CT Capital LLC-Q1 Review–Gen. Dist Ed
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Investment report Q1 2020
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REVIEW AND OUTLOOK
“Faith in the future, out of the now”
–John Lennon
INTRODUCTION
Professionally, I have seen a very wide, often deep, and diverse set of financial circumstances in my almost half-century in this industry, both micro and macro. I have seen firms with seemingly high rates of stable growth decades into the future fail and firms emerge from bankruptcy into market leaders.
The current period ranks as the most difficult from a financially analytical perspective, as the protagonist was not borne out of a financial event and so needs to be solved by the non-financial sector.
The great lesson from the ranks of economic history, regardless of trigger, is the current dark period will end, yet the financial and related impacts will not be known for some time. And so there will be winners and large losers, commensurate with periods of large pricing volatility reflective of the new, higher cost of equity capital.
Firms with abundant credit resources will have an easier time to the other side while others will have a long road back, if at all.
One of the hallmarks of the rise in cost of equity capital is a small change in perception often leads to outsized changes in market value.
The current period requires a deep dive on credit, regardless of the time horizon of salvation. Many firms will, a result of breaking through negative covenants, be prohibited from various actions, including dividend payments, additional borrowings, acquisitions, or asset sales without a bank waiver.
Our assessment commences with the current liquidity profile, sources of potential capital with associated costs, expected loss of revenues and updated cash flow, legal commitments, potential asset sales, and as always, litigation. Smaller supplier firms might find relief at reasonable cost from their larger, stronger capitalized customers for part of their capital needs, both of a monetary and non-monetary nature. Others will look to non-banks or typical lending institutions, depending on their equity access.
Our strong credit firms should be able to capitalize on others weakness as Air Products did this past week in its $530M acquisition of 5 hydrogen plants having assured customer sales.
Where trans-ocean shipping is required, ports might be closed or on slowdown which too would require cash and efficient inventory and operational management.
Our holdings share the important strength of abundant calls on credit; a few have been wise having entered forward equity sales instituted when shares were considerably higher. Most firms have begun to utilize financial options as well as cuts to operations, share repurchases and dividends, capital spending, hiring and other measures. Crisis management teams are in full force.
We are hopeful firms will finally recognize the real cost of share buybacks and dividend payments and carefully weigh that cost when the crisis ends. As many firms that participated in such activities are now in dire need of cash.
We review the impact on employees and key suppliers and any potential fallout, including related alterations to the landscape such as cost and productivity. Contingency plans need to be established and clearly communicated to creditors and shareholders.
President Trump is the de-facto majority owner of firms like General Motors and others relying on federal aid, without which they could well fail. If the President “asks” such firms to switch production to a health-related item, they will feel enormous pressure to follow the directive. This too has a cost and must be considered in the analysis, including any lost market share and related impact going forward, vis-a-vis competitors.
We must not lose sight of the crisis moderating; of understanding where the firms stand on the credit front (liquidity profile, including that of customers and suppliers) and if changed, the new level and sourcing of sales, supply chain, divisional count, plans for implementation of improved and reliable technologies including robotics (don’t get viruses) and of understanding the firm’s plans going forward, including debt reduction, marketing strategy, margins for segments under expected growth rates, asset impairments, change to valuation allowance, taxes, employees working in new locations (i.e. home) and updated costs related to insurance, leases, travel, closings, pension, health, and productivity.
We believe our cost of capital model covers most to all risk elements our firms may confront, from sovereign to insurance, litigation, natural disasters, or elsewhere. While our model includes risk of natural disasters, such as the penalty we place on Japan and elsewhere, it did not previously include health related risk.
That is why we scoff at recent comments “the cost of capital is low enough,” as they are evidently looking only at the cost of debt, not equity which is based on the risk to the free cash flows.
We feel we can never repeat enough the vast preponderance of a firm’s estimate of fair value is composed of their free cash flows many years out, even should the next few prove disappointing. It is why stocks rise over time, as investors typically overweight nearby cash flows.
In fact, for a hypothetical firm currently selling at a free cash flow multiple (that maximum cash that can be distributed each year to the equity owners without impairing the firm’s optimal future rate of growth) of 15 or a free cash yield of 6.7%, and whose real free cash flows are expected to grow by 0% per share for the coming 3 years, then 5%, 87% of the current value of the firm is composed of those cash flows 5 years and out. Not next quarter or even the next 4 years.
We believe our firms have the ability to ride out a period of deep stress (we own no energy, airlines or firms currently requiring federal assistance) and while estimates of fair value are now lower for all firms in the portfolio given we have cut expected growth rates across the board and raised cost of equity, we also believe there are no firms in the portfolio that could be bought out for cash at a lower price than were at the end of 2019. Certain stock transactions (such as if xxxx bought xxxxx) could make sense near that valuation. Next line omitted from general distribution edxition
So, even though our invested firms generate, over the normal cycle, more cash per investment dollar than benchmark commensurate with higher interest rate coverage, more stable and consistent key metrics such as stronger calls on credit, and lower cost of capital, their investment performance still suffered.
Banks are facing a crucial period, given the term structure of interest rates and negative interest rates around the world. That backdrop and required reserves alters the landscape for the sector, especially when pricing loans and deposits. Treasury help will continue to be essential in keeping the system sound, liquid and dependable.
ANALYSIS
And so, we must view the current dislocations–operating and financial, micro to macro, capitalistic states to communist—as ranking near the top distress points in financial market history.
The analytical process for us begins, at the operating level, at the collection of receivables, and the level of uncertainty associated therewith. Are there likely credit losses? Or are collections merely slower? What is the likelihood and magnitude of orders slowing both during and post-crisis? To what extent can expenses be slashed or eliminated? What is the degree of tax offsets including those resulting out of the new stimulus law; will there be follow-up legislation including reimplementation of the tax-loss carryback? To what extent can the firm operate at all, and to what extent are clients impacted with the approximate shape of the snap-back period?
Credit analysis must be tailored to both the individual firm and its competition. The stronger possess the ability to raise external financing at levels that allow value-adding deals regardless of the level of stress.
It must also include means to boost service or other income, cost of hedging and counterparty risk; potential renegotiations leading to cost savings such as leases; strength of banking relations and other such relationships; yield curve impact; customer and supplier impact, impact of stock options (as a provider of funds and tax implications) ability to retain executives, regulatory reporting and requirements, and updated credit rating.
Other areas of inspection include impairment to goodwill, tax valuation allowance and impairment of equity method investments.
Then there are analysis, estimates, and possibilities related to additional uncertainty related to prospective Fed and Congressional actions, consumer response, insurance costs, tax (many factors here), employee benefit costs related to pension and other benefits and perks, executive compensation, possibilities of timely acquisitions and joint ventures, cost sharing, sovereign risk and, lest we forget, the ongoing trade issues with China and Europe, US election cycle, and so on.
Cash flow hedges may be moved to earnings though may still be included in AOCI.
We have, as would be expected, re-normalized rates of growth of 2020 and 2021 sales and free cash flow—hence return on capital. Many firms will not generate free cash flows this and possibly next year, while quite a few will be within normal bounds followed by large bounce-backs as the health issue is under control.
We feel our methodologies are appropriate given how the world economies and especially our holdings were operating prior to the health crisis and prospects for growth in newer technologies, notably 5G.
Even considering large cuts to our 2020 and 2021 outlook, we conclude our portfolio is worth holding, while if the health issue is resolved or moderates prior to that time, our holdings would see very large rises in financial metrics and coincident expansion in valuation multiples within short duration.
THE OPTIMAL COURSE OF ACTION
I have seen corporate executive officers take advantage of past crises in making strong value-adding deals while others acted in haste making acquisitions of declining businesses; some get “gun shy” or make other poor cash decisions such as failure to recognize a change in marketplace.
Well-managed firms with a history of making appropriate use of capital and strongly defined acquisition criteria will again benefit when the current period subsides.
Survivability and debt negotiations are the chief concern for firms facing s cash commitments and should lead to a large rise in default rate. Many firms rated BBB- will now fall into junk territory forcing certain investors to sell (or not buy) their securities placing additional pressure on their ability to finance the business at a reasonable cost. In my almost 50 years in this business, a firm owned on behalf of clients has never filed under the laws of protection.
Many firms, in preparation for, and in reaction to the spike in yields, are drawing complete lines while others are preparing filings—-requests for new CUSIPS have surged. These additional incremental costs are significant on top of the revenue issue and should prod investors away from riskier assets.
Pension liabilities will soar for the over half of the S&P 500 firms which, over the past decade, have been severely underfunding (and more so in relation to that reported under GAAP) their liabilities in hopes of greater investment returns. Several of our firms have been impacted, but not to the degree that would cause us to alter those position given their long-term cash flow stability. Congressional offsets could be of help here and is being discussed for multi-employer and single employer plans.
Even with the current barrage of news, our deep scrub analysis will be of enormous help when the current health issue is, if not completely resolved, at least lowered. We expect many of our holdings to make use of their deep pool of resources to acquire assets and world-class talent, which will lead their shares to new high ground over time.
The stark reality is whoever thinks “Corona” is a six month or even a 2-year event is kidding themselves. There is currently much work to be done by our Government, our corporations, and our citizenry. Expenses will need to be realigned, having profound impact on many sectors; a few will benefit as firms move more to virtual, robotics, lower lease expense, and significant costs re-optimized, including right-sizing of facilities, labor, and supply chain. Share buybacks and dividend growth will slow or stop, boosting credit.
All firms in our universe have seen their cost of equity capital raised by 15-40 basis points minimum. Over time, our expectation is the reduction in expected free cash flows will aid in reversing said rise.
Aside from credit, the main current issue facing valuation is the new long-term expected rate of growth of free cash flows, not the size of the of cut to the current year’s adjusted and normalized free cash flows. We already pointed out the preponderance of current valuation is due to cash flow years out, meaning the ability of the firm to provide excellent product and service will see them prosper.
We do not need to see real return on capital back to where it was in 2019 for a restoration of values if there is belief stability of prospective metrics will rise. In life and investing, there is great value in certainty.
As supply chains are enhanced, including moving out of high-risk zones (a process underway), and which may even take years, cost of capital will fall as stability metrics improve.
As firms begin to report and hold their yearly analyst meetings there will be intense scrutiny on the cash burn for the current and upcoming periods, as well as changes to operations, investment and financing decisions.
Our cost analysis includes an “invisible handshake” firms make with employees that, if possible, their jobs are safe, permitting a restoration of revenues and avoid re-training expense when the smoke clears.
Lastly, we add, is our strong desire for legislators to be better prepared for the next health scare or crisis, whenever it may occur. This includes everything from sanitizers to cyber. Of current utmost importance is the capability of the U.S. to produce the active pharmaceutical ingredients for life-saving drugs currently relied on from China and India.[1]
CONCLUSION
Stocks have always risen to newer high ground despite wars, nuclear crisis, assassinations, oil embargos, catastrophic financial crises and deep economic depression.
We conclude the optimal option is to stay with the program, even if we see this short-term pain lasting over a year. In the meantime, there isn’t a medical facility of higher learning or pharmaceutical company in the world not looking for both a treatment and vaccine.
In this report we detailed those many areas of importance central to our analysis. We are confident this will lead to a restoration of values, and then some.
For reasons discussed, will trust you will then view the current value of your account as an anomaly, to be restored as it was following March 2009. Our firms are world-leaders fully capable of generating excellent excess cash over the normal cycle under prudent credit, allowing them to withstand financial stress while providing the fodder to take advantage of value-adding opportunities.
Kenneth S. Hackel, CFA
Eli C. Hackel, CFA
[1] Sen. Marsha Blackburn of Tennessee has introduced such a measure.
