New PBGC Fees to Have Significant Impact on Many Firms Cash Flows

January 6th, 2014 by hackel No comments »

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………………




JCP Update

December 4th, 2013 by hackel No comments »

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……….



A Hugely Overpriced Stock With Bankruptcy Possibilities

October 29th, 2013 by hackel No comments »

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 The cost is $50,000.



Sovereign Risk

October 23rd, 2013 by hackel No comments »

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…


Report is available for $50,000

CT Capital LLC

September 27th, 2013 by hackel No comments »

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.


JCP- Update

August 5th, 2013 by hackel No comments »

Since we last warned about credit conditions at JCP……….


Updated report now available. Price $125,000.

July 2013 Summary Review- Full Review to Clients Only

August 4th, 2013 by hackel No comments »

In the News

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.

Exhibit 1          Stability of Free Cash Flows-Three Year Average



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.

Exhibit 2           Three Year Average Free Cash Flows versus Market Value




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.

Exhibit 3       Debt Summary



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.

J.C. Penney Company Inc.(JCP)

June 16th, 2013 by hackel No comments »


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……



June 15th, 2013 by hackel No comments »


Last  month we purchased our first company based in China, coming after greater than normal research and investigation, lasting several years.

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.

Report on Bed Bath & Beyond (BBBY) Available

March 25th, 2013 by hackel No comments »

There is plenty about BBBY  investors do not understand or account for in their valuation of the firm

Our report is available for the introductory price of $2500. If you are interested, please contact CT Capital LLC

For a Real Edge, Calculate Free Cash Flow Correctly

March 13th, 2013 by hackel No comments »

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.

If you are unsure how to accomplish this, buy the text to your right

February 2013 Investment Review-Abridged Version

March 3rd, 2013 by hackel No comments »


Sorry, the full version is sent to clients of CT Capital LLC. For information, please see


February 2013 Monthly Review-General Distribution

January 2013 Abridged Review

February 10th, 2013 by hackel No comments »




PDF Jan 2013 reivew=credittrends site

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

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……..


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

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.





Follow me on Twitter @credittrends

July 12th, 2012 by hackel No comments »

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
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.
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%
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.



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………………….




April 14th, 2012 by hackel No comments »

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IBM-A Case Study and Fair Value

April 8th, 2012 by hackel No comments »

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Cost of this report is $75,000

Review- March 31, 2012

April 3rd, 2012 by hackel No comments »
Portfolio Review and Comment – March 31, 2012
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.”
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, 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.
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.
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