Archive for July, 2010

Equity Valuation

July 30th, 2010

Since the beginning of the year, we have recommended caution for stock investors, with a 8% limit upside versus 7 % downside risk.

Cost of capital has been overpowering the large valuation discount.

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Pension Facts: Why The Hit to Earnings and Cash Flow Is Upon Us

July 29th, 2010

Despite this past week’s 3.4% earnings-related stock rally, as of this writing, the S&P 500 Index is just near break-even for the year.

I bring up this unfortunate news as we are about to close out another month for the calendar year 2010, now 58% done.  By August end, the year will be two-thirds over, and so will vacation time.

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To Evaluate Cash Flows, Lease Obligations Must Be Studied-Are Low Credit Stocks Being Unnecessarily Punished?

July 28th, 2010

This week, a prominent financial journalist was reporting on the cash flows of a well-known company, accentuating its strength and growth.

The reporter detailed the analysis of this public company by a firm which “specializes” in cash flow-based security analysis; however, as I looked into their analysis (which I have a hunch is a computer generated number as they are a small firm, yet issue cash flow reports on every S&P segment), I discovered they neglected the effect of lease obligations, which for this company, was substantial. The company does produce healthy and consistent cash flows, and its credit strength allows them to sign large capital leases which, under Generally Accepted Accounting Standards (GAAP), appear on the balance sheet, as opposed to operating leases, which do not, but should. Thus, capital leases result in more conservative reporting as they are included in normal debt and leverage ratios. This is not always the case with operating leases, similar to other post-retirement benefits, like health care, which are not normally included on the balance sheet and are not pre-funded.

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Ken Hackel Featured on Forbes

July 28th, 2010

 
July 28, 2010: Forbes Online – Why Corporate Dividends Are A Sign Of Weakness

Ken Hackel presents his analysis of why dividends do nothing to enhance long-term shareholder value. If anything, he asserts, they send a signal that management has failed to find better uses for cash. He suggests, that with free cash flow valuation multiples currently suppressed, firms that have the financial flexibility should seriously consider acquisitions within their core areas of competency.

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Dudley Off To A Shaky Start at BP

July 27th, 2010

BP’s new head, Robert Dudley, has not gotten off to an auspicious beginning. In fact, he begins his initiative with two large financial blunders, a term we do not take lightly.

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Ken Hackel Featured on Canada’s Business News Network

July 27th, 2010


July 27, 2010: Business News Network: Impact of Senior Management Changes at BP

Canada’s BNN interviews Ken on the likely impact of changes in BP’s senior management in 2 parts.

Ken’s full interview (beginning at approximately 03:45 into tape):


Part 2:

View additional press coverage at www.credittrends.com

Why It Would Be Unwise For Firms to Boost Dividends

July 27th, 2010

While a dividend increase will often provide a stock “pop” , I believe it would be unwise to expect, and for an enterprise to pay out, substantially increased dividends at this time. For example, I couldn’t disagree more with BP’s statement today of $39 billion in possible asset sales and a commensurate look at reinstating the dividend. Why not liquidate the entire company and pay a huge dividend (payback of capital)? Obviously, BP should not consider dividend resumption until its liabilities are confidently estimated and its maximum growth is unimpaired resulting from a dividend.

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Gain The Advantage Over Those $1 MM+ Salary Wall St. Analysts

July 26th, 2010

An essential aspect of the evaluation of investment risk is taking on the roll of a Las Vegas odds maker-and not just when it comes to earnings, cash flows or revenues.

For example, in its June 30th 10-Q, filed last week, Cash America (CSH), a strong producer of Free Cash Flow, in the business of pawn lending, cash advances, and check cashing wrote:

Certain consumer advocacy groups and federal and state legislators have also asserted that laws and regulations should be tightened so as to severely limit, if not eliminate, the availability of certain short-term products to consumers, despite the significant demand for it. In particular, both the executive and legislative branches of the federal government have recently exhibited an increasing interest in debating legislation that could further regulate short-term consumer loan products. The U.S. Congress has debated, and may in the future debate, proposed legislation that could, among other things, place a cap on the effective annual percentage rate on consumer loan transactions (which could encompass both the Company’s consumer loan and pawn businesses), place a cap on the dollar amount of fees that may be charged for short-term loans, ban rollovers (payment of a fee to extend the term of a short-term loan), require the Company to offer an extended payment plan, allow for minimal origination fees for advances, limit refinancings and the rates to be charged for refinancings and require short-term lenders to be bonded.

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Superior Management Manifested in Value Creation–Good-bye Mr. Ballmer?

July 23rd, 2010

Sometimes it’s better not to hire your friends, admittedly some late advice for former Bear Stearns executives.  For Bill Gates, it’s definitely not to late given the superiority in Microsoft’s strength and consistency in its  cash flows. However, enough time has gone by to render a verdict on the leadership ability of Steve Ballmer. For Microsoft (MSFT), the tables below are telling, as we compare some important metrics to those of Oracle (ORCL), its largest and most important competitor.

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CNBC Interview – Are Buybacks Good for Shareholders?

July 23rd, 2010

Ken Hackel discussed whether or not buybacks are good for shareholders on CNBC’s The Call.

View additional press coverage at www.credittrends.com

Details Matter

July 22nd, 2010

This week, IBM, one of the world’s leading producers of Free Cash Flow (FCF), saw its stock tumble, when, among other things, it failed to produce the expected top line growth. What did investors really expect from a company soon to celebrate its 100th anniversary doing business in a near-recessionary climate? We’ll see how Apple (AAPL) is doing in 2076. Meanwhile, there were small details in IBM’s reporting that signaled what was to come.

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Pensions-Big Hits to Earnings On The Way

July 21st, 2010

As we’ve been writing about for quite a while…………..

Boards cannot maintain a 5.9% discount rate to their liabilities when 10 year Treas. are at 2.9% and annuities aren’t much higher.

Boards cannot maintain 8% and higher investment assumptions in this era of low growth with high volatility

Boards must recognize the extent of their underfunding in financial statements.

Boards must recognize the extent their actuarial assumptions are distorting reality.

Gone must be  the days of playing around with the pension to boost earnings and executive compensation and retirement benefits.

Please see articles on this site, as Boards will soon recognize the extent of the issue. Investors must recognize it now!

The Folly of Stock Buybacks-Part II

July 20th, 2010

There have been more than a few stories making the rounds advocating share repurchases, in which the authors attempt to make the point that firms which repurchase their shares tend to outperform the general market.

What do Bear Stearns, Freddie Mac, Lehman and Station Casinos have in common? Their executives believed they were so well-funded they began very large buyback programs, even though they borrowed to do so.

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Maintain Maximum Cash Positions……….but

July 20th, 2010

We see no reason, with a 9.1% cost of equity capital, to change our current thinking.

But good values do in fact exist, and so I am not advocating an equity portfolio be 100% cash. In fact, a couple of weeks ago, I wrote stocks could conceivably rise as much as 8% this year, given the current FCF multiple, and a small fall to the cost of equity.

Equities of firms which produce strong, consistent free cash flows, and as importantly, have a return on their invested capital greater than their cost of capital, will see their stock prices rise over time. But investors must buy such firms having a  current free cash flow yield in excess of  7%. These firms are priced to comfortably rise to a greater degree than bonds, money funds, or real estate.

Please see related stories, and tables throughout this site.

Return of the “Hostile” Takeover?

July 19th, 2010

Sounds crazy, no?

Given corporate Boards remaining relentless in cash maximization policies, alongside reluctance to spend without a confident payback period, the obvious outlet is stepped-up acquisitions. Given a strategic free cash flow-based acquisition, firms could put themselves in a position of stepping up their return on invested capital, given the very low cost of debt that might need to be raised to fund the purchase. A well-priced and timed acquisition can significantly add to shareholder value, while of course, an ill-priced, ill-executed  and poor candidate would severely destroy value.

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IBM – Again, Pension Underfunding a Leading Indicator

July 19th, 2010

IBM, although a very strong credit, has been shrinking equity and buying back its shares (see our earlier articles: CFOs Making the Same Mistake and The Folly of Share buybacks).

It has also been underfunding its pension. When firms look to squeeze cash, the pension is an obvious target, and more often than not, disappointment, especially relative to expectations, is on the way. A couple of weeks ago we wrote IBM is underfunding its plans.

Please see our related articles on pensions and free cash flow implications of underfunding:

  1. Details Matter
  2. Pensions-Buyer Beware
  3. CNBC Strategy Session – Underfunded Pensions Earnings Bombshell
  4. CNBC’s Herb Greenberg – Underfunded Pensions are Red Flag for Investors
  5. The Next Shoe to Drop?
  6. The Other Shoe – Part 2
  7. With 3-, 5-, and 10-Year Stock Returns Negative: Why Are Pension Funds Assuming 8% Returns?

Disclosure: No positions

Kenneth S. Hackel, C.F.A.
President
CT Capital LLC

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For additional information on the implications of pension underfunding and its impact on free cash flow, cost of equity and return on invested capital, pre-order- “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

Taxes-A Large Issue Looming

July 19th, 2010

“Last year we made $112 million before taxes….except we don’t pay no taxes”

-from “Some Like it Hot”

Publicly held firms try their best to replicate the Mafia’s tax rate, but normally only get there if losses are involved. As such, taxes must be carefully scrutinized for its effect on cash flow and leverge.

CT Capital’s risk (equity cost of capital) model incorporates many tax variables, including both the effective (that reported to shareholders) rate and that based on the actual taxes paid.

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Alcoa-A Coincidence?-We Think Not!

July 17th, 2010

Alcoa stock has fallen by 33% this year.  Analysts of cash flow and risk could have avoided this issue (see earlier article).

Firms that, when they halt receivables sales and tell their shareholders their cash flows would have been higher (without mentioning the positive boost to prior quarters), are raising a warning flag.

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Now You See Why The Cost of Equity Capital is So Important

July 16th, 2010

The stock volatility we have been seeing does not come without warning. On numerous occasions, I have written a high cost of equity and a low valuation multiple is a recipe for extreme volatility.

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CFOs Making the Same Mistake Again-Stock Buybacks

July 16th, 2010

As if public enterprises didn’t learn their lesson the first time (see our earlier article, The Folly of Share Buybacks), we are again seeing stepped-up buyback activity. For the S&P 500, during their latest reporting quarter, the firms in aggregate bought back $80.8 billion in common and preferred stock versus $67 billion a year earlier, a greater than 20% increase. As of the latest reporting period, S&P firms in aggregate have reported the following:

Interesting how cash dividends have deceased as a whole. Bristol-Myers ($65 MM), Deere ($117 MM)  and Goldman Sachs ($182 MM) were a few paying lower dividends. The fall in long term debt issuance is a reflection of the build in cash resulting from increased free cash flow.

Disclosure: No positions

Earlier Post: The Folly of Share Buybacks

Kenneth S. Hackel, C.F.A.
President
CT Capital LLC

Subscribe to CreditTrends.com by Email

For additional information on this type analysis, pre-order- “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

Even Under The Most Glorious Scenario BP Only Slightly Undervalued

July 15th, 2010

Surprise!  Investors get giddy, and we are seeing it with BP.

In fact, BP’s 7.5% rise today questions investor logic, absent a takeover bid, (less than 3% chance), or the price of crude jumping over $ 90/bbl.

This is because under the most optimistic of logical scenarios, one in which is as follows:

(1)  BP generates in excess of $3 billion in free cash flow this year and over $6 billion next (events which are extremely unlikely), and

(2)  its free cash flows exceed its past three-year average (pre-Gulf tragedy) starting in 2014,

(3)  its free cash flows rise by 45% over its past three-year average by 2016, and

(4)  we attach no more risk to this cash flow scenario than exists for the median S&P Industrial firm, meaning the increase in risk  associated with the past 2 months disappears.

These four assumptions, if realized, result in a current fair value of $43.25. A more realistic fair price is $40.37, which also takes off the table any additional negative event impacting the best-case cash flow forecast.

However, given another nasty surprise, the cost of equity capital (risk) is almost certain to jump over 11% .  I say an investment in BP is not worth  the risk for a minor return, especially as far greater opportunities, with considerably less risk exists elsewhere, both inside the sector and outside of it.

A 10% fall in the price of energy, even given a market cost of capital, takes the stock down at least 15%.  Of course, there is always the possibility that rumor and innuendo could take the stock higher, but I’m not one to invest in the greater fool theory, although that seems to work more often than I care to think.  Remember residential real estate?

See related articles:

Kenneth S. Hackel, C.F.A.
President
CT Capital LLC

www.credittrends.com

For additional information on this type analysis, pre-order- “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

Pensions-Buyer Beware-These Firms Exposed to Greater Risk

July 15th, 2010

Pension plans are making news-from local and state governments to large corporations. They are being cut back, eliminated or, for many, in trouble without the workforce recognizing the extent of the problem.

Most firms have been forced to prop up their plan’s health with additional cash contributions, while many other firms are simply hoping the financial markets, as they did during 2009, will bail them out.

Meanwhile, for others, the plans are so underfunded, it is just a matter of time before the inevitable takes hold-larger than expected contributions or a bailout by the Pension Benefit Guaranty Corp. Those firms have been able to make it this far due to overzealous actuarial assumptions which have moderated the true liability. However, with both stocks and hedge fund performance below zero the past three years, which firms stock prices are the most vulnerable?

The list below shows the bottom 20% of that S&P grouping, with each firm on the list underfunded to the extent such amounts to at least 5% of both their total debt (including capitalizing the operating leases, shown as a separate column), and 5% of its current stock price.  Many are in much more precarious position, as is shown.  In addition, each company on the list has both an expected return on plan assets and a discount rate at least equal to the market average. Of the S&P group of companies, the average investment assumption is 8% and the average discount rate 5.8%, both of which is presently too high and understates the true liability confronting firms with defined benefit plans. The firms on the list have expectations greater than that! Also shown are last fiscal year’s plan contributions, benefits paid and projected benefit obligation (PBO).


The PBO is the actuarial present value of all benefits earned by an employee as of a specified date for service rendered prior to that date plus projected benefits attributable to future salary increases. Indicated is the funded status of a pension plan as either overfunded or underfunded, however, all of these firms plans are currently underfunded as of their latest fiscal.

The underfunded status of defined as the sum of:

  1. Pension – Long Term Asset

minus the sum of

  1. Pension – Current Liability
  2. Pension – Long-Term Liability

Accumulated pension plan benefits are reflected at present value to remain on a comparable basis with plan assets. The assumed rate of return on assets is the discount rate used to arrive at the present value of plan benefits.

If the financial market does not bail these firms out, the alternative could quite well be additional significant  and currently unforeseen contributions which will impair reported and expected earnings, cash flows, return on invested capital, and cost of capital.

I would strongly urge all investors in these firms to thoroughly review the actuarial soundness of their plans as this represents significant  risk that can be avoided prior to the headlines.

Disclosure: No positions

Kenneth S. Hackel, C.F.A.
President
CT Capital LLC

Subscribe to CreditTrends.com by Email

To learn how to analyze pension soundness and the pension soundness and the pension footnote and reporting requirements, please pre-order “Security Valuation and Risk Analysis“, out this fall from McGraw-Hill, by Kenneth Hackel, C.F.A.

The Folly of Stock Buybacks

July 15th, 2010

Regardless of how the current earnings season is “spun”, given a boost to operating cash flows (regardless of how “manufactured), we should see an incentive to set up, or re-instate, share buybacks.  The folly of buybacks have proven substantial over the past four years, including the large number of firms that have subsequently re-sold the same securities at much lower prices; investors continue to falsely believe in the information content stock buybacks hold.

It is not unusual for buybacks  to take place even though  free cash flow is subpar, with these entities borrowing to engage in a buyback program.

Share buybacks have been traditionally viewed as an outlet for free cash flow and excess balance sheet liquidity with the intent of bolstering a firm’s valuation. By shrinking the equity base and number of shares outstanding, it is believed, the firm  would enhance its earnings and cash flow per share, economic profit, and hence its market valuation. As has been seen by the number of companies which bought back significant amounts of their stock for treasury, and later returning to investors to sell back shares at a considerably lower price, share buybacks are often a poor choice. The loss of financial flexibility and equity cushion was a central reason for the demise of many firms which had acquired large amounts of their own stock during 2007-2008. For most firms, share buybacks are used to offset the dilution resulting from stock based compensation.

Financial theory states that companies that shrink equity by buying back shares or paying of dividends with balance sheet cash and new debt tend to see their cost of capital decline. This occurs for two reasons.

The first has to do with the mystery of what management might wind up doing with the cash. Too often, bad acquisitions burn cash or lower return on invested capital, waste management time and increase leverage. This most often occurs when companies acquire outside of their own industry (Mobil, Montgomery Ward), but also when firms seek to diversify outside of their core competency from within their industry (AT&T, NCR).

As stated in the 2009 10K of Perrigo Inc. (PRGO):

As part of the company’s strategy, it evaluates potential acquisitions in the ordinary course of business, some of which could be and have been material. Acquisitions involve a number of risks and present financial, managerial and operational challenges. Integration activities may place substantial demands on the company’s management, operational resources and financial and internal control systems. Customer dissatisfaction or performance problems with an acquired business, technology, service or product could also have a material adverse effect on the company’s reputation and business.

The other benefit concerns the tax shield of interest payments. Using excess balance sheet cash to pay common stock dividends does not change the cost of capital, according to popular finance,  as payment is made after taxes, and the entity receives no tax benefit as does a credit against taxes for interest expense. It is the tax shield of interest expense which reduces a firm’s cost of (debt) capital since profits paid to creditors in the form of interest are not taxed. Unlike financial theory, if a firm paid a dividend through borrowing, it could raise cost of capital in our credit model because of the increase in leverage and debt metrics.

The Chapter 8 credit model would not lower cost of capital due to a stock repurchase program. It does not provide cash flow and reduces financial flexibility.  It has been observed, in widespread practice over the course of several business cycles, such programs actually wind up raising cost of capital more often than lowering it.

Entities buying back stock in the midst of a large capital spending program significantly raising leverage ratios would be especially prone to increases in their cost of debt and equity capital.  Business runs in cycles and even investment grade companies, like Home Depot, have seen higher cost of capital resulting, in part due to large stock repurchases.

Seen too often are share buybacks forced upon management by aggressive and vocal shareholders, hoping a share repurchase program will either support the stock or allow them the flexibility to sell their holdings.

But what if the entity has surplus cash on its balance sheet, low leverage, no promising investment opportunities, and is a consistent producer of free cash flow?  Rather than continually shrinking its equity, which has not shown to improve stock valuation, shareholders are best rewarded changing management who can find worthwhile opportunities either within or outside of the firm. Providing cash to selling shareholders has not proven to improve the wealth of the remaining shareholders if ROIC falls below cost of capital.

The road to superior stock performance has always been for management to raise the ROIC, not stock buybacks[1]. Berkshire Hathaway (BRK.A) was a slow growth, stable free cash flow producer until new management arrived, deploying excess cash at every opportunity to buy high ROIC companies, finding hundreds of opportunities, from very small to very large, including furniture manufacturers, newspapers, brokerage, food, and now a railroad.  Despite Berkshire outperforming the S&P by a huge margin, Berkshire has never repurchased its own shares.  And even today, being a company with a $195 bn. market value, the company is finding no shortage of investment opportunities, of the kind that are generally available to all investors.

BUT BUYBACKS DO NOTHING TO IMPROVE ECONOMIC RETURN

Example:

Aside from the probable loss in financial flexibility, do share buybacks otherwise improve valuation? Take the case of a hypothetical company,  Worldwide Electric Co. Think of Worldwide as having two parts, (1)the operating company which produces $ 100 mil in annual free cash flow, and (2) Worldwide’s cash and cash equivalents ( 14.3% of equity) which can be used to buy back its shares.  The firm has $100 mil in payables and no other liabilities.

Assume the company generates $ 100 mil in free cash flow (putting aside taxes), with a market value of $ 1.3bn. and 100 mil shares outstanding, so they generate $ 1.00 per share ( including interest), and the stock sells at $ 13 per share.

If they were to use their $100 million in cash to buy back 7.7 mil million shares (at its current market price), the multiple on its shares would fall to that of the operating company, or 12.5, and the company would now have approximately 92.3 mil shares outstanding.

Worldwide’s return on invested capital would remain exactly the same as we exclude interest income from our metric; we are only interested in the cash on cash return. While their GAAP ratios would  fall, including the P/E, as a result of the reduced number of shares outstanding, the more vital cash flow return ratio is identical. And by that measure, the company still produces $ 96mil in free cash flow on the same capital base, or a 13.4% return on invested capital. The only differences are the shares outstanding and the reduced cash. If Worldwide had a greater amount of cash on its balance sheet to repurchase stock, the fall in P/E and free cash flow multiples would be more dramatic and yet the return on invested capital would still remain the same 13.4%. The free cash flow multiple falls to that of the operating company, so from the shareholders point of view, their value is not enhanced. And certainly lost is their financial flexibility. If they had balance sheet debt or operating leases, their debt ratios would have increased in addition to the elimination of cash which might have been used for expansion as a low cost of capital.

Under typical circumstances, as we see in our example to follow on Clorox, a large stock buyback can completely eliminate shareholders equity.

WORLDWIDE ELECTRIC CO.
  BEFORE BUYBACK AFTER BUYBACK
Balance Sheet    
Cash 100 0
Property, Plant& Equipment 700 700
Liabilities 100 100
Equity 700 600
Market Value of Operating Co 1,200 1,200
Value of Cash 100 0
Market Value 1,300 1,200
     
Income Statement    
Free Cash Flow-Operations 96 96
Interest Income-tax free 4 0
Free Cash Flow 100 96
Shares Outstanding 100 92.3
Share price $13.00 $13.00
Free Cash Flow per share $1.00 $1.04
Free Cash Flow Multiple 13.0 12.5
Return on Invested Capital 13.4% 13.4%

 

Related Articles:

Kenneth Hackel, C.F.A.
President
CT Capital LLC

Subscribe to CreditTrends.com by Email

For additional information, please pre-order, Security Valuation and Risk Analysis, out this fall from McGraw-Hill.


[1] For example, a Wall Street Journal article, “America’s New Cash Conundrum,” January 21, 2010, pointed out that over the prior ten years, over half of the companies surveyed had a zero or negative return on their stock repurchases.

Impact to Free Cash Flow From Sale of Receivables

July 14th, 2010

Included in Alcoa’s (AA) press release this week was the statement its cash flows would have been even higher had it not been for the ending of its sales of accounts receivables.

What Alcoa didn’t state is that such sales enhanced its prior quarters, with the amount of additional sales, above the prior period (adjusted for normalized growth) to be subtracted from cash flow from operations. Alcoa’s prior periods cash flows, using traditional methods have benefited from such sales. In our analysis we back out such favorable impact to arrive at a normalized free cash flow and operating cash flows.

The sale of receivables is part of the analysis of all asset sales.

Asset Sales

For entities needing to raise cash, asset sales are always considered in addition to external financing. The least costly capital raise will always be considered first, especially if the financial turbulence is expected to be short-term and the cost of debt and equity are high.

The continual sale of inventory for below market prices, or accounts receivable factoring, normally provide an  unmistakable warning that should raise a flag for students of cash flow and risk, as the realization price reflects a cost which would not normally be acceptable to a well-financed organization. Asset sales are often a de-facto partial liquidation. Continuing asset sales that take place for lower than balance sheet values are indeed  telltale signs.

To improve operating cash flows, companies often sell operating divisions, as they rebalance their portfolio of companies in search of the highest return opportunities. Small asset sales and balance sheet management typically constitute good business practice, and add to free cash flow and reduced cost of capital. Managers committed to weeding out poorly performing business units can significantly enhance their company’s market valuation.

Significance, in accounting parlance, relates to size and whether the failure to report an event as a separate line item would mask a change in earnings or trend. The analyst should determine if the company under analysis has indeed sold assets during any particular reporting period due to weakness in its borrowing capacity, or an attempt to bolster disappointing operation cash flow. Both Enron and Delphi Corp, prior to their bankruptcies, were selling inventory with the understanding they would be repurchased at a later period, a clever way to raise cash but a telling sign of liquidity shortfall.

The securitization of assets for sale into a Special Purpose Entity, as was invoked by Enron, may not, by itself, represent a reason to sell a security or dismiss the purchase of one, especially in light of otherwise undervaluation by the marketplace. In fact, many companies have raised cash via the securitization of accounts receivable, redeploying those funds back into a business which resulted in high rates of growth in cash flows. When viewed under the light of other metrics, asset sales could form part of a mosaic, indicative of a financial risk urging avoidance of the particular security, or to place a higher discount rate on its free cash flow, accounting for the new, higher level of uncertainty.

Entities which have substantial accounts receivables, like retailers, often discount these future cash receipts for immediate cash, as Macy’s did during 2006. The figure below reveals the impact on its average collection period resulting from that sale. Of course, average collection period and similar credit metrics, such as cash conversion cycle, will be distorted by the sale of receivables.

Selling receivables boosts current period operating cash flow and thus must be normalized by the analyst in evaluating historical and prospective cash flows. To do so, one would compute the past 4 years average accounts receivable to sales and apply that to the current year, as if the financing did not occur. At that point, the analyst can evaluate the Operating and Power cash flows for that year, including the sales of receivables.

More importantly, since the upcoming year(s) cash collections will be lower, an updated cash flow projection must reflect the new expected collections, with emphasis on the ability of the entity to retire or recast upcoming debt and other obligations coming due.  Macy’s has, according to its “Financing” footnote, $2.6 bn. in principal payments due over the coming 3 years.  Since prospective cash flows will be diminished by the present value of the change in future collections, fair value could shift, depending on how the cash from the sale is deployed.  In its statement of cash flows, seen is the drop in cash flows from operations, with management reacting to by cutting budgets company wide.

MACY’S, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(millions)

2008 2007 2006
Cash flows from continuing operating activities:
Net income (loss) $ (4,803 ) $ 893 $ 995
Adjustments to reconcile net income (loss) to net cash provided by continuing operating activities:
(Income) loss from discontinued operations 16 (7 )
Gains on the sale of accounts receivable (191 )
Stock-based compensation expense 43 60 91
Division consolidation costs and store closing related costs 187
Asset impairment charges 211
Goodwill impairment charges 5,382
May integration costs 219 628
Depreciation and amortization 1,278 1,304 1,265
Amortization of financing costs and premium on acquired debt (27 ) (31 ) (49 )
Gain on early debt extinguishment (54 )
Changes in assets and liabilities:
Proceeds from sale of proprietary accounts receivable 1,860
Decrease in receivables 12 28 207
(Increase) decrease in merchandise inventories 291 256 (51 )
(Increase) decrease in supplies and prepaid expenses (7 ) 33 (41 )
Decrease in other assets not separately identified 1 3 25
Decrease in merchandise accounts payable (90 ) (132 ) (462 )
Decrease in accounts payable and accrued liabilities not separately identified (227 ) (396 ) (410 )
Increase (decrease) in current income taxes (146 ) 14 (139 )
Decrease in deferred income taxes (291 ) (2 ) (18 )
Increase (decrease) in other liabilities not separately identified 65 (34 ) 43
Net cash provided by continuing operating activities 1,879 2,231 3,692
Cash flows from continuing investing activities:
Purchase of property and equipment (761 ) (994 ) (1,317 )
Capitalized software (136 ) (111 ) (75 )
Proceeds from hurricane insurance claims 68 23 17
Disposition of property and equipment 38 227 679
Proceeds from the disposition of After Hours Formalwear 66
Proceeds from the disposition of Lord & Taylor 1,047
Proceeds from the disposition of David’s Bridal and Priscilla of Boston 740
Repurchase of accounts receivable (1,141 )
Proceeds from the sale of repurchased accounts receivable 1,323
Net cash provided (used) by continuing investing activities (791 ) (789 ) 1,273

Source: Macy’s 2008 10K

In many cases, it is less expensive to borrow funds with the creditor taking a security interest in accounts receivables and inventory. This would be a loan, not a factoring agreement where the accounts receivable are sold. In a factoring arrangement, the cost to the firm is typically higher.

When receivables are financed through borrowings, it is shown as a finance activity, even though the actions are basically identical to its sale. Also, by factoring, the firm keeps the loan off of its balance sheet. Another issue to consider is whether the receivables being sold were done so on a non-recourse basis, so that if they are ultimately uncollectable, Macy’s has no further legal obligation. A moral obligation, may exist, however, and must be considered.

The figure below shows Macy’s average collection and payables period for 2003-2009 fiscal years.  When Macy’s sold about $ 4.1 bn. of their in-house receivables during 2005-2006, it dropped their collection period, but of course, the company paid a price for the immediate cash. They did reduce total debt by about $ 1.5 bn. but unfortunately they also succumbed to shareholder pressure and expended $2.5 bn. on the repurchase of shares, hopeful the buyback would boost the stock price, which it did not, since their cash flows were weak.

To Macy’s, which had substantially increased its leverage resulting from its $ 5.2 bn. purchase of May Department Stores the year earlier, the cash resulting from the sale of receivables might have ultimately staved off bankruptcy two years later when its business fell due to the recession and loss of market share to competitors, the latter not a atypical byproduct of a large business combination. For sure, management wished the $ 2.5 bn. stock buyback never took place. The $2.5 bn. outflow robbed Macy’s of needed financial flexibility by eliminating a large cushion when its business turned down.

While the sale of receivables does indeed provide immediate cash, it is important to consider why the action was taken, especially for companies that operate on tight margins. For such entities, the sale may eliminate profits those sales initially produced. For them, if the cash is not used to pay down trade payables or other business related obligations, the analyst must question where such cash will eventually come. Because Macy’s wasted funds from the sale on share buybacks, they cut their purchases of PPE in half over the next two years. It is difficult to imagine a large sale of accounts receivable to buy back shares is ever a good idea.

Macy’s-Days to Pay vs. Collections Period

For additional information on this type analysis, pre-order- “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

Disclosure: No positions

Kenneth S. Hackel, C.F.A.
President
CT Capital LLC

www.credittrends.com

AMD (Reporting Tomorrow)—It’s not Intel

July 14th, 2010

At the end of last year, to avoid having to consolidate its  83% ownership investment in Globalfoundries, which, if undertaken would have harmed its financial results and balance sheet, AMD took the unusual step of renouncing its control in that large enterprise.

Adopted by FASB in June, 2009 for adoption beginning in 2010, FAS 166, Accounting for Transfers of Financial Assets, and No. 167, Amendments to FASB Interpretation No. 46(R), changes the method by which entities account for securitizations and special-purpose entities. FASB 166 relates to the consolidation of variable interest entities, and 167 amends existing guidance for when a company “derecognizes” transfers of financial assets. A variable interest entity is a business structure that allows an investor to hold a controlling interest in the entity, without that interest translating into possessing enough voting privileges to result in a majority. The new standard requires noncontrolling interests be reported as a separate component of equity and that net income or loss attributable to the parent and noncontrolling interests be separately identified in the statement of operations.

Under this recent accounting rule dealing with variable interest entities, which took effect this year, AMD would have been required to consolidate Globalfoundries  its debt and income into AMD. By renouncing its control, AMD is merely required to state its investment as a single line entry, even though it may be partially or wholly on the hook for a share, or all,  of its debt.

These type of actions, while having little to no impact on cash flow, can nevertheless serve as signals of impending busineess conditions. For if AMD’s position was strong, we doubt such a transaction would be considered. But that’s the result of a firm with large negative free cash flow with high cost of capital-unlike Intel.

No wonder AMD’s stock has continued to fare poorly.