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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(full tables and charts available to CT Capital clients only)
Let me begin by clearing up a common misperception perpetuated by CFO’s during company conference calls: share buybacks do not reward shareholders, only higher valuations and dividends do that. And because they do zilch to improve ROIC, they routinely force multiple contraction despite improved GAAP metrics, such as return on equity and per share metrics, including earnings and book value.
The logic is irrefutable: long-term shareholder value takes place through increases in free cash flows, with risk remaining at appropriate levels. This occurs via proper investments in assets, projects, and research, the polar opposite of what many firms are doing today in an appeasement to institutional shareholders.
Share repurchases are often construed as acquisitions identical to the assets of the firm. This line of thought is incorrect for several reasons, not the least of which is the negative repercussion to cost of capital.
It can be easily proven that if an entity was able to purchase another firm having identical free cash flows, cost of capital, and normalized safe positive spread among the two, presuming its post-acquisition cost of capital remains unchanged, it should purchase the outside asset rather than its own stock, for by expanding its capital base, its prospective free cash flows, return on invested capital and economic profit would also grow, thus enhancing shareholder wealth. Likewise, if the free cash flows were used to reduce cost of capital, fair value would be enhanced. This is true almost regardless of the free cash flow yield of the acquired entity.
Berkshire Hathaway, during the period it was disengaged from share repurchases as it was expanding its capital base, saw its shares widely outperform the general equity markets, while, after announcing it was prepared to inwardly direct its free cash flows, has seen its stock underperform.
If a material[1] level of resources results in value-adding activities, shareholder value is enhanced. If invested capital or other opportunities were limited due to de-capitalization measures, investors will ultimately pay the price, as free cash flow growth is unstable and unpredictable for many periods along the business cycle; firms which engage in share buybacks with cash on hand also find their cost of capital ( and share price volatility) rise for the same reason.
If leverage is required to aid share buybacks, cost of capital rises and financial flexibility declines even more so. This may occur for reasons other than the attrition of the cash cushion, including workforce reductions, credit rating downgrade, incapacity to hold onto market share, instability of financial metrics and reduction in interest charge cover.
In furtherance of my argument, for firms like Apple, which have high (free cash flow) in relation to its capital base, share repurchases mean little in terms of enhancing shareholder value, even though the return on a large cash hoard is close to zero. In Apple’s case, economic profit is driving results, which, aside from product acceptance, is exceptionally high due to a very effective supply chain, including parts, technology services and assembly.
A leading indicator of management and Board effectiveness is the direction of the firm’s capital. Entities that have opportunities to deploy capital at rates consistently and safely above their cost have the opportunity to enhance shareholder value. Unfortunately, most firms, as shown in the text box, rely on a surrogate cost of capital (stock beta) instead of metrics reflecting all known and possible risks to prospective free cash flows. For more information on this, see Security Valuation and Risk Analysis.
In acquisition analysis, the reliance on beta to depict cost of capital, managers and investors may be using inappropriate hurdle rates, thus unknowingly engaging in value destroying acquisitions.
Then there is the gray area, where, in fact most acquisitions fall. Such purchases may in fact be properly evaluated on the ROIC side but may raise cost of capital due to equity depletion, such that the firm is now constrained from engaging in prospective activities which may have added significant value relative to the recent material acquisition. This comment is of direct significance for entities engaging in excessive share buybacks, meaning the Board has approved the impairment to the financial structure.
It is to this latter point the balance of this article is directed, given my deep concern capital depletion will undoubtedly lead to subdued economic growth. Believing the hype fed upon them by fear and greed, it is not uncommon to see firms commit a significant percentage of their free cash flows toward share buybacks, dividends and executive compensation (total direct compensation), instead of worthwhile projects and opportunities.
Firms such as Berkshire, Regal Beloit and P&G, have had long periods of successful acquisition programs due to their understanding of products, people, cash flows and risk, and by such virtue, have been rewarding shareholders. Former “high flyers’ often succumb to the falling stock price syndrome in the form of massive buybacks.
In this regard, technology firms could learn a lot from the manufacturing sector, which is not to say manufacturers have not made grievous errors, including the likes of GM, Exxon, and GE.
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.
The following is a distilled version of that sent to clients.)
Quarterly Review- September 30, 2011
A Disappointing Quarter
When the financial markets have difficulty quantifying risk, volatility is the conventional result.
The inability of investors to find comfort with their projected return on investment has undoubtedly forced the cost of equity capital considerably higher than should have otherwise been the case, even given current circumstances. Whereas, I have constructed models specifically for this purpose— risk analysis—which normalizes historical and current metrics, and as importantly, carefully evaluates those metrics which could cause prospective cash flows and financial structure to deviate, even wildly given historic volatility, the financial marketplace has, our work shows, overcompensated for such risk. When investors ratchet down their queasiness levels, even given below-normalized cash flow estimates, we should begin to see equity markets improve rather quickly. In fact, I surmise earnings and cash flow estimates have not changed with the drama one would have expected given the quarter’s decline in share prices-rather it was the discount rate applied to those metrics.
History has indeed shown firms always snap to new highs from disheartening and ungraspable valuations. Over the past three months, leading quality energy shares were down 21%, materials 25%, copper shares 41%, and insurance 22%.
Good news from quite a few firms in other sectors has fallen on deaf ears.
Investors in the midst of bear markets tend to believe that “this time is different.” And, while each recession and bear market leaves its own imprint, with each depth of varying proportion dependent on the cause, strong fiscal and monetary inducements eventually come riding to the rescue. This is followed by a renewed sense of confidence, or at least an uplifting of “worse case scenarios.” Thankfully, there has never been a recession, bear market, or depression, which did not eventually end, although given the severity of the 2007-2009 credit crisis, investors should have expected a long recovery period.
Despite what I might have believed at a younger time, I have come to learn everything ends and nothing stays, which at least economically speaking, we should accept as more than a snippet of optimism, even factoring news the Chinese economy is not immune to the rest of the world.
The industrialized world’s economic malaise had its seeds rooted in the 2008-2009 financial, credit, and sovereign crises, from which the weak credits never fully emerged. No permanent solution was offered and none accepted. The blood transfusions and loose bandage held for a short time as investors prayed the wounded would somehow self-heal.
The crisis will end, but not before stronger, permanent solutions are put in place. This, of course, applies to our own sovereign struggle, which must include altering entitlement programs and means testing, as well as changes to the tax code.
In the corporate world, left standing stronger will always be enterprises which share the characteristics we hold in highest esteem- the rich and thrifty. I have never owned for clients a firm which went on to fail, even years after we sold. The CEO’s and Boards of our investments have, for the most part, been deploying resources having an expected safe and consistent return in excess of their cost
Despite a supply/demand equation balanced on a needlepoint, copper and energy shares fell sharply during the month with an extreme swing in copper pricing. Since reporting, commodity prices for these resources have cracked and with it their shares, yet several well-placed analysts predict a shortage for next year[1]. As the pendulum swings back toward equilibrium, share prices will propel as quickly upward as they have downward. The price of copper, even at its current $3.15/lb, a 14 month low, is above Freeport-McMoRan’s $2.50 marginal cost of production.
Novo Nordisk, one of the world’s truly great companies, saw its stock fall 9% during the month, which I can only tie to exchange rate differentials—the company, as of its last reporting period, is performing in line with expectations, and raised guidance concurrent with its last release. All metrics from sales to free cash flow, margins, and return on capital are far superior to the median firm in the S&P Industrials.
Novartis announced one of its drugs curbs breast cancer, with a Harvard Medical professor being quoted saying “This could be a game changer.”-Its stock, despite coming off a solid quarter, fared poorly for no apparent reason-and I don’t count swings in currency as a legitimate reason given firms like Novartis.
Odds and Ends
In the “ahead of the curve” front, a potential tax bomb awaits many firms when Congress forces the US tax system away from LIFO accounting. I believe this is a virtual certainty, given (1) the long-overdue shift to International Accounting Standards and (2) the large domestic deficit. The inevitable result will be reduced cash flows and valuations for the effected firms.
Kudos to the SEC for seeking additional disclosure on companies offshore cash. There is no such current rule, and therefore we estimate a tax on repatriation based on reporting segment data and an average cash tax rate, if not disclosed during conference calls or other public documents. Many companies hold essentially all their cash overseas, while a considerable number of large firms hold over 50% of their cash in non-US accounts. Firms that have substantial amounts of offshore cash can bid higher for non-US firms to earn the same, or higher, ROIC.
During the quarter, there was renewed focus on supply chain management. While this resulted in lower orders and revenues for many firms as the process works throughout the system, it will help eventually reduce the volatility of the current and future cycles. For those firms which can streamline costs, the savings will boost free cash flows. Together with existing cost reduction programs, operating leverage during the next expansion should be more impressive than investors are currently recognizing.
Health care expense is rising at a greater rate than expected. For firms with inappropriate health care cost trend rates, we have adjusted the cash flows.
Kenneth S. Hackel, CFA
If Warren Buffett wanted to send a message that stocks, including that of Berkshire Hathaway, were undervalued, he should have announced a series of acquisitions across a spectrum of industries.
By doing that he could have both improved the lot of Berkshire shareholders by improving its return on capital, free cash flow and financial structure, and that of consumer and investor confidence, in general.
Through announcing the possibility of large share repurchases, he is doing the opposite. Giving cash to shareholders who want out the door does not create a penny of cash flow, cost of capital or the spread between the two, although it does aid GAAP based metrics. Although Berkshire does not grant stock options to executive officers, many firms do indeed benefit from improvements to GAAP as it is used in many plans determination of compensation.
Berkshire, despite the large cash hoard appearing on its balance sheet, needs to preserve cash. To begin, it does have $59 billion in debt. In addition, it has liabilities to insured’s, both present and to come, especially as management does take risk which many competitors do not. Also, Berkshire has $35 billion in notional value in put contracts ( a bullish market play) which increased by $1.2 billion thru June 30th, and is obviously quite a bit higher today given the downfall in stocks since. Although these a are long term contracts, the liability is real and could be significant, not something credit rating agencies like to see. Nor do they like to see depleting equity, which is the direct result of share buybacks.
I believe, the announcement out of Omaha today is more a reflection of Mr. Buffet’s age then an endorsement of share buybacks. Is there any doubt Berkshire has built value through capital acquisition and resultant free cash flows, rather than share repurchases? Investors have bought stock in the company over the years due to Buffett’s keen analytical ability in building capital-share buybacks destroy it. In fact, if other firms were to follow suit, given the economic slowdown, many would find themselves in a position similar to 2008.
With long-term investors approaching the state of greeting 300 point swings in the Dow Jones Industrial Average with a yawn, some might begin to wonder. When the immense swings persist, yet the speculated causes remain constant, investors should quit wondering and begin looking for more useful investment tools.
Indeed, stock prices around the world have, over the most recent period, undergone historically large daily changes in their market values. During this period, investors have been fed a journalistic diet of pablum, for lack of a more substantive intake out of the ken of mainstream security analysts. However, as even a casual observer of the financial markets can attest, these unvarying causes have rotated with the velocity, without the entertainment value, of a circus juggler.
A European or U.S. banking problem one day, an economic slowdown the next, with an occasional terrorist threat or sovereign budget flare-up, have, for some period of time now, all been reported as reasons behind these 2%-3% seemingly daily swings in the equity markets.
But think about it.
The fact the same issues keep resurfacing and are met by large market reactions (regardless of direction) implies investors have not properly evaluated-or perhaps even taken into account- known risk-for if they had done so, worldwide equity markets would be countering with greater calm as these headlines repeat.
A properly set cost of equity capital, in which investors account for all possible risks (along with their probability) to the prospective free cash flows- results in fair value remaining essentially unchanged should any such event unfold. If the probability of the event remains unchanged, the impact on fair value is nil.
The cost of capital will remain constant until there is absolute reason for the analyst to believe the risk landscape has been altered. In fact, cost of capital tends to remain in a very tight band for most companies throughout an economic cycle. As one cannot say the leading financial news items making the rounds today has changed much over the past quarter, I strongly argue, the recent abnormality in stock price volatility is not just unwarranted, but indicates a fundamental lacking of basic investment principles and application by professional security analysts and investors.
In reality, only new and material information should result in large swings to the prices of financial assets. Everything else is just “noise.”
A central reason, unfortunately, for the recent volatility is investment analyst models in wide practice today do not accord risk on a similar footing with earnings, or, more correctly, free cash flows.
The setting of the cost of equity capital must account for any known risk to a firm’s free cash flows. This forms the denominator of the net present value model. For example, in BP’s 2009 10-K, the company stated they self-insure the risks related to their offshore rig exploration. Yet, almost investors chose to ignore the possibilities, looking at self-insurance as an incremental boost to earnings, not the other side of the coin, risk.
With a proper cost of equity, portfolio turnover will be greatly reduced, as investors will not feel the need or the requirement to re-process information which is already reflected in their estimate of fair price.
Thus, if the stock market were to rise (fall) by 3% tomorrow, because of somber news from Greece or a weak European bank, then you can be sure investors have either not done their homework, or are over-reacting to news implicit in market values. As the kids say, “Tell me something I don’t know.”
Assuming a firm, XYZ Copper, which, despite a cyclical history of normalized positive growth rate in free cash flow is nonetheless exposed to volatile demand (revenues), input costs, and has its chief mine in what many consider to be a country with a government that, at times, has expressed hostility towards the U.S., and, in fact, whose workforce has struck the mine three times in the past decade, although no strike lasted more than 45 days. Assume there is no threat of nationalization. XYZ’s financial structure is also slightly leveraged, resulting in interest costs as a percentage of normalized and adjusted operating cash flows slightly above average. Whereas the S&P Industrials, itself a high quality group of companies, has an 8.2% cost of equity, we have determined that XYZ Copper has a cost of equity of 9.5%. Thus, the cost of equity takes into account these known potential risks as well as perhaps other risks not discussed here.
Analysts expect XYZ, which has $ 3.93 in net balance sheet cash to generate $ 3.13 in free cash flow during the current year. Due to the economic slowdown, its free cash flows are expected to fall by 20% for the following year, and then to grow 2.5 % per year over the coming 22 years, at which time the company will be sold or can be expected to have a market value at its historic average 10x free cash flow multiple. Fair value, including the net cash, may be approximated using by its net present value, at $34.00.
If XYZ were dealt a wildcat strike (new material information), what would be the impact to its fair value? To begin, its cost of capital, unless there was concrete evidence to believe otherwise, should remain the same. Strikes have been built into our risk to cash flows. As the firm has been in existence for many years, even if the company had cash payments to be satisfied, they would have already lined up adequate credit facilities in addition to the existing cash[1]. The only change in the fair value model would be the decline in the current year’s free cash flows, which instead of$3.13, we cut by 6%, to $2.94, to account for 45 days of free cash flow of which half is recouped, a conservative assumption given firms usually have inventory for such a possibility. Fair value drops to $32.31 or just a 5% difference. If the investor believed the strike was a possibility in year five, current fair value would fall by just 50 cents per share-such is the nature and importance of the discount rate, or cost of capital. It deals with these known risks.
My point: the same logic can and should be applied on the macro level. Make the adjustment to cost of capital as is required, so when the same scary headlines bounce back, you needn’t make any further calibration, other than perhaps the TV station that keeps giving you the chills. Only new information is of relevance and would impact the fair value estimate.
Kenneth S. Hackel, CFA
[1] In practicality, firms would also take other measures to boost cash flows, such as “work” the balance sheet and cut discretionary expenditures.
Pension funds, which benefitted last year, when the financial markets underwent a strong second half rally, may not be so fortunate this year.
And while a headline in today’s Financial Times reported the gap in US pension plans was $388 billion, CT Capital LLC reports the gap is considerably higher, perhaps by as much as 50% when using interest rates available today and the fall in hedged fund returns, which many pension sponsors have been viewing as “high return, low risk.” They have taken the same tact with private equity investments.
In fact, we expect to see a considerable step up in pension contributions later in their year, including selling equity and debt, as well as the contribution of company stock, where allowable.
For the 1400+ public companies we track which have defined benefit plans, the median investment return assumption is currently 7.75% (average 7.36%), a discount rate of 5.4%, and has a 57% exposure to the equity markets, 37% debt markets, and the balance real estate and hedged funds.
The average company reported their plan was $376MM underfunded, but that assumes their assumptions are realistic. The current financial markets tell us otherwise.
For some firms, including Boeing, GM and IBM, the underfunding is in excess of $10 billion each.
This means these firms financial leverage is greater than reported and their cash flows (from operating activities and free) are overstated.
The list of firms in pension trouble is not restricted to U.S. based entities. For example, Allianz SE, BP, Daimler, Deutsche Telecom, Siemens, Toyota, and Volkswagen have huge pension liabilities that must be addressed.
The defense sector is especially prone to large pension liabilities, unfortunate given the slowdown in the defense budget.
And for the many firms like Honeywell, which changed their actuarial methodology from asset smoothing (outside the corridor) to mark-to-market, which recognizes gains and losses in the current period, their timing appears unfortunate.
Although firms may not begin to recognize the financial markets impact on funding until their fourth quarter, analysts should begin to make these important adjustments to cash flows and financial structure immediately.
Kenneth S. Hackel, CFA
Analysts track every conceivable metric, all trying to predict the next big move. There is one metric, however, that deserves some very special attention in that it has never given off a wrong signal.
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