Healthcare Legislation to Severely Impact Cash Flows and Valuation

March 25th, 2010 by hackel No comments »

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.

What Part of Market Volatility Don’t You Understand?

February 4th, 2010 by hackel No comments »

We’ve been saying for years investors DO NOT understand risk. The numerator (cash flow) has not shifted much over the past quarter-it’s the denominator, cost of capital, as only can be measured by our comprehensive credit model, factoring everything from tax rate and revenue stability, free and operating cash flows, yield spreads, and 50 other metrics, all carefully defined.

The problem is, in a nutshell, investors are setting risk thru the Capital Asset Pricing Model, which is terribly flawed. They look towards EDITDA, which is terribly flawed.

COMING THIS FALL: Cash Flow, Cost of Capital, and Security Valuation, McGraw-Hill

Central Tenet: The risk premium should not be set by stock volatility, as implied by the capital asset pricing model, but by the cash flows and credit worthiness of the entity.

Altera, Cost of Capital and Return on Invested Capital

January 30th, 2010 by hackel No comments »

Altera - Cost of Capital and ROICOnly CT Capital LLC has the proprietary free cash flow-based return on invested capital (ROIC) and very detailed cost of capital credit-based models to properly evaluate these most important yardsticks.  All other approaches fall short as they do not accurately reflect the underlying financial profitability and stability of a firm, its growth potential and value enhancement level

No wonder Altera is far outpacing its peer group. Continuing to invest in value enhancing projects, whose cash based return in invested capital exceeds its cost of capital is a value creating management strategy sure to reward equity holders.  Altera’s free cash flow yield, like all the companies in our portfolio, is far in excess of the 10-year Treasury yield, while their debt measures are much higher than the median S&P company.

What Cramer doesn’t understand can hurt his viewers …

January 28th, 2010 by hackel No comments »

Switching stations, I heard the first minute of his show this evening, saying “ investors are looking for a reason to sell.”

Someone please tell Mr. Cramer, large investors look to make money, and will sell if they have information not reflected in the current price of the security. If someone sells, someone who holds the opposite opinion buys.

But what he doesn’t really understand, and something I have been pointing out the past three months, is that current financial risk is greater than stocks are pricing in. When we called the market bottom in March, we did so as free cash flow increased, discretionary expenses were being reigned in, and valuations were low.

Over the past quarter, we are finding cash flows, adjusted for discretionary spending growing very modestly, credit health, as measured by our credit model (which incorporates everything from revenue and tax rate stability to yield spreads and off balance sheet debt, and everything in between), showing just minor improvement over the prior quarter. Yet, stocks were rising such that the free cash flow yield was approaching 4%.

And that is why stocks have, in general, declined. Not because “investors are looking for a reason to sell.”

We stated three months ago that although stocks almost never sell precisely at fair value, they were about 10% overvalued. Today, they are about 4% overvalued, based on a 3.6% 10-year Treasury bond, and a 8.4% cost of equity capital.

Ford Motor Company – Cost of Capital Improves, but …

January 28th, 2010 by hackel No comments »

Investors should not get carried away with Ford just yet. Despite market improvement, its cost of capital is still some 70% higher than the median S&P 500 company, reflecting its credit and financial health are still tenuous.

The cost of capital, which is a function of the risk free rate and the firm’s credit health, suggests Ford stock should only be considered by speculative investors, willing to lose a substantial portion of their investment. Ford will be facing strong competition from China and possibly a resurgent GM over the years ahead, and with their long-term free cash flows in doubt, and reliance on debt ( $ $4 bil cash covenant requirement), Ford’s stock appears fully valued.

Ford - Cost of Capital

Off-Balance Sheet Leverage

December 20th, 2009 by hackel No comments »

Thursday’s > 5% decline in Fedex vs UPS’s 1% decline vividly illustrates the importance of off-balance sheet leverage, namely operating leases.

Next-Credit Ratings Are Still Important In Determining Stock Valuation

October 1st, 2000 by hackel No comments »

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.



Coming Next-Is IBM Losing Its Competitive Edge?

September 16th, 2000 by hackel No comments »

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 by hackel No comments »

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 by hackel No comments »

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


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

August 2nd, 2000 by hackel No comments »

Wednesday-Some Possible Targets

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

July 27th, 2000 by hackel No comments »

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

July 26th, 2000 by hackel No comments »

Ken Hackel Featured on Canada’s Business News Network

July 26th, 2000 by hackel No comments »

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 by hackel No comments »

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

July 23rd, 2000 by hackel No comments »

Alcoa, Sales of Accounts Receivable and Asset Sales

January 1st, 1900 by hackel No comments »

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.


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.




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.
CT Capital LLC