For Some Investors, Time to Rock the Boat

December 20th, 2010 by hackel Leave a reply »

“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.

Complacency is a trait common among stock investors as we saw going into and during the worldwide credit crisis; an attitude, by the way, that reminds me of my father, who was afraid to visit doctors on fear of them “finding something.” For a long time it worked in his favor, and he merrily carried about his business.

For those investors who caught the recent growth stock wave, they would be wise to weigh the prospects for growth in their free cash flow yield relative to the 10-year treasury yield[1]– I speak here of the valuations found in firms like Netflix (NFLX), Priceline (PCLN), (CRM), and the rest of the new nifty fifty. No doubt, trends typically last longer in either direction than logic would dictate, but to deny that valuations should enter into the investment process would be to negate a fundamental building block of security analysis.

As we saw last week with Best Buy (BBY) and some other high powered growth stocks, disappointment can be very costly; for sure, others are on the way. The median firm with 25% sales growth over the past 8 quarters is up 23% so far this year. When you include only those firms which have had normalized and adjusted free cash flow growth of greater than 10% and are also value-adding, the median return rises to 26.9% for the year. This makes sense as CT Capital’s model portfolio holding is up on average over 25% since August 19th when we began its maintenance.

My biggest fear going into 2011 are Board of Directors who believes the key to enhancement of long-term value is through stock buybacks and dividend increases. Sure, there are plenty of firms that have performed remarkably this way, but their key has been the growth in free cash flows which allowed for the distributions, not the shrinking of the equity.  I admire firms that build value both through internal and external actions, allowing for margin improvements and successive rounds of increasing cash flows while keeping a lid on their cost of capital. Should the unexpected occur, financial flexibility becomes a necessary part of future growth and shareholder reward.

My wish list for investors in the New Year is they further their understanding of the role credit plays in security analysis and properly factoring in such thinking into their analysis.  One example is making sure credit facilities are in order and are properly priced, including evaluating the soundness of the institutions that participate in the syndicate (please read my recently released text, Security Valuation and Risk Analysis, to learn more about this).

Investors’ true reward are the free cash flows, and, as such, investors must scrutinize its consistency.  At CT Capital, the free cash flow hurdle rate is based on a sliding scale from the 10-year Treasury note, currently at 130%.

Upon completion of the examination and estimation of free cash flows, cost of capital, and ROIC, a sensitivity analysis must be performed, such as illustrated below (Exhibit 1), for Fluor (FLR), a CT Capital buy list stock. Even though our model assigned an 8% cost of equity, we recognize various risk outlooks, and even with a 9% cost of equity, we see Fluor is undervalued. My point is investors should be more comfortable in a stable boat, even though a shaky one can provide some thrills.

Exhibit 1- Fair Value-Fluor Inc


With so many stocks now selling at free cash flow yields below the 10-year Treasury, the only incentive to make a capital investment in such enterprises is if: (1) you are relatively certain the free cash flows will rise to a level consistent with their current valuation; or, (2) you’ll find a greater fool in the future. Do their products and services provide assurance of such necessary growth?  Do they have growing cost pressures which, even if not apparent, do manifest throughout the cycle? How about taxes, lawsuits, or other risks, aside from competition? You better be sure with the high flyers, many of which are rising from hedge funds and other momentum investors who don’t know or care to know a balance sheet from a balance beam, but know a trend when they see one. And they will ride it for as long as it lasts.

I have problems recommending purchase in stocks like (CRM), despite its successful business model and growth in its free cash flows of 35% per year over the past 7 years and 11.1% compounded annually over the past three. If CRM sees growth in free cash flows of 15% per year compounded over the next 22 years-a pretty tall assumption- its stock is still only worth just $114 currently. That’s because its valuation is extremely high ($18 billion) with just $250 MM in annual free cash flows.

Exhibit 2- Fair


The discrepancy between CRM’s free cash flows and net income (as seen in the Exhibits) evolves from its large growth in subscription revenues, a result of growth in deferred revenues, which provides cash but, because part of the service has not been performed, has not been recognized as income. As such, Exhibits 4 and 5 below show the net profit margin falling relative to free cash flow generation. CRM has continued to spend heavily on marketing, an investment which has paid off in a big way, but, at current valuation, the “valuation party” can’t end for a long time.

Its large growth in marketing expense (found in SG&A) and R&D has thus far paid off for CRM as seen in its free cash flows and revenue growth. Because of marketing’s success in returning revenues, SG&A and R&D+Acquisitions as percentage of revenues have remained flat to down (Exhibits 6 and 7). Asking this margin trend to continue for then next decade is perhaps not realistic, although given we are in the midst of a bull market, the last person holding the bag may not be known for a while.

Microsoft (MSFT) (Exhibit 3) was also, like CRM, a one-decision stock. Can investors reasonably expect any company with $1 billion in revenues to see consistent annual 15% growth for its upcoming 15-20 years?


Exhibit 3- Microsoft Stock Price 1987-November 2010


Exhibit Free Cash Flow and Net Income/Sales



Exhibit 5- Quarterly Year Over Year Growth in FCF and Net Income/Sales



Exhibit Annual-Acquisitions, SG&A and R&D



Exhibit 7 SG&A/Sales and R&D+Acquisitions/ Sales-Annual



Fast growth in free cash flows can truly reward shareholders as they pick up on the changing dynamics.  When these firms sell at reasonable valuation multiples and, given a continuance in adding value, can expect superior returns[2]. Google (GOOG) and Apple (AAPL) certainly come to mind, even at current levels. Less risky firms that fit the bill are the high quality insurers, with many selling at below market free cash flow multiples, and have high economic returns with moderate cost of capital. To me, these investments represent appealing risk/rewards which have historically made for superior outcomes.

For firms which do not have the value-adding projects open to them, they must create value from within to improve ROIC. Improvements to margins are an important component of value creation- more efficient advertising, productivity, tax management, balance sheet, component costs, or supply chain and pricing are required for such enterprises. 

If the essential building blocks of value are not positive—valuation, cost of capital, and return on invested capital—chances are, sooner or later, you will be in for a nasty surprise. So enjoy the growth stock party, if you are involved, for however long it lasts, but be sure to remember how quickly it can end. At that stage you want to be feeling comfortable the securities you own will provide you with the income (free cash flows) you expected when the buy decision was made.

Disclosure: No positions

Kenneth S. Hackel, CFA
CT Capital LLC

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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis,” McGraw-Hill, 2010.

[1] The free cash flow yield is the normalized expected free cash flows as a percentage of the firm’s current market capitalization

[2] Value is created through taking on projects which have a return on invested capital greater than the cost of capital. See Security Valuation and Risk Analysis for a complete understanding.


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