Fore the $2 trillion in defined benefit plans the raising of fees to $64 per participant will have a significant impact on firm cash flows, while at the same time benefiting selected insurers.
However, some firms, by virtue of both their asset allocation and………………
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JCP Update, 12/3/13
There have been a few important developments in the credit of JCP, and equally impacts equity valuation. Yet, as pointed out in our last report, the challenging retail environment, combined with……….
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CT Capital, after intense analysis, has identified a company whose share price does not reflect its economic reality.
Their cash flows, using our adjustments, are not what it appears using traditional metrics. They are also very vulnerable due to other factors, any one of them would serve to undermine their prospects of remaining in business.
This is our first short recommendation since JC Penney.
For a copy of the report, please contact kenhackel@ctcapllc.com. The cost is $50,000.
REPORT SOLD OUT
We have seen changes to cost of equity for various major countries in which US firms derive significant cash flows and have made large capital and financial commitments. In China, we have recently seen…
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Our Investment Philosophy
CT Capital’s methodology is quite simple, when distilled to its underlying elements. We compare an equity investment’s free cash flow yield and cash based return on capital to that of the yield on the risk free rate and cost of capital. We then look at the risks to the firm at least maintaining the above spreads—its cost of capital— with normalized nominal free cash flows growing. When invested capital is low or not meaningful, we look to economic profits.
Since we last warned about credit conditions at JCP……….
Updated report now available. Price $125,000.
I have been reading a number of articles lately on the subject of share buybacks, the works of both highly placed academics and practitioners. Yet, in no analysis have I seen the authors adjust for (1) an upward shift to cost of capital resulting from the equity impact including increased leverage and impaired credit, (2) superior utilization of that cash which could improve return on capital (3) excess tax benefits[1] resulting from share based compensation listed under financing activities in the statement of cash flows that should be moved to operating activities and (4) reduction in financial flexibility. I have written previously that while buybacks may improve upon GAAP numbers such as return on equity it does not change return on invested capital as it neither improves free cash flow nor adds to capital.
Regarding the trillion or so dollars held by US corporations overseas, an analyst should not assume this cash is available for share buybacks as most of it won’t see the light of day in the US, even given a drop to a 28% tax rate put forward by the administration this week and other credits which could bring the rate down even further. Such cash is, most often, better used for overseas expansion where the taxes have already been paid and could raise the firms’ return on capital by being deployed in faster growing economies or new acquisitions.
Lastly, Detroit proved that pension liabilities still matter. Even for strong firms, the liability impacts fair value. This month, portfolio holding Lockheed-Martin reported a very strong quarter, and would have reported considerably further strength if their cash contribution was level with last year. Unfortunately, the firm, although not mentioned in its press release, most likely has at least seven such years of stepped-up contributions ahead of them, given the enormity of their unfunded liability. Nonetheless, its shares are trading very near to its all-time high.
In these reports, it is important I comment on a position that has lagged the benchmarks. Several of the holdings of prior comment have been acquired, and almost all have had very strong runs in excess of the benchmarks, such as Google, EBay and Nu Skin (latter two since sold) as well as the entire insurance space.
In March, I illustrated a cash flow worksheet on Bed, Bath and Beyond, which at the time was being heavily sold by investors after reporting a weaker than anticipated quarter. In reality, a single quarter has a quite minimal impact on the actual valuation for most firms with a long history of generating normalized and adjusted free cash flows with low cost of capital. BBBY shares now trade near its all-time high.
And so, on July 12th, when Domtar (UFS) announced weaker than expected results its shares fell to a 52 week low, and have only modestly rebounded since, down 16.8% for the year.
UFS, under a purchase (accounting) with no retroactive subsequent adjustments and $300MM in goodwill (subsequently written off), acquired the Weyerhaeuser fine paper business in 2006 with shares and debt assumption ($1.6bn), becoming the largest integrated manufacturer and marketer of uncoated paper in North America and the second largest in the world. They own or license 16MM acres.
Table 1 shows why UFS shares have declined, yet even so, continues to produce acceptable free cash over two, three and four year periods. Its free cash flow stability index (shown as its standard deviation/average) of .6 is above average but not unacceptable. For example, International Paper’s free cash flows have a stability index of .41.
EXHIBITS SHOWN IN CLIENT REPORT ONLY
As shown in exhibit 2, there is a strong association between UFS’s 3 year average free cash flows and market value. Free cash flows in the table are not adjusted for tax subsidies related to alternative fuel credits, which biased 2010 results. In that year UFS received a $368MM cash refund, the impact of which has been somewhat minimized in both the three and four year averages. An additional credit of $198MM remains for 2009 which could be released this year pending audit. No credits were claimed for 2012. SG&A has been influenced by stock based compensation which is adjusted into our models.
For our positive thesis to hold we would need to see a continuation of the growing three year average free cash flow, which will not occur on an adjusted basis until sales begin to improve. The firm could, however, adjust discretionary spending to mitigate further erosion in sales until economic strength reconvenes. Yet, to delay equity investment in a strong credit cyclical firm like UFS until a positive turn is underway when the market value is long term attractive is a common error most responsible for missing the greatest jump in share price.
EXHIBITS SHOWN IN CLEINT REPORT ONLY
As shown by Exhibits 1 and 3, UFS is unlikely to struggle servicing its debt, with very strong fixed charge cover. Maturity structure is well spread out. Total debt (including leases) has increased just 3 of the past 10 years. Our cost of capital model penalizes firms which require frequent trips to raise capital either to maintain or grow free cash flows.
Funding improvement to pension plans, its one significant credit issue, is taking place despite reporting a $96MM increase in non-funded status. This comes about from the firm’s more realistic actuarial assumptions and $666MM in company contributions over the past 5 years; its discount rate has dropped to 4.8% (from 6.3% two years earlier), with plan assets growing to $1.7 billion. The 2012 actual return on the plans ($182MM) plus company and employee contributions ($93MM) exceeded actual paid benefits of $97MM. With 41% of their plans in equities and 59% in debt, funding status could, however, be further strained if interest rates continue to rise and equities markets fell. If UFS were to close out part (or all) of its plans, a logical step, it would lower cost of capital by up to 40 basis points in our model. In any event, given the stronger funding status, firm cash flow should be boosted. This year UFS expects to contribute considerably less than last year (again hoping for aid from financial markets) versus the past 5 years average of $133MM; the contribution is being swayed by the lower production volumes.
They are a member of 7 multiemployer plans with unknown member financial status for at least one of the plans. As contributions into these plans have been small ($6MM/year), I presume the risk is not significant in relation to its cash. One of the plans, however, is in Red (less than 65% funded) Status, yet their contribution to that plan was just $3MM last year. Of late, unions in general have been working with employers to improve funding, including the reduction of benefits.
UFS uses derivatives almost primarily as hedges in currency and natural gas (no losses shown in AOCI).
Their rate of increase in healthcare expenses is moderating although the post-retirement liability rose 9.7% to $124MM over 2011. Remaining litigation risk relates to various actions on hazardous waste clean-up stemming from 1999, having settled one large suit the past quarter. They continue to take remedial action ($32MM in asset retirement obligations) and I believe the 25 basis add-on to cost of capital recognizes the liability. Relations with unions have been generally satisfactory, although testy at times, including strike votes.
UFS has had an unstable tax rate, not uncommon given the cyclicality of the industry. In four of the past 10 years the cash rate has changed by over 10% from the prior year. Stock based compensation has been minimal, including tax benefits.
Capital spending has more than doubled ($106MM to $236MM) over the past 4 years despite flat sales. Resultantly, our worksheet picks up some of the excess as the firm could reduce this budget while maintaining similar sales, especially with their plants running below normal capacity. The last two year step up in capital spending, acquisitions and joint ventures ($974MM) less disposals ($93MM) has been financed by cash from operations and a debt raise, with only minor balance sheet management. Share repurchases, which have totaled $650MM the past two years, has been a poor choice by its Board, given the needed debt raise, lack of sales growth and cloudy near term expectation.
Other metrics which have caused cost of capital to rise include adjusted cash flow from operations which have benefited from the tax refund, growth rate in free cash flows, inventory accumulation, economic profit/sales LFY of 1.9%, capital spending in relation to sales growth, deterioration of working capital to total debt, stability of cash tax rate (average cash payment of $46MM past 6 years), and productivity. Negative metrics point to the needed reduction in headcount.
Despite the above flags, normalizing UFS’s metrics underlie our faith in its shares. Over the past 3, 5 and 8 years, its normalized return on capital has remained in the high teens with strong, although declining, free cash flows. It easily earns its cost of capital for which there is substantial room for improvement in spite of the current sales stagnation. If and when the world’s economies perk up, its shares should outperform all benchmarks by a very substantial margin due to significant operating leverage. Other large winning positions in the account have come from similarly depressed conditions and playing “the waiting game.” I believe the risks are known and accounted for.
A buyout is certainly within the realm of possibility given how several other large paper manufacturers shares have held up which could finance a deal.
Kenneth S. Hackel, CFA
[1] When a restricted stock vests or a nonqualified option is exercised, the amount of the employer’s corporate tax deduction is fixed. At that time it is evident whether the amount deductible on the tax return is greater or less than the cumulative compensation cost amortized (using Black-Scholes) over the vesting period.
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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