Seth Klarman, the famed value investor, is a horse racing enthusiast. At one point he owned a horse that was a legitimate candidate to race in the Kentucky Derby. In 2004 the horse was a three-time graded stakes winner and had one of the highest Beyer Speed Figures for the year. Unfortunately a knee problem sidelined the horse and he was unable to participate at the highest level of horse racing. While the horse will not be remembered as going down in history as one of the greats of horse racing, it will be remembered for its very unique name: 'Read The Footnotes'.
Investors can learn a lot from this horse’s name and the importance of reading the footnotes of financial statements. This week I came across a company that illustrates this importance. The company is Whirlpool (NYSE:WHR). Whirlpool has been consistently profitable, generates attractive returns on capital and produces decent levels of free cash flow. I have financial data going back to 1987 and they have been profitable every year. Return on invested capital has averaged 31.4% over this period. Last year they earned 35.0%. In their worst year,1997, at the depths of the Asian Currency Crisis, they earned 18.3%. Overall this is an attractive business and a company that has a solid brand name.
I also liked the fact that on the surface the company is attractively priced. The company has a market capitalization of $6.31 billion. Net debt was $1.14 billion. This amounted to an Enterprise Value of $7.45 billion. Trailing 12 month EBITDA was $1.64 billion. Hence, on an Enterprise Value/EBITDA basis the company was valued at 4.55. This looked like a very attractive investment opportunity since my estimate of fair value for this type of company was a 7.0 EV/EBITDA multiple. However, if you dug into the footnotes of Whirlpool's financial statements, you would see a glaring problem.
Footnote number 12 in Whirlpool’s 2010 10-K indicates a huge postretirement liability. The fair value of Whirlpool’s pension assets is $2.46 billion. The company’s estimated postretirement obligations are $4.67 billion. The difference between these two items is a shortfall of $2.21 billion. This shortfall is equal to 29.7% of the Enterprise Value of the company! To properly value the company, this $2.21 billion shortfall should be added to the company’s Enterprise Value. Hence, Whirlpool’s adjusted Enterprise Value is $9.66 billion and its adjusted EV/EBITDA multiple is 5.9.
On the surface, before taking in account the post retirement liabilities, the implied stock price associated with an EV/EBITDA multiple of 7.0 is $131.75. At the recent closing price of $82.09, this implies a 38 percent ’margin of safety’. This is very close to my goal of buying a stock at a 40 percent discount to my intrinsic value estimate for a company. However, if you include the post retirement liabilities, the implied price associated with the adjusted EV/EBITDA multiple of 7.0 is $103.25. By looking at the footnotes an investor gains invaluable information and the company goes from being an attractive investment candidate to an average investment at best.
Seth Klarman’s horse, ‘Read The Footnotes’, illustrates an important concept in investing. There is essential information in the footnotes of financial statements. Investors who ignore this information are at a disadvantage and invest at their own peril.