Credit Trends

The 3.5% decline in the S&P has now brought the index to approximate fair value, given our expectation of 4% annual growth in free cash flow over the coming five years and a 8.1% cost of equity capital. The last time we wrote this was the case, the S&P rallied 15% over the coming 3 months.

Although the cost of capital has risen over the past month, the decline in valuations, to 17.8x FCF, has resulted in a fair valuation. Although many firms are reporting impressive growth in operating cash flow, we are finding much of this cash is to be consumed in newfound growth initiatives. We would avoid these entities, and would continue to concentrate on firms which have shown continual improvements in their cost structure.

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We have noticed a very broad trend on the part of firms which have, over the past three quarters, shown good growth in free cash flow, especially when associated with moderate top line growth, to begin to pick-up their cost structure.

New growth initiatives, share buy-backs, and increases in SG&A, do not bode well for free cash flow later in the year. If this expected growth does not materialize, the stocks of these companies would give back much of the gains seen over the past year and a half.

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Lower interest rates on the ten-year Treasury (risk-free rate) do not always lead to a lower cost of capital. This was clearly seen during 2008 as interest rates fell yet cost of capital rose, as credits weakened due to the effects of the recession and illiquid credit markets. Conversely, higher rates may not always lead to higher cost of capital, as particular industries benefit from (the fear of) inflation and price increases relative to costs. Where the yield spread and risk-free rate do not capture inflation on the security level,  we adjust cost of capital.
Contrary to popular thinking, a rise in inflation cannot be overcome by a similar rise in revenues-it must be overcome by a similar rise in free cash flows, or cost of capital will increase. Also to be taken into account is the effect of inflation on capital to be replaced. If the cost of such capital has increased at a rate greater than the increase in free cash flows, this metric would result in a greater penalty.
The inflation rate affects economic and business risk, including the value of balance sheet inventory, which may be severely understated for firms using LIFO accounting. And, as history has shown (see Illustration), the impact of inflation is not always accurately divined in the risk free rate, which is used as the beginning building block for the cost of equity capital model. Also, the inflation rate and the expected rate of inflation affect firms differently, and thus this metric may need to be adjusted for those groups. Those enterprises with high leverage, sensitive to commodity price swings, or those enterprises that own significant investments whose values are tied (directly or indirectly) to the level of interest rates, will be more greatly affected by changes in the expected rate of inflation than those entities which can pass along its consequences, such as some utilities.

Risk Free Rate

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We have received a number of emails regarding our perception of the increase in risk overwhelming the rise in free cash flow.

There are many factors which contribute to credit risk, with Sovereign debt and foreign exposure being just two. Please do not forget the rise we are seeing in free cash flow is made possible, in good measure, from cost cutting, to the extent when we adjust for normalized changes in working capital, the increase, while, positive, loses about 40% of its magnitude.

This is not unusual for the initial stage coming out of recession, but must be compared to the very large rise, over the same period, in valuation multiples.

Additionally, our credit metrics, especially our consistency measures, have increased over the past month, while other measures, such as health care, taxes ( not just federal income), and foreign pension burden, have all been rising.

All in all, the S&P is about 5% over-valued. Typically, as stocks can fluctuate wildly around fair value, a 5% over-valuation is within normal range-and can even result in a rally. If that were to occur, we would recommend, as we have been, to sell into such rally.

There are, however, stocks that are as much as 40% undervalued, based on free cash flow growth and valuation, cash based ROIC compared to a credit-based cost of capital, and financial flexibility, and it is there where we continue to focus.

For additional information, contact either myself or Simon Adams

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Unlike research and development (R&D), which, as we pointed out yesterday, has not seen severe budget cuts, the same cannot be said for capital expenditure budgets.
Although, for all S&P 500 companies, capital spending has rebounded from the Sept 2009 quarter, given lethargic top line and employment growth, we believe any quick snapback in capital spending is unlikely.

As the largest stock returns evolve from a turn of events, not a continuation of one, we are recommending investors (as we have) reduce their exposure to those effected sectors, and overweight sectors with ties to productivity improvements, low cost of capital and high ROIC.

For additional information call Kenneth Hackel, C.F.A. or Simon Adams

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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.

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.

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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.

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.

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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

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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

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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.

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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.

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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.

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Only 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.

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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.

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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.

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

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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

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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?

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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.

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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

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Wednesday-Some Possible Targets

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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.

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