Archive for December, 2010

Slowing Economic Growth Means Greater Focus on Economic Profit

December 31st, 2010

As I have long pointed out, firms which can add to their capital base projects that are value adding (have a return on invested capital (ROIC) greater than cost of capital, with a good margin of safety), will reward shareholders. But what happens when firms cut back their own such spending or have the ability to piggyback others’ capital or resources, such as R&D or support functions?

As the current period of slow economic growth continues, firms may continue to ration their capital base, seeking creative means toward higher free cash flows. Included will be using “others” capital as well as the time-honored low cost producing outlets.

Companies can, especially as the trend to low-cost manufacturing countries evolves, be expected to continue to reduce their property, plant and equipment (PPE) relative to revenues, with a resultant increase in balance sheet cash, short-term investments, and expansion opportunities. Certainly, Apple Computer (AAPL) has been a leading company in this regard, and in the process has been generating very high amounts of excess cash. Investors are, in Apple’s case, ignoring the very low returns on its cash in their valuation of the company, focusing instead on its high economic profit.

As industrial efficiencies evolve, improvements in technology take place, and management consultants develop techniques to enhance supply and production methods, productivity improves and the growth rate of productive capital falls. This need for less capital intensity positively affects return on invested capital, cash required and financial ratios.  McKinsey & Co. found the median level of invested capital for U.S. industrial entities dropped from around 50% of revenues in the early 1970s to just above 30% in 2004.[1]

What McKinsey found in 2005 has only picked up momentum since. Worldwide competition for sales and market share, especially as economic growth has slowed, has led to additional expense skimming and creative means to reduce or minimize the capital base given a projected revenue stream.

For certain industries, which have a naturally low capital base, such as service-oriented entities, return on invested capital will be naturally high. And for manufacturing entities which effectively utilize outsourcing or other entity’s capital for a substantial part of assembly or service, they too, would have an unnaturally low capital base resulting in high ROIC. That does not make return on invested capital any less important; however, we introduce another measure, which is intended to evaluate the cash return on the company’s deployment of resources—its economic profit. The economic profit should then be compared to sales. Doing so can remove many of the distortions of ROIC and improve inter-company comparability.  Even when ROIC makes sense, economic profit should be employed as another measure to evaluate the firm.

Economic profit could also be related to other firm factors, such as total employees or units sold. Doing so would provide the analyst with comparability measures specific to a particular industry or situation. When used in this way, economic profit can indicate management ability to create value relative to its peer group or the direction and efficiency of its spending. For example, a pharmaceutical company analyst may wish to look at the economic profit per researcher.

Economic profit is defined as a company’s free cash flow exclusive of interest income minus a capital charge, with the charge calculated as the company’s weighted average cost of capital multiplied by the operating invested capital. The traditional definition of economic profit utilizes after-tax operating profits in lieu of free cash flow.

Example

Calculating the 2008 Economic Profit for 3M (MMM) using the following financials:

From the free cash flow, interest income is subtracted since we are computing the economic return on the invested capital, not the total free cash flows, which include the returns on the financial assets as well.

MMM’s economic profit was $ 2.2 bn. during 2008

When we compare MMM’s economic profit to its 2008 revenues of $ 25,269 mil, we arrive at 8.9%, which could then be compared to its historic results or to other companies in its industry.  The economic profit could also be related to employee headcount or other useful factors important to the company.

Example:

This is how Clorox (CLX) computed its economic profit for fiscal years 2007-2009. As seen, it utilized a partial cash flow format by excluding some non-cash charges.

Source: Clorox Corp 2009 10K

Clorox could have taken its definition a step further, as we did with MMM, by substituting free cash flow for operating profit, since operating profits are subject to GAAP and we are gauging cash return, to compare the result to revenues or other useful measures, including invested capital.  We believe our definition of free cash flow and capital employed to be more reflective of invested capital than is Clorox’s definition. Clorox uses a weighted average cost of capital (WACC) of 9% but doesn’t reveal how that was determined. It is most likely they are using the Capital Asset Pricing Model (CAPM) to compute the equity cost of capital.

I have found that firms that focus on economic profits as well as ROIC, have a greater tendency to engage in value creating opportunities. The beneficial effect of higher free cash flows results in superior stock performance for their shareholders. The trend toward using other entity’s capital is not confined to the manufacturing sector, as service entities also deploying labor outside of their cost structure.

Related articles:

Disclosure: No positions

Kenneth S. Hackel, CFA
President
CT Capital LLC

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[1] McKinsey & Co. study based on an analysis of more than 600 companies with sales of more than $ 100 mil. “Comparing Performance when Invested Capital is Low,” 2005, McKinsey Quarterly.

Protected: How I Learned to Stop Worrying and Started Analyzing Risk

December 29th, 2010

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December 22nd, 2010

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About CT Capital LLC

December 21st, 2010

Credit Trends is owned by CT Capital LLC.

CT Capital was established to manage equity portfolios based upon:1- Free Cash Flow-the maximum amount of cash an entity could distribute to shareholders from operations, includes an analysis of discretionary expenditures, both over- and under spending as well as those liabilities which should have been reflected on the primary financial statements. It also includes classification errors in the stamtment of cash flows

2-Return on Invested Capital-presents us with a real cash on cash return management has been able to earn on invested capital.It begins with our proprietary definition of free cash flow, not operating earnings

3-Cost of Capital-our models capture the true operating and financial risk of the entity and form the important discount rate from which fair value is derived. It captures everything from sales, input  and tax stability to litigation, yield spreads and sovereign risk. It is a true measure of the risk to prospective free cash flows.

CT Capital’s proprietary definition of cost of capital was developed using sophisticated modeling and analytic techniques supported by a decade of research.Its models consist of over 70 factors which result in a superior discounting mechanism from which to discount an entity’s free cash flows.
CT Capital’s free cash flows result from converting to a quasi cash accounting thru eliminating many of the accounting conventions companies utilize which can help create an “artificial” result. We also add to this result by incorporating enhancements such as evaluating unncessary and exaggerated discretionary areas which could be used to enhance free cash flows.
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Protected: Why Cash Flow from Operations Must Be Adjusted

December 21st, 2010

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For Some Investors, Time to Rock the Boat

December 20th, 2010

“don’t rock the boat, don’t tip the boat over
rock the boat, don’t rock the boat baby
rock the boat-t-t-t-t”

– Hues Corporation

The current bull market in equities, taking the S&P 500 from a fall of 10% to a rise of 14%, is making many investors complacent when, perhaps, they should be acting. Investor analysis and action has greater implications if interest rates and cost of capital rise, which would be common at this stage of the economic cycle. Firms which have a large spread between their cost of capital and return on invested capital (ROIC) will have a critical advantage over those firms which have more narrow spreads, which will ultimately lead to earnings and cash flow disappointments for the latter group. To the extent the bull market has made these firms overvalued, their stocks should be sold.

» Read more: For Some Investors, Time to Rock the Boat

Firms Holding On To Cost Cuts

December 17th, 2010

The bull run in stocks with increasing consumer confidence would ordinarily lead to a partial reversal of the significant cost cutting which has been more than partially responsible for the large increase in free cash flows. Typically found is reduction in overhead both during and several quarters out of recession, at which point costs once again flair up.  According to McKinsey & Co., only 10 percent of cost reduction programs sustain their results three years on.

» Read more: Firms Holding On To Cost Cuts

Will the New Year’s Rally be Reversed with a Low Score in the Super Bowl?

December 14th, 2010

Investors are a superstitious bunch, and with superstitions or inkblots, many see patterns that are figments of the imagination. January effect, summer rally (or doldrums), Super Bowl effect (low scores associated with poor stock markets), Yom Kipper rally, Santa Clause rally, or perhaps even an October massacre, may be in the cards for 2011.

» Read more: Will the New Year’s Rally be Reversed with a Low Score in the Super Bowl?

Protected Posts Open to……..

December 13th, 2010

Anyone who purchases a copy of the acclaimed text, Security Valuation and Risk Analysis

Protected: Apple Inc. (AAPL) – CT Capital’s Fair Value Estimate

December 13th, 2010

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How Dividends Can Destroy Value

December 13th, 2010

News from the Federal Reserve last week that balance sheet cash represents 7.4% ($1.9 trillion) of non-financial corporation’s assets presents as much reason for fear as celebration. In fact, the CT Capital credit model may actually penalize firms having excess cash due to: (1) fear it will be unwisely spent; and, (2) balance sheet cash lowering the return on invested capital (ROIC). I much prefer firms invest excess cash into additional opportunities which offer even greater prospective free cash flows (adjusted for its cost of capital)—that is the very essence of a value-producing entity which brings superior returns to shareholders.

» Read more: How Dividends Can Destroy Value

Next Up-Fair Value- Apple

December 11th, 2010

Over the course of the next year we will provide up to date fair values of the equity securities of widely held and in-the news companies.

The analysis will be based on the methodology of “Security Valuation and Risk Analysis” and will only be available (through password) to those who have purchased the text. After January, 1, the cost for a year’s subscription will be fixed at $1000.00 for the year. There will be no extensions and the offer will not be repeated.

We will also publish in this location general stories of interest, for which a purchase of the text is not required.

Please read the interview below to learn of our  detailed and leading-edge security analysis-sure to be emulated by others in the years ahead, as was true with my prior text: Cash Flow and Security Analysis

http://www.facebook.com/note.php?created&&note_id=289434414966&id=97400503724

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Thanks,

Ken

Protected: Fair Value – IBM

December 9th, 2010

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Protected: Growth, IBM and Google

December 8th, 2010

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Friday’s Labor Report, Stock Options and Fair Treatment of Equity Investors

December 6th, 2010

The payroll data from the Department of Labor released last Friday suggests economic growth will remain sluggish, despite otherwise suggestions from the recent blip in the stock market. As CT Capital has shown in the past, it is credit, not the level of stock prices that pinpoint turns in the economy—both recession and expansion.

» Read more: Friday’s Labor Report, Stock Options and Fair Treatment of Equity Investors

Credit Trends Going to Paid Subscription Site

December 2nd, 2010

As I wrote a few weeks ago, I preferred to keep Credit Trends a free site. I was hoping to sell just 100 books from this location, which would just cover the expense of maintainence-unfortunately, this has yet to be the case.

Therefore, effective immediately,  all articles which offer an investment opinion on individual companies will require a password and ID. The charge for a yearly subscription is $1,000.00.

Anyone who purchases a copy of Security Valuation and Risk Analysis in the next 30 days, or has already done so, and can offer proof, contact us, and you will be given accreditation. Fill out the “Contact Us” form with your email address and the first word on page 485 of the book. This offer will definitely expire on January 1, 2011.

Kenneth S. Hackel, CFA

Protected: Google Versus Intel-What Their Option Pricing Strategy Reveals About Their Cash Flows

December 1st, 2010

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