Credit Trends

 

The most implicit building block of security and company valuation is use of the risk free rate.

Whether undergoing a fairness opinion, a discounted cash flow model, or any number of other on-going concern valuation estimates, the starting point is the rate attainable with an investment in a risk-free security. It is the initial yield from which other elements of risk are added to arrive at the cost of equity capital. Simply stated, the higher (lower) the cost of equity, the lower (higher) the fair price investors would be willing to pay, given a set level of free cash flows.

Since the formulation of the capital asset pricing model, the risk free rate used has been the US government bond.

At CT Capital LLC, we use the 10 year Treasury bond, as that security best matches long-term asset programs, whether they be the building of a factory or a merger partner, from which a return on that invested capital is demanded.

Of late, as talk has gathered momentum, led by House Majority leader Eric Cantor, that politicians are willing to allow the U.S. to default on its obligations, analysts must now carefully appraise whether a defaulted security is, in the truest sense, a risk-free instrument.

One must conclude, even if a limited duration default were to occur, the answer would be no, and would be even more undeniable if seconded by a downgrade by a major credit rating agency, as Moody’s has threatened last week. Standard & Poor’s also downgraded its outlook for the U.S., citing “very large budget deficits and rising indebtedness…”

For this reason, should the U.S. Congress not come to its senses, CT Capital LLC will, if, due to QE2 or other Fed intervention, the 10 year Treasury bond not reflect economic reality, utilize an additional penalty being the cost of a credit default swap, currently 53 basis points. Thus, a current risk-free rate 10 year Treasury bond yielding 3% would in effect be raised to a 3.53% risk free rate.

Another alternative would be utilizing the 10 year rate on a liquid AAA corporates, currently 3.42%. However, even a basket of the cash instruments could present liquidity constraints and thus may not, for the time being, present a realistic alternative compared to the $9.7 trillion of U.S. debt in the hands of the public.

The brunt of a raise in the risk free rate is to force lower valuation multiples for the equity market in general, as would always be the case when the cost of capital rises. Investors demand a higher return for committing their risk-based capital as prospective free cash flows are attached to greater uncertainty reflective of the new higher rate.

Even if U.S. Government securities were to escape a default and credit downgrade in August, the tea leaves indicate it remains a matter of time before that inevitability occurs.

 

And when that time comes, investors, company stock analysts, and buyers and sellers of businesses, would feel a swift and powerful jolt to their reward expectations, as pronounced by the cost of equity beginning with that new risk free rate of interest.  And they will act and invest accordingly.

 

 

 

Kenneth S. Hackel, CFA

 

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Tin, while not ranking as high as mercury, is still a weak metal. And many investors continue to exhibit its malleability, over-reacting to a single quarter’s financial results, even for firms which have growing cash flows, have added value during the quarter, and possess strong financial structure and flexibility.

Investors must understand that firms do not operate with the smoothness of a well-crafted tool. They are not machines- yet enterprises that are well managed will continue to build value, even during periods when planning, rather than providing actual results, take place. For example, smart managers acquire during recessions, and aren’t afraid to do so, a time when weak firms are forced to sell assets.

This leads me to Google.

Google disappointed investors during its first quarter due to a perceived lack of financial discipline, as operating expenses rose over twice as fast as its 27% revenue growth; the company hired over 1900 new employees, handed out large salary raises while boosting other discretionary expenses, especially marketing. While GAAP based income disappointed, normalized free cash flow growth clearly exceeded our model’s metrics. Revenues represent a lofty model weighting as discretionary expenses can typically be controlled, while product acceptance reflects the quality of and demand for the product or service. This is not to downplay expense control, as efficiencies including improvements to supply chain and other direct expenditures have the same effect as boosting cash flows and hence, market valuation. Clearly, Google’s products are being very well received in the marketplace with collections from customer receivables growing at a near 24% rate.

With Google selling at 6.1% yield on enterprise value, we view its stock quite appealing, and can point to any number of lower quality companies selling at considerably higher valuations. Although Google shares are currently fair valued at $604 a share, that estimate would jump if managers keep expenses and margins in line and revenues grow as expected.

Obviously, if Google needs to continue to write $500MM checks to settle lawsuits, its fair value will fall and cost of capital will rise. However, its very strong and predictable near-term free cash flows can fight off these legal issues assuming they can indeed be put to an an end. Given the sensitivity analysis below, using our free cash flow model (please refer to Security Valuation and Risk Analysis), current fair value for Google is sufficiently above its current price. The 18.5% tax on repatriation represents the company’s five year average cash tax rate, based on Google’s net cash of $32 billion.

 

Google Fair Value Sensitivity Using CT Capital Free Cash Flow Model

Disc Rte. Probability FV

7% 10% $732.04

8% 10% $642.04

8.25% 10% $621.91

8.50% 15% $602.64

8.75% 20% $584.18

9.00% 20% $566.49

10.00% 15% $502.76

 

 

Fair Value Cash Flow 100% $595.54

Net Cash/Debt* 8.1

Fair Value Per Share $603.64

*includes tax on repatriation and working capital

 

 

Note: Google shares are held by clients of CT Capital LLC.

 

 

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Large Share Buybacks Again Prove They Are Misguided

 

As if we needed additional evidence large share buybacks are almost always a waste of corporate resources , I present a list of all companies having current market values of greater than $500MM that have repurchased at least 15% of their current market values and placed into treasury. As seen, the list includes many well known firms, including several that have bought back over 50% of their current market values. The average of these large firms have repurchased an astounding 36% of their current market value – yet, as opposed to their helping their shareholders-they have done the opposite-as their stocks have underperformed the return on the S&P 500!

As seen, stock buybacks have proved no refuge in a flat and falling equity market. The latest example is the current year, as the current quarter to date, with the S&P slipping 36 basis points thru last night’s close, the average of these firms has seen its stock fall by 52 basis points. Care for a longer time horizon?

For the past 5 years, the names on the list have returned 2.4% versus a return on the S&P 500 of 3.77%. To make matters worse, the list excludes those bankrupt or merged firms which repurchased large amounts of their own shares prior to their demise such as Bear Stearns, Lehman, and many, many others.

For the current quarter, Big Lots, Brunswick, Ferro,, Lamar Advertising, , Lenox Int’l, , Lexmark, Terex, Timberland have each fallen by greater than 20% this quarter.

I am not implying these firms will meet the same fate as Lehman, but rather time has proven again and again share repurchases, other than to perhaps offset stock based compensation, do not improve the lots of shareholders or bondholders. And for sound economic reason.

Share buybacks, like dividends must be rubber-stamped by Boards of Directors. They should understand that share repurchases, despite improving GAAP-based metrics do nothing to improve cash based return on invested capital.  On the contrary, by altering the financial structure, it often raises risk and hence, the cost of capital to the firm whose value they are entrusted to enhance. Value is created by adding to the capital base, joint ventures, increasing revenues, and by running the firm more efficiently-not by shrinking the equity cushion.

One lot whose fortunes share buybacks does improve are high paid executives whose bonuses and stock options are often based on GAAP accounting.

Warren Buffet recognizes this, and has never bought back a share of Berkshire. Adding to the capital base assets whose cash based return is safely and consistently above ROIC is a proven method for share outperformance over the long-term.

While part of the problem lies with shareholders themselves, as they continue to believe share buybacks “support the stock”, history has again clearly shown otherwise.

For a detailed example on why share buybacks do not increase ROIC, please contact CT Capital LLC and see “Security Valuation and Risk Analysis.”

 

Company Name	Ticker Symbol	Treasury Stock ($M)	Current Market Value ($M)	% of Current Market Value in Treasury	Total Return-Year to Date	Total Return-Qtr to Date	5-Year Total Return
3M CO	MMM	10,266	65,721	15.6%	8.4	(0.5)	5.4
ACI WORLDWIDE INC	ACIW	172	1,031	16.6%	14.8	(5.9)	(3.7)
ACTIVISION BLIZZARD INC	ATVI	2,194	13,124	16.7%	(6.4)	4.6
ADOBE SYSTEMS INC	ADBE	3,264	17,369	18.8%	11.9	3.8	(3.1)
ADVANCE AUTO PARTS INC	AAP	1,029	4,904	21.0%	(4.7)	(4.0)	10.9
AFLAC INC	AFL	5,386	22,833	23.6%	(12.5)	(7.0)	5.6
AGILENT TECHNOLOGIES INC	A	8,038	16,945	47.4%	18.5	9.6	6.7
ALCATEL-LUCENT -ADR	ALU	2,078	13,029	15.9%	89.9	(3.3)	(14.1)
ALCOA INC	AA	4,146	16,964	24.4%	4.2	(9.4)	(10.9)
ALLIANCE DATA SYSTEMS CORP	ADS	2,080	4,529	45.9%	25.0	3.4	11.6
ALLSTATE CORP	ALL	15,910	16,409	97.0%	(0.8)	(1.1)	(7.0)
ALTRIA GROUP INC	MO	23,469	58,301	40.3%	14.8	7.0	16.7
AMDOCS LTD	DOX	1,309	5,570	23.5%	9.2	4.0	(3.7)
AMERCO	UHAL	526	1,694	31.0%	(10.0)	(10.9)	(0.5)
AMERICAN TOWER CORP	AMT	3,382	21,081	16.0%	2.9	2.6	8.9
AMERIPRISE FINANCIAL INC	AMP	2,620	14,782	17.7%	6.7	0.3	6.6
AMERISOURCEBERGEN CORP	ABC	4,373	11,328	38.6%	21.9	4.8	15.1
AMERN EAGLE OUTFITTERS INC	AEO	938	2,635	35.6%	(6.9)	(14.9)	(3.5)
AMR CORP/DE	AMR	367	2,184	16.8%	(15.9)	1.4	(24.9)
AMTRUST FINANCIAL SERVICES	AFSI	300	1,259	23.9%	21.1	10.7
ANN INC	ANN	864	1,472	58.7%	3.7	(2.4)	(3.5)
APOLLO GROUP INC  -CL A	APOL	2,408	5,649	42.6%	1.4	(4.0)	(6.0)
APPLIED MATERIALS INC	AMAT	9,396	18,195	51.6%	(1.4)	(11.7)	(1.0)
ASSURANT INC	AIZ	1,764	3,620	48.7%	(1.8)	(2.1)	(2.4)
ASTORIA FINANCIAL CORP	AF	1,431	1,391	102.8%	3.4	(0.8)	(10.5)
AUTOMATIC DATA PROCESSING	ADP	6,540	26,694	24.5%	16.2	4.1	9.4
AVERY DENNISON CORP	AVY	831	4,380	19.0%	(2.6)	(2.3)	(4.8)
AVIS BUDGET GROUP INC	CAR	5,874	1,765	332.8%	8.0	(6.1)	(3.4)
AVON PRODUCTS	AVP	4,559	12,785	35.7%	3.9	10.7	0.6
AXIS CAPITAL HOLDINGS LTD	AXS	1,381	4,207	32.8%	(8.8)	(6.9)	6.0
BALL CORP	BLL	2,123	6,492	32.7%	13.8	7.8	14.3
BANK OF HAWAII CORP	BOH	450	2,263	19.9%	1.5	(0.8)	1.6
BAXTER INTERNATIONAL INC	BAX	5,655	33,681	16.8%	17.3	9.8	10.6
BECTON DICKINSON & CO	BDX	4,806	19,134	25.1%	4.0	9.9	8.2
BED BATH & BEYOND INC	BBBY	2,814	13,426	21.0%	9.2	11.2	7.9
BEMIS CO INC	BMS	544	3,448	15.8%	1.7	0.5	3.0
BERKLEY (W R) CORP	WRB	1,750	4,616	37.9%	19.3	1.2	(1.9)
BIG LOTS INC	BIG	1,079	2,534	42.6%	10.6	(22.4)	23.3
BJ’S WHOLESALE CLUB INC	BJ	636	2,725	23.3%	6.0	4.0	10.9
BLOCK H & R INC	HRB	2,057	4,963	41.4%	37.9	(2.9)	(2.5)
BMC SOFTWARE INC	BMC	2,294	9,580	23.9%	14.9	8.9	18.5
BOEING CO	BA	17,187	56,316	30.5%	18.2	3.7	1.6
BP PLC  -ADR	BP	21,085	137,666	15.3%	1.6	0.7	(4.6)
BRIGGS & STRATTON	BGG	202	1,022	19.8%	3.5	(10.6)	(3.5)
BRINKER INTL INC	EAT	1,678	2,187	76.7%	24.2	1.9	0.7
BRISTOL-MYERS SQUIBB CO	BMY	17,454	48,109	36.3%	9.2	6.7	7.3
BRUNSWICK CORP	BC	406	1,802	22.5%	8.0	(20.4)	(8.5)
CA INC	CA	2,095	11,529	18.2%	(6.4)	(5.6)	0.1
CAMPBELL SOUP CO	CPB	7,459	11,192	66.6%	1.4	6.5	3.7
CAPITOL FEDERAL FINL INC	CFFN	330	1,966	16.8%	4.9	4.9	1.7
CARPENTER TECHNOLOGY CORP	CRS	535	2,201	24.3%	25.2	17.5	(1.0)
CATERPILLAR INC	CAT	10,397	65,688	15.8%	9.7	(8.1)	11.7
CBS CORP	CBS	3,689	17,868	20.6%	41.2	6.7	3.3
CBS CORP	CBS	3,689	17,868	20.6%	40.5	6.7	3.3
CHARLES RIVER LABS INTL INC	CRL	769	1,968	39.1%	7.2	(0.7)	(2.2)
CHEESECAKE FACTORY INC	CAKE	558	1,789	31.2%	1.0	3.0	(1.4)
CHEMED CORP	CHE	409	1,420	28.8%	5.3	0.2	5.7
CHOICE HOTELS INTL INC	CHH	872	2,104	41.5%	(7.6)	(9.4)	(5.0)
CHUBB CORP	CB	3,783	18,957	20.0%	9.4	5.7	7.5
CIGNA CORP	CI	5,242	13,120	40.0%	32.4	9.5	5.7
CINCINNATI FINANCIAL CORP	CINF	1,201	4,921	24.4%	(3.6)	(7.9)	(1.2)
CINTAS CORP	CTAS	799	4,602	17.4%	13.3	4.6	(4.2)
CITRIX SYSTEMS INC	CTXS	2,417	15,434	15.7%	20.0	11.8	16.1
COCA-COLA CO	KO	27,762	154,502	18.0%	3.4	1.7	13.2
COLGATE-PALMOLIVE CO	CL	11,305	42,079	26.9%	8.6	7.3	9.9
COMERICA INC	CMA	1,565	6,328	24.7%	(15.0)	(2.5)	(4.4)
COMMERCIAL METALS	CMC	290	1,689	17.2%	(11.2)	(15.3)	(7.0)
CON-WAY INC	CNW	341	2,094	16.3%	3.9	(3.6)	(5.9)
CONAGRA FOODS INC	CAG	2,945	10,374	28.4%	14.6	7.8	5.2
CONOCOPHILLIPS	COP	20,710	100,825	20.5%	6.6	(9.9)	6.6
CONSTELLATION BRANDS  -CL A	STZ	904	4,642	19.5%	(1.9)	7.4	(1.9)
CONSTELLATION BRANDS  -CL A	STZ	904	4,642	19.5%	(1.6)	7.5	(1.9)
CONVERGYS CORP	CVG	1,060	1,571	67.5%	(1.7)	(9.8)	(5.7)
COOPER TIRE & RUBBER CO	CTB	468	1,461	32.0%	0.2	(8.7)	20.4
CORPORATE EXECUTIVE BRD CO	EXBD	629	1,413	44.5%	9.5	1.4	(15.5)
COVANCE INC	CVD	734	3,526	20.8%	13.1	6.2	1.4
COVENTRY HEALTH CARE INC	CVH	1,268	5,007	25.3%	28.0	6.0	(8.3)
CVS CAREMARK CORP	CVS	9,086	51,485	17.6%	10.0	11.0	4.9
CYMER INC	CYMI	493	1,428	34.5%	3.8	(17.3)	(1.4)
CYPRESS SEMICONDUCTOR CORP	CY	1,203	3,599	33.4%	15.3	10.5	38.7
DARDEN RESTAURANTS INC	DRI	2,944	7,022	41.9%	12.3	5.5	5.9
DAVITA INC	DVA	1,361	8,069	16.9%	21.6	(1.2)	9.4
DEERE & CO	DE	5,790	34,972	16.6%	0.4	(14.3)	19.6
DELL INC	DELL	28,704	29,536	97.2%	14.3	6.8	(10.0)
DIEBOLD INC	DBD	436	2,089	20.9%	1.5	(9.0)	(1.5)
DIGITAL RIVER INC	DRIV	255	1,208	21.1%	(11.5)	(18.6)	(5.7)
DILLARDS INC  -CL A	DDS	1,356	2,759	49.1%	39.7	32.0	14.2
DISH NETWORK CORP	DISH	1,569	6,070	25.9%	49.6	20.8	2.1
DISNEY (WALT) CO	DIS	23,663	77,799	30.4%	9.7	(4.5)	10.6
DONNELLEY (R R) & SONS CO	RRD	1,166	4,256	27.4%	20.7	9.9	(6.2)
DOVER CORP	DOV	2,322	11,708	19.8%	7.8	(4.5)	8.8
DREAMWORKS ANIMATION INC	DWA	688	1,798	38.3%	(16.0)	(11.4)	(0.5)
DST SYSTEMS INC	DST	2,815	2,176	129.4%	6.4	(11.3)	(3.9)
DUN & BRADSTREET CORP	DNB	2,214	3,965	55.8%	(1.8)	0.0	2.6
EASTMAN CHEMICAL CO	EMN	1,615	7,105	22.7%	19.5	0.7	18.3
ECOLAB INC	ECL	2,521	12,219	20.6%	4.8	3.2	8.2
EL PASO ELECTRIC CO	EE	338	1,269	26.6%	9.4	(0.9)	9.4
EMERSON ELECTRIC CO	EMR	6,320	40,515	15.6%	(4.6)	(7.2)	10.4
ENERGIZER HOLDINGS INC	ENR	1,668	5,314	31.4%	4.6	7.2	8.1
ENSTAR GROUP LTD	ESGR	422	1,351	31.2%	16.6	(1.3)
ENTERGY CORP	ETR	5,525	12,013	46.0%	(2.5)	1.6	3.4
EQUIFAX INC	EFX	2,032	4,559	44.6%	5.0	(4.2)	0.1
ERIE INDEMNITY CO  -CL A	ERIE	872	3,514	24.8%	10.3	0.8	11.4
EVEREST RE GROUP LTD	RE	981	4,803	20.4%	4.9	0.3	2.1
EXPEDIA INC	EXPE	2,241	6,826	32.8%	10.2	21.6	6.4
EXTERRAN HOLDINGS INC	EXH	204	1,273	16.0%	(16.9)	(16.1)	(18.9)
EXXON MOBIL CORP	XOM	156,608	397,387	39.4%	11.6	(3.6)	9.2
FAIR ISAAC CORP	FICO	1,556	1,145	135.9%	23.2	(9.0)	(3.9)
FEDERATED INVESTORS INC	FII	779	2,655	29.3%	(1.2)	(4.2)	(0.2)
FERRO CORP	FOE	164	1,021	16.1%	(18.9)	(28.5)	(2.9)
FIDELITY NATIONAL INFO SVCS	FIS	2,359	9,629	24.5%	15.2	(3.7)	11.1
FISERV INC	FISV	2,340	8,980	26.1%	6.8	(0.3)	6.3
FOREST LABORATORIES  -CL A	FRX	3,783	9,967	38.0%	8.9	7.9	(3.9)
FORTUNE BRANDS INC	FO	3,215	9,680	33.2%	4.9	1.8	(1.8)
GANNETT CO	GCI	5,300	3,417	155.1%	(5.6)	(6.7)	(19.7)
GAP INC	GPS	10,866	11,234	96.7%	(12.1)	(14.5)	7.2
GARTNER INC	IT	1,045	3,627	28.8%	12.3	(10.5)	25.1
GATX CORP	GMT	560	1,778	31.5%	9.5	(0.9)	1.1
GENERAL DYNAMICS CORP	GD	4,535	26,557	17.1%	1.8	(6.2)	4.2
GENERAL ELECTRIC CO	GE	31,938	205,893	15.5%	6.7	(3.3)	(6.4)
GENWORTH FINANCIAL INC	GNW	2,700	5,372	50.3%	(16.7)	(18.6)	(17.3)
GOLDMAN SACHS GROUP INC	GS	36,295	70,329	51.6%	(19.0)	(14.4)	(0.3)
GRAINGER (W W) INC	GWW	2,857	10,314	27.7%	8.7	8.6	16.7
GREENHILL & CO INC	GHL	331	1,624	20.4%	(32.6)	(16.8)	(1.5)
HANOVER INSURANCE GROUP INC	THG	720	1,880	38.3%	(10.9)	(8.6)	(3.0)
HARLEY-DAVIDSON INC	HOG	4,674	8,591	54.4%	5.1	(14.4)	(3.8)
HARMAN INTERNATIONAL INDS	HAR	1,048	3,252	32.2%	0.6	(0.6)	(11.1)
HARSCO CORP	HSC	737	2,595	28.4%	15.0	(8.3)	(0.9)
HASBRO INC	HAS	2,102	6,459	32.5%	1.7	1.9	21.8
HEALTH NET INC	HNT	1,627	2,825	57.6%	14.4	(4.5)	(3.9)
HEINZ (H J) CO	HNZ	4,751	17,169	27.7%	8.9	9.3	8.2
HERSHEY CO	HSY	4,052	9,091	44.6%	18.5	2.1	4.4
HIBBETT SPORTS INC	HIBB	205	1,083	18.9%	7.1	10.3	4.5
HILL-ROM HOLDINGS INC	HRC	558	2,856	19.5%	15.2	19.0	12.5
HOLLY CORP	HOC	678	3,229	21.0%	49.0	(0.3)	10.3
HONEYWELL INTERNATIONAL INC	HON	8,299	46,024	18.0%	11.3	(1.5)	10.4
HUDSON CITY BANCORP INC	HCBK	1,726	4,761	36.2%	(27.5)	(5.8)	(3.3)
HUNT (JB) TRANSPRT SVCS INC	JBHT	1,173	5,443	21.6%	11.6	(0.1)	16.4
IAC/INTERACTIVECORP	IACI	8,364	3,007	278.2%	22.8	14.0	5.5
IDEXX LABS INC	IDXX	1,061	4,473	23.7%	12.7	1.0	14.4
INTEGRA LIFESCIENCES HLDGS	IART	284	1,422	19.9%	5.3	5.0	4.5
INTERDIGITAL INC	IDCC	569	1,904	29.9%	1.2	(11.8)	12.9
INTL BANCSHARES CORP	IBOC	250	1,108	22.6%	(17.4)	(10.8)	(5.3)
INTL BUSINESS MACHINES CORP	IBM	96,161	203,797	47.2%	15.6	3.6	17.7
INTL FLAVORS & FRAGRANCES	IFF	1,383	5,043	27.4%	13.4	0.7	15.0
INTUIT INC	INTU	3,315	16,016	20.7%	7.4	(0.3)	15.5
ITT EDUCATIONAL SERVICES INC	ESI	566	1,879	30.1%	5.1	(7.2)	2.5
JACK IN THE BOX INC	JACK	571	1,082	52.8%	0.9	(6.0)	(0.2)
KEYCORP	KEY	1,904	7,863	24.2%	(6.5)	(6.9)	(23.4)
KIMBERLY-CLARK CORP	KMB	4,726	26,692	17.7%	8.9	4.1	6.4
KNIGHT CAPITAL GROUP INC	KCG	766	1,222	62.7%	(11.7)	(9.1)	(3.9)
KOHL’S CORP	KSS	3,643	15,967	22.8%	1.7	3.7	(1.1)
KROGER CO	KR	6,732	14,907	45.2%	10.9	3.0	5.2
L-3 COMMUNICATIONS HLDGS INC	LLL	2,658	8,783	30.3%	18.7	6.3	1.2
LAM RESEARCH CORP	LRCX	1,581	5,760	27.5%	(10.6)	(18.3)	(0.2)
LAMAR ADVERTISING CO  -CL A	LAMR	885	2,258	39.2%	(27.1)	(21.3)	(9.1)
LANCASTER COLONY CORP	LANC	680	1,667	40.8%	6.8	0.3	11.1
LANDSTAR SYSTEM INC	LSTR	763	2,196	34.8%	12.3	0.5	2.6
LAUDER (ESTEE) COS INC -CL A	EL	2,850	11,831	24.1%	21.8	2.0	22.8
LAWSON SOFTWARE INC	LWSN	327	1,823	17.9%	19.9	(8.3)	7.6
LEGGETT & PLATT INC	LEG	1,093	3,641	30.0%	13.3	4.0	4.7
LENNAR CORP	LEN	615	3,228	19.1%	(7.2)	(1.8)	(17.5)
LENNOX INTERNATIONAL INC	LII	947	2,456	38.6%	(2.3)	(12.4)	10.0
LEXMARK INTL INC  -CL A	LXK	404	2,303	17.6%	(16.5)	(21.5)	(7.9)
LOUISIANA-PACIFIC CORP	LPX	280	1,045	26.8%	(16.4)	(24.7)	(18.3)
MACY’S INC	M	2,431	12,170	20.0%	13.2	17.8	(7.7)
MAGELLAN HEALTH SERVICES INC	MGLN	382	1,643	23.2%	8.7	4.7	5.1
MANPOWERGROUP	MAN	1,258	4,942	25.4%	(4.2)	(4.4)	1.6
MARRIOTT INTL INC	MAR	5,348	13,045	41.0%	(12.2)	2.3	0.3
MATTEL INC	MAT	1,881	9,149	20.6%	5.4	6.5	14.9
MATTHEWS INTL CORP  -CL A	MATW	207	1,082	19.2%	5.2	(4.7)	3.6
MAXIMUS INC	MMS	359	1,406	25.6%	24.0	0.0	19.4
MBIA INC	MBI	2,225	1,756	126.7%	(26.7)	(12.5)	(28.9)
MCDONALD’S CORP	MCD	25,143	85,600	29.4%	8.4	8.4	21.4
MCGRAW-HILL COMPANIES	MHP	4,958	12,901	38.4%	17.1	7.5	(3.9)
MCKESSON CORP	MCK	6,470	21,221	30.5%	19.9	6.5	12.2
MEDCO HEALTH SOLUTIONS INC	MHS	11,066	25,451	43.5%	3.9	13.4	17.4
MEDICIS PHARMACEUT CP  -CL A	MRX	348	2,266	15.3%	37.3	14.5	2.3
MEMC ELECTRONIC MATRIALS INC	WFR	456	2,343	19.5%	(9.7)	(21.5)	(21.9)
MENS WEARHOUSE INC	MW	413	1,706	24.2%	33.2	22.5	(3.5)
MERCK & CO	MRK	22,433	113,895	19.7%	3.6	11.8	5.1
METTLER-TOLEDO INTL INC	MTD	1,057	5,298	20.0%	9.0	(4.2)	23.7
MICROSTRATEGY INC	MSTR	475	1,085	43.8%	58.4	0.7	8.6
MINE SAFETY APPLIANCES CO	MSA	271	1,310	20.7%	16.6	(1.8)	1.9
MINERALS TECHNOLOGIES INC	MTX	466	1,172	39.8%	(1.8)	(6.4)	3.9
MOLEX INC	MOLX	1,098	4,338	25.3%	18.1	6.1	(3.9)
MOLEX INC	MOLX	1,098	4,338	25.3%	18.9	7.5	(3.9)
MOODY’S CORP	MCO	4,407	8,634	51.0%	43.9	12.2	(7.7)
NASDAQ OMX GROUP INC	NDAQ	796	4,406	18.1%	5.1	(3.5)	(6.2)
NRG ENERGY INC	NRG	1,503	5,955	25.2%	26.4	14.7	0.3
NU SKIN ENTERPRISES  -CL A	NUS	477	2,272	21.0%	22.6	28.5	17.1
NVR INC	NVR	3,240	4,303	75.3%	5.8	(3.3)	(0.4)
OMNICOM GROUP	OMC	4,697	13,140	35.7%	2.6	(4.7)	3.4
PARTNERRE LTD	PRE	1,083	5,141	21.1%	(3.9)	(3.2)	7.9
PETSMART INC	PETM	1,335	5,094	26.2%	13.5	10.1	9.8
PITNEY BOWES INC	PBI	4,480	4,958	90.4%	3.6	(3.9)	(5.6)
POLYONE CORP	POL	306	1,304	23.4%	12.1	(1.8)	10.3
PPG INDUSTRIES INC	PPG	4,708	13,705	34.4%	4.4	(8.4)	10.9
PRINCIPAL FINANCIAL GRP INC	PFG	4,725	10,022	47.1%	(4.2)	(2.9)	(6.2)
PROCTER & GAMBLE CO	PG	61,309	187,156	32.8%	5.9	9.7	4.9
PRUDENTIAL FINANCIAL INC	PRU	11,173	30,322	36.8%	6.3	1.3	(2.4)
QUAD/GRAPHICS INC	QUAD	296	1,343	22.0%	(0.6)	(3.6)
QUEST DIAGNOSTICS INC	DGX	2,158	9,085	23.8%	7.4	0.2	1.0
RADIOSHACK CORP	RSH	949	1,643	57.8%	(16.2)	3.2	0.1
RAYTHEON CO	RTN	6,900	17,599	39.2%	8.4	(2.0)	4.3
REGIONS FINANCIAL CORP	RF	1,402	8,582	16.3%	(2.3)	(5.9)	(24.6)
RENT-A-CENTER INC	RCII	904	1,991	45.4%	(2.7)	(10.2)	2.2
RLI CORP	RLI	393	1,261	31.1%	14.5	3.9	5.5
ROCKWELL AUTOMATION	ROK	2,136	11,748	18.2%	14.5	(13.6)	6.2
ROCKWELL COLLINS INC	COL	1,497	9,309	16.1%	4.5	(6.4)	3.6
SAFEWAY INC	SWY	6,284	8,821	71.2%	11.4	5.8	0.8
SCHWAB (CHARLES) CORP	SCHW	4,247	20,744	20.5%	1.1	(4.3)	2.7
SEACOR HOLDINGS INC	CKH	903	2,081	43.4%	(4.9)	3.9	5.1
SEARS HOLDINGS CORP	SHLD	5,826	7,737	75.3%	(2.6)	(13.1)	(9.8)
SHERWIN-WILLIAMS CO	SHW	4,391	9,084	48.3%	2.8	2.0	12.5
SIGMA-ALDRICH CORP	SIAL	2,051	8,314	24.7%	2.8	7.3	16.8
SLM CORP	SLM	1,876	8,433	22.3%	27.0	4.5	(20.4)
SPX CORP	SPW	2,516	4,020	62.6%	10.6	(0.7)	11.3
ST JOE CO	JOE	931	2,038	45.7%	1.1	(11.9)	(13.8)
STAPLES INC	SPLS	3,787	11,917	31.8%	(26.2)	(14.0)	(3.1)
STEEL DYNAMICS INC	STLD	728	3,625	20.1%	(8.8)	(11.6)	5.1
SUNOCO INC	SUN	4,387	4,753	92.3%	(1.9)	(13.6)	(10.0)
SUPERVALU INC	SVU	521	2,155	24.2%	6.6	13.8	(14.7)
SYNAPTICS INC	SYNA	282	972	29.0%	(3.4)	5.0	10.2
SYSCO CORP	SYY	4,408	18,858	23.4%	11.9	16.7	2.5
TECH DATA CORP	TECD	467	2,188	21.3%	6.7	(7.6)	7.7
TECHNICOLOR  -ADR	TCLRY	207	1,172	17.7%	40.8	(7.7)	(45.5)
TELEPHONE & DATA SYSTEMS INC	TDS	739	2,943	25.1%	(12.1)	(5.0)	(2.0)
TELEPHONE & DATA SYSTEMS INC	TDS	739	2,943	25.1%	(10.8)	(5.1)	(2.0)
TELETECH HOLDINGS INC	TTEC	323	1,009	32.0%	(13.6)	(8.2)	9.1
TELLABS INC	TLAB	1,222	1,664	73.4%	(31.9)	(12.2)	(20.7)
TEMPLE-INLAND INC	TIN	584	2,419	24.1%	5.7	(4.6)	4.3
TEMPUR PEDIC INTL INC	TPX	713	4,291	16.6%	56.5	23.7	32.6
TENET HEALTHCARE CORP	THC	1,479	3,074	48.1%	(6.1)	(15.7)	(3.6)
TEREX CORP	TEX	599	3,094	19.4%	(9.1)	(23.8)	(4.3)
TEXAS INSTRUMENTS INC	TXN	16,411	39,770	41.3%	6.2	(0.5)	2.0
TIMBERLAND CO  -CL A	TBL	747	1,313	56.9%	29.6	(22.8)	5.8
TIME WARNER INC	TWX	29,033	38,710	75.0%	13.1	1.3	2.8
TRAVELERS COS INC	TRV	14,857	25,735	57.7%	11.0	3.3	10.2
UMB FINANCIAL CORP	UMBF	361	1,696	21.3%	1.5	12.0	6.1
UNITED STATIONERS INC	USTR	773	1,625	47.5%	11.2	(0.5)	6.2
UNITED TECHNOLOGIES CORP	UTX	17,468	78,795	22.2%	10.5	2.3	9.7
VALASSIS COMMUNICATIONS INC	VCI	508	1,380	36.8%	(13.2)	(3.6)	(0.3)
VALERO ENERGY CORP	VLO	6,462	14,787	43.7%	12.6	(12.9)	(14.0)
VARIAN SEMICONDUCTOR EQUIPMT	VSEA	733	4,615	15.9%	65.5	25.7	13.9
VERISK ANALYTICS INC	VRSK	1,106	5,179	21.4%	(0.4)	3.6
VIACOM INC	VIA.B	5,725	29,895	19.2%	30.3	11.8	5.5
VIACOM INC	VIA.B	5,725	29,895	19.2%	26.6	7.5	5.5
WASHINGTON POST  -CL B	WPO	2,158	2,770	77.9%	(4.9)	(5.0)	(9.2)
WASTE MANAGEMENT INC	WM	4,904	18,224	26.9%	5.2	2.9	4.4
WATERS CORP	WAT	2,509	8,913	28.2%	25.2	11.9	16.7
WEIGHT WATCHERS INTL INC	WTW	1,794	6,140	29.2%	124.8	19.9	11.7
WESCO INTL INC	WCC	591	2,259	26.2%	(0.7)	(16.1)	(3.8)
WHIRLPOOL CORP	WHR	1,823	6,139	29.7%	(8.3)	(5.1)	1.8
WOLVERINE WORLD WIDE	WWW	377	1,890	19.9%	19.8	2.1	11.5
WYNDHAM WORLDWIDE CORP	WYN	1,107	5,745	19.3%	13.4	6.3
ZEBRA TECHNOLOGIES CP  -CL A	ZBRA	462	2,275	20.3%	9.6	6.1	(0.2)
ZIMMER HOLDINGS INC	ZMH	3,545	12,861	27.6%	24.8	10.7	0.7
AVERAGE		4,876	15,661	35.9%	7.8	(0.5)	2.4

 

Kenneth Hackel, CFA

 

 

 

 

 

 

 

 

 

 

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Over 90% of security analysts and companies which file with the SEC define free cash flow as cash flow from operating activities minus capital spending. This is incorrect. Of course, many firms tailor-make their own free cash flow definition.

It ignores the important misclassifications, one-time items, and areas of overspending as well as required spending (underpayments to pension plans, claims, etc.) that firms have not made, but need to.

A rather obvious example is that of Dr Pepper Snapple Group, which a simple investment screen would show as selling for 4x free cash flow. The reason is the recording as an operating cash flow activity one-time nonrefundable cash payments of $900 million from PepsiCo and $715 million from Coca-Cola, both recorded as deferred revenue.

Unfortunately, at CT Capital LLC, we come across a large number of less obvious and even “hidden”  within footnote and income statement items, activities which most analysts may not consider and which beefed up operating (therefore “free”) cash flows. For instance many firms bury asset sales and collections on insurance within broad classifications. Including these and other such items provides for a faulty appraisal of fair value.

For a complete discussion on this topic see Security Valuation and Risk Analysis..

 

Kenneth S. Hackel, CFA

 

 

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There Must Be a Better Way to Reward Shareholders

 

In Microsoft’s 10-Q filed today, it was revealed that for only the second quarter in at least 10 years, the firm did not buy back net shares (repurchases minus new issuance). In fact, shares outstanding actually increased over the prior quarter.  Is management learning, or does it represent an anomaly? Over the past decade, MSFT has spent over a third of its current market value on its repurchase program, when it initially had a market value of $325 billion, or 46% higher than today.

In the past 20 years, Microsoft repurchased a net $93.5 billion of its outstanding shares, surely to go down as a landmark waste of corporate cash.

When Microsoft announced its two $40 billion buyback authorizations, analysts were out front hailing the acts as “bold” and predicted they would be cheered by investors.

Quite obviously, shares in Microsoft have been a subpar investment, yet, to date, its largest shareholder continues to endorse the failed programs. If Mr. Gates would like to have more capital for his foundation, I would recommend he make better investments in technology, including joint ventures.  Imagine if someone at Microsoft had the foresight to invest in Facebook, or in one or several of the hundreds of successful internet based enterprises, at reasonable values, when such was possible. They didn’t see the tablet revolution, which one would think would have been “in their wheelhouse” given the billions they spend each year on R&D.

During the past 12 months MSFT spent almost $11 billion net, or 4.8% of its current market value to repurchase 3.8% of its current market value, continuing to prove the folly of share buybacks.

Share buybacks do nothing to improve return on invested capital, serve to bump up the cost of capital due to the shift in financial structure, and most often, are a reflection of managerial ineffectiveness in deploying the firm’s capital. Microsoft has certainly proven the latter to be true.

 

MICROSOFT CORP
TICKER:	MSFT
SIC:	7,372.000
GICS:	45103020
	Purchase Com & Pref Stock	Sale of Com/Pref Stock	Net
Jun01	6,074.000	1,620.000	4,454.000
Jun02	6,069.000	1,497.000	4,572.000
Jun03	6,486.000	2,120.000	4,366.000
Jun04	3,383.000	2,748.000	635.000
Jun05	8,057.000	3,109.000	4,948.000
Jun06	19,207.000	2,101.000	17,106.000
Jun07	27,575.000	6,782.000	20,793.000
Jun08	12,533.000	3,494.000	9,039.000
Jun09	9,353.000	579.000	8,774.000
Jun10	11,269.000	2,311.000	8,958.000
YTD Mar	10,299.000	2,242.000	8,057.000
SUM			83,645.000

 

 

 

CT Capital LLC is an investment advisory firm based in Alpine, New Jersey, specializing in the detailed analysis of free cash flow, cost of capital, and return on invested capital.

 

 

Kenneth S. Hackel, CFA President  Follow me on Twitter @ credittrends www.ctcapllc.com

 

 

Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making, Fall 2010, McGraw-Hill

 

 

 

 

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Last month I sat down with David Larrabee, CFA,  of the CFA Institute to discuss how investors and analysts should define and measure free cash flow, cost of capital and return on invested capital.

It may be seen at http://www.cfawebcasts.org/modules/catalog/CourseDetails.aspx?ProductGroupID=8499

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While I have written on the subject of sovereign or country risk before, the tragic earthquake in Japan again forces us to revisit the topic.

One source in our analysis is the US State Department website. They write:

“Japan is faced with the ever-present danger of deadly earthquakes and typhoons.  Japan is one of the most seismically active locations in the world; minor tremors are felt regularly throughout the islands.  While responsibility for caring for disaster victims, including foreigners, rests with the Japanese authorities, one of the first things you should do upon arriving in Japan is to learn about earthquake and disaster preparedness from hotel or local government officials.”

Prior to the disaster, at CT Capital, we had marked-up all Japanese based firms by 35 basis points over Canada, and 10 basis points over the U.S. This mark-up is now 90 basis points over Canada and 65 basis points over the U.S. The additional mark-up reflects the stepped-up exposure to disasters and the current impact on of the disaster on the general economy. There is also some exposure to terrorism in Japan, but not at a level greater than the U.S.

 

Country Risk-Summary

Companies that are subject to certain jurisdictions may be riskier (political, currency, taxes) for investors than U.S. – based companies.  This was acutely reflected during the fiscal crises in Greece during 2010, with almost immediate repercussions throughout Europe, Asia and the United States. The resultant weakness in the euro impacted US entities with operations in Europe or sold into that market with the US dollar based goods. On the other hand, the price of oil dropped since its price is quoted in dollars.  During the period the crisis was at its peak, many entities which had planned to enter the debt markets to raise capital were not able to do so.

The conditions under which a company operates and has major facilities or markets will thus influence cash flows, consistency measures and leverage. As we have seen, energy exploration companies have had their operations nationalized, while many companies have been harmed by high inflation outside the United States. If an entity receives a significant portion of its cash flows from a non-US geography, the risk to those cash flows must be assessed, with a mark up to cost of capital, where appropriate. This is especially true for companies operating in emerging markets, where a mark-up to cost of capital is always made, even if the cash flows from those areas are currently strong and without incident.

All possible threats and the entity’s sensitivity to any related factors must be considered, including sanctions, tariffs, threat of retaliation of US Government actions, stability of currency, exchange control, inflation, threat of its neighboring countries, restrictions, etc.

At CT Capital, we evaluate 19 factors in our cost of equity capital model, including, in addition to the above, form of government, natural disasters, energy dependence, corruption and commitment to markets and business.

 

For additional information, please see “Security Valuation and Risk Analysis”

 

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The decision by Ford to eliminate its tax liability valuation reserve represents financial engineering in its truest sense. While, according to Bloomberg, the act will add $10 billion to $13 billion in net income this year, it has no impact on free cash flows.

Given the volatility in the automotive sector, there is little assurance that Ford will remain a tax paying entity, given it has received refunds (a negative tax rate) in four of the past 10 years.

Consistent tax rate companies at any level normally also have cash flows that are more predictable- Ford, it cannot be argued has been a historically consistent generator of free cash flows.

 

Owing to losses occurring during 2008, many entities were forced to establish or increase their valuation reserves based on their historical taxable income and projected future taxable income, including the expected timing of the reversals of existing temporary differences. If the entities operated at a loss for an extended period of time, were unable to generate sufficient future taxable income, or if there was a material change in the effective tax rates or time period within which the underlying temporary differences become taxable or deductible, these entities could be required to record a valuation allowance against all or a significant portion of their deferred tax assets, which could increase their effective tax rate for such a period substantially. This could affect cash flows for those firms that used a simple definition of cash flow as net profit plus depreciation.

 

Obviously, Ford management wished to avoid a continuation of this scenario.

 

Kenneth S. Hackel, CFA

 

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RISK RISING MODESTLY

Changes in risk-real or perceived-has been at the crux of every major economic and financial dislocation. Most recently, the fall in prices of financial instruments leading up to the 2008 worldwide credit crisis and subsequent 2009 price recovery began with a whiff of credit depression and later, relaxation.

Even for periods between crisis and recession, political and self-inducing events can place valuations and prices under strain, forcing an upward revaluation of cost of capital.  As such, equity investors must continuously monitor change in the financial markets risk profile. If the perception of risk is increasing, even if cash flows and credit health are currently strong, one should expect the prices of financial instruments to decline.

This risk to cash flows is incorporated and is the purpose of the cost of equity capital.

Current political tensions have slightly elevated the risk to free cash flows, causing us to raise our cost of equity capital by 15 basis points for all U.S.-based companies. From China to the Mid-East, the re-valuation of risk metrics in our models is apparent; however, an over-reaction to events  is also not justified given the factors we look at. We do not carry direct investments in the most effected countries.

Included in the factors we assess when assigning a cost of capital score for the sovereign risk metric include terrorism, inflation history, fear of nationalization, hunger, poverty, and corruption. Needless to say, most of these metrics pointed to the negative outcome we are witnessing today.

The groundswell that began in Egypt is empowering citizens around the globe, and while it has not spread to the most industrialized nations, it would be naive to assume, given large budget deficits in U.S. States and Federal government, there could not be some backlash here as well. Pensions and rising costs (education, food, and clothing) could spur scattered protests and widespread news coverage.

At present such risks are contained, but one which could impact both the current level of consumer confidence as well as capital decisions. And while a 15 basis point increase will not result in a shift to our current portfolio, it does serve to ratchet up the required return for making equity investments.

Inflation is also a weighty factor in the cost of capital, entering into both the risk free rate as well as other metrics.

It is difficult to find a reporting firm that has not been negatively impacted by the rise in input costs, with warnings of a continuing negative impact to come. In China, some companies are reporting wages are rising as much as 40% for factory workers. We currently assess a cost of capital for Chinese companies 75 basis points greater than Canadian companies given similar free cash flows and credit health. US firms receive a 25 basis point mark-up over Canadian firms.

Here in the U.S., yields are rising due to commodity cost pressure and, according to Federal Reserve data, lower foreign purchases of U.S. bonds. Hedge funds are also increasing their leverage, according to Federal Reserve data which tracks borrowing against bonds not tied to the US Government, as these funds attempt to leverage up.

While our credit models continue to indicate improvements to free cash flow, we are not seeing a strengthening in credit for the S&P Industrials over the past 2 quarters, which we can tie directly to the outlays for share repurchases.

All in all, we cannot be so blind as to ignore recent happenings, as is captured by our various model metrics, including credit spreads and political tensions. We see that yields on third world debt and credit default swaps have been rising as well, while the latter remain steady for U.S. fixed income instruments, perhaps a result of Federal Reserve policy and hedge fund buying.

With cost of capital having slightly risen, one would expect investors to pay closer attention to cash flow and credit. This has not generally been the case over the past year and a half, as evidenced by the tightness of junk bond yield spreads.

Kenneth S. Hackel, CFA

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A review of EDGAR filings, the SEC system for which public companies transmit financial information, finds over 90% of reporting companies defining free cash flow as operating cash flow minus capital expendituresExample:

MORRIS TOWNSHIP, N.J., January 28, 2011– Honeywell (NYSE: HON) today announced full-year 2010 sales increased 8% to $33.4 billion vs. $30.9 billion in 2009. Earnings per share (proforma) were up 12% to $3.00 versus $2.69 in the prior year, excluding the unfavorable impact of the pension mark-to-market adjustment. Reported earnings per share for 2010 were $2.59 versus $2.05 in the prior year. Free cash flow (cash flow from operations less capital expenditures) was a record $3.6 billion (cash flow from operations of $4.2 billion).

Source: Honeywell 8K

Unfortunately, corporate financial reporting does not often provide investors with an accurate assessment of the real free cash flows, and hence adjustments to reported financial statements are required. Free cash flow should be defined as the maximum amount of cash an entity could distribute to shareholders without impairing its rate of growth or through return of capital.

Hence, it is up to the analyst to reclassify those financing and investing activities which are more appropriately operating activities and, as such, would provide (potential) investors with a more realistic indication of the true free cash flow generating capacity of the enterprise. This is true even though classification of a particular activity is prescribed or generally accepted, as we see in the examples below.

Example:

For “payments to noncontrolling interests”, to whom as long as they continue to operate profitable operations may be due cash, payments are classified as financing activities while the purchase of the noncontrolling interests would be classified as an investing activity. Unfortunately, for investors who fail to reclassify the payments to the operating activity section, under the common definition of free cash flow, the reader of the financial statement is left with the impression of exaggerated, and incorrect, free cash flows.

For instance, AmSurg Corporation (AMSG), in partnership with physicians, operates surgery centers, where the partnerships may result in cash payments due the minority owners. Such operating cash payments which may result from profitable locations are as much a cost of doing business as payment of salaries or taxes. In common practice, the company classifies these outflows as Financing Activities, the payments representing “outflows or other distributions to owners”, as set forth under FAS 95.

Under the microscope of free cash flow, where free cash represents the income to shareholders of the common stock, the analyst would need to deduct such outflows, which in AmSurg’s case, is sizeable, accounting for over half of reported Cash Flow from Operating Activities (see below). To do otherwise would seriously misrepresent free cash flows as these payments could not be given to shareholders without impairing capital.

To conclude that AmSurg had free cash flows of $214 MM (we add sale of PPE in the Statement shown) would be incorrect. The analyst would need to reclassify the $130.9 MM as an operating activity from which capital spending and proceeds from PPE would be factored, leaving free cash flow as $83.1 MM, or 37% less than would normally be defined.

At CT Capital, as explained in Security Valuation and Risk Analysis, we also account for overspending in discretionary areas, so that, in the case of AmSurg, we would add $2.7 MM back to free cash flow to account for overspending in its cost of goods sold, which could represent overspending of many items in the production and sales process. We would also deduct half of the share repurchases, or $6.3MM, which represents that amount of cash necessary to maintain a steady share count over the prior year. Share based compensation has a real cost. The other half of the buyback would in fact represent free cash flow. Thus free cash flow for the year would approximate $79.5MM, which would depict the maximum distributable cash available for shareholder distribution, or free cash flow.

When making adjustments to published financial statements, the analyst must also adjust or normalcy of one-time (extraordinary) payments or events. Also, taxes, interest and dividends a firm would classify as an investing or financing activity should most often be melded into operating activities. This will also allow for better comparability.

AmSurg Corp.
Consolidated Statements of Cash Flows
Years Ended December 31, 2009, 2008 and 2007
(In thousands)

		2009				2008				2007
Cash flows from operating activities:
Net earnings		$	181,350			$	165,926			$	150,303
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization			22,927				20,815				18,648
Net loss on sale and impairment of long-lived assets			455				922				724
Share-based compensation			4,068				4,710				4,560
Excess tax benefit from share-based compensation			(32	)			(1,351	)			(3,322	)
Deferred income taxes			14,703				14,729				8,063
Increase (decrease) in cash and cash equivalents, net of effects of acquisitions and dispositions, due to changes in:
Accounts receivable, net			1,494				3,792				(2,300	)
Supplies inventory			(60	)			(83	)			47
Prepaid and other current assets			(733	)			2,344				(2,958	)
Accounts payable			1,289				(1,904	)			962
Accrued expenses and other liabilities			6,666				(487	)			8,128
Other, net			457				283				61
Net cash flows provided by operating activities			232,584				209,696				182,916
Cash flows from investing activities:
Acquisition of interests in surgery centers and related transactions			(95,826	)			(118,671	)			(162,777	)
Acquisition of property and equipment			(19,930	)			(18,379	)			(24,640	)
Proceeds from sale of interests in surgery centers			1,298				3,812				5,433
Repayment of notes receivable			1,666				1,458				2,616
Net cash flows used in investing activities			(112,792	)			(131,780	)			(179,368	)
Cash flows from financing activities:
Proceeds from long-term borrowings			137,178				157,787				178,316
Repayment on long-term borrowings			(116,951	)			(114,788	)			(89,712	)
Distributions to noncontrolling interests			(130,855	)			(118,769	)			(103,545	)
Proceeds from issuance of common stock upon exercise of stock options			201				9,970				17,661
Repurchase of common stock			(12,587	)			(12,413	)			–
Capital contributions and ownership transactions by noncontrolling interests			1,036				582				480
Excess tax benefit from share-based compensation			32				1,351				3,322
Financing cost incurred			(17	)			(41	)			(200	)
Net cash flows (used in) provided by financing activities			(121,963	)			(76,321	)			6,322
Net (decrease) increase in cash and cash equivalents			(2,171	)			1,595				9,870
Cash and cash equivalents, beginning of year			31,548				29,953				20,083

Exhibit 2

In the Statement of Cash Flows for Boeing (BA), we would reclassify both the “Payments to noncontrolling interests” and the “payments on guarantees” to the operating activity section, thereby reducing free cash flows. Payments on guarantees represent the impact and success of the firm’s operations, including its ability and technical skills in the manufacturing process as well as their ability to provide services promised, and should therefore be considered operating, not financial or investing activities. Payment on guarantees would be considered a reversal of profits, which is an operating activity under the indirect method.

The Boeing Company and Subsidiaries

Consolidated Statements of Cash Flows

(Dollars in millions)
Years ended December 31,		2009				2008				2007
Cash flows – operating activities:
Net earnings		$	1,312			$	2,672			$	4,074
Adjustments to reconcile net earnings to net cash provided by operating activities:
Non-cash items –
Share-based plans expense			238				209				287
Depreciation			1,459				1,325				1,334
Amortization of other acquired intangibles			207				166				152
Amortization of debt discount/premium and issuance costs			12				11				(1	)
Investment/asset impairment charges, net			151				50				51
Customer financing valuation provision			45				84				(60	)
(Gain)/loss on disposal of discontinued operations			36				(28	)			(25	)
(Gain)/loss on dispositions, net			24				(4	)			(38	)
Other charges and credits, net			214				116				197
Excess tax benefits from share-based payment arrangements			(5	)			(100	)			(144	)
Changes in assets and liabilities –
Accounts receivable			(391	)			564				(392	)
Inventories, net of advances and progress billings			(1,525	)			(6,168	)			(1,577	)
Accounts payable			1,141				318				(198	)
Other accrued liabilities			1,327				554				1,126
Advances and billings in excess of related costs			(680	)			(1,120	)			2,369
Income taxes receivable, payable and deferred			607				744				1,290
Other long-term liabilities			(12	)			(211	)			71
Pension and other postretirement plans			1,140				14				(143	)
Customer financing, net			104				432				1,458
Other			199				(29	)			(247	)
Net cash provided/(used) by operating activities			5,603				(401	)			9,584
Cash flows – investing activities:
Property, plant and equipment additions			(1,186	)			(1,674	)			(1,731	)
Property, plant and equipment reductions			27				34				59
Acquisitions, net of cash acquired			(639	)			(964	)			(75	)
Contributions to investments			(2,629	)			(6,673	)			(5,710	)
Proceeds from investments			1,041				11,343				3,817
Payments on Sea Launch guarantees			(448	)
Reimbursement of Sea Launch guarantee payments			40
Purchase of distribution rights							(178	)			(182	)
Net cash (used)/provided by investing activities			(3,794	)			1,888				(3,822	)
Cash flows – financing activities:
New borrowings			5,961				13				40
Debt repayments			(551	)			(738	)			(1,406	)
Payments to noncontrolling interests			(40	)
Repayments of distribution rights financing							(357	)
Stock options exercised, other			10				44				209
Excess tax benefits from share-based payment arrangements			5				100				144
Employee taxes on certain share-based payment arrangements			(21	)			(135	)
Common shares repurchased			(50	)			(2,937	)			(2,775	)
Dividends paid			(1,220	)			(1,192	)			(1,096	)
Net cash provided/(used) by financing activities			4,094				(5,202	)			(4,884	)
Effect of exchange rate changes on cash and cash equivalents			44				(59	)			46
Net increase/(decrease) in cash and cash equivalents			5,947				(3,774	)			924
Cash and cash equivalents at beginning of year			3,268				7,042				6,11

Additional disclosure: CT Capital is long AMSG for client portfolios

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Capital deploying investments typically have a negative effect on their current period’s cash flows. If viewed as projects which safely add to ROIC above cost of capital, such investments can be expected to benefit shareholders, even if the short-term cash flows are impaired. As firms ramp up production or go through the common but expensive integration costs, investors should not lose sight of longer term benefits. Unfortunately, this is often not the case, and so, for investors who can spot and take advantage of the market’s skepticism, superior returns await.

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(The following article appeared on CNBC’s Guest Blog on Friday, January 7^th, 2011.)

If you really want to know what will happen to stock prices, look no further than the cost of equity, also known as the discount rate.

Put simply, this arcane-sounding metric is a stock investor’s return requirement for making a particular investment. The more the risk, the higher the expected return.

But the real question is: How should investors measure risk?

Academics believe it should generally be tied to the risk-free rate like the 10-year Treasury yield plus a mark-up for the volatility of the stock.

They’re wrong, and here’s why it is important:

A change in perceived risk significantly alters a firm’s fair value, even when current free cash flow and growth rate remain unchanged.

For example, a one percentage point rise in a company’s cost of equity to 9% from 8% equals a one percentage point rise in risk. That one percentage point rise in risk, in turn, translates into a staggering 25% decline in fair value. If the company’s risk rises further – to, say, a 12% cost of equity — the fair value should be expected to fall by 57%.

That’s why the cost of capital is so important. If a company’s cost of capital rises, its share price, must, by definition, fall until it reaches its new lower fair value, as shown in the following table.

In general, risk is measured by the uncertainty of the firm’s future free cash flows. Free cash flows are, in essence, the income to the investor; they represent the maximum amount of cash the firm could distribute without impairing its growth.

Sure, analysts use other measures to arrive at fair value, including market value of the individual parts, liquidation value, price/sales, price/earnings, or price/book. Book value has proven to be an unreliable metric if the book consists of assets where buyers at fair market prices are absent. What is the value of an asset for which there are either no buyers or buyers at unreasonably low prices?

It is the free cash flows, which must then be discounted. But at what rate?

In order to arrive at a fair value estimate for an equity security, an analyst or investor must discount the firm’s free cash flow by a rate equal to the perceived risk. And the risk is a reflection of the uncertainly of the free cash flows. Treasuries will be discounted at the risk free rate plus a small mark-up for the loss of its investment grade status. The amount of the markup is up to the analyst.

That’s why estimates of free cash flow and earnings are called estimates! And because they’re estimates, they’re at the whim of such risks as the loss of patents or customers, volatility in input costs, litigation, inadequate insurance (e.g., BP (BP) was self-insured), foreign government-related issues and rollover of debt, whatever. These risks must be captured by the cost of equity. The fewer and less serious these risks are, the more certain we can feel about the free cash flows. For such an enterprise with above average normalized free cash flow and moderate leverage, lower cost of equity will normally place the entity in a position to add value-adding projects with more facility than its competitors.

The ability to assess risk to the free cash flows through the adjustment of the cost of equity (discount rate) will provide you with a tool which will place you head and tails over just about every securities analyst you see on CNBC or elsewhere. I can also assure you that over the coming years you will be hearing and reading a lot about the appropriate setting of the cost of capital.

So where do things stand now?

According CT Capital LLC’s comprehensive credit model, and, as outlined in my text, “Security Valuation and Risk Analysis,” (McGraw-Hill), the fall in yield spreads, sovereign risk, improvement in credit strength, and rise in free cash flows, have reduced the cost of equity capital to 7.9% for the S&P Industrials from 8.3% a year earlier. Thus, one should expect a 7.9% return for the S&P over the next year, based on the current level of risk.

So, next time your hear during a company presentation or read in an analyst’s report a cash flow estimate, make sure you understand all of the potential risks to the forecast, made possible through a thorough reading of all SEC filings, for in so doing, your expected return will not only shift, but be more realistic.

Kenneth S. Hackel is president of CT Capital LLC, an institutional investment advisory firm. An internationally recognized expert in security analysis, he has managed the nation’s leading mutual fund, a large investment advisory firm, and has consulted and written on mergers and acquisitions and fairness opinions. He is the author of the leading textbook on cash flow based security analysis,“Security Valuation and Risk Analysis.” To read more visit his blog,www.credittrends.com. You can contact Ken here or request additional information on institutional US Equity advisor, CT Capital, here.

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As I have long pointed out, firms which can add to their capital base projects that are value adding (have a return on invested capital (ROIC) greater than cost of capital, with a good margin of safety), will reward shareholders. But what happens when firms cut back their own such spending or have the ability to piggyback others’ capital or resources, such as R&D or support functions?

As the current period of slow economic growth continues, firms may continue to ration their capital base, seeking creative means toward higher free cash flows. Included will be using “others” capital as well as the time-honored low cost producing outlets.

Companies can, especially as the trend to low-cost manufacturing countries evolves, be expected to continue to reduce their property, plant and equipment (PPE) relative to revenues, with a resultant increase in balance sheet cash, short-term investments, and expansion opportunities. Certainly, Apple Computer (AAPL) has been a leading company in this regard, and in the process has been generating very high amounts of excess cash. Investors are, in Apple’s case, ignoring the very low returns on its cash in their valuation of the company, focusing instead on its high economic profit.

As industrial efficiencies evolve, improvements in technology take place, and management consultants develop techniques to enhance supply and production methods, productivity improves and the growth rate of productive capital falls. This need for less capital intensity positively affects return on invested capital, cash required and financial ratios.  McKinsey & Co. found the median level of invested capital for U.S. industrial entities dropped from around 50% of revenues in the early 1970s to just above 30% in 2004.^[1]

What McKinsey found in 2005 has only picked up momentum since. Worldwide competition for sales and market share, especially as economic growth has slowed, has led to additional expense skimming and creative means to reduce or minimize the capital base given a projected revenue stream.

For certain industries, which have a naturally low capital base, such as service-oriented entities, return on invested capital will be naturally high. And for manufacturing entities which effectively utilize outsourcing or other entity’s capital for a substantial part of assembly or service, they too, would have an unnaturally low capital base resulting in high ROIC. That does not make return on invested capital any less important; however, we introduce another measure, which is intended to evaluate the cash return on the company’s deployment of resources—its economic profit. The economic profit should then be compared to sales. Doing so can remove many of the distortions of ROIC and improve inter-company comparability.  Even when ROIC makes sense, economic profit should be employed as another measure to evaluate the firm.

Economic profit could also be related to other firm factors, such as total employees or units sold. Doing so would provide the analyst with comparability measures specific to a particular industry or situation. When used in this way, economic profit can indicate management ability to create value relative to its peer group or the direction and efficiency of its spending. For example, a pharmaceutical company analyst may wish to look at the economic profit per researcher.

Economic profit is defined as a company’s free cash flow exclusive of interest income minus a capital charge, with the charge calculated as the company’s weighted average cost of capital multiplied by the operating invested capital. The traditional definition of economic profit utilizes after-tax operating profits in lieu of free cash flow.

Example

Calculating the 2008 Economic Profit for 3M (MMM) using the following financials:

From the free cash flow, interest income is subtracted since we are computing the economic return on the invested capital, not the total free cash flows, which include the returns on the financial assets as well.

MMM’s economic profit was $ 2.2 bn. during 2008

When we compare MMM’s economic profit to its 2008 revenues of $ 25,269 mil, we arrive at 8.9%, which could then be compared to its historic results or to other companies in its industry.  The economic profit could also be related to employee headcount or other useful factors important to the company.

Example:

This is how Clorox (CLX) computed its economic profit for fiscal years 2007-2009. As seen, it utilized a partial cash flow format by excluding some non-cash charges.

Source: Clorox Corp 2009 10K

Clorox could have taken its definition a step further, as we did with MMM, by substituting free cash flow for operating profit, since operating profits are subject to GAAP and we are gauging cash return, to compare the result to revenues or other useful measures, including invested capital.  We believe our definition of free cash flow and capital employed to be more reflective of invested capital than is Clorox’s definition. Clorox uses a weighted average cost of capital (WACC) of 9% but doesn’t reveal how that was determined. It is most likely they are using the Capital Asset Pricing Model (CAPM) to compute the equity cost of capital.

I have found that firms that focus on economic profits as well as ROIC, have a greater tendency to engage in value creating opportunities. The beneficial effect of higher free cash flows results in superior stock performance for their shareholders. The trend toward using other entity’s capital is not confined to the manufacturing sector, as service entities also deploying labor outside of their cost structure.

Related articles:

• How I Learned to Stop Worrying and Started Analyzing Risk
• Why Cash Flow from Operations Must Be Adjusted
• Apple Inc. (AAPL) – CT Capital’s Fair Value Estimate
• Credit and Cost of Capital As Superior Predictors of Recession, Expansion and Stock Prices
• What Return Can Stock Investors Reasonably Expect?
• Do You Really Understand Cash Flow Analysis
• New Age Security Analysis
• Use ROIC, Not EBITDA for Superior Performance

Disclosure: No positions

Kenneth S. Hackel, CFA
President
CT Capital LLC

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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

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[1] McKinsey & Co. study based on an analysis of more than 600 companies with sales of more than $ 100 mil. “Comparing Performance when Invested Capital is Low,” 2005, McKinsey Quarterly.

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“don’t rock the boat, don’t tip the boat over
rock the boat, don’t rock the boat baby
rock the boat-t-t-t-t”

– Hues Corporation

The current bull market in equities, taking the S&P 500 from a fall of 10% to a rise of 14%, is making many investors complacent when, perhaps, they should be acting. Investor analysis and action has greater implications if interest rates and cost of capital rise, which would be common at this stage of the economic cycle. Firms which have a large spread between their cost of capital and return on invested capital (ROIC) will have a critical advantage over those firms which have more narrow spreads, which will ultimately lead to earnings and cash flow disappointments for the latter group. To the extent the bull market has made these firms overvalued, their stocks should be sold.

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