Archive for February, 2011

Risk Rising Modestly

February 22nd, 2011


Changes in risk-real or perceived-has been at the crux of every major economic and financial dislocation. Most recently, the fall in prices of financial instruments leading up to the 2008 worldwide credit crisis and subsequent 2009 price recovery began with a whiff of credit depression and later, relaxation.

Even for periods between crisis and recession, political and self-inducing events can place valuations and prices under strain, forcing an upward revaluation of cost of capital.  As such, equity investors must continuously monitor change in the financial markets risk profile. If the perception of risk is increasing, even if cash flows and credit health are currently strong, one should expect the prices of financial instruments to decline.

This risk to cash flows is incorporated and is the purpose of the cost of equity capital.

Current political tensions have slightly elevated the risk to free cash flows, causing us to raise our cost of equity capital by 15 basis points for all U.S.-based companies. From China to the Mid-East, the re-valuation of risk metrics in our models is apparent; however, an over-reaction to events  is also not justified given the factors we look at. We do not carry direct investments in the most effected countries.

Included in the factors we assess when assigning a cost of capital score for the sovereign risk metric include terrorism, inflation history, fear of nationalization, hunger, poverty, and corruption. Needless to say, most of these metrics pointed to the negative outcome we are witnessing today.

The groundswell that began in Egypt is empowering citizens around the globe, and while it has not spread to the most industrialized nations, it would be naive to assume, given large budget deficits in U.S. States and Federal government, there could not be some backlash here as well. Pensions and rising costs (education, food, and clothing) could spur scattered protests and widespread news coverage.

At present such risks are contained, but one which could impact both the current level of consumer confidence as well as capital decisions. And while a 15 basis point increase will not result in a shift to our current portfolio, it does serve to ratchet up the required return for making equity investments.

Inflation is also a weighty factor in the cost of capital, entering into both the risk free rate as well as other metrics.

It is difficult to find a reporting firm that has not been negatively impacted by the rise in input costs, with warnings of a continuing negative impact to come. In China, some companies are reporting wages are rising as much as 40% for factory workers. We currently assess a cost of capital for Chinese companies 75 basis points greater than Canadian companies given similar free cash flows and credit health. US firms receive a 25 basis point mark-up over Canadian firms.

Here in the U.S., yields are rising due to commodity cost pressure and, according to Federal Reserve data, lower foreign purchases of U.S. bonds. Hedge funds are also increasing their leverage, according to Federal Reserve data which tracks borrowing against bonds not tied to the US Government, as these funds attempt to leverage up.

While our credit models continue to indicate improvements to free cash flow, we are not seeing a strengthening in credit for the S&P Industrials over the past 2 quarters, which we can tie directly to the outlays for share repurchases.

All in all, we cannot be so blind as to ignore recent happenings, as is captured by our various model metrics, including credit spreads and political tensions. We see that yields on third world debt and credit default swaps have been rising as well, while the latter remain steady for U.S. fixed income instruments, perhaps a result of Federal Reserve policy and hedge fund buying.

With cost of capital having slightly risen, one would expect investors to pay closer attention to cash flow and credit. This has not generally been the case over the past year and a half, as evidenced by the tightness of junk bond yield spreads.

Kenneth S. Hackel, CFA

Protected: Pensions – Is $3 Trillion in Equities About to Hit the Market?

February 11th, 2011

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For An Accurate Presentation of Free Cash Flow, Correct Classification of Statement Items Required

February 7th, 2011

A review of EDGAR filings, the SEC system for which public companies transmit financial information, finds over 90% of reporting companies defining free cash flow as operating cash flow minus capital expendituresExample:

MORRIS TOWNSHIP, N.J., January 28, 2011– Honeywell (NYSE: HON) today announced full-year 2010 sales increased 8% to $33.4 billion vs. $30.9 billion in 2009. Earnings per share (proforma) were up 12% to $3.00 versus $2.69 in the prior year, excluding the unfavorable impact of the pension mark-to-market adjustment. Reported earnings per share for 2010 were $2.59 versus $2.05 in the prior year. Free cash flow (cash flow from operations less capital expenditures) was a record $3.6 billion (cash flow from operations of $4.2 billion).

Source: Honeywell 8K

Unfortunately, corporate financial reporting does not often provide investors with an accurate assessment of the real free cash flows, and hence adjustments to reported financial statements are required. Free cash flow should be defined as the maximum amount of cash an entity could distribute to shareholders without impairing its rate of growth or through return of capital.

Hence, it is up to the analyst to reclassify those financing and investing activities which are more appropriately operating activities and, as such, would provide (potential) investors with a more realistic indication of the true free cash flow generating capacity of the enterprise. This is true even though classification of a particular activity is prescribed or generally accepted, as we see in the examples below.


For “payments to noncontrolling interests”, to whom as long as they continue to operate profitable operations may be due cash, payments are classified as financing activities while the purchase of the noncontrolling interests would be classified as an investing activity. Unfortunately, for investors who fail to reclassify the payments to the operating activity section, under the common definition of free cash flow, the reader of the financial statement is left with the impression of exaggerated, and incorrect, free cash flows.

For instance, AmSurg Corporation (AMSG), in partnership with physicians, operates surgery centers, where the partnerships may result in cash payments due the minority owners. Such operating cash payments which may result from profitable locations are as much a cost of doing business as payment of salaries or taxes. In common practice, the company classifies these outflows as Financing Activities, the payments representing “outflows or other distributions to owners”, as set forth under FAS 95.

Under the microscope of free cash flow, where free cash represents the income to shareholders of the common stock, the analyst would need to deduct such outflows, which in AmSurg’s case, is sizeable, accounting for over half of reported Cash Flow from Operating Activities (see below). To do otherwise would seriously misrepresent free cash flows as these payments could not be given to shareholders without impairing capital.

To conclude that AmSurg had free cash flows of $214 MM (we add sale of PPE in the Statement shown) would be incorrect. The analyst would need to reclassify the $130.9 MM as an operating activity from which capital spending and proceeds from PPE would be factored, leaving free cash flow as $83.1 MM, or 37% less than would normally be defined.

At CT Capital, as explained in Security Valuation and Risk Analysis, we also account for overspending in discretionary areas, so that, in the case of AmSurg, we would add $2.7 MM back to free cash flow to account for overspending in its cost of goods sold, which could represent overspending of many items in the production and sales process. We would also deduct half of the share repurchases, or $6.3MM, which represents that amount of cash necessary to maintain a steady share count over the prior year. Share based compensation has a real cost. The other half of the buyback would in fact represent free cash flow. Thus free cash flow for the year would approximate $79.5MM, which would depict the maximum distributable cash available for shareholder distribution, or free cash flow.

When making adjustments to published financial statements, the analyst must also adjust or normalcy of one-time (extraordinary) payments or events. Also, taxes, interest and dividends a firm would classify as an investing or financing activity should most often be melded into operating activities. This will also allow for better comparability.

AmSurg Corp.
Consolidated Statements of Cash Flows
Years Ended December 31, 2009, 2008 and 2007
(In thousands

2009 2008 2007
Cash flows from operating activities:
Net earnings $ 181,350 $ 165,926 $ 150,303
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization 22,927 20,815 18,648
Net loss on sale and impairment of long-lived assets 455 922 724
Share-based compensation 4,068 4,710 4,560
Excess tax benefit from share-based compensation (32 ) (1,351 ) (3,322 )
Deferred income taxes 14,703 14,729 8,063
Increase (decrease) in cash and cash equivalents, net of effects of acquisitions and dispositions, due to changes in:
Accounts receivable, net 1,494 3,792 (2,300 )
Supplies inventory (60 ) (83 ) 47
Prepaid and other current assets (733 ) 2,344 (2,958 )
Accounts payable 1,289 (1,904 ) 962
Accrued expenses and other liabilities 6,666 (487 ) 8,128
Other, net 457 283 61
Net cash flows provided by operating activities 232,584 209,696 182,916
Cash flows from investing activities:
Acquisition of interests in surgery centers and related transactions (95,826 ) (118,671 ) (162,777 )
Acquisition of property and equipment (19,930 ) (18,379 ) (24,640 )
Proceeds from sale of interests in surgery centers 1,298 3,812 5,433
Repayment of notes receivable 1,666 1,458 2,616
Net cash flows used in investing activities (112,792 ) (131,780 ) (179,368 )
Cash flows from financing activities:
Proceeds from long-term borrowings 137,178 157,787 178,316
Repayment on long-term borrowings (116,951 ) (114,788 ) (89,712 )
Distributions to noncontrolling interests (130,855 ) (118,769 ) (103,545 )
Proceeds from issuance of common stock upon exercise of stock options 201 9,970 17,661
Repurchase of common stock (12,587 ) (12,413 )
Capital contributions and ownership transactions by noncontrolling interests 1,036 582 480
Excess tax benefit from share-based compensation 32 1,351 3,322
Financing cost incurred (17 ) (41 ) (200 )
Net cash flows (used in) provided by financing activities (121,963 ) (76,321 ) 6,322
Net (decrease) increase in cash and cash equivalents (2,171 ) 1,595 9,870
Cash and cash equivalents, beginning of year 31,548 29,953 20,083

Exhibit 2

In the Statement of Cash Flows for Boeing (BA), we would reclassify both the “Payments to noncontrolling interests” and the “payments on guarantees” to the operating activity section, thereby reducing free cash flows. Payments on guarantees represent the impact and success of the firm’s operations, including its ability and technical skills in the manufacturing process as well as their ability to provide services promised, and should therefore be considered operating, not financial or investing activities. Payment on guarantees would be considered a reversal of profits, which is an operating activity under the indirect method.

The Boeing Company and Subsidiaries

Consolidated Statements of Cash Flows

(Dollars in millions)
Years ended December 31, 2009 2008 2007
Cash flows – operating activities:
Net earnings $ 1,312 $ 2,672 $ 4,074
Adjustments to reconcile net earnings to net cash provided by operating activities:
Non-cash items –
Share-based plans expense 238 209 287
Depreciation 1,459 1,325 1,334
Amortization of other acquired intangibles 207 166 152
Amortization of debt discount/premium and issuance costs 12 11 (1 )
Investment/asset impairment charges, net 151 50 51
Customer financing valuation provision 45 84 (60 )
(Gain)/loss on disposal of discontinued operations 36 (28 ) (25 )
(Gain)/loss on dispositions, net 24 (4 ) (38 )
Other charges and credits, net 214 116 197
Excess tax benefits from share-based payment arrangements (5 ) (100 ) (144 )
Changes in assets and liabilities –
Accounts receivable (391 ) 564 (392 )
Inventories, net of advances and progress billings (1,525 ) (6,168 ) (1,577 )
Accounts payable 1,141 318 (198 )
Other accrued liabilities 1,327 554 1,126
Advances and billings in excess of related costs (680 ) (1,120 ) 2,369
Income taxes receivable, payable and deferred 607 744 1,290
Other long-term liabilities (12 ) (211 ) 71
Pension and other postretirement plans 1,140 14 (143 )
Customer financing, net 104 432 1,458
Other 199 (29 ) (247 )
Net cash provided/(used) by operating activities 5,603 (401 ) 9,584
Cash flows – investing activities:
Property, plant and equipment additions (1,186 ) (1,674 ) (1,731 )
Property, plant and equipment reductions 27 34 59
Acquisitions, net of cash acquired (639 ) (964 ) (75 )
Contributions to investments (2,629 ) (6,673 ) (5,710 )
Proceeds from investments 1,041 11,343 3,817
Payments on Sea Launch guarantees (448 )
Reimbursement of Sea Launch guarantee payments 40
Purchase of distribution rights (178 ) (182 )
Net cash (used)/provided by investing activities (3,794 ) 1,888 (3,822 )
Cash flows – financing activities:
New borrowings 5,961 13 40
Debt repayments (551 ) (738 ) (1,406 )
Payments to noncontrolling interests (40 )
Repayments of distribution rights financing (357 )
Stock options exercised, other 10 44 209
Excess tax benefits from share-based payment arrangements 5 100 144
Employee taxes on certain share-based payment arrangements (21 ) (135 )
Common shares repurchased (50 ) (2,937 ) (2,775 )
Dividends paid (1,220 ) (1,192 ) (1,096 )
Net cash provided/(used) by financing activities 4,094 (5,202 ) (4,884 )
Effect of exchange rate changes on cash and cash equivalents 44 (59 ) 46
Net increase/(decrease) in cash and cash equivalents 5,947 (3,774 ) 924
Cash and cash equivalents at beginning of year 3,268 7,042 6,11

Additional disclosure: CT Capital is long AMSG for client portfolios