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Nu-Skin Enterprises
January 10th, 2013 by hackel No comments »Shares in Nu Skin Enterprises (NUS) rallied strongly after reporting an excellent quarter and upwardly revised record outlook for the upcoming year. Just 2 days later its shares tumbled after a well-known publicity seeking hedge fund operator attacked another firm in their sector which also uses a direct selling approach[1]. This hedge fund operator last year urged investor’s short Green Mountain (GMCR) in the low $20’s, helping knock its shares to the teens—GMCR now stands in the $40’s and his hedge fund is up just 6% this year after being down last year, which some are saying may have propelled his latest rampage, including petitioning the FTC and hiring, according to his own words “two of the top law firms in the country” to investigate the firm. God only knows what he is really paying these law firms to do, and why he felt compelled to take such action if his analysis was correct.
One brokerage analyst dropped coverage of his short position, saying for the foreseeable future its shares will not follow fundamentals, while at the same time calling the hedge fund’s case as “light.” Again, he did not short NUS, but it did have a strong associative impact which purged its shares by almost 20% this month. Nu Skin’s Board is extremely strong in direct selling as are its senior management and the firm has earned high cash returns on capital every year over at least the past decade. Its auditor has been PWC throughout and the firm has a high cash tax rate (33.3% last year). Although I am not immune to the risks of a large direct sales workforce working solely on commission, I believe it is fully captured by the higher cost of capital for this firm.
Hedge funds are becoming a frustrating part of this business as they often sway investors, including beseeching financial intermediaries and legislators, often with misleading information and then taking their trumped-up cases to institutional funds. This selling often begets more selling by day traders and high frequency trading houses. The shorted stock in the cited case traded over 110% of its outstanding shares in 3 days.
While not one to often promote added legislation, I believe congress and the SEC should take a closer look at the tactics used by hedge funds, especially how they influence the confidence and integrity of the financial markets.
[1] See Wall Street Journal, Nu Skin Suffers As Investors Back Away, at http://blogs.wsj.com/corporate-intelligence/2012/12/21/nu-skin-falls-as-investors-back-away-from-door-to-door/?mod=yahoo_hs
Google-What Investors Have Been Missing; Fair Value Estimate
August 14th, 2012 by hackel No comments »
Investors have been focusing on the wrong financial metrics in their analysis of Google equity securities.. Cost per click and other such highfalutin tech analyst measures are naiive indicators of a firm……..
THIS REPORT IS AVAILABLE FOR $50,000 FOR NON CLIENTS OF CT CAPITAL LLC CLIENTS
Is your investment advisor worth a hill of beans?
August 10th, 2012 by hackel No comments »Ask the following 8 questions:
1-Explain, in detail, once you’ve estimated the entity’s free cash flows, how you arrive at the discount rate?
HINT: It’s not what you learned in grad school or the CFA exam.
2-Explain, again in detail, all of the adjustments you make to the published financial statements, to arrive at an estimate of free cash flow?
HINT: Lots of adjustments are required.
3-How do you define return on invested capital?
HINT: We’re looking for cash on cash.
4-How do you define economic profit and when should it be use?
HINT, Because many companies are not capital intensive
5-Explain how companies account for (s) derivatives and (b) pensions and other post-employment benefits
6-How should value be derived?
HINT: It’s not through relative value, such as a firm’s PE against its peers or some index
7-How do you account for a firms over-spending or under spending?
8-Have you read “Security Valuation and Risk Analysis?
HINT: If not, call CT Capital LLC
Any Risk To Prospective Free Cash Flows Must Be Used When Determining Discount Rate for Share Prices
August 2nd, 2012 by hackel No comments »Imagine if surgeons used same methods as 50 years ago-Crazy, right?
Then why are investors using same tools to analyze risk, given superior methods are available?-see http://amzn.to/T4x71d
Sales, cost of sales, SG&A and tax rate stability. Free cash flows and operating cash flows with the making of proper adjustments. Self-insurance. Litigation. Credit. Derivatives. Yield Spreads, etc, etc. If you are not doing this as part of your risk analysis and much much more, you don’t know how to analyze and quantify risk. Your are using the wrong discount rate ( cost of equity) in concluding the fair valuation of the enterprise and share price.
I show you how.
Stop using the same tools as investors who continually dole out poor advise.
Order Security Valuation and Risk Analysis. After all, it took 40 years of my experience in this business to write
Why Many REITS Are Similar to Ponzi Schemes
July 22nd, 2012 by hackel No comments »
We feel the stocks listed below carry significant risk.
While their valuations have held, it is due to an unsustainable dividend being financed by equity investors in search of yield, rather than the inherent ability of these firms to generate consistent free cash flows.
In addition, as will be pointed out, each of these firms have a questionable financial structure as well as carry risk to prospective free cash flows.
REPORT AVAILABLE FOR $250,000
High Yielding Equity Portfolio Studies Found Biased
May 14th, 2012 by hackel No comments »Monday, April 30, 2012
High Yielding Equity Portfolio Studies Found Biased
Introduction
The worldwide economic slowdown has brought forward a movement toward high dividend yielding equity investing. While this is typical of every such part of the economic cycle, investors, both individual and institutional, are being misled by a slew of biased research on the part of academics and money management firms.
In general, firms which, by virtue of their products, services and financial management are proven to be historically consistent above-average dividend yielding companies are also good free cash flow producing firms, and that is the reason for outperformance relative to various benchmark indexes. If these firms were to instead have deployed their free cash flows into projects above their cost of capital, their shareholders would have been further rewarded.
The Dividend Decision
The implicit assumption behind a high yield equity strategy— whose basis is by purchasing shares in a diversified portfolio of firms having high payout ratios and above-average dividend yield— is an investor can earn a higher rate of return on that cash than the entity itself.
Over time, firms which produce free cash flows have traditionally had open to them, and are presented with, opportunities which are not generally available to the public at large. For firms which are net borrowers or have limited access to capital, value-adding opportunities cannot be pursued to similar degree, if at all.
Additionally, firms which are able to retain high quality management teams possess levels of expertise superior to that of the ordinary investor and can invest in size to take advantage of the opportunities presented. They then have the financial and management flexibility to negotiate and improve upon returns of the acquired assets, or in the parlance of management consultants— can become a better owner. This can take the form of improvements to the supply chain and manufacturing process or introduce labor and technology savings, cross-selling, and conceivably lower borrowing costs.
On the other hand, firms which chose to forego available opportunities in light of a dividend policy, bypass many value creating acquisitions, capital and software additions, and joint-ventures and partnerships.
A popular refrain among executives is they cannot find such opportunities available at a safe higher cash on cash return over their weighted average cost of capital, are capital constrained, or are regulated. Firms having poor acquisition records, have a top heavy financial structure, lazy or near-sighted managements, or succumb to the desires of vocal shareholders, including those insiders who own stock, and look for the simple way out of returning the excess cash to shareholders, are generally destroying, or not maximizing, value for its shareholders. While these firms’ shares may outperform generally recognized stock benchmarks during periods of poor economic growth, their ability to continue to pay dividends must remain a function of their ability to produce long-term free cash flows.
At issue in the academic literature is the bias introduced in the comparison of firms which pay dividends as compared to firms that do not. Such bias exists as firms that pay dividends are overwhelmingly free cash flow producers. It is my contention that yield studies should only use the universe of free cash flow producers, as the real argument is how such firms could best maximize value.1 Studies must look retrospectively to see what assets and decisions involving cash were open at the time a decision on the dividend was reached, including assets that were both passed over and those that were approved.
When studying firms having high payout ratios, the analyst/investor should not restrict their summary results to stock price performance but rather present comparison between capital deployment choices of those firms in the same industry, especially drawing on those firms having chosen lower payout ratios. From that point, the investor can then estimate what the firm’s financial metrics would have been had all choices been made.
After all, it is the primary responsibility of a firm’s asset guardians—its group leaders, executives and Board of Directors— to not merely protect the assets, but seek such means to see the capital base grow such that increasing amounts of free cash flows are produced under a sound financial base. The firms return on capital and, where additional amounts of capital are not required, economic profit— as opposed to its return on equity, is the preferred measure. To see how ROIC and economic profit should be defined I refer you to chapter, 5, Security Valuation and Risk Analysis.
When undergoing such an analysis, an analyst may need an inside knowledge of the firm to account for and explain the choices which lay before the CEO. Since most acquisition candidates, including that of privately-held firms are out of the sphere of ordinary investors, only the CEO, or perhaps those on his team, may know of such decisions.
Some firms had real opportunities before them while others might have been constrained from serious investments; for example Merck, which currently has a high 4.4% dividend yield, has clearly had many opportunities over the past decades, generates substantial free cash flows, yet whose shares might be looked at as slight outperformers during a down equity markets but whose shares have vastly underperformed the S&P since the last bull market began. One can easily make the case its shareholders would have been considerably better off if the firm made an acquisition of a related industry firm such as Allergan, Perrigo, or Watson.
1 See for example, Journal of Financial Economics, The Effect of Personal Taxes and Dividends on Capital Asset Prices, 1979.
Altria, another high yielder, has been divesting assets, and should be looked at using different metrics than Merck, as would be true of any firm facing a potentially large legal settlement. Similarly, other firms which are cash generators but face a potential call on cash, such as when asbestos manufacturers were confronted with and ultimately required to pay many billions of dollars in lawsuit settlements and legal fees, would not be in a position to be aggressively leveraging the financial structure.
Clearly, the recommendations of the CEO to the Board on how a firm should deploy free cash flows begins to form the basis of valuation, as these decisions impact prospective free cash flows, cost of capital and return on capital.
Yield Objective
As for the investment objective of an income producing portfolio, and hence safety of principal is an implied consideration, high grade fixed income instruments of varying high quality maturities should be preferred rather than equities, due to their higher yield and stronger collateral cover.
If long-term capital appreciation is desired to offset inflation alongside of income, both equities and bonds should be utilized, not the hybrid stock, unless the latter’s share price is low in relation to its future income stream.
Firms which cannot deploy cash into opportunities which earn a rate higher than its weighted average cost of capital should seek to distribute its excess cash, although far-sighted executives rarely run up against such a wall. As such, firms run by executives and acquisition teams with poor records of successfully finding and integrating acquisitions should not be looked at as a preferential income investments, given such entities would be less likely to see their dividends grow at a real (inflation-adjusted) rate.
Example
In the following example, I look at a firm deciding on a payout ratio. The firm currently produces $4 per share in adjusted free cash flows— that is including normalized working capital, capital spending and other discretionary spending, statement misclassification as well as adjustment for spending that should have taken place, such as pension underfunding, unfunded commitments, and purchase and payment obligations either related to materials or a prior acquisition. At CT Capital LLC, we routinely make such adjustments.
Understandably, while what follows is a simple analysis, it is not far from reality, as the basic analytical principles are similar to what occurs in actual practice. Also in actuality, a firm will weigh a host of financial metrics and qualitative factors in reaching a decision, including the current and expected level of interest rates(inflation), refinancing, covenants, calls on cash and expected business conditions and changes to current regulations and taxes. Presume in both instances the financial structure is similar, although the more aggressive management is likely to approve of higher leverage which could alter average cost of capital.
The distinction in the following example is that in the first instance (Decision “A”) the Board of Directors has decided to plow back all cash flows into the company to add to its capital base and expand output, which results in greater future free cash flows. They have decided to pursue an acquisition led strategy. In the second instance, its Board, after receiving a report from its consulting firm concluding its shareholders prefer cash be returned, foregoes larger-scale projects and instead institutes a higher payout ratio. Hence, its prospective free cash flows are lower.
Decision “A”
As a result of bypassing a dividend, all free cash flows are directed toward additions to capital and software, joint-ventures, acquisitions, and other related expenses, such as marketing, working capital, taxes, etc. The firm’s free cash flows are expected to grow by 8% per year for the coming 6 years and then tail off to 6%, not unreasonable, as in fact many firms in our portfolio have considerably greater normalized (four year average) rates of growth over long periods of time, including that period encompassing the worldwide credit crisis. While such growth will not occur in linear fashion, the average growth rate is not unreasonable.
Using an 8% cost of equity, roughly equal to that of the median S&P Industrial, this firm’s fair value is approximately $104.05, or 26 times its current free cash flow; in actuality, this firm might be expected to have a lower than market cost of capital. The valuation premium makes sense given the current 2% 10 year treasury yield and the firm’s prospective growth rate in free cash flows, as well as its return on capital and economic profit, both of which is superior to that of the median firm in the S&P. At the end of 10 years, presuming the firm is still meeting its historical and expected normalized growth in free cash flows, if still selling at 26 times free cash flows, fair value would have grown to $208.26, or double the initial investment for a compounded annual return of 8%, which logic would dictate would match the growth in free cash flows.
Decision “B”
The firm’s Board has instead decided to pay a higher percentage of current free cash flows in the form of a 4% dividend yield, and so future cash flow growth is limited to 2% per year. The current fair value now equates to just $63.43, assuming the same cost of capital, 8%. At the end of year 10, fair value rises to just $77.22, or just a 2.2% compounded annual rate of growth, again equal to the growth in free cash flows.
In reality, it would be difficult to estimate the two firms cost of capital unless additional information was known, especially with regard to financial structure, inflation rate, expected cash flow stability, sovereign risk, etc. Let us assume the 8% cost of capital accounts for these other factors. Also, a 2% growth rate in free cash flows is so close to the flat line one could presume its inflation adjusted free cash flows were near zero, inducing a higher cost of capital and lower fair value.
Thus, the results show that even for the investor who relied on the “Decision B” dividend for living expenses, he/she would have been placed in a superior position under “Decision A” had they merely sold shares from year to year. Again, in reality results are not linear, yet one can presume in some years the valuation multiple will be higher than average as shares are sold for income or other purpose.
Dividend Reinvestment
Further presume the investor under “Decision B” is able to earn the rate on current 10 year treasury bonds, or 2.2%, and all interest income were to be reinvested at that rate to purchase additional bonds. The total value of a $1000 bond, assuming all reinvestment of interest at the current coupon rate, at the end of year 10 would be $1,491, or a total annual return on the bond of 4.5%, which shows the power of interest on interest. Of course, if interest rates were to rise (fall), the interest on interest were to be substantially higher (lower). Yet, even with the investor reinvesting all of the interest income, the total value does not approach that of the company’ stock, which was compounding at 8% and then 6%.
If the investor consumes the cash dividend, his total return would of course be negatively impacted, as the cash on cash return from the dividends would be zero. In the above analysis, I presume the absence of taxes on the dividends and interest income—as opposed to preferential capital gains—which would have further penalized the income-seeking investor relative to the capital gains outcome. For example, Florida, Maine and Texas have a zero state tax rate while Hawaii taxes a high as 11%, California, 10%, DC and Vermont, 8.95%, and New York, 8.82%
Conclusion
Popular studies purporting to prove the relative superiority of investing in a high yield portfolio are biased as they include firms that are not consistent free cash flow producers as well firms that burn cash. The relative superiority of a high (payout) dividend strategy exists only as such firms are generally free cash flow producers; had such entities chosen to deploy excess cash into value-adding projects, their total value to shareholders would have been enhanced. Only if the investor is capable of earning a higher after tax return than the firm is capable of, would it serve the investors pecuniary interest such cash be distributed.
Kenneth S. Hackel, CFA
How Apple Shares Can Regain Favor
April 24th, 2012 by hackel No comments »Apple share have now declined on the order of 12% from its highs set just couple of weeks ago.
Meanwhile, the much anticipated share buyback and dividend has not helped–and for good reason. It is not the dividend or buyback that creates value.
If, however, Apple’s Board is desirous of changing the downward momentum while bringing in value investors, there is a solution, one which will certainly raise the multiple on its shares.
While I am certainly not privy to what Apple may announce this evening during its earnings release, if I were advising the company-and their Board is now intent on distributing cash-the most logical approach would be to hold on to its current cash hoard of about $100 billion, and distribute 75% of prospective free cash flows, quarterly. A distribution of the current balance would not be expected to aid the share price any more than it helped Microsoft some years back-for good reason-a stock is worth the present value of prospective free cash flows. The current small dividend is not sufficient to bring in a new class of investors.
Maintaining the current cash, with its pristine balance sheet while continuing to hold 25% of prospective free cash flows would permit the firm to pursue even the most aggressive of acquisition, partnership and expansion strategies. Giving shareholders 75% of future free cash flows equates to a dividend of about 4.5%, given estimated growth, and almost certainly propel the stock.
IBM
April 18th, 2012 by hackel No comments »IBM announced a generally positive bag of results last night. We have several concerns, from the commitment of nearly 100% of their cash flow from operations toward dividends and share buybacks to other metrics discussed below. AOCI was also used to boost the current quarter, as explained.
As we’ve been pointing out, their foreign pension plan liabilities have only recently begun to be seriously addressed, a process that will eat up free cash flows for years to come. Execution, on the other hand has continued to improve as top executives and managers have done an excellent job directing cash………………….
THE BALANCE OF THE REPORT AVAILABLE ONLY TO CLIENTS OF CT CAPITAL
Review- March 31, 2012
April 3rd, 2012 by hackel No comments »Portfolio Review and Comment – March 31, 2012
Summary
The accounts had a good quarter—outperforming all benchmarks by a wide margin the first two and a half months, only to then abruptly retreat, precipitated by the steady drip of disconcerting economic news in China, a major engine of the world economy and sparkplug for the more cyclically inclined businesses. Although we have been warning of such weakness for some time (see first comment under “Review” section), the sell-off is almost certainly unwarranted.
Apple’s exclusion also negatively impacted relative performance, as it was responsible for about 13% of the first quarter’s advance in the S&P 500, a greater percentage since inception. Our models are indicating that Apple, despite being the world’s largest public company, strongest credit, and having a striking short-term outlook, also now carries risk to its valuation, which should become apparent over the coming year. This includes size, sector, stability metrics, reliance on China, as well as political and consumer pressures related to its success.
The accounts are nonetheless outperforming all the Russell benchmarks for the quarter and since inception.
A recent purchase, Quest Software, which I had intended to detail in this space on valuation and consistency, received a takeover bid in a financial led-deal, and was sold. I will highlight another holding next month hoping it meets with the same fate. While the Quest deal could not overcome the valuation contraction in our economically sensitive, ultra-high quality portfolio, I look forward to the stabilization of the world economies, which, as it takes hold, will truly accentuate our firms against the benchmark indexes.
Our models are particularly sensitive to mispricing of normalized free cash flows, return on capital and cost of capital, the latter a strong function of financial structure as well as any potential risk to prospective free cash flows. And at present, it is in these underperforming sectors where the greatest opportunities for superior returns exist, hence the current weighting. I (and you) should expect the mispricing will be corrected rather quickly when normality is restored. Superior returns are rarely seen for those who prefer to “wait and see.”
Overview
Last month I wrote “the more economically sensitive groups will see steady metrics in the normalized range for the coming six months- as opposed to growth. This could conceivably lead to some multiple contraction for the affected shares…” This has taken place as business in China has indeed continued to abate, and for some firms, contract, over the prior year’s results. I expect these stock underachievers in our portfolio to see improved valuations in the second half of the year given the sustained reduction in customer supply chain inventories with commensurate loosening of credit by the Chinese authorities in an attempt to combat a further decline in real estate values.
While the preponderance of firms selected by our models, including subsequent qualitative evaluation, are sensitive to economic and unique market niches, such as Ancestry.com, so too are their valuations. So, while US stocks have seen multiple expansion, many internationally exposed firms have not seen the improvement to return and cost of capital in the U.S. I therefore believe the investment performance of the non-cyclical portion of the portfolio also has quite a bit of run in it.
Despite the rise in U.S. interest rates during the quarter, with 10 year treasuries closing to yield 2.2%, long-term debt money remains cheap and especially so for normal consistent taxpayers. They thus represent a minor hurdle when comparing equity valuations to the treasury yield and for potential margin of safety for firm financing of capital projects. Yield spreads, an important metric in our models, narrowed, helping motivate the expansion in most sectors valuation multiples during the quarter.
The chart below shows the 2 year swap, with data from Bloomberg ( CHART NOT SHOWN).
This year, average spreads on investment-grade bonds have narrowed to 184 basis points from 234bp at the end of 2011, according to a Barclay’s index. Average yields this month fell to 3.27 per cent, the lowest level since the index began in 1973. Our models use this index for firms which have no fixed income instruments (American Eagle, Garmin, Nice Systems, and True Religion) when evaluating cost of capital, for such firms are still impacted by credit spreads, as we saw during the credit crisis. .
Most companies do not see a significant upward turn in Europe this year, leaving cost savings as the prime motivating factor influencing free cash flows and return on capital. An entity’s ability to improve its return on capital is now an especially important metric, as opposed to periods when top line growth in anticipation of a higher ROIC down the road bids up share prices. Fuel prices are now beginning to provide headwinds to some of the recent cost improvements for business. Our model considers energy prices a separate component to cost of capital, hence valuation multiples.
Coming Capital Shortage?
It is conceivable a capital shortage is on the way, and so we are gratified by our models ability to monitor and probe for changes in financial structure and access to capital, whether through low cost commercial paper or facilities with strong lenders. Being barely removed from the worldwide credit crisis, I am seeing large capital deployment for many firms where improvements to improving return on existing capital should be taking place; for much of the world, the deleveraging process has years to run.
I fear a restrictive credit scenario for its effect on cost of capital and fund raising—both debt and equity. One can certainly recant the many firms— including WorldCom, Calpine and MTG, which went from investment grade to junk in a matter of months. And yet, in these and other case histories, corporate boards had the power to limit the “worst-case scenario” through the prudent allocation of capital.
A capital scarcity could occur due to bank lending capital restrictions, zealous monitoring by regulatory agencies and congressional oversight committees, as well as the close out of pension funds defined benefit plans, once a source of massive flows of capital.
Of course, share buybacks remain the principal culprit. The S&P 500 group, over the past four quarters, repurchased around $434billion in their stock while paying $221 billion in dividends. Too many firms pay out over 70% of their cash flow from operating activities for a combination of dividends and buybacks.
Security analysts must pay strict attention to, and the impact resulting from, firms’ cash being deployed on poorly thought out acquisitions, including purchases having uncertain payback periods and large deviation of the yearly free cash flows relative to the cost of capital. This is typical of slow growth periods where managements try to buy revenues and market shares and why our stability metrics cause a high build into cost of capital into certain sectors, such as oil refiners.
This same logic applies to our penalty to cost of capital for large capital spending programs.
Alternatively, firms that build cash reserves could very well find their competitive advantage widening over firms with shrinking equity. While investors enjoy getting dividend checks, banking system and sovereign risk issues are too far from resolved not to prudently identify projects that could better maximize shareholder value.
There will, as always, be many value-enhancing opportunities for firms with strong financial structure to gain access to assets which produce high returns on capital. I believe our firms will be among such opportunistic buyers if they “play their cards right.” This capital shortage I fear will be exacerbated by excessive trading desks that are responsible for an overwhelming percentage of stock exchange volume—but harm the system by raising cost of capital.
For instance, this past month, shares of Sauer-Danfoss (SHS), the global manufacturer of hydraulic equipment declined 19% one morning on very heavy volume as the company reported some weakness in their business in China. My issue is that with 48MM shares outstanding in SHS, of which 36MM is owned by its parent, short sellers are taking advantage of both unsophisticated and even professional investment advisors who believe share prices represent “the truth and nothing but the truth.” Suppliers, who can be unknowing as well, might suppose a company is experiencing problems and contain credit, while workers, by virtue of the decline in their “paper” net worth,’ evoke a decline in productivity. In the case of SHS, a 5% reduction in their coming year’s free cash flow should not have forced more than a 5% fall in the value of their shares. SHS generates normalized $220MM in adjusted free cash, including payments to its majority owner, realistic cash pension payments, recapture of overspending on R&D and SG&A, against a $2.3 billion market value.
The growth of super fast trading firms has done nothing to build confidence, does not provide important liquidity, and raises cost of debt and equity capital.
Regal-Beloit
I am pleased to report that Regal-Beloit (RBC), whose valuation multiple was hammered in 2011, yet which I have been reporting in this space as engaging in one value-adding acquisition after another, reported a quarter that positively surprised many investors, sending its shares higher. I believe RBC remains quite undervalued despite the economic slowdown.
My analyses over the years have consistently shown investors ignore the smaller, yet over time, significant value additions that RBC engages in. While any particular acquisition, especially of a privately held-concern, almost always goes unnoticed, the conversion to public company valuation of many such deals can create surprising additional value.
Other Holdings By far, most portfolio holdings reported above average normalized free cash flow and return on capital metrics, yet, despite that, their shares did not react accordingly. I have been through irrational behavior too many times to recant. Wall Street analysts fall over themselves looking for negatives having little or loose bearing to investment reality— such as Nike and Accenture which, during the quarter made the prudent decision to price competitively.
This month the Federal Reserve reported MetLife had failed its stress test whereby examiners tested its equity given a 13% unemployment rate and a 50% decline in stocks prices, hardly a plausible scenario. Yet, it was not MetLife, the company which failed, but MetLife’s management, whom, after the Fed refused approval of a share repurchase six months earlier, was now asking the agency to support $2 billion in shares repurchases and a 48% dividend hike. Had management been prudent in their request, and had Fed examiners really understood the securities and associated risks with each of the company’s asset tiers, MetLife would have easily passed the test, even though the company claims—and rightly so in my estimation—the Fed’s analysis was faulty. In Europe, where Solvency II comes into force January 2014, setting out stronger EU-wide requirements on capital adequacy and risk management for insurers, MetLife will easily exceed requirements, according to my analysis. Hence, we agree with MetLife’s response to the Fed, that they “don’t understand their math”.
Personally, I am gratified MET will not—for the moment at least— waste cash on a $2 billion repurchase program, inasmuch as the firm’s recent ALICO acquisition has proved to be value-adding. In addition, the stronger financial structure will lower weighted average cost of capital. The cash which it had requested to be distributed out of the company will rest comfortably on its balance sheet awaiting a useful purpose, or until MET sells its bank, at which time the buyback issue will almost unfortunately but assuredly be revisited.
Covidien, the medical equipment and pharmaceutical manufacturer announced it was spinning off its drug business. We are planning to sell the medical equipment component, deploying the cash proceeds in exchange for the drug component, given the expected valuation. This segment offers very steady returns on capital and consistency of free cash flow growth, in excess of benchmarks.
Express Scripts (ESRX), an impressive generator of free cash flow accentuated thru large-scale acquisitions is awaiting FTC approval for the purchase of former CT Capital holding Medco Health Solutions (MHS). Should the deal go through, as expected, ESRX shares should benefit by investor discounting of additional growth in free cash flows and return on capital. ESRX would own 59% of the combined entity. Management of ESRX is extremely aggressive, both in acquisitions and buybacks, and is a firm whose shares are particularly inexpensive, despite the share repurchases. Buybacks should moderate due to the large liability (additional $8.4 billion+) incurred to help pay for the deal. The free cash flows of MHS are sufficient to service the debt and should enhance shareholders equity and its stock price. If buybacks do continue at its recent pace, the position could be let go, as risk to financial structure might be tilted.
I would have thought Google would have seen greater multiple expansion given estimates of a market value for Facebook of upwards of $75 billion+, or a free cash flow yield of a fraction of Google. Although Facebook shares would be undervalued if it were to grow its free cash flows 50% per year over the coming 4 years, at this juncture our models prefer Google, especially with Facebook’s limited operating history.
My studies have long shown, that even for ultra-consistent free cash flow producers, when undergoing large (accentuated by net borrowing greater than 20% of equity) capital spending programs, their stocks tend to underperform. Corning will complete such a program this year, and as such, I expect its multiple valuation multiple to rise upon completion.
Sovereign Risk
The factors we look at in examining sovereign risk improved this past quarter, reducing cost of capital and reducing the discount rate used in equity valuation. The one exception was Argentina. Although we do not own shares domiciled there, last year we bought and sold YPF, its largest energy company. This past month, the Argentine government sent out invitations to reclaim oil areas owned by the company. I bring this up as another Argentine company made our quantitative screens this month, Pan American Silver (PAAS), and was summarily dismissed. This company goes through hoops when converting payments back to dollars and in forced buying requirements.
Inflation
The slight rise in interest rates this quarter leads me to the following illustration (NOT SHOWN) , which shows the required normalized free cash flow yield demanded by our valuation model compared to the current 10 year Treasury note. As seen, lower interest rates command a higher percentage premium, while during periods of rising rates, the spread narrows. For example, at the current Treasury yield, we demand a minimum 3.35% free cash flow return while at 13%, a historically rare event, we demand a free cash flow yield similar to the 10 year instrument. At very high rates of inflation, valuation multiples are severely compressed, while, in practice, this has shown to be opportune times to invest as yields have subsequently declined or firms have been able to pass on much of the inflation risk.
Many Sophisticated Investors Being Swayed by Naive Research
I would like to conclude this piece with a comment on a strong push among academics and investment consultants toward low volatility investing. While the concept makes reasonable investment sense, the vital point is being missed. By failing to recognize the reasons for, or the implication behind, such a strategy’s success or failure, they are merely standing outside the five star restaurants. Stop sniffing the food and go in!
Academics have not been exposed to—nor are they remotely aware of— the risks that CFO’s face, so they are forced to rely on the tools they do know, that of naive models developed decades ago.
The concept of risk has, and will always, include metrics, both quantitative and qualitative that change over time, including new factors. Over the past five years such includes sovereign risk, derivative risk and pension risk. Other factors including management (including make-up of Board), patent loss, moral obligations, filing delays, insurance adequacy,8-K information, stability metrics, internal controls,taxes (holidays and changes to rate) or risk to the financial structure. These are ignored in favor of simplicity.
If greater sophistication were utilized, their risk portfolios would almost assuredly generate higher returns.
Kenneth S. Hackel, CFA
Follow the Capital: The Real Impact to Shareholders
February 1st, 2012 by hackel 1 comment »- Decapitalization Impairs Prospective Growth
- Is IBM Vulnerable?
(full tables and charts available to CT Capital clients only)
Let me begin by clearing up a common misperception perpetuated by CFO’s during company conference calls: share buybacks do not reward shareholders, only higher valuations and dividends do that. And because they do zilch to improve ROIC, they routinely force multiple contraction despite improved GAAP metrics, such as return on equity and per share metrics, including earnings and book value.
The logic is irrefutable: long-term shareholder value takes place through increases in free cash flows, with risk remaining at appropriate levels. This occurs via proper investments in assets, projects, and research, the polar opposite of what many firms are doing today in an appeasement to institutional shareholders.
Share repurchases are often construed as acquisitions identical to the assets of the firm. This line of thought is incorrect for several reasons, not the least of which is the negative repercussion to cost of capital.
It can be easily proven that if an entity was able to purchase another firm having identical free cash flows, cost of capital, and normalized safe positive spread among the two, presuming its post-acquisition cost of capital remains unchanged, it should purchase the outside asset rather than its own stock, for by expanding its capital base, its prospective free cash flows, return on invested capital and economic profit would also grow, thus enhancing shareholder wealth. Likewise, if the free cash flows were used to reduce cost of capital, fair value would be enhanced. This is true almost regardless of the free cash flow yield of the acquired entity.
Berkshire Hathaway, during the period it was disengaged from share repurchases as it was expanding its capital base, saw its shares widely outperform the general equity markets, while, after announcing it was prepared to inwardly direct its free cash flows, has seen its stock underperform.
If a material[1] level of resources results in value-adding activities, shareholder value is enhanced. If invested capital or other opportunities were limited due to de-capitalization measures, investors will ultimately pay the price, as free cash flow growth is unstable and unpredictable for many periods along the business cycle; firms which engage in share buybacks with cash on hand also find their cost of capital ( and share price volatility) rise for the same reason.
If leverage is required to aid share buybacks, cost of capital rises and financial flexibility declines even more so. This may occur for reasons other than the attrition of the cash cushion, including workforce reductions, credit rating downgrade, incapacity to hold onto market share, instability of financial metrics and reduction in interest charge cover.
In furtherance of my argument, for firms like Apple, which have high (free cash flow) in relation to its capital base, share repurchases mean little in terms of enhancing shareholder value, even though the return on a large cash hoard is close to zero. In Apple’s case, economic profit is driving results, which, aside from product acceptance, is exceptionally high due to a very effective supply chain, including parts, technology services and assembly.
A leading indicator of management and Board effectiveness is the direction of the firm’s capital. Entities that have opportunities to deploy capital at rates consistently and safely above their cost have the opportunity to enhance shareholder value. Unfortunately, most firms, as shown in the text box, rely on a surrogate cost of capital (stock beta) instead of metrics reflecting all known and possible risks to prospective free cash flows. For more information on this, see Security Valuation and Risk Analysis.
In acquisition analysis, the reliance on beta to depict cost of capital, managers and investors may be using inappropriate hurdle rates, thus unknowingly engaging in value destroying acquisitions.
Then there is the gray area, where, in fact most acquisitions fall. Such purchases may in fact be properly evaluated on the ROIC side but may raise cost of capital due to equity depletion, such that the firm is now constrained from engaging in prospective activities which may have added significant value relative to the recent material acquisition. This comment is of direct significance for entities engaging in excessive share buybacks, meaning the Board has approved the impairment to the financial structure.
It is to this latter point the balance of this article is directed, given my deep concern capital depletion will undoubtedly lead to subdued economic growth. Believing the hype fed upon them by fear and greed, it is not uncommon to see firms commit a significant percentage of their free cash flows toward share buybacks, dividends and executive compensation (total direct compensation), instead of worthwhile projects and opportunities.
Firms such as Berkshire, Regal Beloit and P&G, have had long periods of successful acquisition programs due to their understanding of products, people, cash flows and risk, and by such virtue, have been rewarding shareholders. Former “high flyers’ often succumb to the falling stock price syndrome in the form of massive buybacks.
In this regard, technology firms could learn a lot from the manufacturing sector, which is not to say manufacturers have not made grievous errors, including the likes of GM, Exxon, and GE.
The Impact on Shareholders’ Equity
As a consequence of share buybacks, shareholders’ equity has, for many firms, including Sears, The Gap, and Wendy’s, fallen quite considerably from peak levels, despite strong cash flows and GAAP based earnings. For firms in general, shareholders’ equity has risen just 17% for the S&P Industrials (see chart) from the March 2009 bottom.
For some well-known firms, the decline in shareholders’ equity has been dramatic, even excluding material off-balance sheet liabilities such as pension plans and other benefits, operating leases and market value adjustments.
IBM-A Case in Point
IBM saw its shareholders’ equity peak in its September 2006 quarter at $34.3 billion. Due to share repurchases it has been on a continual decline, currently standing (FYE 2011) at $20.2 billion, or 41% lower. IBM has placed the majority of its free cash flows into repurchases, boosting its GAAP metrics while its free cash flow growth since 2008 has been sub-par. If IBM’s economic return were to slow from its current level, its share price would fall greater than currently perceived due to the removal of its safety cushion. Would not IBM’s shareholders have benefitted more greatly if the company had not, over the past three years, spent two and a half times the value of acquisitions on share buybacks? Sooner or later, IBM management must also come to grips with the underfunding of its foreign pension plans. Balance sheet pension (which is understated by at least 20%) liabilities grew by 11% during its past year and now accounts for over 90% the amount of shareholders equity. Investors have yet to focus on the liability for which, I am sure, IBM’s CEO is thankful. Although the company spent $33.4 billion on stock repurchases over the past three years, shares outstanding declined just 12% through September (2012 10-K not yet filed).
Invested Capital Steady Despite Fall in Equity
If IBM achieved 9% cash based ROIC return on the cash used for share buybacks, even allowing for the increase in shares resulting from issuance, its share price fair valuation would have increased by 23%, and, when the next downfall comes, its shares will have declined less. Even if IBM had taken half the buyback to cut its pension liability, cost of capital would have declined by half a percent, adding about 12% to its shares fair value.
This point is illustrated as while IBM’s shareholders’ equity fell almost 13% from its year end 2010, its invested capital fell slightly for the year, $44.98 billion versus $ 45.45 billion. While IBM’s invested capital dropped from the 2006 level of $54.45 billion, such was due to the company’s shrewd exit from the PC business, and into software and consulting services. Over the past 5 years, IBM has altered its financial structure, now needing less of a financial cushion from the new business mix and other efficiencies. I believe, however, IBM, in its attempt to reach $20 per share in GAAP earnings, as it promised security analysts, it is taking on excessive risk while compromising worthwhile prospects, as is seen by its limited acquisition program. Meanwhile, its R&D budget has been flat for 5 years.
While supply chain and other streamlining aid cash flows, playing with equity as a means to reward shareholders is illogical. Shrinking equity will harm corporations as a whole, and, as such should be a concern to investors, analysts, creditors and lawmakers who may be considering following the IBM model. Recall only a few years ago to the worldwide financial crisis how important equity was to many institutions.
Perhaps Boeing shareholders would not have seen its stock price fall to below $30 in 2009 had the company not repurchased almost $3 billion of its shares during 2008, destroying equity. Boeing, which also has large liabilities not reflected in its financial statements, has yet to see its old highs. Its shares started recovering as its share repurchase program was halted and equity was rebuilt. Cyclical firms should almost always avoid share repurchases except for normalized free cash flow producers with low cost of capital wishing to offset share based compensation. Analysts must deduct those tax based effects listed under financing activities in the statement of cash flows in their cash flow models, such that the real impact of stock-based compensation is reflected, including tax affects.
I look forward to the day I hear investors grill companies on their misuse of capital. Today, revenue growth is the most desired metric. Although product acceptance is of utmost concern, one must recognize it takes assets and capital to have that come about, something that is destroyed through capital depletion.
Kenneth S. Hackel, CFA
[1] Materiality is a function of the change in revenues, units, cash flows, employees, assets, liabilities, and other risk measures and security level metrics. See Security Valuation and Risk Analysis.
Return on Equity (ROE) Pales Compared to Return On Invested Capital (ROIC)
January 9th, 2012 by hackel No comments »
I just heard an analyst from a leading firm state one of his primary metrics is return on equity.
Return on equity is important is important only as it provides a reflection of the firm’s return on capital.
For an obvious case, look at Apple, whose ROE pales compared to its ROIC as the firm is extremely adept at deploying cash as well as using other firms assets. In fact its equity is mostly cash.
If two firms have similar ROE, yet one has a higher ROIC, almost always go for the firm with the higher ROIC, as deploying cash into productive assets will yield higher free cash flows. Its cost of capital is also important, especially as it reflects its financial structure.
In today’s investment marketplace, where many firms are overflowing with cash, the ability to redeploy cash having a low after-tax tax yield into projects and assets having a high return on capital will, in most cases be value-adding opportunities. If the firm is unaware of, shy regarding acquisitions, has a high cost of capital, or whose opportunities are currently producing low ROIC, deploying cash into new projects may be questionable. Mere accounting manipulation-such as an asset write-down-will improve ROE, as will a share buyback, yet both activities will not improve ROIC.
It is for this reason why investors and analysts should measure and prefer the cash on cash return in their acquisition analysis, to which ROE has a back seat. Income from cash is not included in the return on invested capital (ROIC) metric.
Example UPS
To calculate UPS’s return on invested capital, I employ the definition espoused in Chapter 5 of my book Security Valuation and Risk Analysis, and the information contained in is 10K.
ROIC =Free cash flow – Net Interest Income/Invested Capital (Equity +Total Interest Bearing Debt +PV of Operating Leases-Cash +Marketable Securities).
UPS had produced normalized $2.9 billion in free cash flow from which we
exclude its $100MM in net interest income as we are seeking its return on capital
employed.
=2.9 -0.1/6.78+ 9.87 +1.1-1.05
=2.8/16.7
=16.8% excluding loss in comprehensive income
=12.5% including loss on comprehensive income
Incorporating operating leases into the denominator lowers UPS’s ROIC by about
6 percent. If the loss on comprehensive income (or part of it) were added back to
shareholders’ equity, the difference would have been meaningful. The
company’s ROIC is sufficiently above their weighted-average cost of capital
(8.35 percent) to state that UPS most likely has many value-adding investments
it could make.
This would not be as apparent by merely looking at its ROE.
Kenneth Hackel, CFA
CT Capital LLC
www.ctcapllc.com
December Review
December 31st, 2011 by hackel No comments »Password……………..
ID……………………
available only for clients of CT Capital LLC
November Review and Analysis
December 2nd, 2011 by hackel No comments »November Summary
While the past week’s rally was certainly gratifying, recent large price swings represent investors’ admission they are uncomfortable in their ability to assess the current level of credit risk. Access to capital at a reasonable price is vital to our economic well-being and weighted accordingly in our valuation models. Even for firms having strong credits, their suppliers or customers may be at the mercy of lending institutions.
I remain slightly concerned the coming bank stress testing, in spite of today’s actions by the Fed, ECB and other central banks, could further constrain the supply of capital, placing the industrialized economies in greater jeopardy than need be. We are already seeing banks restructure balance sheets to provide regulatory Tier 1 capital, and in the process, limiting lending to mid-scale businesses. If these concerns are not realized, fully expect to see equity markets undergo valuation multiple expansion as the cost of capital should fall from its current 9.1% down to the 8.6% range. This alone could fuel a 25% rally in valuations.
While raising permanent equity is appreciated by creditors, greatest efficiency occurs when capital is at an optimal point—excessive capital is not always the solution and can harm valuation multiples while increasing cost of equity as it lowers prospective return metrics.
Credit concerns began in August, almost coincident with the fall in stocks. In the chart appearing below, measured is the interest rate being charged by London banks, in US dollars, for loans to other banks having a 3 month maturity. While this and other real-time metrics, including credit default swaps, have become an important component in the setting of cost of capital, they do not rule the roost—longer-term free cash flow, return on capital, cost of capital and valuation do.
The balance of the report is available for clients of CT Capital LLC
October Review and Commentary
November 1st, 2011 by hackel No comments »
Portfolio Review- October 31, 2011
Summary
Despite a sour windup to the month, free cash flow multiples expanded from the cruel levels in September. The portfolio is showing out-performance against both the Russell 1000 value and Russell Midcap since inception of the account this year. That said, investors would be prudent to expect a prolonged period of slow worldwide growth, the kind of environment which is beneficial to our invested firms-those with sound financial structure and ability to earn superior returns on capital.
Devoting lots of time reviewing our firms almost weekly acquisitions, it was nice to have it go the other way with Healthspring receiving an offer close to fair value, and as a result the position was sold. Other portfolio firms have, by and large, reported free cash flows and either return on capital or economic profit, and financial structures, in line with model requirements.
I am devoting this month’s letter to one position (Regal-Beloit-RBC) which in many ways, epitomizes the portfolio—an industrial manufacturer which has seen its stock decline resulting from the current and likely to continue, economic malaise, typical following deep credit crisis.
In the following example, our models, which include the alteration to RBC’s financial structure as a result of its most recent, and large acquisition[1], indicate an undervalued cash flow stream available to the equity holders. This is also evident on a historical basis by the chart at the end of the report, showing RBC’s historical three-year average free cash flows and market values. The chart shows investors have always responded favorably, although it often took an ensuing economic expansion, to respond to the firm’s improvement in operations resulting from its operating and financial decision-making.
Regal-Beloit Corporation (RBC, market capitalization $1.7 billion)
A firm with a normalized consistency of metrics for a cyclical business, a history of value-adding acquisitions, and a free cash flow yield which over the cycle is safely above its cost of capital, Regal Beloit shares, despite above-market volatility, should continue to provide above normal return to shareholders. The firm’s shares, since inception of the account, have been underperforming the benchmark. Over the long-term, its superior metrics have resulted in outperformance, and in fact, was a position I owned for clients over 20 years ago. Management has continued to employ and promote executives who believe in the time-tested and economically proven philosophy of acquiring firms which exceed its cost of capital within one year. Smaller acquisitions, it appears, have taken longer to become value-adding, although financial details are sketchy at best with such deals.
As organizations strive to improve energy efficiency, and with RBC enjoying a pre-eminent position in motors, generators, and electrical manufacturing, benefits should accrue continue to both equity and credit holders. Prospective results should also be bolstered by the recent AO Smith electrical products division acquisition, which has a stronger presence in faster growing markets. RBC has leading positions in Asia and North America and is attempting to be 50% non-US in total sales.
Management has kept to its knitting in their “bolt-on” acquisitions (14 in the past 36 months) in which the firm has a knowledge base whereby it can be a better owner than the seller, meaning, it can improve upon the financial metrics at the time of acquisition. It also has a history of making good fits, culture wise, always and an important yet somehow underappreciated consideration in merger analysis. Their larger acquisitions tend to be those which RBC has a long history of competing and has deep familiarity in both product and people.
RBC funded the AO Smith purchase with cash, equity, borrowings under their credit facility and additional debt. The size of the acquisition (41% of its market value, amounting to $700MM in cash and 2.8MM shares of stock) and the impact to the financial structure caused us to raise cost of equity by half a percentage point. Of the $700MM, $500MM of long-term debt is at 4.74% with a $100MM revolver at 2%. RBC expects large cross selling opportunities, which is often overlooked in these type of mergers, as analysts prefer to concentrate on cost synergies, which RBC estimates at over $35MM over 4 years. I believe RBC will be able to pay down the added leverage rather quickly given data from the seller’s 10-K’s and RBC’s ability to improve upon existing, as well as internal, cash flows.
Total debt as a percentage of total capital, due to the acquisition, is at the company’s historic high range, even when bringing the debt to present value.
RBC claims they will, despite the current economic climate, continue to be active acquirers; I view this as a positive as most well financed companies shy away from acquisitions during slowdowns. If however, any upcoming deal is not immediately value-adding or brings the financial structure out of line with normalized free cash flows, or brings its cost of capital above acceptable levels, our positive position will be re-accessed.
RBC is comfortably within all loan covenants. Capital spending, despite its acquisitions, is higher than normalized, in part due to the requirement of the Chinese Government to relocate 2 of its plants while funding a manufacturing facility that was previously leased. Our worksheets (see table-excess capital spending) reflect these expenditures. Litigation is normal and derivatives within fair hedges. Pension liability adds 16% to total debt, and operating leases about 8%. Purchase and other commitments, including outstanding letters of credit are normal. Although the tax effective rate has remained in a 30%-35% band the past 7 years, its cash rate has been more erratic, owing to credits and other normal factors. NOL benefits are minimal. Unremitted US earnings are $131 MM.
The free cash flow worksheet shown below (and attached for larger print reading) is for the six months ended June, as the current quarter results are not to be released until November 2. One would expect a below average performance given the macroeconomic factors, results from other cyclical firms, and acquisition related expenses. As you have seen, yearly worksheets are more detailed and reliable, given firms’ estimation procedures and the incorporation of additional data.
As the half year worksheet illustrates, RBC has been able to continue to show the ability to produce superior free cash flows, resulting in a cash yield above that for the median S&P industrial entity, a fact being currently overlooked by investors focusing on the general economic slowdown and the European debt crisis, rather than the gathering of the firm’s operating leverage, which I believe will become quite evident as those problems unwind. RBC, as with other firms doing business in Asia, is seeing a noticeable slowdown in China; they are not overly exposed in Europe.
Included in free cash flows is part of last quarter’s $28MM charge from the addition to their warranty cost provision due to a defect, shown in cost of goods sold, and with the total charge to be paid over upcoming current quarters.
The models also added minor free cash flows due to higher than normalized input costs reflected in COGS, which grew to 77.8%, due to higher commodity and other expense. The models added other free cash flows to operating expenses (SG&A) which were high relative to historic levels. As sales grow, new acquisitions absorbed, the supply chain continuing to be squeezed, and acquisition related improvements placed, I expect these expenses to normalize. Given general economic weakness, however, it might take a while longer than management currently believes. Regardless, employment cuts should be expected which could free up cash not fully reflected in our models which partially pick up a percentage (between 15%-20%) of the excess expenditures. Other discretionary expenses are within normal limits.
Half of RBC’s employees are covered by defined benefits plans which were frozen in 2009; foreign employees are covered by government sponsored plans. As stated, we added 16% to total debt to account for current market rates based on RBC’s somewhat high 8.25% investment assumption (72% in equities) and 6% discount rate assumption. We have also penalized cash flow from operations based on the announced $2.2MM contribution this fiscal year and cash payments running slightly under $5MM. Most US employees participate in their savings plan.
The following chart shows the relationship between Regal Beloit’s three year average free cash flows, as defined, and its corresponding market values. We also show trend lines for each series. As is not unexpected for cyclical manufacturers, the lines are somewhat jagged; the trends however are unmistakably close and positive, which has resulted in strong performance for the patient investor.
The free cash flow worksheet shows higher free cash flows than the company has, in its presentation slides, been reporting to shareholders. The reasons are twofold. First, we adjust for normalized expenditures, including commodity costs, which have impaired the results of RBC. The model also picks up and includes as overspending, excess expenditures, and since RBC has been an active acquirer, the model accounts for some reductions in labor and other cost redundancies. In fact, during its most recent conference calls the company admitted it is diligently working to reduce expenses from acquisitions.
We recognize firms like RBC will always be impacted by economic forces, as will be seen again this coming week. However, once an expansion takes hold, however slight, and as energy becomes costlier, and the benefits of its most recent acquisitions return cash to reduce leverage (and cost of capital), investors will begin to appreciate the superior normalized yield.
Please call me with your investment questions.
Ken
[1] Large may be defined by CT Capital as the percentage addition to market value, revenues, employees, total debt, leverage, the term structure of the debt, and related normalized and adjusted free cash flows and cost of capital.
Why It Received Bid Today- And Why We Own- Healthspring
October 24th, 2011 by hackel No comments »Learn the techniques of cash flow and cost of capital. If you are not making serious adjustments to published financial statements, you really need the book to your right.
October 6th, 2011 by hackel No comments »
The following is a distilled version of that sent to clients.)
Quarterly Review- September 30, 2011
A Disappointing Quarter
When the financial markets have difficulty quantifying risk, volatility is the conventional result.
The inability of investors to find comfort with their projected return on investment has undoubtedly forced the cost of equity capital considerably higher than should have otherwise been the case, even given current circumstances. Whereas, I have constructed models specifically for this purpose— risk analysis—which normalizes historical and current metrics, and as importantly, carefully evaluates those metrics which could cause prospective cash flows and financial structure to deviate, even wildly given historic volatility, the financial marketplace has, our work shows, overcompensated for such risk. When investors ratchet down their queasiness levels, even given below-normalized cash flow estimates, we should begin to see equity markets improve rather quickly. In fact, I surmise earnings and cash flow estimates have not changed with the drama one would have expected given the quarter’s decline in share prices-rather it was the discount rate applied to those metrics.
History has indeed shown firms always snap to new highs from disheartening and ungraspable valuations. Over the past three months, leading quality energy shares were down 21%, materials 25%, copper shares 41%, and insurance 22%.
Good news from quite a few firms in other sectors has fallen on deaf ears.
Investors in the midst of bear markets tend to believe that “this time is different.” And, while each recession and bear market leaves its own imprint, with each depth of varying proportion dependent on the cause, strong fiscal and monetary inducements eventually come riding to the rescue. This is followed by a renewed sense of confidence, or at least an uplifting of “worse case scenarios.” Thankfully, there has never been a recession, bear market, or depression, which did not eventually end, although given the severity of the 2007-2009 credit crisis, investors should have expected a long recovery period.
Despite what I might have believed at a younger time, I have come to learn everything ends and nothing stays, which at least economically speaking, we should accept as more than a snippet of optimism, even factoring news the Chinese economy is not immune to the rest of the world.
The industrialized world’s economic malaise had its seeds rooted in the 2008-2009 financial, credit, and sovereign crises, from which the weak credits never fully emerged. No permanent solution was offered and none accepted. The blood transfusions and loose bandage held for a short time as investors prayed the wounded would somehow self-heal.
The crisis will end, but not before stronger, permanent solutions are put in place. This, of course, applies to our own sovereign struggle, which must include altering entitlement programs and means testing, as well as changes to the tax code.
In the corporate world, left standing stronger will always be enterprises which share the characteristics we hold in highest esteem- the rich and thrifty. I have never owned for clients a firm which went on to fail, even years after we sold. The CEO’s and Boards of our investments have, for the most part, been deploying resources having an expected safe and consistent return in excess of their cost
Despite a supply/demand equation balanced on a needlepoint, copper and energy shares fell sharply during the month with an extreme swing in copper pricing. Since reporting, commodity prices for these resources have cracked and with it their shares, yet several well-placed analysts predict a shortage for next year[1]. As the pendulum swings back toward equilibrium, share prices will propel as quickly upward as they have downward. The price of copper, even at its current $3.15/lb, a 14 month low, is above Freeport-McMoRan’s $2.50 marginal cost of production.
Novo Nordisk, one of the world’s truly great companies, saw its stock fall 9% during the month, which I can only tie to exchange rate differentials—the company, as of its last reporting period, is performing in line with expectations, and raised guidance concurrent with its last release. All metrics from sales to free cash flow, margins, and return on capital are far superior to the median firm in the S&P Industrials.
Novartis announced one of its drugs curbs breast cancer, with a Harvard Medical professor being quoted saying “This could be a game changer.”-Its stock, despite coming off a solid quarter, fared poorly for no apparent reason-and I don’t count swings in currency as a legitimate reason given firms like Novartis.
Odds and Ends
In the “ahead of the curve” front, a potential tax bomb awaits many firms when Congress forces the US tax system away from LIFO accounting. I believe this is a virtual certainty, given (1) the long-overdue shift to International Accounting Standards and (2) the large domestic deficit. The inevitable result will be reduced cash flows and valuations for the effected firms.
Kudos to the SEC for seeking additional disclosure on companies offshore cash. There is no such current rule, and therefore we estimate a tax on repatriation based on reporting segment data and an average cash tax rate, if not disclosed during conference calls or other public documents. Many companies hold essentially all their cash overseas, while a considerable number of large firms hold over 50% of their cash in non-US accounts. Firms that have substantial amounts of offshore cash can bid higher for non-US firms to earn the same, or higher, ROIC.
During the quarter, there was renewed focus on supply chain management. While this resulted in lower orders and revenues for many firms as the process works throughout the system, it will help eventually reduce the volatility of the current and future cycles. For those firms which can streamline costs, the savings will boost free cash flows. Together with existing cost reduction programs, operating leverage during the next expansion should be more impressive than investors are currently recognizing.
Health care expense is rising at a greater rate than expected. For firms with inappropriate health care cost trend rates, we have adjusted the cash flows.
Kenneth S. Hackel, CFA
Buffett Sending Wrong Message
September 26th, 2011 by hackel No comments »
If Warren Buffett wanted to send a message that stocks, including that of Berkshire Hathaway, were undervalued, he should have announced a series of acquisitions across a spectrum of industries.
By doing that he could have both improved the lot of Berkshire shareholders by improving its return on capital, free cash flow and financial structure, and that of consumer and investor confidence, in general.
Through announcing the possibility of large share repurchases, he is doing the opposite. Giving cash to shareholders who want out the door does not create a penny of cash flow, cost of capital or the spread between the two, although it does aid GAAP based metrics. Although Berkshire does not grant stock options to executive officers, many firms do indeed benefit from improvements to GAAP as it is used in many plans determination of compensation.
Berkshire, despite the large cash hoard appearing on its balance sheet, needs to preserve cash. To begin, it does have $59 billion in debt. In addition, it has liabilities to insured’s, both present and to come, especially as management does take risk which many competitors do not. Also, Berkshire has $35 billion in notional value in put contracts ( a bullish market play) which increased by $1.2 billion thru June 30th, and is obviously quite a bit higher today given the downfall in stocks since. Although these a are long term contracts, the liability is real and could be significant, not something credit rating agencies like to see. Nor do they like to see depleting equity, which is the direct result of share buybacks.
I believe, the announcement out of Omaha today is more a reflection of Mr. Buffet’s age then an endorsement of share buybacks. Is there any doubt Berkshire has built value through capital acquisition and resultant free cash flows, rather than share repurchases? Investors have bought stock in the company over the years due to Buffett’s keen analytical ability in building capital-share buybacks destroy it. In fact, if other firms were to follow suit, given the economic slowdown, many would find themselves in a position similar to 2008.
Why Equity Prices Are So Volatile
September 9th, 2011 by hackel No comments »
With long-term investors approaching the state of greeting 300 point swings in the Dow Jones Industrial Average with a yawn, some might begin to wonder. When the immense swings persist, yet the speculated causes remain constant, investors should quit wondering and begin looking for more useful investment tools.
Indeed, stock prices around the world have, over the most recent period, undergone historically large daily changes in their market values. During this period, investors have been fed a journalistic diet of pablum, for lack of a more substantive intake out of the ken of mainstream security analysts. However, as even a casual observer of the financial markets can attest, these unvarying causes have rotated with the velocity, without the entertainment value, of a circus juggler.
A European or U.S. banking problem one day, an economic slowdown the next, with an occasional terrorist threat or sovereign budget flare-up, have, for some period of time now, all been reported as reasons behind these 2%-3% seemingly daily swings in the equity markets.
But think about it.
The fact the same issues keep resurfacing and are met by large market reactions (regardless of direction) implies investors have not properly evaluated-or perhaps even taken into account- known risk-for if they had done so, worldwide equity markets would be countering with greater calm as these headlines repeat.
A properly set cost of equity capital, in which investors account for all possible risks (along with their probability) to the prospective free cash flows- results in fair value remaining essentially unchanged should any such event unfold. If the probability of the event remains unchanged, the impact on fair value is nil.
The cost of capital will remain constant until there is absolute reason for the analyst to believe the risk landscape has been altered. In fact, cost of capital tends to remain in a very tight band for most companies throughout an economic cycle. As one cannot say the leading financial news items making the rounds today has changed much over the past quarter, I strongly argue, the recent abnormality in stock price volatility is not just unwarranted, but indicates a fundamental lacking of basic investment principles and application by professional security analysts and investors.
In reality, only new and material information should result in large swings to the prices of financial assets. Everything else is just “noise.”
A central reason, unfortunately, for the recent volatility is investment analyst models in wide practice today do not accord risk on a similar footing with earnings, or, more correctly, free cash flows.
The setting of the cost of equity capital must account for any known risk to a firm’s free cash flows. This forms the denominator of the net present value model. For example, in BP’s 2009 10-K, the company stated they self-insure the risks related to their offshore rig exploration. Yet, almost investors chose to ignore the possibilities, looking at self-insurance as an incremental boost to earnings, not the other side of the coin, risk.
With a proper cost of equity, portfolio turnover will be greatly reduced, as investors will not feel the need or the requirement to re-process information which is already reflected in their estimate of fair price.
Thus, if the stock market were to rise (fall) by 3% tomorrow, because of somber news from Greece or a weak European bank, then you can be sure investors have either not done their homework, or are over-reacting to news implicit in market values. As the kids say, “Tell me something I don’t know.”
Assuming a firm, XYZ Copper, which, despite a cyclical history of normalized positive growth rate in free cash flow is nonetheless exposed to volatile demand (revenues), input costs, and has its chief mine in what many consider to be a country with a government that, at times, has expressed hostility towards the U.S., and, in fact, whose workforce has struck the mine three times in the past decade, although no strike lasted more than 45 days. Assume there is no threat of nationalization. XYZ’s financial structure is also slightly leveraged, resulting in interest costs as a percentage of normalized and adjusted operating cash flows slightly above average. Whereas the S&P Industrials, itself a high quality group of companies, has an 8.2% cost of equity, we have determined that XYZ Copper has a cost of equity of 9.5%. Thus, the cost of equity takes into account these known potential risks as well as perhaps other risks not discussed here.
Analysts expect XYZ, which has $ 3.93 in net balance sheet cash to generate $ 3.13 in free cash flow during the current year. Due to the economic slowdown, its free cash flows are expected to fall by 20% for the following year, and then to grow 2.5 % per year over the coming 22 years, at which time the company will be sold or can be expected to have a market value at its historic average 10x free cash flow multiple. Fair value, including the net cash, may be approximated using by its net present value, at $34.00.
If XYZ were dealt a wildcat strike (new material information), what would be the impact to its fair value? To begin, its cost of capital, unless there was concrete evidence to believe otherwise, should remain the same. Strikes have been built into our risk to cash flows. As the firm has been in existence for many years, even if the company had cash payments to be satisfied, they would have already lined up adequate credit facilities in addition to the existing cash[1]. The only change in the fair value model would be the decline in the current year’s free cash flows, which instead of$3.13, we cut by 6%, to $2.94, to account for 45 days of free cash flow of which half is recouped, a conservative assumption given firms usually have inventory for such a possibility. Fair value drops to $32.31 or just a 5% difference. If the investor believed the strike was a possibility in year five, current fair value would fall by just 50 cents per share-such is the nature and importance of the discount rate, or cost of capital. It deals with these known risks.
My point: the same logic can and should be applied on the macro level. Make the adjustment to cost of capital as is required, so when the same scary headlines bounce back, you needn’t make any further calibration, other than perhaps the TV station that keeps giving you the chills. Only new information is of relevance and would impact the fair value estimate.
Kenneth S. Hackel, CFA
[1] In practicality, firms would also take other measures to boost cash flows, such as “work” the balance sheet and cut discretionary expenditures.
Pension Funds-Analysts Need to Immediately Make Adjustments to Cash Flow and Financial Structure
September 5th, 2011 by hackel No comments »
Pension funds, which benefitted last year, when the financial markets underwent a strong second half rally, may not be so fortunate this year.
And while a headline in today’s Financial Times reported the gap in US pension plans was $388 billion, CT Capital LLC reports the gap is considerably higher, perhaps by as much as 50% when using interest rates available today and the fall in hedged fund returns, which many pension sponsors have been viewing as “high return, low risk.” They have taken the same tact with private equity investments.
In fact, we expect to see a considerable step up in pension contributions later in their year, including selling equity and debt, as well as the contribution of company stock, where allowable.
For the 1400+ public companies we track which have defined benefit plans, the median investment return assumption is currently 7.75% (average 7.36%), a discount rate of 5.4%, and has a 57% exposure to the equity markets, 37% debt markets, and the balance real estate and hedged funds.
The average company reported their plan was $376MM underfunded, but that assumes their assumptions are realistic. The current financial markets tell us otherwise.
For some firms, including Boeing, GM and IBM, the underfunding is in excess of $10 billion each.
This means these firms financial leverage is greater than reported and their cash flows (from operating activities and free) are overstated.
The list of firms in pension trouble is not restricted to U.S. based entities. For example, Allianz SE, BP, Daimler, Deutsche Telecom, Siemens, Toyota, and Volkswagen have huge pension liabilities that must be addressed.
The defense sector is especially prone to large pension liabilities, unfortunate given the slowdown in the defense budget.
And for the many firms like Honeywell, which changed their actuarial methodology from asset smoothing (outside the corridor) to mark-to-market, which recognizes gains and losses in the current period, their timing appears unfortunate.
Although firms may not begin to recognize the financial markets impact on funding until their fourth quarter, analysts should begin to make these important adjustments to cash flows and financial structure immediately.
Kenneth S. Hackel, CFA
