Everyone loves large-cap stocks.
They give us so much pleasure when they’re rising in value — something they’ve done the last nine years, since the latest bull market began in March 2009.
The success of large-cap stocks is literally part of our personal financial satisfaction.
The American Institute of CPAs (AICPA) keeps track of a bunch of data that measures both our financial pleasure and financial pain. Combining the Personal Financial Pleasure Index with the Personal Financial Pain Index, AICPA creates what’s called the Personal Financial Satisfaction Index (PFSi) using four equally weighted factors for each sub-index.
One of the factors it uses to measure pleasure is the PFS 750 Market Index, a proprietary stock index with 750 of the largest U.S.-listed companies excluding ADRs. In the third quarter ended Sept. 30, the index gained 10.2%, contributing in a big way to the PFSi setting a 24-year record.
As I said, Americans love their large-cap stocks.
However, as companies get bigger, they tend to get bloated with all kinds of assets that can come back to bite you in the keister if you’re not paying close enough attention.
A big thing for many large-cap stocks is to create financial subsidiaries to make money lending to their customers. Sometimes it works, and sometimes it doesn’t. The important thing is to understand there exists a potential financial dark side.
These seven large-cap stocks are at the top of the list.
Large-Cap Stocks With a Financial Dark Side: Apple (AAPL)
An article in The Economist made me revisit the idea of the financial subsidiary. Apparently, Apple Inc. (NASDAQ:AAPL) has a financial arm that’s half the size of Goldman Sachs Group Inc (NYSE:GS). That’s no tiny endeavor.
Not an official Apple operating segment — neither is the retail business and I consider that the real reason for the company’s growth — the magazine cobbled together all of the company’s financial activities into one bucket dubbed “Apple Capital.”
Apple Capital, the magazine suggests, has $262 billion in assets, $108 billion in debt and has traded more than $1.6 trillion in securities since 2011, keeping Apple CFO Luca Maestri very busy.
One paragraph of The Economist’s excellent article sticks out for me.
“Apple Capital has grown in a forgiving period for financial markets. That won’t last. Over time, the risk of mission creep will rise, as will the temptation to invest in riskier assets,” stated the Economist October 28. “On the current trajectory, by 2022 its assets will reach $400bn and debts $250bn. By then financial regulators, who do not supervise Apple, will be grinding their teeth at night.”
So, the next time you boast about owning Apple, just remember that a dark side lurks just below the surface.
Large-Cap Stocks With a Financial Dark Side: Volkswagen AG (VLKAY)
We’re not that far removed from the diesel scandal that almost brought down Volkswagen AG (ADR) (OTCMKTS:VLKAY) in 2015. Sales are starting to rebound in the U.S. — up 33% in September 2017 over the same month a year earlier and 12% in October 2017 — and that’s got Volkswagen’s financial services division cranking out the loans.
According to the Financial Times, VW Financial Services has $151 billion in customer receivables on its balance sheet, up almost 50% in the last five years alone.
“There are worries that rising interest rates will expose gung-ho lending and delinquencies will rise. Falling used car prices could trigger writedowns against expected residual values,” wrote Jonathan Eley in early July.
But before we sound the alarm, it’s important to note that loss allowances during the worst part of the 2008-2009 global economic crisis never went higher than 2.5% of receivables, which translates to $4 billion in losses given the $151 billion in receivables outstanding.
Next time you’re looking at the financial statements of Detroit’s big three, you might want to have a look at their financial arms. Everything’s rosy until it’s not.
Large-Cap Stocks With a Financial Dark Side: Snap-on (SNA)
You tend to see financial divisions in businesses that have expensive products such as cars, computers and, in the case of Snap-on Incorporated (NYSE:SNA), tools and diagnostic equipment used by automotive repair shops.
If you’re entering the automotive repair business and you need to invest in new equipment, who are you going to buy from? The company that provides financing or the one that doesn’t? That’s why it’s rare to find companies in industries like Snap-on’s that don’t have some financial arrangement for their customers.
In late summer I recommended Snap-on’s stock to InvestorPlace readers. In it, I discussed the delinquency rate of Snap-on customers — those 60-plus days late — and concluded that although the 1.4% rate for U.S. customers, who account for 89% of Snap-on’s overall revenue, was something to keep an eye on, it wasn’t a red flag.
In its Q3 2017 conference call, CFO Aldo Pagliari pointed out that its 60-plus day delinquency rate for extended credit increased 30 basis points to 1.7%, about ten basis points higher than usual.
However, that didn’t stop the profits, which were 10.7% higher than a year earlier and 2.6% higher than in the second quarter.
Bottom line, the financial services segment through the first three quarters of the year generated $233.5 million in revenue and $163.1 million in operating profits from $1.9 billion in receivables.
That’s a return of 8.6% on the $1.9 billion outstanding.
Like Volkswagen, higher interest rates could become a problem for Snap-on, but that said, a repair shop’s not going to be delinquent for more than 90 days if they want to keep the lights on and the business running.
You can get along without a car, but if your business is all about the tools to repair those vehicles, it’s the last thing you stop paying.
Large-Cap Stocks With a Financial Dark Side: Conn’s (CONN)
If you’ve owned Conn’s Inc (NASDAQ:CONN) stock since Christmas 2013, you’ve been on quite a ride. Closing out the 2013 holiday shopping season just shy of $80, the furniture, electronics and home appliance retailer was sitting on top of the world.
Then its business started to slow after several years of booming revenues and profits. That in itself wouldn’t have been a big deal; all retailers go through these same-store sales declines from time to time.
No, what got it in trouble was the fact that 77% of its customers were buying the products on credit supplied by the company’s in-house credit operation. To make matters worse, Conn’s was lending to people with mediocre credit scores and not taking the proper allowances for loan losses.
Translation: They were making more money than they should have and as we know, earnings drive share prices.
Conn’s considered selling its loan portfolio but ultimately chose not to. In the second quarter ended July 31, 93.6% of its customers financed their purchases, a big chunk using the company’s in-house financing. The number of customers 60-plus days past due is 10.4%. By comparison, Snap-on’s 60-plus days past due I referenced earlier is one-fifth that percentage.
Today, CONN stock sits near a 52-week high of $32.90 on the back of an average credit score of 589 and an average income of $42,300.
I don’t know about you, but that’s not the kind of financial stability I’m looking for in an investment.
Large-Cap Stocks With a Financial Dark Side: John Deere (DE)
Here is another example of a stock that’s trading at or near its 52-week high riding on the back of financed equipment sales.
A July article from the Wall Street Journal highlighted the move by American farmers away from traditional banks into the open arms of Deere & Company (NYSE:DE) and its financial arm.
“Farmers are getting by with loans and leases from John Deere, even though their incomes are half what they were a few years ago and their debt is near the levels of the 1980s bust,” states WSJ’s Facebook Inc (NASDAQ:FB) lead into the article.
So, if you own DE stock, how aware are you that Deere has become the local pusher?
At the end of July, Deere had $28.6 billion in financing receivables outstanding after $189 million in allowances for loan losses. Of those receivables, $216 million is 60-plus days past due, a delinquency rate of 0.76%.
All’s good, you say to yourself? No so fast.
In Q2 2012, Deere had $22.6 billion in financing receivables, which translates to annual growth of 4.8% over the past five years. At the same time, receivables 60-plus days late had a delinquency rate of 0.5%, or 34% lower than it is today.
Over the same five years, revenues declined by 4% annually.
Deere’s profits have been fueled almost entirely by its financial arm. That’s not the makings of a strong business model.
Large-Cap Stocks With a Financial Dark Side: Harley-Davidson (HOG)
Like Deere, Harley-Davidson Inc (NYSE:HOG) is going through a rough patch, experiencing declining sales. In the third quarter ended Sept. 24, all five of its operating regions saw unit sales decrease including an 8.1% decline in the U.S., its biggest region accounting for 65% of its overall sales. On a dollar basis revenues decreased by 9.6% in the quarter to $1.2 billion.
Harley’s financial services arm managed to make a terrible quarterly operating profit of $19.6 million from the sale of motorcycles look a little better overall.
In Q2 2017, financial services generated a $77.1 million operating profit from $189.1 million in revenue, up 11.0% and 3.2% respectively.
Unlike Deere, which is trading near a 52-week high, HOG is trading near a 52-week low and not too far from a five-year low.
Harley Davidson’s finance receivables at the end of the third quarter were $7.1 billion. In the previous quarter they were $7.3 billion with $194 million in loan allowances. The 30-day delinquency rate in the second quarter was 3.25%. By comparison, Deere’s 30-day delinquencies are less than one-third that percentage.
If you’re thinking about buying HOG stock, you might want to consider this before doing so.
Large-Cap Stocks With a Financial Dark Side: Boeing (BA)
What would a story about the financial dark side of large-cap stocks be without including Boeing Co (NYSE:BA), whose recent misdeeds surrounding Bombardier Inc (OTCMKTS:BDRAF), warrants a closer look at its financial arm.
Boeing Capital, the aircraft manufacturer’s finance arm, is a surprisingly small part of the company’s overall business.
I don’t spend a lot of time following the aircraft manufacturing industry, but I would imagine most airlines finance their aircraft purchases through other asset-backed finance organizations not related to Boeing or lease the aircraft through companies such as AerCap Holdings N.V. (NYSE:AER).
Thus, the fact that Boeing’s customer financing at the end of September amounted to just $3.5 billion, a pittance for a company with total assets of $91 billion, it’s not surprising that you rarely hear about its financial arm.
I guess when you get as much government pork as Boeing does, you don’t need to provide financing for your customers to goose sales.
Move on, nothing to see here.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.