due more than a year from now. However, an excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years worth of earnings.
Unfortunately, this is not the case with either AT&T or Verizon. AT&T currently carries over $66B in long-term debt, while Verizon has almost $48B. This, of course, is due mostly to their network and infrastructure investments that are needed to stay at the top of their industry.
In determining how many years worth of earnings it will take to pay off the long-term debt, I use the average of non-GAAP earnings over the last 3 years. AT&T's average non-GAAP earnings is $13.4B. Unfortunately, I could only get the last 2 years of non-GAAP earnings for Verizon. This average is about $6.4B. When you divide the long-term debt by the average earnings of each company, here is what we find.
Years of Earnings to Pay off LT Debt = LT Debt / Average Earnings
For AT&T, here is how it looks: $66.4B / $13.5B = 4.92 years
For Verizon, it looks like this: $47.6B / $6.37B = 7.47 years
This isn't good for either company, but I'd have to give the edge to AT&T. The long-term debt is one of my biggest concerns for both companies.
In the equity portion of the balance sheet, you will find the treasury stock. This figure represents the shares that the company in question has repurchased over the years, but has yet to cancel, giving the company the opportunity to re-issue them later on if the need arises. Even though treasury stock appears as a negative on the balance sheet, you generally want to see a lot of treasury stock, as strong, fundamentally-sound companies will often use their huge cash flows to buy back their stock. For this reason, I will usually exclude treasury stock from my calculations of return on equity and the debt-to-equity ratio, as the negative effect of the treasury stock on the equity will make the company in question appear to be mediocre when doing the debt-to-equity calculation, when in reality, it might be a very strong company.
Fortunately, AT&T has approximately $32.9B in treasury stock on its balance sheet, while Verizon has $4.07B.
The debt-to-equity ratio is simply the total liabilities divided by the amount of shareholder equity.The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how AT&T and Verizon stack up here.
Debt To Equity Ratio = Total Liabilities / (Shareholder Equity + Treasury Stock)
For AT&T, it looks like this: $179B / ($92.7B + $32.9B) = 1.42
And for Verizon: $140B / ($85.5B + $4.07B) = 1.56
For the sake of comparison, I also calculated this ratio as of the end of 2011. AT&T had a debt-to-equity ratio of 1.30, while Verizon carried a ratio of 1.59. So, the debt-to-equity ratio for AT&T is creeping up, while Verizon's is holding steady for the time being. This is something that you definitely need to be aware of before buying either of these two stocks.
Return On Equity
Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula.
Return On Equity = Net Income / (Shareholder Equity + Treasury Stock)
Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks. Once again, this is why I strip the negative effect of treasury stock from my calculations. I also am using non-GAAP earnings.
So, the return on equity for AT&T is as follows:
$13.5B / ($92.7B + $32.9B) = 10.7%
For Verizon it comes out as: $6.52B / ($85.5B + $4.07B) = 7.3%.
If you do the calculation like most and count the treasury stock as a negative to equity, then AT&T would have a return on equity of 14.6%, while Verizon would have a return on equity of 7.6%.
Although I like to see double-digit returns on equity, and while I do give AT&T the edge here, there's nothing overly inspiring about either company when it comes to this metric.
Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:
Retained Earnings = Net Income - Dividend Payments - Stock Buybacks
On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.
I am not going to go into much detail on the retained earnings of either AT&T or Verizon, because the balance sheets are using values based off of the reported earnings instead of the non-GAAP earnings that represent a more accurate reflection of the operations of the two companies. However, if you do decide to calculate retained earnings growth based on reported earnings, then you will see that AT&T grew retained earnings from $21.9B in 2009 to $22.5B in 2012, a cumulative rise of just 3%. Meanwhile, Verizon's retained earnings shrank from $7.26B in 2009 to a deficit of $3.73B in 2012. However, I would not make an investment decision based on these retained earnings figures.
After reviewing the balance sheets of both AT&T and Verizon, we see that both of these companies have several things in common. Some of these include a small cash position relative to their market capitalizations, less than desirable current ratios, high amounts of long-term debt, and debt-to-equity ratios that are more than desirable.
However, you must also take into account that these two companies are the leaders in their industry, which isn't going away any time soon. Their dominant positions are cemented in a large part by their huge asset totals of well over $200B, making it hard for anyone, including Sprint (NYSE:S), to knock them off the top. AT&T has returned value to shareholders with over $12B in repurchased stock, and a hefty dividend that is well supported by its free cash flow of almost $20B. Verizon's generous dividend is supported by its free cash flow as well. And, no matter how bad the economy gets, people are not going to shut off their cell phones, making both of these companies relatively defensive investments going forward.
So, while I am concerned about the high amounts of debt shown on the balance sheets of both AT&T and Verizon, I would not let this information alone deter me from continuing my research into whether or not these two companies make for good investments.
Disclosure: I am long T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.