Credit Trends

There is not a single firm that measures risk as we do. As you know, we have been bearish on stocks for the good part of a year. Even when stocks were reaching new post-credit crisis highs, we did not bulge.

Why?

Because every firm measures risk using the same old, worn-out, models that base risk off of volatility or non-distributable earnings.

We measure risk using the most important factors to a business. Items including sales growth, sales volatility, cash burn, credit spreads, ability to roll over debt, foreign risk, insurance, possible loss of a patent or key executive, taxes, and over 60 other variables.

Everything we do is more intensive.

From how we define free cash flow which includes excess expenditures to invested capital which is based off of our proprietary free cash flow.

Maybe you would benefit from learning these credit and cash flow methods?

If you are interested in becoming a better securities analyst, pre-order “Security Valuation and Risk Analysis” available at all online book outlets.

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I doubt the merger talk making today’s news will lead to a buyout of BP.

There is just too much unpredictable risk involved and the size of any buyout too large ($100 billion+), to say nothing of probable earnings and cash flow dilution, for such a deal to have merit.

As for Exxon, the name most prominently mentioned, I would be shocked if they accepted the risk a buyout of BP would entail, especially given a glut of oil going into a period of a worldwide economy showing clear signs of fragility.

While we have written we expect BP to engage in at least $10 billion in asset sales, which should be part of a program to bring the cost of capital down, and which should aid the stock price,a full out buyout is quite unlikely.

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Despite a free cash flow multiple that would normally signal a rally in the equity markets, stocks are sinking.

Even we started to believe, after being negative most of  the year, we would see such a rally, given the past 25 years of data. Investors are not lengthening their time horizon, preferring to focus on an increased cost of capital, rather than potential return-unfortunately, there is no way of forecasting an end to this current valuation/risk matrix, which can, in fact, exist for many years.

Why has this been the case? The answer lies in the cost of equity capital, the true and only real measure of fundamental risk, which began the year for the S&P Industrials at 8.3%, but now stands at 9.1%. Simply put, investors are demanding a 9.1% return to invest in the average equity, or else are content to “sell” or sit on the sidelines. At CT Capital, we measure at least 60 metrics of cash flow, credit, and other variables, fundamental in nature, which measure everything from a firm’s cash flow consistency to its credit spreads-and, by and large, the cost of equity has been increasing, with minor exception, throughout the year. We believed the low valuation multiple would overcome this, but thus far has clearly not been the case. Currently, 9.1% expected returns are not readily available, and thus despite a 16.2x free cash flow multiple, compared to the average 21.5 multiple of the 1990’s, a rally is not in sight.

Equity markets are normally volatile when cost of capital and free cash flow multiples are moving in opposite directions, so that alone does not scare us.

Despite the S&P, when looking at our free cash flow/cost of equity model, showing undervaluation of 7.1%, we should not expect an equity rally until there is a sustained improvement in risk. While at market peaks, little attention is paid to risk, at current, the 7.1% undervaluation is not sufficient reward to entice investors given the risk to corporate cash flows. This risk may not be apparent with the upcoming earnings season, even though much of the free cash flows reported last quarter represented managed expense and catch-up spending, rather than add-on growth.

As such, we would move portfolios back to maximum cash until cost of capital falls back to below 8.5%.

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The company must:
1-Produce detailed pro-forma five year financial statements showing they have the capacity to make it through the period given the steps below.

2-Announce a sale of 1 billion shares, something we called for at the very beginning of the event, and has, by delaying, cost the firm at least $5 billion. The UK Government might be needed now to buy half the shares, which they will agree not to sell for at least ten years.

3-Announce asset sales of at least $5-$10 billion

4-Sell production into the futures market, thereby taking in at least $15 billion, of future revenue.

5-Announce they are eliminating the dividend for at least three years.

6-Work out a back-up contingency loan with the UK, at a very low rate, perhaps, with an equity kicker, if needed.

7-Cut back capital expenditures to no more than $ 15 billion, the level of 3 years ago.

If they announce and carry out these measures, I am confident the stock, after perhaps an initial fall, will rebound 20% from current levels, given no further setbacks in the Gulf of Mexico. They will have provided investors and current and potential creditors of the financial flexibility assuring not just their survival, but normalized growth. With the capital raise, and corporate squeeze on spending, they will have at least $75 billion currently needed to reduce their current high cost of capital.***************

*****************UPDATED FAIR VALUE TABLE IF BP DOES NOT TAKE 7 STEPS**************************

FAIR VALUE =$20.48

			Year
Discount Rate	11%	Probability	1	$       3.00
Present Value	$31.1	35%	2	$       1.00
			3	$       2.00
			4	$       3.00
Discount Rate	12%	30%	5	$       3.00
Present Value	$28.14		6	$       3.00
			7	$       4.00
Discount Rate	15%	15%	8	$       3.00
Present Value	$21.58		9	$       3.00
			10	$       4.00
			11	$       5.00
Discount Rate	18%	15%	12	$       5.00
Pres. Val	$17.22		13	$       5.00
			14	$       5.00
			15	$       5.00
Discount Rate	25%	10%	16	$       5.00
Pres. Vale	$11.39		17	$       5.00
			18	$       5.00
			19	$       5.00
Current FV		$20.48	20	$       5.00
			21	$       5.00
			22	$       5.00
			23	$       5.00
			24	$       5.00
			25	$       5.00
			26	$       5.00
			27	$       5.00
			28	$    30.00

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Even if absolute certainty existed with regard to a firm’s cash flows, earnings, sales and equity, its stock would still have risk, such as inflation, potential litigation, management change, loss of a patent, currency exposure, or any of many potential macro events.

When one introduces typical risks that confront a business daily, and I would include recent events in Greece and BP among them-an investor may believe the quantification of such risk is impossible.

I can tell you this is not the case.

We use a checklist of such events, both common and those very infrequent, and the only real risk is, I have found, to ignore their possibility. This is why I hope you order “Security Valuation and Risk Analysis” on Amazon or other online outlet. I am releasing a credit spreadsheet which will save you a lot of grief and perhaps a lot of money. It is also, of course,  intended to help you earn you superior returns by helping you point out firms which investors in general do not recognize, or have overstated their risks. The spreadsheet will help you in fundamental security analysis on a level which is not being done by any firm or analyst today-it will force you to examine and make adjustments to cash flows and risk, as measured by the cost of equity capital, which, I am sure, will place you head and shoulders above the competition.

In the meantime, please visit this site often, as I plan on releasing tidbits (but not the credit spreadsheet) which will be of help. For example, see the recent post of how to make adjustments to cash flow from operations.

If you are surprised by risk in the stocks you own, you probably didn’t do your homework.

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The firms in the following list all derive at least 10% of their sales and operating profits from the Asian region and have at least 10% of their total assets there.

Disclosure: No positions

Kenneth S. Hackel, C.F.A.
President
CT Capital LLC
www.credittrends.com

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The median free cash flow multiple for the S&P Industrials fell to 16.8x and the cost of equity to 8.6%, the first time this has occurred in four months.

This is a bullish sign given the free cash flow multiple is in the bottom half of the valuation funnel. Holding the equity market back thus far in 2010 has, no doubt, been the upward re-valuation of risk. A large caveat is the cost of capital (risk), is in the top half of historic ranges, indicative of a volatile equity market with considerable risk. When the two are placed into a model, total valuation is indicative of an undervalued equity market which bears slightly more reward than risk for the patient investor.

Given the cost of capital/free cash flow valuation is in the lower half of the funnel, it would appear, baring an increase in the cost of capital, the nascent rally has a good chance for continuation over the coming year. As a whole, the S&P Industrials are undervalued by 5%

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These past several weeks saw the stock of one of the world’s largest firms plummet, with only minor, as yet, effect on cash flows. It was of course risk, or more correctly, impending risk to cash flows, that worried investors in both equity and fixed income assets of BP.

While surprises cannot be predicted, security analysts must constantly evaluate all risks, for even in BP’s historic 10Ks, we learned the extent of their insurance coverage for an event of this magnitude; and insurance adequacy is but one of the 60+ variables we look at in constituting the cost of equity, the required return shareholders expect.

We will learn more of these other risks in later blogs, any one of which could cause a seismic shift to valuation. Today, we will look at the risk to cash flow from operating activities. We will see, also during a later blog, we measure consistency of many factors, operating cash flow included.

The operating cash flow of the company in our credit spreadsheet is from the form 10K’s and 10Q’s. Cost of capital is penalized if operating cash flow (OCF) is negative. The greater the number of periods for which OCF is negative, the greater then penalty.  For some items such as postretirement benefits and other retirement obligations, we include the net cost for the period rather than actual cash outflows, in order to separate what we view as financing of these obligations from the operating cost component.

Adjustments to the operating cash flows may be made to the extent current reporting obscures the ability of the analyst to place a correct economic valuation on the enterprise. For example, the sale of accounts receivable would be picked up under operating cash flows, if reported as a financing activity. Capitalizing interest would be reclassified from investing to operating cash flow, as might interest, dividends and taxes that have been reported as investing or financing activities.

The signing of capital leases may artificially enhance operating cash flows. This is because that while the interest portion of capital leases are counted as an operating activity, the reduction in the lease, through those principal payments, are reported as a financing activity. We typically make adjustments to reported operating cash flow to remove items we consider nonrecurring and include those we consider recurring, so the historical financial ratios will be more indicative of future performance. These adjustments cover items including discontinued operations; effects of natural disasters; gains or losses on asset sales and sale/leasebacks; and one-time charges for asset write-downs, restructurings and plant shutdowns.

Other adjustments could be made to allow for better comparability among peer companies and to derive actual cash from operating activities which may be included as financing or investment activities. The nature of any adjustment is to more accurately reflect the ability of the enterprise to satisfy its obligations and enhance forecasting. When making adjustments, they must be consistently applied or comparability will be lost.

Typically, companies need to generate cash from their operations in order to survive. However, businesses may from time to time show negative operating cash flows in trough years, which should be offset by larger positive operating cash flows in good years. Similarly, a company may occasionally have, due to adverse business conditions or changes in balance sheet items, a year in which cash from operations is negative. However, an enterprise cannot sustain negative operating cash flows for long periods without obtaining additional financing, liquidating assets, or falling into bankruptcy.

If the firm’s business is contracting, the firm’s executives will attempt to extract cash through “working” the balance sheet, in which case we will see considerably stronger operating than power operating cash flows (which adjust for a normalized balance sheet)  and net income reported under GAAP. In these instances, power operating cash flow metrics would be granted greater weight than operating cash flow metrics.

For a complete discussion on this topic as well as all metrics in our credit spreadsheet, please order “Security Valuation and Risk Analysis,” Kenneth Hackel, C.F.A, at Amazon and all online bookstores.

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If the equity market were to rise less than 7% this year, the following firms would be particularly impacted. Column 3 shows some firms have expected returns of 9%, which would appear particularly optimistic, especially since all firms on the list have plans that are underfunded by at least $1bil. and have a substantial asset allocation to equities.

Disclosure: No positions

Kenneth Hackel, C.F.A.
President
CT Capital LLC

www.credittrends.com

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We have run our free cash flow model given an expected haircut to BP’s (BP) free cash flow (less so this year) with a very gradual build. We have also upped the cost of equity to both 10% and 11%, (although we are now using 11% in our own model).

We have also run more conservative estimates, which show a large hit to free cash flow than is being used by the average analyst. For example, in Scenario 1, we show zero free cash flow in 2012, and model minimal free cash flows in 2011and 2013-2015, with a permanently reduced impact in the years 2016-2023. The same free cash flows are used for Scenario 2 except with an 11% cost of equity (COE).

An average of the 4 scenarios, based on 15% probability for scenarios 1 and 2 and 30% probability for Scenario 3 and 40% for Scenario 4, equates to a current fair value of $36.24 a share. Of course, if one believed the bullish free cash flows of Scenarios 3 and 4 to be more likely, then fair value would be closer to $41.

We feel confident that cost of equity is at least 11%, especially given BP’s current 8.5% bond yield. This being the case, unless an investor was fairly confident BP would see the estimated free cash flows realized, there would appear to be greater value elsewhere in the financial markets than BP.

Kenneth Hackel, C.F.A.
CT Capital, LLC

www.credittrends.com 
Follow me on twitter @credittrends

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A story that never received the proper publicity during the bull market of 2009-2010 was its very positive (savior) effect on pension funding status, and employer contributions. The rise in equity markets allowed many hundreds of billions of dollars to appear on the balance sheet as equity instead of having to be spent to plug the pension gap.

But most of those firms which benefited are not out of the woods, as the negative stock performance during 2010 is sure to re-introduce such large employer expenditures which could very well impair security analyst estimates.

The following is a list of firms which

• Have, for their most recent fiscal year, accrued a greater expense for their pension plans than they actually contributed;
• Have seen a decline in the value of their plan assets over the past 2 years;
• Have either maintained or increased their discount rate (assumed rate of return) over the past 2 years;
• Have seen an increase in their pension benefit obligation over the past 2 years.

Table 1[1]

Source: S&P Data Services, Company reports

Presumably, firms which have suffered a decline in their plan assets should not be forecasting an increase in their settlement rate, which is the rate their projected benefit obligation could be settled. Firms might do this to show a lower liability and to lower their plan contributions. Their auditors and actuaries should only allow this for a short time before demanding stepped-up contributions.

The following table shows, for the same firms in Table 1, last year’s pension expense as a percentage of net income, the funded status of their plans, these firm’s total debt which to which we include operating lease obligations and shareholders’ equity.

Table 2

Source: S&P Data Services, Company reports

While there might be to some, a number of surprising names on the list, keep in mind that additional large funding into the plans would most likely cause a disappointment to earnings estimates, even though the firm might have the credit capacity to fund with low cost of capital. In the game of expectations, such firms are particularly vulnerable given their funding status and have not, of late, contributed their actual expense.

Several firms on the list look particularly vulnerable. One such is Goodyear Tire (GT), whose plan (see Table 3 summary below) is very underfunded, they have not had the financial ability to catch up, and have a high cost of capital. However, as the list shows, many firms are vulnerable.

Table 3

Source: S&P Data Services, Company reports

The pension and other post-retirement benefit area should be receiving greater scrutiny that it currently receives, as time is sure to tell.

Kenneth Hackel, C.F.A.

President, CT Capital LLC
www.credittrends.com

Data Source: Research Insight, CT Capital, Company 10Ks

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[1] Pension-Funded Status Indicates the funded status of a pension plan as either overfunded or underfunded.  This item is the sum of: Pension – Long Term Asset  minus the sum of  (1) Pension – Current Liability and (2)   Pension – Long-Term Liability

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Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making

Kenneth S. Hackel, C.F.A.

Reason Book was Written: To introduce a successful and innovative approach to the valuation of equity securities.

Central Tenets: (a) Cost of capital, a principal component of valuation, should not be determined by stock volatility, as is widely practiced by enterprises, investors, consultants and security analysts, but by the entity’s cash flows and credit health; (b) Return on Invested Capital (ROIC), a principal component of valuation, should be measured as a function of the assets production of free cash flows, as it should benchmark the expected cash return for cash expended, and (c) Free cash flow should include cash the entity could easily free up, and this can be captured thru analysis of various discretionary spending areas. EBITDA, an income statement based accounting concept, is not a measure of the true economic return.

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Sell 1 billion shares at $30 per share and agree to eliminate the dividend for 3 years.

Currently, BP pays about $10 bil. a year in common dividends, so that after 3 years, if the company’s normalized free cash flows continue at the past three year rate, and the $30 bil. is dispersed, their book value will not have declined, as BP managers will be working all discretionary expenditures to generate cash.

They will then have $60 bil.+ ( with interest) to pay claims, which would be more than sufficient as cases drag through the courts and perhaps funds could be set up to pay effected parties. More than likely, given BP’s current balance sheet, they would have closer to $ 68 bil. without impairing its current financial structure.

As much as BP is making horrific headlines now, in three years, it will be a bad memory for most-the world will have gone through many crises by then.

If the price of crude rises, BP’s cash flows will be much stronger- as much as a combined $ 100 bil in operating cash flows and $40 bil. in free cash flow, with the added free cash available to pay claims, making for a total $75 bil.+ without severely impacting current financial structure.

With $75 bil.+,  BP would approach and put together various insurance syndicates with the huge pool in guaranteed funds to take over the liability.

Given the cost of the Exxon Valdex cleanup was $ 2.1 bil., with another $1 bil or so (after insurance) to settle claims, it is doubtful BP cannot satisfy claims from its financial flexibility.

After a couple of years, as it becomes apparant BP will work itself out of the disaster, and as management begins to “mop up” the additional shares from free cash flow, its stock should be at a level seen early this year. If the price of crude were to rise above  $ 95 bbl, the share price of BP could be expected to rise substantially.

As for the immediate issuance of equity, would BP be able to float the issue? Given its trading volume is averaging 300 mil shares a week on the NYSE alone, a deal that size would seem quite do-able.

The company’s first step, is to hit the equity markets for the raise. After the deal is placed, there is a good chance for a rebound in the shares.

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For most industrial entities, return on invested capital (ROIC) represents the most important measure of management ability. Projects whose ROIC exceeds its cost of capital, create value, and as value-enhancing projects continue to grow, the results are reflected in the acquirer’s share price. If the executives in charge of the firm’s assets are consistently able to invest in such projects, it represents the most management- proven technique to reward shareholders looking to build long-term value. Improvements in ROIC are seen in companies able to achieve higher margins, stronger cash flow, and low cost of capital.

For entities which operate on minimal capital, we employ a technique which is based on ROIC, but works better, since, as ROIC approaches zero, it results in extremely large, impractical returns, both positive and negative.

As Oracle Corporation, a very successful acquirer, wrote in its 2009 10K report: “We estimate the financial impact of any potential acquisition with regard to earnings, operating margin, cash flow and return on invested capital targets before deciding to move forward with an acquisition.”

When interest rates are low, corporate planners evaluate taking on projects they might not consider when interest rates are higher. The saving on cost of marginal debt might make such projects worthwhile for equity holders. However, if the cost of debt is variable (i.e., tied to LIBOR) and interest rates rise, the project might become unprofitable. For this reason, that possibility is almost always hedged, allowing the enterprise to eliminate that risk.

Return on invested capital is becoming one of the more widely used analyst metrics. It is of particular relevance however, when under competition with the entity’s cost of capital. By itself, only a vital, but often, partial picture emerges. And for entities or divisions of entities which cannot earn a greater return (on projects) on their invested capital than their cost of capital, its value will decline.

The ROIC is not a measure of security valuation. An entity can continue to accept projects which exceeds its cost of capital, but if its valuation multiple is excessive, its stock could very well decline in the short-run.

Entities which are underleveraged may be denying shareholders a higher valuation if they decline projects having a ROIC greater than the after-tax yield on the excess cash and cost of debt.

Corporate managers evaluate the firm and the business units return on invested capital versus those units cost of capital. Underperforming assets typically have a specific period to improve performance before strategic alternatives are considered. The inability to successfully divest or improve the returns on such assets in a timely manner, meaning, if the unit cannot achieve its cost of capital, could have a negative effect on the entire operations of the enterprise, including its stock price. Management attention is diverted to underperforming units in hopes of turning them around or getting them ready for sale. In addition, the process of divestitures could cause strains on the remaining business segments in need of cash to expand or retool their operations.

The theory behind return on invested capital is to present investors and creditors with an accurate measurement of the cash on cash return management has been able to earn. They need to spend cash to purchase assets in the hopes of a cash return greater than the cost to acquire them.

It is for this reason the analyst should not begin with a GAAP measurement such as net income or EBITDA, but rather free cash flow, in the computation of return on invested capital. Creditors, as with stockholders, expect a cash return, which may not be possible with accounting profits.

EBITDA INAPROPRIATE AS A VALUATION TOOL AND IN MERGER ANALYSIS

Return on invested capital, being one of the central determinants of valuation, has clear advantages over the use of EBITDA.

For example, EBITDA:

• excludes important tax payments that represents a reduction in cash available;
• does not consider capital expenditure requirements for the assets being depreciated and amortized that may have to be replaced in the future;
• does not reflect changes in, or cash requirements in working capital needs; and
• does not reflect the significant interest expense, or the cash requirements necessary to service interest or principal payments, on debt.

Even in a merger analysis, for which EBITDA was originally intended, its use is limited. In addition to the above drawbacks, it may not be useful since it:

• does not include share-based employee compensation expense, goodwill impairment charges and other charges which can impact prospective free cash flows;
• does not include restructuring, severance and relocation costs incurred to realize future cost savings and enhance the operations of the entity;
• does not include the impact of business acquisition purchase accounting adjustments;
• does not reflect company sale transaction expenses and merger related expenses, and
• may include other adjustments required in calculating debt covenant compliance such as pro forma adjusted EBITDA for companies acquired during the year.

To begin analysis of the ROIC metric, we first look at how return on invested capital is commonly defined by security analysts and enterprises, as a search on EDGAR, the SEC database reveals. Here too, as with free cash flow, definitions reported in financial statements differ for filers, making comparability often difficult to impossible. As with free cash flow, many firm’s tailor-make a ROIC definition, attempting to both place themselves in a favorable light, and adjust for peculiarities of their business.

A search through the Edgar database reveals a commonly used definition of ROIC to be:

ROIC=(EBITDA+Interest Income*(1-Tax Rate)+Goodwill Amortization)/(Total Assets-(Current Liabilities+Short Term Debt+Accumulated Depreciation))

National Semiconductor, has an even simpler definition, as spelled out in their 2009 10K: “We determine return on invested capital based on net operating income after tax divided by invested capital, which generally consists of total assets reduced by goodwill and non-interest bearing liabilities.”

Not only does beginning with EBITDA suffer from the shortfalls listed above, it is not a measure of distributable cash and is thus not a measure of real return to holders of equity securities. Excluding goodwill, like National Semiconductor, ignores a real cash outflow for which management is expected to earn free cash flows.

A SUPERIOR ROIC METHODOLGY USING FREE CASH FLOW

Using free cash flow as a base allows for comparability, uniformity, and offers what ROIC is really supposed to capture, the cash return on cash spent for capital. A more logical definition for ROIC, and one being proposed for analyst adoption to be:

 ROIC= (Free Cash Flow-Net Interest Income)/(Invested Capital (Equity+Total Interest Bearing Debt+Present Value of Leases-Cash and Marketable Securities) )

This more precise definition includes:

• Intangible assets, as those funds were used to acquire cash producing assets
• All interest bearing debt, as they too were sold to purchase productive assets
• Present value of operating leases, as this represents contractual debt in exchange for required assets needed to produce revenue, hence cash flows. To exclude operating leases would be to unfairly boost the return on invested capital and to distort the comparison between companies that buy assets or enter into capital leases and those that enter into operating leases.
• Since free cash flow is used, it includes the payment of cash taxes and the elimination of other accruals.

We do not add back, as true with EBITDA-based measures, interest income to free cash flow as we are attempting to measure the cash return on productive, not financial assets.

Investors, large and sophisticated to small and naive, with the latter often dependent on, and trusting of the former, often fail to understand the complicated relationship between valuation metrics and return on invested capital.

It is easy to want a simplified approach to investing, such as price/earnings multiple or price/book, but quite another to be able to and understand the bearings behind the numbers, and why so many entities sell for what appears to be an incredibly low valuation multiple or ratio.

In essence, entities having a low return on invested capital or dependent on large capital expenditures resulting in small amounts of distributable cash flows deserve low valuation metrics despite their higher rates of growth in GAAP related yardsticks. This is why many investors are fooled having invested in low P/E multiple companies. It is for this reason we advocate adoption of the return on invested capital metric using free cash flow as a base and, in our model portfolio only invest in entities which have shown the ability to consistently produce an average free cash flow yield in excess of the 10 year treasury yield.

Under the cash flow based definition, goodwill, intangible assets, and all other productive assets which required cash expenditure are counted in the capital base. Operating leases should also be included in the capital base, as they represent a financing decision for capital expected to return cash to the firm. We would not, however, impute an interest charge on the operating leases to deduct from free cash flow, as the entire lease payment is deducted in the computation of free cash flow, as reported under operating activities.

You will find by using the more precise and logical definition of ROIC, to be used in comparison to cost of capital, your portfolio will exhibit lower risk and higher returns.

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Insurance is most often a missing link in fundamental security analysis.

For example, despite BP’s strong credit health (was rated “A” by credit trends) to date, its lack of adequate coverage related to the spill ($1 bil. per occurrence) has caused us to raise our cost of of capital on the firm by 500 basis points. By so doing, the stock has become over-valued at these levels, despite producing over $ 18 bil. in free cash flow during 2008 and $9.7 bil during 2009. Recall our free cash flow model includes the addition of a portion of discretionary expenditures.

If however, the price of crude, a sensitivity analysis reveals, were to rise to $98/bbl, cash flow from operations over the coming two years would approximate $70 bil, when including the added efficiencies of working capital, capital spending, and other discretionary expenditures.

Insurance and Litigation
The role of insurance is an often underappreciated and under-analyzed area of security analysis, which could affect the cost of capital if it was insufficient or its cost grew greater than the rate of growth in operating cash flows.

Regarding uninsured losses, current accounting rules require a company disclose “specific quantitative and qualitative information” about loss contingencies, but does not require them to provide for the fair value impact losses would have on earnings or cash flows. Insurance adequacy is, unfortunately, rarely discussed during investor conferences.

Needing to be uncovered are:
• How is the company protected in the event of major damage to its computer system or warehouse?
• What is their coverage for product liability?
• How are they protected for worst case scenario in the event of a cyber attack, business interruption, due to strike, fire, or power outage?
• Is key man life insurance required to attract a replacement executive?
• Are they attempting to save cash and under-insuring?
• Does the firm require back-up facilities or other redundancies? Are they adequate to allow them to continue providing goods and service?

Example
Murphy Oil had large uninsured damage, impacting free cash flow, during 2006:
Uninsured damages, higher insurance premiums, settlement of the class action oil spill litigation and other hurricane-related pretax costs in the company’s North American operations were $3.0 million in 2007 and $107.3 million in 2006. The hurricane expense in 2007 was caused by a downward adjustment of expected insurance recoveries based on an updated loss limit published by the company’s primary insurer.

Security analysts are typically late in their evaluation of insurance adequacy, relegating their questioning to an event that has already occurred or is forecast, necessitating a review. Not true for the entity itself. For this reason, all large companies have dedicated employees, if not departments, whose sole purpose is to handle the insurance for the organization. If not for insurance, many companies would have filed for bankruptcy, the policies allowing them to collect cash resulting from large lawsuit awards or other catastrophic events. Many firms with facilities on the Gulf Coast of Louisiana would certainly have been out of business had it not been for property and business interruption insurance, resulting from Hurricane Katrina. If an entity not having the resources to cover potential claims exposes its productive capital by being underinsured, its cost of capital should be increased.

Companies have lost large awards resulting from non-awareness of legal liabilities pre-dating their acquisition of a business and for which they did not possess adequate insurance coverage. Other times, new scientific studies determined a company was selling a product which was later found to be unsafe. Such was the case with asbestos, which drove scores of previously financially healthy companies into bankruptcy, including Armstrong World Industries, which did not recognize the problem at its asbestos division at the time it was purchased. In fact, the US Government, at the time Armstrong acquired the company, required their buildings contain asbestos. Armstrong was a very strong and consistent producer of free cash flow, but eventually the asbestos liabilities became too great for their balance sheet and calls on capital. When the lawsuits began, Armstrong did not buy sufficient insurance, estimating they could work their way out of the problem with their strong operating cash flows.

When the price of insurance rises, entities may choose to self-insure part of the risk; the analyst must determine the soundness of self-insurance given a catastrophic event.

Example:
Self Insurance: The company utilizes a combination of insurance and self insurance for a number of risks including workers’ compensation, general liability, automobile liability and employee related health care benefits (a portion of which is paid by its employees). Liabilities associated with the risks that the company retains are estimated by considering historical claims experience, demographic factors, severity factors and other actuarial assumptions. Although the company’s claims experience has not displayed substantial volatility in the past, actual experience could materially vary from its historical experience in the future. Factors that affect these estimates include but are not limited to: inflation, the number and severity of claims and regulatory changes. In the future, if the company concludes an adjustment to self insurance accruals is required, the liability will be adjusted accordingly.
Source: Bed Bath & Beyond, 2009 10K

Example:

The marketing and sale of our products may involve product liability risks. Although we currently have product liability insurance, we may not be able to maintain our current coverage at an acceptable cost, if at all, and there is no guarantee that our insurance coverage will be adequate to meet all types of product liability claims we may encounter. In addition, our insurance may not provide adequate coverage against potential losses. If claims or losses exceed our liability insurance coverage, we may go out of business.
Source: ecoSolutions, 2009 10K

Most companies have key man whole life insurance on its top executives. Such policies are a tax deductible expense while the cash surrender value most often grows significantly over time. These policies belong to the company, and, as such, their cash surrender values are placed on the balance sheet, although the amount is often hidden with “Other Assets.” This cash can be called on by the entity at any time, if needed, but normally is used to fund key executives retirement benefits.

Not only must the current adequacy of insurance be considered, so too must the risk of litigation that, if took place, would result in a weakened financial condition. Some industries are, by their nature, more subject to lawsuit, while other industries may evolve to become of a higher risk. An increase in such risk is not to be taken lightly, as was seen by the toy industry during 2006 when lead paint was found in many of their products, resulting in free cash flow that could not be reasonably estimated. As was discussed earlier under “Contingent Liabilities,” a thorough review of such prospects (including adequacy of product liability insurance) needs to be explored.

If legal costs exceed, or are expected to exceed 5% of normalized (3 or 4-year) cash flow from operations, a penalty is assessed. If, in the opinion of the analyst, an existing lawsuit, or the threat of one for which the analyst believes has merit, which will result in a payment of greater than 5% of normalized operating cash flows, a penalty is assessed.

Potentially large payments which could emanate from manageable small lawsuits for which a payment has been made would result in a large penalty. Often, however, a firm is reluctant to discuss payment associated with a lawsuit to discourage publicity.

Insurance inadequacy will penalize cost of capital, the amount dependant on the risks involved. Firms that under-insure workers compensation are especially at risk.

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Despite a fall in the cost of debt and common valuation multiples, like P/E or Price/Free Cash Flow, the cost of equity capital again rose this past week.

Many analysts and investment strategists have, over the weekend, quoted a low valuation multiple, as reason for hope of a quick equity market rebound. We doubt this will be the case as the cost of equity is a much more reliable indicator than the valuation multiple-think back to March, 2009, when financial markets rebounded as the cost of equity was falling, many months prior to an actual impact on those factors which reflect upon valuation measures.

It is difficult for us to understand why the credit measures we have been preaching for so long have not received more financial press, but are hopeful, when my text is released, devout followers will be reading more on the denominator of the discounted cash flow model. As we now so coldly see, earnings projections has its limits.

As written last week, neither earnings or free cash flow are as strong as being reported, and thus, combined with higher risk, is not conducive for an environment under which investors should feel confident regarding future distributions.

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Simply put, the cost of capital is the rate investors demand for use of their cash. This rate will, of course shift, depending to whom they are lending or where they are investing, as well as the economic setting.

For the firm, if managers are able to invest in assets or projects which can consistently earn a rate in excess of the rate they must pay for the use of capital ( its cost), it is creating value for shareholders. If that rate of return is below its cost, it is a value-destroying entity.

The rate the entity pays for capital out on loan (bonds and other fixed debt) is almost always below their cost for equity capital. This is because fixed rate debt is typically backed up by a security interest in its assets, it is given preference in the event of bankruptcy and, the payments it makes to creditors are tax deductible, that is, it does not pay federal income taxes on those profits it pays to creditors in the form of interest.

The calculation of the cost of equity capital is not so easy to determine. To begin, as we have all been witness, the return demanded by shareholders is constantly shifting-minute by minute, second by second-and often quite wildly. But not to estimate cost of equity is to miss half the root by which the fair value of a equity security is determined.

The more profound question and the genesis for cost of equity capital is to evaluate the risk to the free (distributable) cash flows of the firm. An enterprise with perfectly predictable free cash flows would have a low cost of equity capital, since investors could reasonably depend on those flows for their income. Enterprises with unpredictable free cash flows should logically have higher cost of capital as investors may receive sporadic or inconsistent cash returns from the firm.

At CT Capital, we have identified 60+ variables which relate to cash flow and credit which help us identify the risk to the firm’s free cash flows. But this is not how investors in general compute cost of capital, and is, I am convinced, the very reason for the vast financial market volatility we have been going through.

Wall Street analysts, investment strategists, corporate finance departments and their advisor consultants and investment bankers evaluate cost of equity capital based on the swings in the firm’s stock price, known as its beta. There are some other factors thrown in, notably the risk free rate and the market return, but beta is pulling the wagon.

Cost of equity as calculated via the misty lens of stock volatility has been followed by consultants who received their M.B. A.’s at university’s teaching this faulty gospel. These leading management consultants, in turn, have advised Board of Directors these methodologies are the most appropriate approaches, and since they are taught at leading universities, have not been questioned. Because it is forcing investors to evaluate risk incorrectly, it results in large and unnecessarily wide swings, often based on incrementally minor news, whereas the real cost of capital should be based on the long-term ability to generate free cash flows.

All we need to do is think back to May 10th when equity markets rallied about 3% worldwide, only to fall back rather abruptly. Such unnecessary “noise” can be expected to continue unless investors understand how to place a correct cost of capital into their decision-making.

Consider the following:

Fair Value Based on Differing Cost of Equity Capital Assumptions

Fair Value	Current Free Cash flow Per Share	Growth Rate	Discount Rate (Cost of Equity Capital)
$42.00	$1.20	5%	8%
$31.50	$1.20	5%	9%
$18.00	$1.20	5%	12%

The only factor causing fair value to change in the table is the cost of equity capital-current free cash flow and its growth rate remain identical. As evidenced, a one percentage point change, from 8% to 9% in the cost of equity equates to a staggering 25% decline in fair value. If the entity’s risk rises further, to a 12% cost of equity, the stock should be expected to fall by 57%. Such is the importance of the cost of equity (the discount rate), and the reason it must be precisely established to calculate fair value. If an entity’s cost of capital rises, its share price, must, by definition fall, until it reaches its new lower fair value, as shown in the table.

One might ask: If the current free cash flow and growth rate are known, why would fair value differ? It is because the numerator of the present value model is only a guess, even if an educated one, supported by appropriate research and investigation. There are risks to any free cash flow or earnings estimate-patent or customer loss, volatility in input costs, foreign government risk, rollover of debt risk, etc, and these are captured by the cost of equity. The fewer and less serious these risks are, the more certain we can feel about the numerator, 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.

Unless investors understand the many cash flow and credit factors which determine cost of equity capital, in favor of basing it on stock price movements, expect investors to not truly understand the reason the equity security should have been purchased in the first place.

Kenneth S. Hackel, C.F.A.
credittrends.com

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Despite the commonly held belief stocks are selling at preposterously low valuation levels, the same is not true for free cash flows.

When we adjust cash flow from operations to reflect normalized balance sheet activity and working capital items, including the recent spurt in discretionary spending on items such as capex, R&D, SG&A, bonuses, etc, much of this purported free cash in being consumed. For example, Autodesk, which today filed its 10Q, under the most common definition of free cash flow of operating cash flow minus capital spending, showed approx. $132 MM. in free cash flow. Yet, when normalizing working capital, taxes and discretionary items are taken into account, the amount of free cash flow is less than half, at $ 57 MM.

Thus, while we expect press releases to continue to show strong year over year comparisons in net income and even free cash flow, firms, because they do not make the necessary adjustments to cash flow from operating activities, from which free cash flow is based, enterprises will in essence be reporting a misleading number.

The number being reported does not represent cash that could be distributed to shareholders while still allowing for maximum growth.  The CT Capital definition of free cash flow represents the true income for the equity investor resulting from an investment in the enterprise.

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

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Investors have been selling risk. This is not uncommon during periods of uncertainty, but is rare when the economy is just a year or so out of recession, when earnings and cash flows are expected to rise over the coming years.

When this risk divergence occurs, undervalued and oversold equities often result in large returns compared to other asset classes, as well as stocks in general. Investors, who assign risk based on beta, rather than on fundamental factors, may not be properly calibrating the credit health of the entity.  The list below was assembled with those investors in mind, who believed they were selling (or avoiding) risky assets, when in fact, they were not.

The list was run for entities which are value adding, that is, they have a higher return on invested capital than their cost of capital. After all, that is the primary responsibility of corporate executives. These firms have lower than average leverage, even when including operating leases and pension underfunding. For firms which have seen their operating leases growing by greater than 5% per year over the past 5 years, we assumed such growth would continue, instead of using the GAAP mandated 5-year minimum signed lease obligations. These firms have also been generating positive free and operating cash flows, although over the short-term, even firms in distress tend to produce free cash flows as they take any and all actions to produce maximum cash. Obviously, this can only go on for so long.

Although these firms appear undervalued, they may not be appropriate to all investors, hence strongly urge you do your own due diligence. They would appear, however, as a group, to offer significantly greater value, than the equity market in general.

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