Archive for the ‘General’ category

R&D Budgets Rebounding

May 12th, 2010

For all S&P reporting companies through May 12, 2010, the median entity has surprisingly maintained its R&D budget.
For the latest reporting quarter, the median S&P firm spent 4.9% of total sales on R&D, compared to the March 2005 quarter of 4.2%. This is up from March 2009 quarter of 3.9%. Total estimated spending on R&D over this period rose quarterly from $34 bn. to $39.4 bn. These numbers are approximate as not all companies report R&D each quarter, as picked up by S&P Compustat services.

R&D As a Percentage of Sales

The data in the chart is fairly accurate as when we look at annual data for all S&P reporting companies, total R&D expenditures rose from $ 121.4 bn. to $164.7 bn.
CT Capital looks at research spending in relation to revenues, unit growth, cash flows and cost of sales when analyzing free cash flow. A percentage of any overspending in R&D is added to free cash flow. Over the past year, enterprises have, in general, been judicious in their R&P spending as they have in managing their other corporate assets. They continue to be optimistic regarding the potential of their R&D spending.

Reporting firms’ R&D (as opposed to capital spending budgets), have, in general, been maintained within historical standards.

Kenneth Hackel, C.F.A.

Goldman Sachs-Congress Holds the Key to Its Valuation

May 6th, 2010

According to today’s Wall Street Journal, Lloyd Blankfein, Goldman Sachs’ chairman, would like the firm’s clients to know it will be an ethical leader.

 

           
 

Sales

Operating Profit

Depreciation

Assets

 
 

 

 

 

 

 

Asset Management & Securities

6,003

1,343

274

184,706

 

Investment Banking

4,797

1,270

159

1,482

 

Trading & Principal Investment

34,373

17,320

1,510

662,754

 

Totals

45,173

19,933

     
           

That will, as an inspection of their trading reveals, be quite difficult, unless they do away with their proprietary trading desk. For as long as the firm continues to trade billions of dollars a day for its own account, it will be placing, at times, large bets against its clients.

Unfortunately, its trading desk is too profitable to relinquish voluntarily- at least without a fight. But how does it fight to keep it, given the spate of anti-Goldman sentiment, with its only real beneficiaries being its employees and shareholders? It serves no greater economic or financial good. To the extent the trading desk can manipulate, with its billions of dollars in capital (no figures are released), financial markets in the direction it is betting, its clients’ interests are not just served-they could very well be hurt.

This represents a diametrically opposite picture given by its chairman before the Senate committee last week, in which he gave the impression its trading activities, were incidental to that of its clients. It is apparent that the prop desk represents a very large percentage of its revenues, profits, and cash flow, although it is difficult to precisely determine, especially given the firm’s large interest income, and the extent to which interest results directly or indirectly from the trading desk.

But Goldman will obviously not give up its prop desk unless it is forced to. As the table shows, of its $45.2 bn. in firm revenues, it received 76% from trading; interest income and trading provided 95% of total firm revenue. Of operating profits, 87% came from trading. Included in its trading operations are trading in the most speculative of derivatives, the kind which a slight information edge can result in $1 bn. profit within weeks. Goldman controls over half of the principal program trading on the NYSE. It would be noteworthy to find out the extent to which its short and derivatives portfolio were active bets-not hedges-against clients, and if they solicited such trading so that they could make such active bets. It would be of interest to know how much capital Goldman has, on average, throughout the past years, committed to its prop desk.

One thing is for certain. If Goldman is forced to give up proprietary trading for its own account, or under the careful eye of government regulators must cut back such trading, Goldman Sachs’ franchise value will suffer irreparable harm.

To what extent could we see Goldman Sachs stock drop? To get a clearer picture of the effect of its trading prowess, I looked back 10 years and evaluated the growth in trading had on cash flow and net income. Given Goldman’s last fiscal year $13.4 bn. in net income prior to preferred dividends, I estimate 30% resulted from proprietary trading of its own accounts, or about $4 bn. Given net income of $9 bn., and 526.2 MM shares outstanding, we would still looking at roughly $17 per share, if a cutback were in order. On the other hand, if the firm returns to the wild pre- derivatives era of 2000-2005, when Goldman earned, on average about $6.50 per share, as trading revenue were considerable less than half current levels, but was still very profitable, that absent prop trading, net income could easily be reduced back to the $6.50 per share level. If that were the case, Goldman’s stock would be expected to fall to the $70s, especially given slow economic growth, which would be offset by their high market share given competitor weakness both in the US and Europe.

The most reasonable scenario is some cutback in prop trading, the extent of which cannot be determined or even reasonably estimated. But at its current levels, there appears to be too much risk in the shares of Goldman, despite current strong cash flows and a low valuation multiple. If however, Goldman is able to carry out its business with essentially no change to its prop desk or other businesses, a low probability scenario, I would expect to see a large rally in its shares to the $200 level. For shareholders, the fate of the firm is in the hands of the Congress. And that’s not a risk worth taking.

Apple (AAPL) and its Cash

May 5th, 2010

What do you do when you have $50bn. in loose change in your pockets? This is the dilemma Apple Computer will be facing by the end of its fiscal year. And that may be conservative given Apple’s cash hoard has already risen by $ 10bn. since the end of September.

With its only debt related to lease obligations, Apple has been as big a cash machine as their exists in the US financial marketplace.

Financial theory posits a company that continues to watch its excess cash rise, to the point it is greater than its shareholder’s equity, with no debt other than a reasonable lease structure, would be frowned upon by investors. It is expected such an entity should either return that cash to shareholders in the form of dividends or share buybacks, re-invest back into the business, or to make acquisitions above its weighted average cost of capital.

Apple, however, is an exception to financial theory. They have been so adept at using other firms’ capital, there is really no need, at this time to spend more within, than they are already doing. From their supply chain to their marketing and R&D, Apple is unparalleled.

As Steve Jobs and the board of directors at Apple have so far shown no inclination to pay a dividend or buy back stock, the only remaining outlet for that continuing cash rise is a large acquisition.
And there, the universe is extremely limited, baring a large number of small acquisitions, which Apple can do anyway.

Under a reasonable scenario, Apple management would most likely only approve a large business combination meeting all of the following criteria:

1-Size of Deal- Not greater than $100bn.
2-Target must, like Apple, be conservatively managed, with a strong credit
3-Target must also be strong producer of normalized and prospective free cash flow
4-Target must be in a business Apple understands which can propel their respective competitive positions going forward
5-Target must have return on invested capital at least 3% above its cost of capital

When all these factors are set in motion, only one company stands out: Qualcomm

New Book: Security Valuation and Risk Analysis

April 9th, 2010

Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making
COMING THIS OCTOBER FROM McGRAW-HILL

Kenneth S. Hackel, C.F.A.
Reason Book was Written: To introduce a successful and innovative approach to the valuation of equity securities.
Central Tenets:

(a) Cost of capital, a principal component of valuation, should not be determined by stock volatility, as is widely practiced by enterprises, investors, consultants and security analysts, but by the entity’s cash flows and credit health.

(b) Return on Invested Capital (ROIC), a principal component of valuation, should be measured as a function of the assets production of free cash flows, as it should benchmark the expected cash return for cash expended; and

(c) Free cash flow should include cash the entity could easily free up, and this can be captured thru analysis of various discretionary spending areas. EBITDA, an income statement based accounting concept, is not a measure of the true economic return.

Security Valuation and Risk Analysis is a book written to help investors appraise the expected return from an investment in an equity security.

To accomplish the endeavor, half the book is allocated to risk, as measured by cost of capital; half to return, as measured by the investment’s expected cash flows.

Because security analysts are not confronted with the daily barrage of problems and exposures that managers and executives directly working for the entity confront, and rarely are many mentioned during investor presentations, this wide swath of risks tend to be ignored or not properly calibrated. Investors need to think and identify with the chief financial officer to truly appreciate the multitude of exposures the firm faces to accurately determinate a cost of capital that properly takes into account these uncertainties, of which any one could damper cash flows or even threaten the entity’s survival. On the other hand, if investors were to overweight such risks, the entity’s valuation multiple would depress, leading to out-sized investment performance for investors who properly weighed them.

The determination of the proper discount rate is a function of these risk factors, as defined by the cost of equity capital. Only thru an accurate and reliable cost of equity capital can fair value be established, as well as the determination if management is creating value for shareholders, as measured by the free cash flow-based ROIC capital compared to its cost.

The book’s comprehensive credit model replaces and improves upon the Capital Asset Pricing Model, by providing rating criteria of financial health resulting in a superior discount rate which is applied to the firm’s free cash flows. From this, fair value is established.

The text explains why entities having a low ROIC resulting in small amounts of distributable cash flows deserve low valuation metrics despite having higher rates of growth in revenues and/or earnings.
Tax effects are discussed in detail throughout the text as it relates to those affected areas, both from a cash flow effect and its associated financial reporting.

This book explains relevant current accounting requirements and how they are applied by reporting entities, especially to the Statement of Cash Flows. The text is replete with examples to illuminate each topic.
Prominent discussions, analysis and topics relate to:

  • Free Cash Flow
    * How to compute the maximum distributable cash available to equity holders without impairing growth
    * Are cash flows and income telling the same story?
    * The many failings of EBITDA and why it is inappropriate for use by practitioners and business analysts, including its use as a measure of unlevered cash flow
    * Adjustment procedures for normalizing reported cash flow from operating activities to both improve comparability and eliminate management influence.
    * The adjustment of various other expenses which could free cash, such as cost of sales, SG&A, and capital spending.
    * The analysis of taxes, including cash rate stability and cash versus effective rates.
    * Shows how improved balance sheet management has the same impact as an increase in revenues or free cash flow
    * Analysis of cash flow volatility
  • Cost of Capital
    * Why a 1 percentage point change in the cost of capital often results in a 25% change to fair value
    * Why analysts often ignore the Capital Asset Pricing Model
    * A discussion of the prominent cost of capital models and how IBM could not accurately estimate its cost of capital using them
    * Importance of yield spreads to the cost of capital
    * Sensitivity analysis for components of cost of capital
  • Return on Invested Capital
    * How it should be defined using free cash flow (not EBITDA, net income or operating cash flow) and a realistic capital base
    * Why it is management’s chief responsibility to continue to improve the firm’s ROIC and reduce cost of capital.
    * Why share buybacks only rarely add value and do not improve ROIC
    * How a new large capital investment would be analyzed and discussed from the point of view of the firm.
    * How economic profit, using free cash flow, should be implemented, when ROIC is not appropriate.
  • Financial Structure
    * A thorough analysis of the roles debt, equity and hybrid securities play in the capital structure including possible calls on capital such as commitments, contingencies, guarantees, convertible securities, exposure to lawsuits and other cash requirements, such as sinking funds. Also explored are contingent capital, debt covenants, adjusted debt, goodwill, special purpose entities, contingent liabilities, and the importance of sensitivity analysis in evaluating financial structure.
    * Detailed explanation, with examples of the accounting for pension and other post-retirement benefits, including healthcare. Importance of studying non-US plans, whose liabilities are often growing much more quickly than a firm’s US plans.
    * Detailed explanation with examples, of derivatives and hedges, used for risk reduction as well as a speculation.
    * Thorough explanation of lease accounting, including why current accounting rules almost always result in an understated liability. Clarification of tax accounting and reporting under the Statement of Cash Flows.
    * Analysis of the roles played by of credit rating agencies, including how they evaluate ratings as well as their importance and influence

Underperformance of High Capital Intensive Firms

April 7th, 2010

Capital intensive firms have had a rough time of it the past five years. Not only has business slowed, but lots of property, plant and equipment (PPE) means lots of debt, not all of which appears on the balance sheet. Nevertheless, debt, like operating leases and that associated with special purpose entities, represents legal obligations that demand repayment.

The chart below shows the five-year performance of firms which have gross PPE at least three times that of their positive shareholders equity, assets of at least $500 million, and a market value of at least $250 million.

 

While the chart shows these firms have had, as expected, negative relative performance, there is now reason to believe, based on CT Capital’s cash flow/cost of capital models, many of the set are primed to recover ground, the extent of which is dependent on their upcoming ability to generate growing free cash flows.  Others, especially, when off-balance sheet debt is included, appear to offer little in the way of potential return to equity holders.

As with all bull market runs, investors look for laggards, and especially investment managers who make a habit of accepting high risk hoping to show strong catch-up investment performance.

The catchword is to be very careful with this group; yet quite a few names appear to offer excellent relative value.

However, if the industries in which these companies operate do not grow as expected, their operating and financial leverage could result in financial failure or extreme loss of market value.

For information on the study please email kenhackel@ctcapllc.com and look for “Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making” later this fall from McGraw-Hill.

Kenneth S. Hackel, C.F.A.

Healthcare Legislation to Severely Impact Cash Flows and Valuation

March 25th, 2010

From Caterpillar’s 8K released today:

As a result of the Patient Protection and Affordable Care Act (H.R. 3590) signed into law on March 23, 2010 (the “Act”), beginning in 2011 the tax deduction available to Caterpillar Inc. (“Caterpillar”) will be reduced to the extent its drug expenses are reimbursed under the Medicare Part D retiree drug subsidy (RDS) program. Although this tax increase does not take effect until 2011, Caterpillar is required to recognize the full accounting impact in its financial statements in the period in which the Act is signed. As retiree healthcare liabilities and related tax impacts are already reflected in Caterpillar’s financial statements, the change will result in a charge to Caterpillar’s earnings in the first quarter of 2010 of approximately $100 million after tax. This charge reflects the anticipated increase in taxes that will occur as a result of the Act. As mentioned on page A-106 of Caterpillar’s Form 10-K for the year ended December 31, 2009, Caterpillar’s 2010 Profit Outlook is based on tax law in effect as of February 19, 2010 and does not include the impact of the Act.

The recently approved healthcare legislation will have a material impact on cash flows not currently reflected in stock prices. Companies like Caterpillar, P&G, 3M, and IBM, which have a high ratio of retired and near retired, to an active workforce, will be most affected by the rise in cash taxes. But almost all firms will be impacted.

We have reviewed our model portfolio, and believe other investors will be doing the same. The result will be an increase to cost of capital which will reduce valuation multiples.

As firms have been able to show large reductions to pension plan liabilities, resulting from the large rally in stocks during 2009, with commensurate improvement to shareholder’s equity, the healthcare law will refocus investors to the benefits area. If the 2009 valuation benefit is not repeated, the cost to S&P 500 companies will be in the many billions of dollars.

And if the reduction in valuation multiples causes stocks to falter, as we expect, the health care legislation will turn out to be a very costly.

Next-Credit Ratings Are Still Important In Determining Stock Valuation

October 1st, 2000

During the height of the credit crises a short 2 years ago, the hint of a credit downgrade was sure to result in an outsized drop in the underlying stock. Now, with balance sheet re-liquefaction and built-up capital, the fear of a credit rating is not near as worrisome.

ARTICLE WILL BE POSTED OVER THE WEEKEND

IF YOU ENJOY THIS SITE, ORDER BOOK TO THE RIGHT—GAIN AN IMPORTANT  EDGE OVER THE LARGEST OF INVESTORS AND WALL STREET ANALYSTS

Coming Next-Is IBM Losing Its Competitive Edge?

September 16th, 2000

In this article we look at evidence that strongly suggests that IBM, despite being turned into a cash “machine,” has done so not through its own R&D efforts but rather through massive cost cutting.

Would Sam Palmisano fire Sam Palmisano?

Coming Later This Week

August 16th, 2000

Is the selling in HPQ overdone?

It appears that HPQ offers investors good value- but is there anything brewing beneath the surface?

If you had a copy of that book to the right, you would know.

A Better Indicator Than Net Income

August 9th, 2000

Over the past 10 years, this variable has had a remarkable correlation to with future stock prices- and it’s not net income.

COMING NEXT

Tuesday-Why M&A Frenzy May Not Be a Good Thing

August 2nd, 2000

Wednesday-Some Possible Targets

Later-Is BP’s Announced $30 Billion Asset Sale Another Blunder?

July 27th, 2000

T’Mow on Credit Trends: Why It Would Be Unwise For Firms to Boost Dividends

July 26th, 2000

Ken Hackel Featured on Canada’s Business News Network

July 26th, 2000

Tomorrow I will be appearing on Canada’s BNN (Business News Network) at appx. 11:20 am. est. , taking place at the NASDAQ.

You can see the my full interview on BNN  here (beginning at approximately 03:45) or a shortened webcast version here.

Coming Next-Getting an Edge Over Those $1MM+ Salary Wall Street Analysts

July 24th, 2000

Coming Later-Executive Metrics-Should Steve Ballmer be Fired?

July 23rd, 2000

Alcoa, Sales of Accounts Receivable and Asset Sales

January 1st, 1900

Included in Alcoa’s press release yesterday was the statement its cash flows would have been even higher had it not been for the ending of its sales of accounts receivables.

What Alcoa isn’t stating is that such sales enhanced its prior quarters, with the amount of additional sales, above the prior period (adjusted for normalized growth) to be subtracted from cash flow from operations. Alcoa’s prior periods cash flows, using traditional methods have benefited from such sales. In our analysis we back out such favorable impact to arrive at a normalized free cash flow and operating cash flows.

The sale of receivables is part of the analysis of all asset sales.

ASSET SALES

For entities needing to raise cash, asset sales are always considered in addition to external financing. The least costly capital raise will always be considered first, especially if the financial turbulence is expected to be short-term and the cost of debt and equity are high.

The continual sale of inventory for below market prices, or accounts receivable factoring, normally provide an  unmistakable warning that should raise a flag for students of cash flow and risk, as the realization price reflects a cost which would not normally be acceptable to a well-financed organization. Asset sales are often a de-facto partial liquidation. Continuing asset sales that take place for lower than balance sheet values are indeed  telltale signs.

To improve operating cash flows, companies often sell operating divisions, as they rebalance their portfolio of companies in search of the highest return opportunities. Small asset sales and balance sheet management typically constitute good business practice, and add to free cash flow and reduced cost of capital. Managers committed to weeding out poorly performing business units can significantly enhance their company’s market valuation.

Significance, in accounting parlance, relates to size and whether the failure to report an event as a separate line item would mask a change in earnings or trend. The analyst should determine if the company under analysis has indeed sold assets during any particular reporting period due to weakness in its borrowing capacity, or an attempt to bolster disappointing operation cash flow. Both Enron and Delphi Corp, prior to their bankruptcies, were selling inventory with the understanding they would be repurchased at a later period, a clever way to raise cash but a telling sign of liquidity shortfall.

The securitization of assets for sale into a Special Purpose Entity, as was invoked by Enron, may not, by itself, represent a reason to sell a security or dismiss the purchase of one, especially in light of otherwise undervaluation by the marketplace. In fact, many companies have raised cash via the securitization of accounts receivable, redeploying those funds back into a business which resulted in high rates of growth in cash flows. When viewed under the light of other metrics, asset sales could form part of a mosaic, indicative of a financial risk urging avoidance of the particular security, or to place a higher discount rate on its free cash flow, accounting for the new, higher level of uncertainty.

Entities which have substantial accounts receivables, like retailers, often discount these future cash receipts for immediate cash, as Macy’s did during 2006. Figure 3-2 reveals the impact on its average collection period resulting from that sale. Of course, average collection period and similar credit metrics, such as cash conversion cycle, will be distorted by the sale of receivables.

Selling receivables boosts current period operating cash flow and thus must be normalized by the analyst in evaluating historical and prospective cash flows. To do so, one would compute the past 4 years average accounts receivable to sales and apply that to the current year, as if the financing did not occur. At that point, the analyst can evaluate the Operating and Power cash flows for that year, including the sales of receivables.

More importantly, since the upcoming year(s) cash collections will be lower, an updated cash flow projection must reflect the new expected collections, with emphasis on the ability of the entity to retire or recast upcoming debt and other obligations coming due.  Macy’s has, according to its “Financing” footnote, $2.6 bn. in principal payments due over the coming 3 years.  Since prospective cash flows will be diminished by the present value of the change in future collections, fair value could shift, depending on how the cash from the sale is deployed.  In its statement of cash flows, seen is the drop in cash flows from operations, with management reacting to by cutting budgets company wide.

MACY’S, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(millions)

2008 2007 2006
Cash flows from continuing operating activities:
Net income (loss) $ (4,803 ) $ 893 $ 995
Adjustments to reconcile net income (loss) to net cash provided by continuing operating activities:
(Income) loss from discontinued operations 16 (7 )
Gains on the sale of accounts receivable (191 )
Stock-based compensation expense 43 60 91
Division consolidation costs and store closing related costs 187
Asset impairment charges 211
Goodwill impairment charges 5,382
May integration costs 219 628
Depreciation and amortization 1,278 1,304 1,265
Amortization of financing costs and premium on acquired debt (27 ) (31 ) (49 )
Gain on early debt extinguishment (54 )
Changes in assets and liabilities:
Proceeds from sale of proprietary accounts receivable 1,860
Decrease in receivables 12 28 207
(Increase) decrease in merchandise inventories 291 256 (51 )
(Increase) decrease in supplies and prepaid expenses (7 ) 33 (41 )
Decrease in other assets not separately identified 1 3 25
Decrease in merchandise accounts payable (90 ) (132 ) (462 )
Decrease in accounts payable and accrued liabilities not separately identified (227 ) (396 ) (410 )
Increase (decrease) in current income taxes (146 ) 14 (139 )
Decrease in deferred income taxes (291 ) (2 ) (18 )
Increase (decrease) in other liabilities not separately identified 65 (34 ) 43
Net cash provided by continuing operating activities 1,879 2,231 3,692
Cash flows from continuing investing activities:
Purchase of property and equipment (761 ) (994 ) (1,317 )
Capitalized software (136 ) (111 ) (75 )
Proceeds from hurricane insurance claims 68 23 17
Disposition of property and equipment 38 227 679
Proceeds from the disposition of After Hours Formalwear 66
Proceeds from the disposition of Lord & Taylor 1,047
Proceeds from the disposition of David’s Bridal and Priscilla of Boston 740
Repurchase of accounts receivable (1,141 )
Proceeds from the sale of repurchased accounts receivable 1,323
Net cash provided (used) by continuing investing activities (791 ) (789 ) 1,273

Source: Macy’s 10K

In many cases, it is less expensive to borrow funds with the creditor taking a security interest in accounts receivables and inventory. This would be a loan, not a factoring agreement where the accounts receivable are sold. In a factoring arrangement, the cost to the firm is typically higher.

When receivables are financed through borrowings, it is shown as a finance activity, even though the actions are basically identical to its sale. Also, by factoring, the firm keeps the loan off of its balance sheet. Another issue to consider is whether the receivables being sold were done so on a non-recourse basis, so that if they are ultimately uncollectable, Macy’s has no further legal obligation. A moral obligation, may exist, however, and must be considered.

The figure below shows Macy’s average collection and payables period for 2003-2009 fiscal years.  When Macy’s sold about $ 4.1 bn. of their in-house receivables during 2005-2006, it dropped their collection period, but of course, the company paid a price for the immediate cash. They did reduce total debt by about $ 1.5 bn. but unfortunately they also succumbed to shareholder pressure and expended $2.5 bn. on the repurchase of shares, hopeful the buyback would boost the stock price, which it did not, since their cash flows were weak.

To Macy’s, which had substantially increased its leverage resulting from its $ 5.2 bn. purchase of May Department Stores the year earlier, the cash resulting from the sale of receivables might have ultimately staved off bankruptcy two years later when its business fell due to the recession and loss of market share to competitors, the latter not a atypical byproduct of a large business combination. For sure, management wished the $ 2.5 bn. stock buyback never took place. The $2.5 bn. outflow robbed Macy’s of needed financial flexibility by eliminating a large cushion when its business turned down.

While the sale of receivables does indeed provide immediate cash, it is important to consider why the action was taken, especially for companies that operate on tight margins. For such entities, the sale may eliminate profits those sales initially produced. For them, if the cash is not used to pay down trade payables or other business related obligations, the analyst must question where such cash will eventually come. Because Macy’s wasted funds from the sale on share buybacks, they cut their purchases of PPE in half over the next two years. It is difficult to imagine a large sale of accounts receivable to buy back shares is ever a good idea.

Macy’s-Days to Pay vs. Collections Period

Source: Research Insight, CT Capital LLC

For additional information on this type analysis, pre-order- “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

Disclosure: No positions.

Kenneth S. Hackel, C.F.A.
President
CT Capital LLC

www.credittrends.com