Author Archive

Change To Risk Free Rate Security to Have Profound and Immediate Impact on Valuations

June 6th, 2011 Comments off


The most implicit building block of security and company valuation is use of the risk free rate.

Whether undergoing a fairness opinion, a discounted cash flow model, or any number of other on-going concern valuation estimates, the starting point is the rate attainable with an investment in a risk-free security. It is the initial yield from which other elements of risk are added to arrive at the cost of equity capital. Simply stated, the higher (lower) the cost of equity, the lower (higher) the fair price investors would be willing to pay, given a set level of free cash flows.

Since the formulation of the capital asset pricing model, the risk free rate used has been the US government bond.

At CT Capital LLC, we use the 10 year Treasury bond, as that security best matches long-term asset programs, whether they be the building of a factory or a merger partner, from which a return on that invested capital is demanded.

Of late, as talk has gathered momentum, led by House Majority leader Eric Cantor, that politicians are willing to allow the U.S. to default on its obligations, analysts must now carefully appraise whether a defaulted security is, in the truest sense, a risk-free instrument.

One must conclude, even if a limited duration default were to occur, the answer would be no, and would be even more undeniable if seconded by a downgrade by a major credit rating agency, as Moody’s has threatened last week. Standard & Poor’s also downgraded its outlook for the U.S., citing “very large budget deficits and rising indebtedness…”

For this reason, should the U.S. Congress not come to its senses, CT Capital LLC will, if, due to QE2 or other Fed intervention, the 10 year Treasury bond not reflect economic reality, utilize an additional penalty being the cost of a credit default swap, currently 53 basis points. Thus, a current risk-free rate 10 year Treasury bond yielding 3% would in effect be raised to a 3.53% risk free rate.

Another alternative would be utilizing the 10 year rate on a liquid AAA corporates, currently 3.42%. However, even a basket of the cash instruments could present liquidity constraints and thus may not, for the time being, present a realistic alternative compared to the $9.7 trillion of U.S. debt in the hands of the public.

The brunt of a raise in the risk free rate is to force lower valuation multiples for the equity market in general, as would always be the case when the cost of capital rises. Investors demand a higher return for committing their risk-based capital as prospective free cash flows are attached to greater uncertainty reflective of the new higher rate.

Even if U.S. Government securities were to escape a default and credit downgrade in August, the tea leaves indicate it remains a matter of time before that inevitability occurs.


And when that time comes, investors, company stock analysts, and buyers and sellers of businesses, would feel a swift and powerful jolt to their reward expectations, as pronounced by the cost of equity beginning with that new risk free rate of interest.  And they will act and invest accordingly.




Kenneth S. Hackel, CFA


Categories: General Tags:

Google Inc. -Security Analysts and Many Investors Show Their Mettle-Tin!

June 2nd, 2011 Comments off

Tin, while not ranking as high as mercury, is still a weak metal. And many investors continue to exhibit its malleability, over-reacting to a single quarter’s financial results, even for firms which have growing cash flows, have added value during the quarter, and possess strong financial structure and flexibility.

Investors must understand that firms do not operate with the smoothness of a well-crafted tool. They are not machines- yet enterprises that are well managed will continue to build value, even during periods when planning, rather than providing actual results, take place. For example, smart managers acquire during recessions, and aren’t afraid to do so, a time when weak firms are forced to sell assets.

This leads me to Google.

Google disappointed investors during its first quarter due to a perceived lack of financial discipline, as operating expenses rose over twice as fast as its 27% revenue growth; the company hired over 1900 new employees, handed out large salary raises while boosting other discretionary expenses, especially marketing. While GAAP based income disappointed, normalized free cash flow growth clearly exceeded our model’s metrics. Revenues represent a lofty model weighting as discretionary expenses can typically be controlled, while product acceptance reflects the quality of and demand for the product or service. This is not to downplay expense control, as efficiencies including improvements to supply chain and other direct expenditures have the same effect as boosting cash flows and hence, market valuation. Clearly, Google’s products are being very well received in the marketplace with collections from customer receivables growing at a near 24% rate.

With Google selling at 6.1% yield on enterprise value, we view its stock quite appealing, and can point to any number of lower quality companies selling at considerably higher valuations. Although Google shares are currently fair valued at $604 a share, that estimate would jump if managers keep expenses and margins in line and revenues grow as expected.

Obviously, if Google needs to continue to write $500MM checks to settle lawsuits, its fair value will fall and cost of capital will rise. However, its very strong and predictable near-term free cash flows can fight off these legal issues assuming they can indeed be put to an an end. Given the sensitivity analysis below, using our free cash flow model (please refer to Security Valuation and Risk Analysis), current fair value for Google is sufficiently above its current price. The 18.5% tax on repatriation represents the company’s five year average cash tax rate, based on Google’s net cash of $32 billion.


Google Fair Value Sensitivity Using CT Capital Free Cash Flow Model

Disc Rte. Probability FV

7% 10% $732.04

8% 10% $642.04

8.25% 10% $621.91

8.50% 15% $602.64

8.75% 20% $584.18

9.00% 20% $566.49

10.00% 15% $502.76



Fair Value Cash Flow 100% $595.54

Net Cash/Debt* 8.1

Fair Value Per Share $603.64

*includes tax on repatriation and working capital



Note: Google shares are held by clients of CT Capital LLC.



Categories: General Tags:

Large Share Buybacks Again Prove They Are Misguided

May 27th, 2011 Comments off


Large Share Buybacks Again Prove They Are Misguided


As if we needed additional evidence large share buybacks are almost always a waste of corporate resources , I present a list of all companies having current market values of greater than $500MM that have repurchased at least 15% of their current market values and placed into treasury. As seen, the list includes many well known firms, including several that have bought back over 50% of their current market values. The average of these large firms have repurchased an astounding 36% of their current market value – yet, as opposed to their helping their shareholders-they have done the opposite-as their stocks have underperformed the return on the S&P 500!

As seen, stock buybacks have proved no refuge in a flat and falling equity market. The latest example is the current year, as the current quarter to date, with the S&P slipping 36 basis points thru last night’s close, the average of these firms has seen its stock fall by 52 basis points. Care for a longer time horizon?

For the past 5 years, the names on the list have returned 2.4% versus a return on the S&P 500 of 3.77%. To make matters worse, the list excludes those bankrupt or merged firms which repurchased large amounts of their own shares prior to their demise such as Bear Stearns, Lehman, and many, many others.

For the current quarter, Big Lots, Brunswick, Ferro,, Lamar Advertising, , Lenox Int’l, , Lexmark, Terex, Timberland have each fallen by greater than 20% this quarter.

I am not implying these firms will meet the same fate as Lehman, but rather time has proven again and again share repurchases, other than to perhaps offset stock based compensation, do not improve the lots of shareholders or bondholders. And for sound economic reason.

Share buybacks, like dividends must be rubber-stamped by Boards of Directors. They should understand that share repurchases, despite improving GAAP-based metrics do nothing to improve cash based return on invested capital.  On the contrary, by altering the financial structure, it often raises risk and hence, the cost of capital to the firm whose value they are entrusted to enhance. Value is created by adding to the capital base, joint ventures, increasing revenues, and by running the firm more efficiently-not by shrinking the equity cushion.

One lot whose fortunes share buybacks does improve are high paid executives whose bonuses and stock options are often based on GAAP accounting.

Warren Buffet recognizes this, and has never bought back a share of Berkshire. Adding to the capital base assets whose cash based return is safely and consistently above ROIC is a proven method for share outperformance over the long-term.

While part of the problem lies with shareholders themselves, as they continue to believe share buybacks “support the stock”, history has again clearly shown otherwise.

For a detailed example on why share buybacks do not increase ROIC, please contact CT Capital LLC and see “Security Valuation and Risk Analysis.”


Company Name Ticker Symbol Treasury Stock ($M) Current Market Value ($M) % of Current Market Value in Treasury Total Return-Year to Date Total Return-Qtr to Date 5-Year Total Return
3M CO MMM 10,266 65,721 15.6% 8.4 (0.5) 5.4
ACI WORLDWIDE INC ACIW 172 1,031 16.6% 14.8 (5.9) (3.7)
ACTIVISION BLIZZARD INC ATVI 2,194 13,124 16.7% (6.4) 4.6  
ADOBE SYSTEMS INC ADBE 3,264 17,369 18.8% 11.9 3.8 (3.1)
ADVANCE AUTO PARTS INC AAP 1,029 4,904 21.0% (4.7) (4.0) 10.9
AFLAC INC AFL 5,386 22,833 23.6% (12.5) (7.0) 5.6
AGILENT TECHNOLOGIES INC A 8,038 16,945 47.4% 18.5 9.6 6.7
ALCATEL-LUCENT -ADR ALU 2,078 13,029 15.9% 89.9 (3.3) (14.1)
ALCOA INC AA 4,146 16,964 24.4% 4.2 (9.4) (10.9)
ALLIANCE DATA SYSTEMS CORP ADS 2,080 4,529 45.9% 25.0 3.4 11.6
ALLSTATE CORP ALL 15,910 16,409 97.0% (0.8) (1.1) (7.0)
ALTRIA GROUP INC MO 23,469 58,301 40.3% 14.8 7.0 16.7
AMDOCS LTD DOX 1,309 5,570 23.5% 9.2 4.0 (3.7)
AMERCO UHAL 526 1,694 31.0% (10.0) (10.9) (0.5)
AMERICAN TOWER CORP AMT 3,382 21,081 16.0% 2.9 2.6 8.9
AMERIPRISE FINANCIAL INC AMP 2,620 14,782 17.7% 6.7 0.3 6.6
AMERISOURCEBERGEN CORP ABC 4,373 11,328 38.6% 21.9 4.8 15.1
AMERN EAGLE OUTFITTERS INC AEO 938 2,635 35.6% (6.9) (14.9) (3.5)
AMR CORP/DE AMR 367 2,184 16.8% (15.9) 1.4 (24.9)
AMTRUST FINANCIAL SERVICES AFSI 300 1,259 23.9% 21.1 10.7  
ANN INC ANN 864 1,472 58.7% 3.7 (2.4) (3.5)
APOLLO GROUP INC  -CL A APOL 2,408 5,649 42.6% 1.4 (4.0) (6.0)
APPLIED MATERIALS INC AMAT 9,396 18,195 51.6% (1.4) (11.7) (1.0)
ASSURANT INC AIZ 1,764 3,620 48.7% (1.8) (2.1) (2.4)
ASTORIA FINANCIAL CORP AF 1,431 1,391 102.8% 3.4 (0.8) (10.5)
AUTOMATIC DATA PROCESSING ADP 6,540 26,694 24.5% 16.2 4.1 9.4
AVERY DENNISON CORP AVY 831 4,380 19.0% (2.6) (2.3) (4.8)
AVIS BUDGET GROUP INC CAR 5,874 1,765 332.8% 8.0 (6.1) (3.4)
AVON PRODUCTS AVP 4,559 12,785 35.7% 3.9 10.7 0.6
AXIS CAPITAL HOLDINGS LTD AXS 1,381 4,207 32.8% (8.8) (6.9) 6.0
BALL CORP BLL 2,123 6,492 32.7% 13.8 7.8 14.3
BANK OF HAWAII CORP BOH 450 2,263 19.9% 1.5 (0.8) 1.6
BAXTER INTERNATIONAL INC BAX 5,655 33,681 16.8% 17.3 9.8 10.6
BECTON DICKINSON & CO BDX 4,806 19,134 25.1% 4.0 9.9 8.2
BED BATH & BEYOND INC BBBY 2,814 13,426 21.0% 9.2 11.2 7.9
BEMIS CO INC BMS 544 3,448 15.8% 1.7 0.5 3.0
BERKLEY (W R) CORP WRB 1,750 4,616 37.9% 19.3 1.2 (1.9)
BIG LOTS INC BIG 1,079 2,534 42.6% 10.6 (22.4) 23.3
BJ’S WHOLESALE CLUB INC BJ 636 2,725 23.3% 6.0 4.0 10.9
BLOCK H & R INC HRB 2,057 4,963 41.4% 37.9 (2.9) (2.5)
BMC SOFTWARE INC BMC 2,294 9,580 23.9% 14.9 8.9 18.5
BOEING CO BA 17,187 56,316 30.5% 18.2 3.7 1.6
BP PLC  -ADR BP 21,085 137,666 15.3% 1.6 0.7 (4.6)
BRIGGS & STRATTON BGG 202 1,022 19.8% 3.5 (10.6) (3.5)
BRINKER INTL INC EAT 1,678 2,187 76.7% 24.2 1.9 0.7
BRISTOL-MYERS SQUIBB CO BMY 17,454 48,109 36.3% 9.2 6.7 7.3
BRUNSWICK CORP BC 406 1,802 22.5% 8.0 (20.4) (8.5)
CA INC CA 2,095 11,529 18.2% (6.4) (5.6) 0.1
CAMPBELL SOUP CO CPB 7,459 11,192 66.6% 1.4 6.5 3.7
CAPITOL FEDERAL FINL INC CFFN 330 1,966 16.8% 4.9 4.9 1.7
CARPENTER TECHNOLOGY CORP CRS 535 2,201 24.3% 25.2 17.5 (1.0)
CATERPILLAR INC CAT 10,397 65,688 15.8% 9.7 (8.1) 11.7
CBS CORP CBS 3,689 17,868 20.6% 41.2 6.7 3.3
CBS CORP CBS 3,689 17,868 20.6% 40.5 6.7 3.3
CHARLES RIVER LABS INTL INC CRL 769 1,968 39.1% 7.2 (0.7) (2.2)
CHEESECAKE FACTORY INC CAKE 558 1,789 31.2% 1.0 3.0 (1.4)
CHEMED CORP CHE 409 1,420 28.8% 5.3 0.2 5.7
CHOICE HOTELS INTL INC CHH 872 2,104 41.5% (7.6) (9.4) (5.0)
CHUBB CORP CB 3,783 18,957 20.0% 9.4 5.7 7.5
CIGNA CORP CI 5,242 13,120 40.0% 32.4 9.5 5.7
CINCINNATI FINANCIAL CORP CINF 1,201 4,921 24.4% (3.6) (7.9) (1.2)
CINTAS CORP CTAS 799 4,602 17.4% 13.3 4.6 (4.2)
CITRIX SYSTEMS INC CTXS 2,417 15,434 15.7% 20.0 11.8 16.1
COCA-COLA CO KO 27,762 154,502 18.0% 3.4 1.7 13.2
COLGATE-PALMOLIVE CO CL 11,305 42,079 26.9% 8.6 7.3 9.9
COMERICA INC CMA 1,565 6,328 24.7% (15.0) (2.5) (4.4)
COMMERCIAL METALS CMC 290 1,689 17.2% (11.2) (15.3) (7.0)
CON-WAY INC CNW 341 2,094 16.3% 3.9 (3.6) (5.9)
CONAGRA FOODS INC CAG 2,945 10,374 28.4% 14.6 7.8 5.2
CONOCOPHILLIPS COP 20,710 100,825 20.5% 6.6 (9.9) 6.6
CONSTELLATION BRANDS  -CL A STZ 904 4,642 19.5% (1.9) 7.4 (1.9)
CONSTELLATION BRANDS  -CL A STZ 904 4,642 19.5% (1.6) 7.5 (1.9)
CONVERGYS CORP CVG 1,060 1,571 67.5% (1.7) (9.8) (5.7)
COOPER TIRE & RUBBER CO CTB 468 1,461 32.0% 0.2 (8.7) 20.4
CORPORATE EXECUTIVE BRD CO EXBD 629 1,413 44.5% 9.5 1.4 (15.5)
COVANCE INC CVD 734 3,526 20.8% 13.1 6.2 1.4
COVENTRY HEALTH CARE INC CVH 1,268 5,007 25.3% 28.0 6.0 (8.3)
CVS CAREMARK CORP CVS 9,086 51,485 17.6% 10.0 11.0 4.9
CYMER INC CYMI 493 1,428 34.5% 3.8 (17.3) (1.4)
CYPRESS SEMICONDUCTOR CORP CY 1,203 3,599 33.4% 15.3 10.5 38.7
DARDEN RESTAURANTS INC DRI 2,944 7,022 41.9% 12.3 5.5 5.9
DAVITA INC DVA 1,361 8,069 16.9% 21.6 (1.2) 9.4
DEERE & CO DE 5,790 34,972 16.6% 0.4 (14.3) 19.6
DELL INC DELL 28,704 29,536 97.2% 14.3 6.8 (10.0)
DIEBOLD INC DBD 436 2,089 20.9% 1.5 (9.0) (1.5)
DIGITAL RIVER INC DRIV 255 1,208 21.1% (11.5) (18.6) (5.7)
DILLARDS INC  -CL A DDS 1,356 2,759 49.1% 39.7 32.0 14.2
DISH NETWORK CORP DISH 1,569 6,070 25.9% 49.6 20.8 2.1
DISNEY (WALT) CO DIS 23,663 77,799 30.4% 9.7 (4.5) 10.6
DONNELLEY (R R) & SONS CO RRD 1,166 4,256 27.4% 20.7 9.9 (6.2)
DOVER CORP DOV 2,322 11,708 19.8% 7.8 (4.5) 8.8
DREAMWORKS ANIMATION INC DWA 688 1,798 38.3% (16.0) (11.4) (0.5)
DST SYSTEMS INC DST 2,815 2,176 129.4% 6.4 (11.3) (3.9)
DUN & BRADSTREET CORP DNB 2,214 3,965 55.8% (1.8) 0.0 2.6
EASTMAN CHEMICAL CO EMN 1,615 7,105 22.7% 19.5 0.7 18.3
ECOLAB INC ECL 2,521 12,219 20.6% 4.8 3.2 8.2
EL PASO ELECTRIC CO EE 338 1,269 26.6% 9.4 (0.9) 9.4
EMERSON ELECTRIC CO EMR 6,320 40,515 15.6% (4.6) (7.2) 10.4
ENERGIZER HOLDINGS INC ENR 1,668 5,314 31.4% 4.6 7.2 8.1
ENSTAR GROUP LTD ESGR 422 1,351 31.2% 16.6 (1.3)  
ENTERGY CORP ETR 5,525 12,013 46.0% (2.5) 1.6 3.4
EQUIFAX INC EFX 2,032 4,559 44.6% 5.0 (4.2) 0.1
ERIE INDEMNITY CO  -CL A ERIE 872 3,514 24.8% 10.3 0.8 11.4
EVEREST RE GROUP LTD RE 981 4,803 20.4% 4.9 0.3 2.1
EXPEDIA INC EXPE 2,241 6,826 32.8% 10.2 21.6 6.4
EXTERRAN HOLDINGS INC EXH 204 1,273 16.0% (16.9) (16.1) (18.9)
EXXON MOBIL CORP XOM 156,608 397,387 39.4% 11.6 (3.6) 9.2
FAIR ISAAC CORP FICO 1,556 1,145 135.9% 23.2 (9.0) (3.9)
FEDERATED INVESTORS INC FII 779 2,655 29.3% (1.2) (4.2) (0.2)
FERRO CORP FOE 164 1,021 16.1% (18.9) (28.5) (2.9)
FIDELITY NATIONAL INFO SVCS FIS 2,359 9,629 24.5% 15.2 (3.7) 11.1
FISERV INC FISV 2,340 8,980 26.1% 6.8 (0.3) 6.3
FOREST LABORATORIES  -CL A FRX 3,783 9,967 38.0% 8.9 7.9 (3.9)
FORTUNE BRANDS INC FO 3,215 9,680 33.2% 4.9 1.8 (1.8)
GANNETT CO GCI 5,300 3,417 155.1% (5.6) (6.7) (19.7)
GAP INC GPS 10,866 11,234 96.7% (12.1) (14.5) 7.2
GARTNER INC IT 1,045 3,627 28.8% 12.3 (10.5) 25.1
GATX CORP GMT 560 1,778 31.5% 9.5 (0.9) 1.1
GENERAL DYNAMICS CORP GD 4,535 26,557 17.1% 1.8 (6.2) 4.2
GENERAL ELECTRIC CO GE 31,938 205,893 15.5% 6.7 (3.3) (6.4)
GENWORTH FINANCIAL INC GNW 2,700 5,372 50.3% (16.7) (18.6) (17.3)
GOLDMAN SACHS GROUP INC GS 36,295 70,329 51.6% (19.0) (14.4) (0.3)
GRAINGER (W W) INC GWW 2,857 10,314 27.7% 8.7 8.6 16.7
GREENHILL & CO INC GHL 331 1,624 20.4% (32.6) (16.8) (1.5)
HANOVER INSURANCE GROUP INC THG 720 1,880 38.3% (10.9) (8.6) (3.0)
HARLEY-DAVIDSON INC HOG 4,674 8,591 54.4% 5.1 (14.4) (3.8)
HARMAN INTERNATIONAL INDS HAR 1,048 3,252 32.2% 0.6 (0.6) (11.1)
HARSCO CORP HSC 737 2,595 28.4% 15.0 (8.3) (0.9)
HASBRO INC HAS 2,102 6,459 32.5% 1.7 1.9 21.8
HEALTH NET INC HNT 1,627 2,825 57.6% 14.4 (4.5) (3.9)
HEINZ (H J) CO HNZ 4,751 17,169 27.7% 8.9 9.3 8.2
HERSHEY CO HSY 4,052 9,091 44.6% 18.5 2.1 4.4
HIBBETT SPORTS INC HIBB 205 1,083 18.9% 7.1 10.3 4.5
HILL-ROM HOLDINGS INC HRC 558 2,856 19.5% 15.2 19.0 12.5
HOLLY CORP HOC 678 3,229 21.0% 49.0 (0.3) 10.3
HONEYWELL INTERNATIONAL INC HON 8,299 46,024 18.0% 11.3 (1.5) 10.4
HUDSON CITY BANCORP INC HCBK 1,726 4,761 36.2% (27.5) (5.8) (3.3)
HUNT (JB) TRANSPRT SVCS INC JBHT 1,173 5,443 21.6% 11.6 (0.1) 16.4
IAC/INTERACTIVECORP IACI 8,364 3,007 278.2% 22.8 14.0 5.5
IDEXX LABS INC IDXX 1,061 4,473 23.7% 12.7 1.0 14.4
INTEGRA LIFESCIENCES HLDGS IART 284 1,422 19.9% 5.3 5.0 4.5
INTERDIGITAL INC IDCC 569 1,904 29.9% 1.2 (11.8) 12.9
INTL BANCSHARES CORP IBOC 250 1,108 22.6% (17.4) (10.8) (5.3)
INTL BUSINESS MACHINES CORP IBM 96,161 203,797 47.2% 15.6 3.6 17.7
INTL FLAVORS & FRAGRANCES IFF 1,383 5,043 27.4% 13.4 0.7 15.0
INTUIT INC INTU 3,315 16,016 20.7% 7.4 (0.3) 15.5
ITT EDUCATIONAL SERVICES INC ESI 566 1,879 30.1% 5.1 (7.2) 2.5
JACK IN THE BOX INC JACK 571 1,082 52.8% 0.9 (6.0) (0.2)
KEYCORP KEY 1,904 7,863 24.2% (6.5) (6.9) (23.4)
KIMBERLY-CLARK CORP KMB 4,726 26,692 17.7% 8.9 4.1 6.4
KNIGHT CAPITAL GROUP INC KCG 766 1,222 62.7% (11.7) (9.1) (3.9)
KOHL’S CORP KSS 3,643 15,967 22.8% 1.7 3.7 (1.1)
KROGER CO KR 6,732 14,907 45.2% 10.9 3.0 5.2
L-3 COMMUNICATIONS HLDGS INC LLL 2,658 8,783 30.3% 18.7 6.3 1.2
LAM RESEARCH CORP LRCX 1,581 5,760 27.5% (10.6) (18.3) (0.2)
LAMAR ADVERTISING CO  -CL A LAMR 885 2,258 39.2% (27.1) (21.3) (9.1)
LANCASTER COLONY CORP LANC 680 1,667 40.8% 6.8 0.3 11.1
LANDSTAR SYSTEM INC LSTR 763 2,196 34.8% 12.3 0.5 2.6
LAUDER (ESTEE) COS INC -CL A EL 2,850 11,831 24.1% 21.8 2.0 22.8
LAWSON SOFTWARE INC LWSN 327 1,823 17.9% 19.9 (8.3) 7.6
LEGGETT & PLATT INC LEG 1,093 3,641 30.0% 13.3 4.0 4.7
LENNAR CORP LEN 615 3,228 19.1% (7.2) (1.8) (17.5)
LENNOX INTERNATIONAL INC LII 947 2,456 38.6% (2.3) (12.4) 10.0
LEXMARK INTL INC  -CL A LXK 404 2,303 17.6% (16.5) (21.5) (7.9)
LOUISIANA-PACIFIC CORP LPX 280 1,045 26.8% (16.4) (24.7) (18.3)
MACY’S INC M 2,431 12,170 20.0% 13.2 17.8 (7.7)
MAGELLAN HEALTH SERVICES INC MGLN 382 1,643 23.2% 8.7 4.7 5.1
MANPOWERGROUP MAN 1,258 4,942 25.4% (4.2) (4.4) 1.6
MARRIOTT INTL INC MAR 5,348 13,045 41.0% (12.2) 2.3 0.3
MATTEL INC MAT 1,881 9,149 20.6% 5.4 6.5 14.9
MATTHEWS INTL CORP  -CL A MATW 207 1,082 19.2% 5.2 (4.7) 3.6
MAXIMUS INC MMS 359 1,406 25.6% 24.0 0.0 19.4
MBIA INC MBI 2,225 1,756 126.7% (26.7) (12.5) (28.9)
MCDONALD’S CORP MCD 25,143 85,600 29.4% 8.4 8.4 21.4
MCGRAW-HILL COMPANIES MHP 4,958 12,901 38.4% 17.1 7.5 (3.9)
MCKESSON CORP MCK 6,470 21,221 30.5% 19.9 6.5 12.2
MEDCO HEALTH SOLUTIONS INC MHS 11,066 25,451 43.5% 3.9 13.4 17.4
MEDICIS PHARMACEUT CP  -CL A MRX 348 2,266 15.3% 37.3 14.5 2.3
MEMC ELECTRONIC MATRIALS INC WFR 456 2,343 19.5% (9.7) (21.5) (21.9)
MENS WEARHOUSE INC MW 413 1,706 24.2% 33.2 22.5 (3.5)
MERCK & CO MRK 22,433 113,895 19.7% 3.6 11.8 5.1
METTLER-TOLEDO INTL INC MTD 1,057 5,298 20.0% 9.0 (4.2) 23.7
MICROSTRATEGY INC MSTR 475 1,085 43.8% 58.4 0.7 8.6
MINE SAFETY APPLIANCES CO MSA 271 1,310 20.7% 16.6 (1.8) 1.9
MINERALS TECHNOLOGIES INC MTX 466 1,172 39.8% (1.8) (6.4) 3.9
MOLEX INC MOLX 1,098 4,338 25.3% 18.1 6.1 (3.9)
MOLEX INC MOLX 1,098 4,338 25.3% 18.9 7.5 (3.9)
MOODY’S CORP MCO 4,407 8,634 51.0% 43.9 12.2 (7.7)
NASDAQ OMX GROUP INC NDAQ 796 4,406 18.1% 5.1 (3.5) (6.2)
NRG ENERGY INC NRG 1,503 5,955 25.2% 26.4 14.7 0.3
NU SKIN ENTERPRISES  -CL A NUS 477 2,272 21.0% 22.6 28.5 17.1
NVR INC NVR 3,240 4,303 75.3% 5.8 (3.3) (0.4)
OMNICOM GROUP OMC 4,697 13,140 35.7% 2.6 (4.7) 3.4
PARTNERRE LTD PRE 1,083 5,141 21.1% (3.9) (3.2) 7.9
PETSMART INC PETM 1,335 5,094 26.2% 13.5 10.1 9.8
PITNEY BOWES INC PBI 4,480 4,958 90.4% 3.6 (3.9) (5.6)
POLYONE CORP POL 306 1,304 23.4% 12.1 (1.8) 10.3
PPG INDUSTRIES INC PPG 4,708 13,705 34.4% 4.4 (8.4) 10.9
PRINCIPAL FINANCIAL GRP INC PFG 4,725 10,022 47.1% (4.2) (2.9) (6.2)
PROCTER & GAMBLE CO PG 61,309 187,156 32.8% 5.9 9.7 4.9
PRUDENTIAL FINANCIAL INC PRU 11,173 30,322 36.8% 6.3 1.3 (2.4)
QUAD/GRAPHICS INC QUAD 296 1,343 22.0% (0.6) (3.6)  
QUEST DIAGNOSTICS INC DGX 2,158 9,085 23.8% 7.4 0.2 1.0
RADIOSHACK CORP RSH 949 1,643 57.8% (16.2) 3.2 0.1
RAYTHEON CO RTN 6,900 17,599 39.2% 8.4 (2.0) 4.3
REGIONS FINANCIAL CORP RF 1,402 8,582 16.3% (2.3) (5.9) (24.6)
RENT-A-CENTER INC RCII 904 1,991 45.4% (2.7) (10.2) 2.2
RLI CORP RLI 393 1,261 31.1% 14.5 3.9 5.5
ROCKWELL AUTOMATION ROK 2,136 11,748 18.2% 14.5 (13.6) 6.2
ROCKWELL COLLINS INC COL 1,497 9,309 16.1% 4.5 (6.4) 3.6
SAFEWAY INC SWY 6,284 8,821 71.2% 11.4 5.8 0.8
SCHWAB (CHARLES) CORP SCHW 4,247 20,744 20.5% 1.1 (4.3) 2.7
SEACOR HOLDINGS INC CKH 903 2,081 43.4% (4.9) 3.9 5.1
SEARS HOLDINGS CORP SHLD 5,826 7,737 75.3% (2.6) (13.1) (9.8)
SHERWIN-WILLIAMS CO SHW 4,391 9,084 48.3% 2.8 2.0 12.5
SIGMA-ALDRICH CORP SIAL 2,051 8,314 24.7% 2.8 7.3 16.8
SLM CORP SLM 1,876 8,433 22.3% 27.0 4.5 (20.4)
SPX CORP SPW 2,516 4,020 62.6% 10.6 (0.7) 11.3
ST JOE CO JOE 931 2,038 45.7% 1.1 (11.9) (13.8)
STAPLES INC SPLS 3,787 11,917 31.8% (26.2) (14.0) (3.1)
STEEL DYNAMICS INC STLD 728 3,625 20.1% (8.8) (11.6) 5.1
SUNOCO INC SUN 4,387 4,753 92.3% (1.9) (13.6) (10.0)
SUPERVALU INC SVU 521 2,155 24.2% 6.6 13.8 (14.7)
SYNAPTICS INC SYNA 282 972 29.0% (3.4) 5.0 10.2
SYSCO CORP SYY 4,408 18,858 23.4% 11.9 16.7 2.5
TECH DATA CORP TECD 467 2,188 21.3% 6.7 (7.6) 7.7
TECHNICOLOR  -ADR TCLRY 207 1,172 17.7% 40.8 (7.7) (45.5)
TELEPHONE & DATA SYSTEMS INC TDS 739 2,943 25.1% (12.1) (5.0) (2.0)
TELEPHONE & DATA SYSTEMS INC TDS 739 2,943 25.1% (10.8) (5.1) (2.0)
TELETECH HOLDINGS INC TTEC 323 1,009 32.0% (13.6) (8.2) 9.1
TELLABS INC TLAB 1,222 1,664 73.4% (31.9) (12.2) (20.7)
TEMPLE-INLAND INC TIN 584 2,419 24.1% 5.7 (4.6) 4.3
TEMPUR PEDIC INTL INC TPX 713 4,291 16.6% 56.5 23.7 32.6
TENET HEALTHCARE CORP THC 1,479 3,074 48.1% (6.1) (15.7) (3.6)
TEREX CORP TEX 599 3,094 19.4% (9.1) (23.8) (4.3)
TEXAS INSTRUMENTS INC TXN 16,411 39,770 41.3% 6.2 (0.5) 2.0
TIMBERLAND CO  -CL A TBL 747 1,313 56.9% 29.6 (22.8) 5.8
TIME WARNER INC TWX 29,033 38,710 75.0% 13.1 1.3 2.8
TRAVELERS COS INC TRV 14,857 25,735 57.7% 11.0 3.3 10.2
UMB FINANCIAL CORP UMBF 361 1,696 21.3% 1.5 12.0 6.1
UNITED STATIONERS INC USTR 773 1,625 47.5% 11.2 (0.5) 6.2
UNITED TECHNOLOGIES CORP UTX 17,468 78,795 22.2% 10.5 2.3 9.7
VALASSIS COMMUNICATIONS INC VCI 508 1,380 36.8% (13.2) (3.6) (0.3)
VALERO ENERGY CORP VLO 6,462 14,787 43.7% 12.6 (12.9) (14.0)
VARIAN SEMICONDUCTOR EQUIPMT VSEA 733 4,615 15.9% 65.5 25.7 13.9
VERISK ANALYTICS INC VRSK 1,106 5,179 21.4% (0.4) 3.6  
VIACOM INC VIA.B 5,725 29,895 19.2% 30.3 11.8 5.5
VIACOM INC VIA.B 5,725 29,895 19.2% 26.6 7.5 5.5
WASHINGTON POST  -CL B WPO 2,158 2,770 77.9% (4.9) (5.0) (9.2)
WASTE MANAGEMENT INC WM 4,904 18,224 26.9% 5.2 2.9 4.4
WATERS CORP WAT 2,509 8,913 28.2% 25.2 11.9 16.7
WEIGHT WATCHERS INTL INC WTW 1,794 6,140 29.2% 124.8 19.9 11.7
WESCO INTL INC WCC 591 2,259 26.2% (0.7) (16.1) (3.8)
WHIRLPOOL CORP WHR 1,823 6,139 29.7% (8.3) (5.1) 1.8
WOLVERINE WORLD WIDE WWW 377 1,890 19.9% 19.8 2.1 11.5
WYNDHAM WORLDWIDE CORP WYN 1,107 5,745 19.3% 13.4 6.3  
ZEBRA TECHNOLOGIES CP  -CL A ZBRA 462 2,275 20.3% 9.6 6.1 (0.2)
ZIMMER HOLDINGS INC ZMH 3,545 12,861 27.6% 24.8 10.7 0.7
AVERAGE   4,876 15,661 35.9% 7.8 (0.5) 2.4


Kenneth Hackel, CFA











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The Folly of 90%+ Security Analysts-How They Define Free Cash Flow

May 4th, 2011 Comments off



Over 90% of security analysts and companies which file with the SEC define free cash flow as cash flow from operating activities minus capital spending. This is incorrect. Of course, many firms tailor-make their own free cash flow definition.

It ignores the important misclassifications, one-time items, and areas of overspending as well as required spending (underpayments to pension plans, claims, etc.) that firms have not made, but need to.

A rather obvious example is that of Dr Pepper Snapple Group, which a simple investment screen would show as selling for 4x free cash flow. The reason is the recording as an operating cash flow activity one-time nonrefundable cash payments of $900 million from PepsiCo and $715 million from Coca-Cola, both recorded as deferred revenue.

Unfortunately, at CT Capital LLC, we come across a large number of less obvious and even “hidden”  within footnote and income statement items, activities which most analysts may not consider and which beefed up operating (therefore “free”) cash flows. For instance many firms bury asset sales and collections on insurance within broad classifications. Including these and other such items provides for a faulty appraisal of fair value.

For a complete discussion on this topic see Security Valuation and Risk Analysis..


Kenneth S. Hackel, CFA



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There Must Be a Better Way to Reward Shareholders

April 29th, 2011 Comments off


There Must Be a Better Way to Reward Shareholders


In Microsoft’s 10-Q filed today, it was revealed that for only the second quarter in at least 10 years, the firm did not buy back net shares (repurchases minus new issuance). In fact, shares outstanding actually increased over the prior quarter.  Is management learning, or does it represent an anomaly? Over the past decade, MSFT has spent over a third of its current market value on its repurchase program, when it initially had a market value of $325 billion, or 46% higher than today.

In the past 20 years, Microsoft repurchased a net $93.5 billion of its outstanding shares, surely to go down as a landmark waste of corporate cash.

When Microsoft announced its two $40 billion buyback authorizations, analysts were out front hailing the acts as “bold” and predicted they would be cheered by investors.

Quite obviously, shares in Microsoft have been a subpar investment, yet, to date, its largest shareholder continues to endorse the failed programs. If Mr. Gates would like to have more capital for his foundation, I would recommend he make better investments in technology, including joint ventures.  Imagine if someone at Microsoft had the foresight to invest in Facebook, or in one or several of the hundreds of successful internet based enterprises, at reasonable values, when such was possible. They didn’t see the tablet revolution, which one would think would have been “in their wheelhouse” given the billions they spend each year on R&D.

During the past 12 months MSFT spent almost $11 billion net, or 4.8% of its current market value to repurchase 3.8% of its current market value, continuing to prove the folly of share buybacks.

Share buybacks do nothing to improve return on invested capital, serve to bump up the cost of capital due to the shift in financial structure, and most often, are a reflection of managerial ineffectiveness in deploying the firm’s capital. Microsoft has certainly proven the latter to be true.


SIC: 7,372.000
GICS: 45103020
Purchase Com & Pref Stock Sale of Com/Pref Stock Net
Jun01 6,074.000 1,620.000 4,454.000
Jun02 6,069.000 1,497.000 4,572.000
Jun03 6,486.000 2,120.000 4,366.000
Jun04 3,383.000 2,748.000 635.000
Jun05 8,057.000 3,109.000 4,948.000
Jun06 19,207.000 2,101.000 17,106.000
Jun07 27,575.000 6,782.000 20,793.000
Jun08 12,533.000 3,494.000 9,039.000
Jun09 9,353.000 579.000 8,774.000
Jun10 11,269.000 2,311.000 8,958.000
YTD Mar 10,299.000 2,242.000 8,057.000
SUM 83,645.000




CT Capital LLC is an investment advisory firm based in Alpine, New Jersey, specializing in the detailed analysis of free cash flow, cost of capital, and return on invested capital.



Kenneth S. Hackel, CFA

Follow me on Twitter @ credittrends



Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making, Fall 2010, McGraw-Hill





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Protected: Upcoming Financial Results—General Issues

April 11th, 2011 Comments off

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Interview with the CFA

March 22nd, 2011 Comments off

Last month I sat down with David Larrabee, CFA,  of the CFA Institute to discuss how investors and analysts should define and measure free cash flow, cost of capital and return on invested capital.

It may be seen at

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Protected: Stock Based Compensation-An Important Metric in Fundamental Cash Flow Analysis

March 22nd, 2011 Comments off

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A Comprehensive Understanding of Individual Security Risk

March 15th, 2011 Comments off

click on book icon to the right

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Japan and Country Risk

March 14th, 2011 Comments off


While I have written on the subject of sovereign or country risk before, the tragic earthquake in Japan again forces us to revisit the topic.

One source in our analysis is the US State Department website. They write:

“Japan is faced with the ever-present danger of deadly earthquakes and typhoons.  Japan is one of the most seismically active locations in the world; minor tremors are felt regularly throughout the islands.  While responsibility for caring for disaster victims, including foreigners, rests with the Japanese authorities, one of the first things you should do upon arriving in Japan is to learn about earthquake and disaster preparedness from hotel or local government officials.”

Prior to the disaster, at CT Capital, we had marked-up all Japanese based firms by 35 basis points over Canada, and 10 basis points over the U.S. This mark-up is now 90 basis points over Canada and 65 basis points over the U.S. The additional mark-up reflects the stepped-up exposure to disasters and the current impact on of the disaster on the general economy. There is also some exposure to terrorism in Japan, but not at a level greater than the U.S.


Country Risk-Summary

Companies that are subject to certain jurisdictions may be riskier (political, currency, taxes) for investors than U.S. – based companies.  This was acutely reflected during the fiscal crises in Greece during 2010, with almost immediate repercussions throughout Europe, Asia and the United States. The resultant weakness in the euro impacted US entities with operations in Europe or sold into that market with the US dollar based goods. On the other hand, the price of oil dropped since its price is quoted in dollars.  During the period the crisis was at its peak, many entities which had planned to enter the debt markets to raise capital were not able to do so.

The conditions under which a company operates and has major facilities or markets will thus influence cash flows, consistency measures and leverage. As we have seen, energy exploration companies have had their operations nationalized, while many companies have been harmed by high inflation outside the United States. If an entity receives a significant portion of its cash flows from a non-US geography, the risk to those cash flows must be assessed, with a mark up to cost of capital, where appropriate. This is especially true for companies operating in emerging markets, where a mark-up to cost of capital is always made, even if the cash flows from those areas are currently strong and without incident.

All possible threats and the entity’s sensitivity to any related factors must be considered, including sanctions, tariffs, threat of retaliation of US Government actions, stability of currency, exchange control, inflation, threat of its neighboring countries, restrictions, etc.

At CT Capital, we evaluate 19 factors in our cost of equity capital model, including, in addition to the above, form of government, natural disasters, energy dependence, corruption and commitment to markets and business.


For additional information, please see “Security Valuation and Risk Analysis”


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Ford-Good Engineering-of the Financial Kind

March 4th, 2011 Comments off

The decision by Ford to eliminate its tax liability valuation reserve represents financial engineering in its truest sense. While, according to Bloomberg, the act will add $10 billion to $13 billion in net income this year, it has no impact on free cash flows.

Given the volatility in the automotive sector, there is little assurance that Ford will remain a tax paying entity, given it has received refunds (a negative tax rate) in four of the past 10 years.

Consistent tax rate companies at any level normally also have cash flows that are more predictable- Ford, it cannot be argued has been a historically consistent generator of free cash flows.


Owing to losses occurring during 2008, many entities were forced to establish or increase their valuation reserves based on their historical taxable income and projected future taxable income, including the expected timing of the reversals of existing temporary differences. If the entities operated at a loss for an extended period of time, were unable to generate sufficient future taxable income, or if there was a material change in the effective tax rates or time period within which the underlying temporary differences become taxable or deductible, these entities could be required to record a valuation allowance against all or a significant portion of their deferred tax assets, which could increase their effective tax rate for such a period substantially. This could affect cash flows for those firms that used a simple definition of cash flow as net profit plus depreciation.


Obviously, Ford management wished to avoid a continuation of this scenario.


Kenneth S. Hackel, CFA


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Risk Rising Modestly

February 22nd, 2011 Comments off


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

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

February 11th, 2011 Comments off

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

February 7th, 2011 Comments off

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

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Mergers, Importance of Factoring Stock Based Compensation, and Are Analysts Too Top Line Oriented?

January 28th, 2011 Comments off

Capital deploying investments typically have a negative effect on their current period’s cash flows. If viewed as projects which safely add to ROIC above cost of capital, such investments can be expected to benefit shareholders, even if the short-term cash flows are impaired. As firms ramp up production or go through the common but expensive integration costs, investors should not lose sight of longer term benefits. Unfortunately, this is often not the case, and so, for investors who can spot and take advantage of the market’s skepticism, superior returns await.

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Protected: Marathon Oil Sure to Be Emulated

January 13th, 2011 Comments off

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Protected: First Solar Inc. (FSLR) – Free Cash Flows Not As Strong As They Appear

January 12th, 2011 Comments off

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The Importance of Cost of Equity in Security Valuation

January 10th, 2011 Comments off

(The following article appeared on CNBC’s Guest Blog on Friday, January 7th, 2011.)

If you really want to know what will happen to stock prices, look no further than the cost of equity, also known as the discount rate.

Put simply, this arcane-sounding metric is a stock investor’s return requirement for making a particular investment. The more the risk, the higher the expected return.

But the real question is: How should investors measure risk?

Academics believe it should generally be tied to the risk-free rate like the 10-year Treasury yield plus a mark-up for the volatility of the stock.

They’re wrong, and here’s why it is important:

A change in perceived risk significantly alters a firm’s fair value, even when current free cash flow and growth rate remain unchanged.

For example, a one percentage point rise in a company’s cost of equity to 9% from 8% equals a one percentage point rise in risk. That one percentage point rise in risk, in turn, translates into a staggering 25% decline in fair value. If the company’s risk rises further – to, say, a 12% cost of equity — the fair value should be expected to fall by 57%.

That’s why the cost of capital is so important. If a company’s cost of capital rises, its share price, must, by definition, fall until it reaches its new lower fair value, as shown in the following table.

In general, risk is measured by the uncertainty of the firm’s future free cash flows. Free cash flows are, in essence, the income to the investor; they represent the maximum amount of cash the firm could distribute without impairing its growth.

Sure, analysts use other measures to arrive at fair value, including market value of the individual parts, liquidation value, price/sales, price/earnings, or price/book. Book value has proven to be an unreliable metric if the book consists of assets where buyers at fair market prices are absent. What is the value of an asset for which there are either no buyers or buyers at unreasonably low prices?

It is the free cash flows, which must then be discounted. But at what rate?

In order to arrive at a fair value estimate for an equity security, an analyst or investor must discount the firm’s free cash flow by a rate equal to the perceived risk. And the risk is a reflection of the uncertainly of the free cash flows. Treasuries will be discounted at the risk free rate plus a small mark-up for the loss of its investment grade status. The amount of the markup is up to the analyst.

That’s why estimates of free cash flow and earnings are called estimates! And because they’re estimates, they’re at the whim of such risks as the loss of patents or customers, volatility in input costs, litigation, inadequate insurance (e.g., BP (BP) was self-insured), foreign government-related issues and rollover of debt, whatever. These risks must be captured by the cost of equity. The fewer and less serious these risks are, the more certain we can feel about the free cash flows. For such an enterprise with above average normalized free cash flow and moderate leverage, lower cost of equity will normally place the entity in a position to add value-adding projects with more facility than its competitors.

The ability to assess risk to the free cash flows through the adjustment of the cost of equity (discount rate) will provide you with a tool which will place you head and tails over just about every securities analyst you see on CNBC or elsewhere. I can also assure you that over the coming years you will be hearing and reading a lot about the appropriate setting of the cost of capital.

So where do things stand now?

According CT Capital LLC’s comprehensive credit model, and, as outlined in my text, “Security Valuation and Risk Analysis,” (McGraw-Hill), the fall in yield spreads, sovereign risk, improvement in credit strength, and rise in free cash flows, have reduced the cost of equity capital to 7.9% for the S&P Industrials from 8.3% a year earlier. Thus, one should expect a 7.9% return for the S&P over the next year, based on the current level of risk.

So, next time your hear during a company presentation or read in an analyst’s report a cash flow estimate, make sure you understand all of the potential risks to the forecast, made possible through a thorough reading of all SEC filings, for in so doing, your expected return will not only shift, but be more realistic.

Kenneth S. Hackel is president of CT Capital LLC, an institutional investment advisory firm. An internationally recognized expert in security analysis, he has managed the nation’s leading mutual fund, a large investment advisory firm, and has consulted and written on mergers and acquisitions and fairness opinions. He is the author of the leading textbook on cash flow based security analysis,“Security Valuation and Risk Analysis.” To read more visit his blog, You can contact Ken here or request additional information on institutional US Equity advisor, CT Capital, here.

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January 4th, 2011 Comments off

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Slowing Economic Growth Means Greater Focus on Economic Profit

December 31st, 2010 Comments off

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.


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.


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.

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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” out this fall from McGraw-Hill.

[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.

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

December 29th, 2010 Comments off

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Password Changed

December 22nd, 2010 Comments off

Sorry, but I didn’t realize anyone could go to Amazon and search the book for the clue to the password.

Please send us proof of purchase—the invoice from Amazon-and we will immediately provide the updated password.

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About Credit Trends

December 21st, 2010 Comments off
Credit Trends 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 statement 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 unnecessary and exaggerated discretionary areas which could be used to enhance free cash flows.
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December 21st, 2010 Comments off

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For Some Investors, Time to Rock the Boat

December 20th, 2010 Comments off

“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.

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