Exposing Johnson’s beating heart

If you scrape away the nasties, the pension fund, the debt and the operating leases, there’s a perfectly viable business at the heart of Johnson Service on sale at a reasonable price. I reckon it earns a 12% return on capital, also promising investors an earnings yield of about 12%, perhaps more, at the current share price.

To reach that conclusion, I’ve adapted a series of ideas starting with the notion you might be able to construct a better long-term price earnings ratio or its inverse, the earnings yield (E/P) by taking the average return on equity over many years and dividing it by the current price to book value (which is the same thing as multiplying the return on equity figure by book to price). So, since net profit is the return and book value is the same as equity, in simple terms:

or

This is better, simply because I can substitute an average ROE figure to derive an earnings yield for a typical year, rather than last year, which may or may not be repeated. Also, if a company has shrunk considerably as Johnson has, averaging past earnings to calculate a long-term PE or earnings yield might be misleading. It’s more realistic to assume ROE will remain consistent than earnings.

Then I noticed Geoff Gannon, doing the same thing with total assets:

or

Summarised in one succinct sentence, he says he just looks at:

What assets am I buying and what kind of return will those assets produce

But if he’s talking about buying all the assets of the business, like a private buyer might, the cost ought to include the debt in the business, which a buyer would assume. In other words, as Greenblatt does in his Magic Formula, use enterprise value, the market value of the equity plus debt, as the price and the operating profit (before interest and tax) aka EBIT to calculate the earnings yield:

Since debt distorts the earnings yield, (see the appendix of The Little Book That Beats the Market for an explanation, or watch this video on the PE conundrum from Khan Academy) it’s a good idea to choose an unlevered earnings yield in preference to the ratio derived from net profit if you are comparing different companies.

I could have stopped there, maybe I should have.

But I thought I could improve the definition of assets by deducting goodwill, which may or not have any real value, and adding operating leases, which are recorded in the notes and so are not considered assets on the balance sheet (though clearly they are. Adding the full value of future lease payments is a bit dubious, as opposed to discounting them to present values, but I’m trying to keep things simple).

And since I’ve assumed the cost of the leases as well as debt in the price of the company, I can add lease payments back to EBIT. My idealised unindebted Johnson Service doesn’t have to pay interest or lease payments.

To turn the return, the adjusted EBIT figure, back into one a private buyer might actually receive in a typical year we need to deduct tax at the standard corporation tax rate.

So let’s call that newly defined group of operating assets ‘capital’ and newly defined EBIT ‘unlevered earnings’. We get:

or

To find the median ROC, I put the data for the last seven years (all I have) into a spreadsheet (click on the valuation tab).  Although it sounds complicated, it’s only a small spreadsheet:

And found that despite nearly defaulting on its debt in 2008, Johnson’s operational heart kept beating. The median return on capital is 12%, the same as this year’s, and since the market values the company at roughly the value of its capital, I think investors can expect an earnings yield of 12%, from my idealised unlevered model.

But Why?

Ignoring how a company is financed and focusing on the company’s operations cuts through the fog of war, the write offs, the ugly looking gearing ratios, and implies Johnson Service is a good business. A private buyer of the whole company could pay off the debt and still earn a decent return.

A private investor buying a small fraction of the company can also recognise it’s a good business. But he’s saddled with the financing that’s in place, and also for that matter, the management. So he has other decisions to make.

As I posted before I went on holiday, it’s a split decision for me. I really like the management. But Johnson’s too aggressively financed for my taste. The leverage in the business might boost the return implied by the earnings yield but at increased risk.

By separating out the financing, management and operations I found it easier to come to that conclusion.