The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [176]
FIRST COMMENT: Among all the takeovers effected in the year 1969 this was no doubt the most extreme in its financial disproportions. The acquiring company had assumed responsibility for a new and top-heavy debt obligation, and it had changed its calculated 1968 earnings from a profit to a loss into the bargain. A measure of the impairment of the company’s financial position by this step is found in the fact that the new 5% bonds did not sell higher than 42 cents on the dollar during the year of issuance. This would have indicated grave doubt of the safety of the bonds and of the company’s future; however, the management actually exploited the bond price in a way to save the company annual income taxes of about $1,000,000 as will be shown.
The 1968 report, published after the Sharon takeover, contained a condensed picture of its results, carried back to the year-end. This contained two most unusual items:
1. There is listed as an asset $58,600,000 of “deferred debt expense.” This sum is greater than the entire “stockholders’ equity,” placed at $40,200,000.
2. However, not included in the shareholders’ equity is an item of $20,700,000 designated as “excess of equity over cost of investment in Sharon.”
SECOND COMMENT: If we eliminate the debt expense as an asset, which it hardly seems to be, and include the other item in the shareholders’ equity (where it would normally belong), then we have a more realistic statement of tangible equity for NVF stock, viz., $2,200,000. Thus the first effect of the deal was to reduce NVF’s “real equity” from $17,400,000 to $2,200,000 or from $23.71 per share to about $3 per share, on 731,000 shares. In addition the NVF shareholders had given to others the right to buy 3½ times as many additional shares at six points below the market price at the close of 1968. The initial market value of the warrants was then about $12 each, or a total of some $30 million for those involved in the purchase offer. Actually, the market value of the warrants well exceeded the total market value of the outstanding NVF stock—another evidence of the tail-wagging-dog nature of the transaction.
The Accounting Gimmicks
When we pass from this pro forma balance sheet to the next year’s report we find several strange-appearing entries. In addition to the basic interest expense (a hefty $7,500,000), there is deducted $1,795,000 for “amortization of deferred debt expense.” But this last is nearly offset on the next line by a very unusual income item indeed: “amortization of equity over cost of investment in subsidiary: Cr. $1,650,000.” In one of the footnotes we find an entry, not appearing in any other report that we know of: Part of the stock capital is there designated as “fair market value of warrants issued in connection with acquisition, etc., $22,129,000.”
What on earth do all these entries mean? None of them is even referred to in the descriptive text of the 1969 report. The trained security analyst has to figure out these mysteries by himself, almost in detective fashion. He finds that the underlying idea is to derive a tax advantage from the low initial price of the 5% debentures. For readers who may be interested in this ingenious arrangement we set forth our solution in Appendix 6.
Other Unusual Items
1. Right after the close of 1969 the company bought in no less than 650,000 warrants at a price of $9.38 each. This was extraordinary when we consider that (a) NVF itself had only $700,000 in cash at the year-end, and had $4,400,000 of debt due in 1970 (evidently the $6 million paid for the warrants had to be borrowed); (b) it was buying in this warrant “paper money” at a time when its 5% bonds were