Very few investors, including apparently major fund managers truly understand the profound changes that have taken place at JCP over the course of the past year, led by a drastically altered credit. This new landscape has been, and will continue to play out……
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Netease (NTES), one of the leading providers of internet services within China, derives 87% of its revenues from online gaming, 10% from online advertising and 3% from email services, the country’s largest with 550 million, and growing, users. Their success with email and gaming is now allowing them to branch out to other services. Total firm revenues are US $1.3 billion with $685MM in adjusted free cash flow against a $7.5 billion market value of equity (36% in cash). Compared to the US, internet penetration in China is low, estimated at just 42% of the populace. The firm’s various websites are, according to independent firms, among the most visited in China, if not the world.
The lengthy review time was needed as the company is not audited by a US firm nor is any inspection of its books evaluated by a US firm, although two Board members are CPA’s. Cost of equity capital was raised by 1% due to lack of well-known oversight, reducing fair value by 16%. While the SEC has brought action against five accounting firms in China, NTES is not involved in such proceedings, but may be ultimately impacted if the case against the auditors is lost. It is conceivable, though quite doubtful, they could lose NASDAQ listing, although its shares would continue to trade and be active. I am hopeful an agreement signed last week allowing the US Accounting Oversight Board permission to review Chinese audit records will develop into full scale cooperation, quell the regulatory riff, lift any conceivable financial veil, and bring down the firm’s cost of capital. It appears this is what the Chinese desire given various scam companies and resulting publicity that have taken place. Also, slower growth in China alongside strong need for credit on local levels will require such action.
China has seen its sovereign risk rise over the recent month according to our models, reflecting its economic slowdown. Its 5 year CDS spread over similarly dated US Treasury bonds also rose this month, going from 29 to 58 basis points, and equity cost of capital is raised by this latter amount over the US risk free rate, still at an historically low 2.15% When all risks are considered, the cost of equity capital hurdle (7.7%)for NTES is high for a firm with its credit, however has been overcome as a result of products, time in business, independent proofs, lack of significant litigation, stock ownership, joint ventures, as well as the financial metrics.
Their auditor is registered in China. Chinese company law is modeled after that of the UK, yet the firm follows international accounting standards. While foreign exchange rules in China are controlled, the Renminbi is freely convertible for current account items including dividend payments, interest and trade transactions.
On the metrics side, NTES sells at a 9.1% free cash flow yield, a 24.5% return on invested capital, economic profit/sales[1] of 27.2% (GOOG is 18.5%, and AAPL is 21.3%) and has zero bank debt or bonds. Operating leases are for rent, server custody and office machines which are modest in relation to cash, operating cash flows and equity. Their share repurchase program is minor.
Over the past 7 years, free cash flow has grown by 356% and revenues by 475%. The stock is volatile and subject to those risks inherent in any technology firm. Given its valuation, however, like portfolio holding Google, which I was forced to write on last fall when its shares fell by $100, only to recently rise to all-time highs, NTES appears to offer strong risk-adjusted long-term prospects, taking into account its cost of capital.
[1] Economic profit removes the distortion of firms which by their nature operate with a low capital base. The CT Capital definition is far superior to the general concept employed by the industry as we use adjusted free cash flow, not EBITDA, which is an analytical trap. For a full explanation, please write.
There is plenty about BBBY investors do not understand or account for in their valuation of the firm
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Free Cash Flow- Must adjust for misclassifications, extraordinary and one-time items and other expenses and events not properly accounted for in either the income statement, statement of cash flows, or footnotes. Examples would be pension over (underfunding), interest, taxes, payment to non-controlling interests, capital leases, moral obligations and overspending in discretionary areas.
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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
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……..
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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
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
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.
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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 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………………….
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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.
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 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).
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.
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
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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.
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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.
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.
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.
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