Archive for the ‘General’ category

The Next Shoe to Drop?

June 10th, 2010

A story that never received the proper publicity during the bull market of 2009-2010 was its very positive (savior) effect on pension funding status, and employer contributions. The rise in equity markets allowed many hundreds of billions of dollars to appear on the balance sheet as equity instead of having to be spent to plug the pension gap.

But most of those firms which benefited are not out of the woods, as the negative stock performance during 2010 is sure to re-introduce such large employer expenditures which could very well impair security analyst estimates.

The following is a list of firms which

  • Have, for their most recent fiscal year, accrued a greater expense for their pension plans than they actually contributed;
  • Have seen a decline in the value of their plan assets over the past 2 years;
  • Have either maintained or increased their discount rate (assumed rate of return) over the past 2 years;
  • Have seen an increase in their pension benefit obligation over the past 2 years.

Table 1[1]

Source: S&P Data Services, Company reports

Presumably, firms which have suffered a decline in their plan assets should not be forecasting an increase in their settlement rate, which is the rate their projected benefit obligation could be settled. Firms might do this to show a lower liability and to lower their plan contributions. Their auditors and actuaries should only allow this for a short time before demanding stepped-up contributions.

The following table shows, for the same firms in Table 1, last year’s pension expense as a percentage of net income, the funded status of their plans, these firm’s total debt which to which we include operating lease obligations and shareholders’ equity.

Table 2

Source: S&P Data Services, Company reports

While there might be to some, a number of surprising names on the list, keep in mind that additional large funding into the plans would most likely cause a disappointment to earnings estimates, even though the firm might have the credit capacity to fund with low cost of capital. In the game of expectations, such firms are particularly vulnerable given their funding status and have not, of late, contributed their actual expense.

Several firms on the list look particularly vulnerable. One such is Goodyear Tire (GT), whose plan (see Table 3 summary below) is very underfunded, they have not had the financial ability to catch up, and have a high cost of capital. However, as the list shows, many firms are vulnerable.

Table 3

Source: S&P Data Services, Company reports

The pension and other post-retirement benefit area should be receiving greater scrutiny that it currently receives, as time is sure to tell.

Kenneth Hackel, C.F.A.

President, CT Capital LLC

Data Source: Research Insight, CT Capital, Company 10Ks

[1] Pension-Funded Status Indicates the funded status of a pension plan as either overfunded or underfunded.  This item is the sum of: Pension – Long Term Asset  minus the sum of  (1) Pension – Current Liability and (2)   Pension – Long-Term Liability

Pre-Order at All Online Bookstores

June 9th, 2010

Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making

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.

A Way To Turn BP Around

June 9th, 2010

Sell 1 billion shares at $30 per share and agree to eliminate the dividend for 3 years.

Currently, BP pays about $10 bil. a year in common dividends, so that after 3 years, if the company’s normalized free cash flows continue at the past three year rate, and the $30 bil. is dispersed, their book value will not have declined, as BP managers will be working all discretionary expenditures to generate cash.

They will then have $60 bil.+ ( with interest) to pay claims, which would be more than sufficient as cases drag through the courts and perhaps funds could be set up to pay effected parties. More than likely, given BP’s current balance sheet, they would have closer to $ 68 bil. without impairing its current financial structure.

As much as BP is making horrific headlines now, in three years, it will be a bad memory for most-the world will have gone through many crises by then.

If the price of crude rises, BP’s cash flows will be much stronger- as much as a combined $ 100 bil in operating cash flows and $40 bil. in free cash flow, with the added free cash available to pay claims, making for a total $75 bil.+ without severely impacting current financial structure.

With $75 bil.+,  BP would approach and put together various insurance syndicates with the huge pool in guaranteed funds to take over the liability.

Given the cost of the Exxon Valdex cleanup was $ 2.1 bil., with another $1 bil or so (after insurance) to settle claims, it is doubtful BP cannot satisfy claims from its financial flexibility.

After a couple of years, as it becomes apparant BP will work itself out of the disaster, and as management begins to “mop up” the additional shares from free cash flow, its stock should be at a level seen early this year. If the price of crude were to rise above  $ 95 bbl, the share price of BP could be expected to rise substantially.

As for the immediate issuance of equity, would BP be able to float the issue? Given its trading volume is averaging 300 mil shares a week on the NYSE alone, a deal that size would seem quite do-able.

The company’s first step, is to hit the equity markets for the raise. After the deal is placed, there is a good chance for a rebound in the shares.

Use ROIC, Not EBITDA for Superior Performance

June 8th, 2010

For most industrial entities, return on invested capital (ROIC) represents the most important measure of management ability. Projects whose ROIC exceeds its cost of capital, create value, and as value-enhancing projects continue to grow, the results are reflected in the acquirer’s share price. If the executives in charge of the firm’s assets are consistently able to invest in such projects, it represents the most management- proven technique to reward shareholders looking to build long-term value. Improvements in ROIC are seen in companies able to achieve higher margins, stronger cash flow, and low cost of capital.

For entities which operate on minimal capital, we employ a technique which is based on ROIC, but works better, since, as ROIC approaches zero, it results in extremely large, impractical returns, both positive and negative.

As Oracle Corporation, a very successful acquirer, wrote in its 2009 10K report: “We estimate the financial impact of any potential acquisition with regard to earnings, operating margin, cash flow and return on invested capital targets before deciding to move forward with an acquisition.”

When interest rates are low, corporate planners evaluate taking on projects they might not consider when interest rates are higher. The saving on cost of marginal debt might make such projects worthwhile for equity holders. However, if the cost of debt is variable (i.e., tied to LIBOR) and interest rates rise, the project might become unprofitable. For this reason, that possibility is almost always hedged, allowing the enterprise to eliminate that risk.

Return on invested capital is becoming one of the more widely used analyst metrics. It is of particular relevance however, when under competition with the entity’s cost of capital. By itself, only a vital, but often, partial picture emerges. And for entities or divisions of entities which cannot earn a greater return (on projects) on their invested capital than their cost of capital, its value will decline.

The ROIC is not a measure of security valuation. An entity can continue to accept projects which exceeds its cost of capital, but if its valuation multiple is excessive, its stock could very well decline in the short-run.

Entities which are underleveraged may be denying shareholders a higher valuation if they decline projects having a ROIC greater than the after-tax yield on the excess cash and cost of debt.

Corporate managers evaluate the firm and the business units return on invested capital versus those units cost of capital. Underperforming assets typically have a specific period to improve performance before strategic alternatives are considered. The inability to successfully divest or improve the returns on such assets in a timely manner, meaning, if the unit cannot achieve its cost of capital, could have a negative effect on the entire operations of the enterprise, including its stock price. Management attention is diverted to underperforming units in hopes of turning them around or getting them ready for sale. In addition, the process of divestitures could cause strains on the remaining business segments in need of cash to expand or retool their operations.

The theory behind return on invested capital is to present investors and creditors with an accurate measurement of the cash on cash return management has been able to earn. They need to spend cash to purchase assets in the hopes of a cash return greater than the cost to acquire them.

It is for this reason the analyst should not begin with a GAAP measurement such as net income or EBITDA, but rather free cash flow, in the computation of return on invested capital. C