HEADLINE ON HEWLETT-PACKARD
Hewlett-Packard (HPQ: $39.72, $-1.0400,-2.55%) is down after Morgan Stanley (MS) says the company needs more aggressive buybacks to boost shares, Bloomberg reports. Morgan Stanley cut its price target to $56 from $62.
If this is a true representation as to how this analyst feels, it speaks poorly as to the state of current day security analysis.
Despite 2 analyst downgrades this past week, OTEX share are up 12% today, and now is now up about 10% since first recommended here.
While I will wait for the 10Q before additional comment, from the estimate of free cash flow and cost of capital, it appears the two large brokerage firm analysts were off the mark in their analysis.
Related article:
Disclosure: No positions
Kenneth S. Hackel, CFA
President
CT Capital LLC
Subscribe to CreditTrends.com by Email
If you are interested in learning how to analyze the pension plan, including plan accounting, effect on earnings, cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.
Because I will be busy with final page proofs on the text, I will be unable to edit the full report on HPQ this week.
The analysis suggests, however, that selling in HPQ has been overdone, given its free cash flow, growth rate in cash flows (from operating activities and free), cost of capital (of 8.1%), return on invested capital, and stability measures. Adjustments were made which lowered reported operating cash flows and increased balance sheet debt.
I’ve been writing for a couple of years now about an impending cataclysm about to hit company earnings, cash flows and credit. As we know, many firms were bailed out from having to make stepped-up contributions thanks to the large rally in the financial markets in 2009.
CT Capital’s cost of capital and other models provide key data from which to decompose stock market risk. With that, our “crash predictor” is presented.
I am currently page proofing my upcoming text, a book I am sure could improve your investment returns, and at the same time, save you a lot of heartache. Order by clicking a picture of the book to the right.
It is a landmark book, half devoted to the analysis of free cash flow and metrics based off of free cash flow, such as return on invested capital. Do not use EBITDA for this. I expect the book will be widely adopted.
Corporate defined benefit plans are no better than 75% fully- funded, when adjusting for more realistic investment assumptions and the more powerful discount rate. This is in contrast to current financial reporting using exaggerated assumptions.
This morning’s report only reinforces what we’ve been writing–slow growth in sales and cash flows, especially if the latter is adjusted for expenses, balance sheet items and mis-classifications.
Expect valuation multiples to remain in check.
Please read the articles below.
Between stock rallies comes news providing a dose of financial and economic reality, as in today’s report on jobless claims.
As I wrote in the article below, much of the cash appearing on balance sheets come courtesy of a lid on expenses and working assets.
As we are now within striking distance of fair stock market value, selectivity and caution is strongly advised.
It’s a hot topic these days.
What are companies to do with the great cash build? Good question—as the data strongly suggests those balances are only going to get larger. The data also suggests it will do so at a more leisurely pace.
Since the beginning of the year, we have recommended caution for stock investors, with a 8% limit upside versus 7 % downside risk.
Cost of capital has been overpowering the large valuation discount.
Despite this past week’s 3.4% earnings-related stock rally, as of this writing, the S&P 500 Index is just near break-even for the year.
I bring up this unfortunate news as we are about to close out another month for the calendar year 2010, now 58% done. By August end, the year will be two-thirds over, and so will vacation time.
This week, a prominent financial journalist was reporting on the cash flows of a well-known company, accentuating its strength and growth.
The reporter detailed the analysis of this public company by a firm which “specializes” in cash flow-based security analysis; however, as I looked into their analysis (which I have a hunch is a computer generated number as they are a small firm, yet issue cash flow reports on every S&P segment), I discovered they neglected the effect of lease obligations, which for this company, was substantial. The company does produce healthy and consistent cash flows, and its credit strength allows them to sign large capital leases which, under Generally Accepted Accounting Standards (GAAP), appear on the balance sheet, as opposed to operating leases, which do not, but should. Thus, capital leases result in more conservative reporting as they are included in normal debt and leverage ratios. This is not always the case with operating leases, similar to other post-retirement benefits, like health care, which are not normally included on the balance sheet and are not pre-funded.
BP’s new head, Robert Dudley, has not gotten off to an auspicious beginning. In fact, he begins his initiative with two large financial blunders, a term we do not take lightly.
While a dividend increase will often provide a stock “pop” , I believe it would be unwise to expect, and for an enterprise to pay out, substantially increased dividends at this time. For example, I couldn’t disagree more with BP’s statement today of $39 billion in possible asset sales and a commensurate look at reinstating the dividend. Why not liquidate the entire company and pay a huge dividend (payback of capital)? Obviously, BP should not consider dividend resumption until its liabilities are confidently estimated and its maximum growth is unimpaired resulting from a dividend.
An essential aspect of the evaluation of investment risk is taking on the roll of a Las Vegas odds maker-and not just when it comes to earnings, cash flows or revenues.
For example, in its June 30th 10-Q, filed last week, Cash America (CSH), a strong producer of Free Cash Flow, in the business of pawn lending, cash advances, and check cashing wrote:
Certain consumer advocacy groups and federal and state legislators have also asserted that laws and regulations should be tightened so as to severely limit, if not eliminate, the availability of certain short-term products to consumers, despite the significant demand for it. In particular, both the executive and legislative branches of the federal government have recently exhibited an increasing interest in debating legislation that could further regulate short-term consumer loan products. The U.S. Congress has debated, and may in the future debate, proposed legislation that could, among other things, place a cap on the effective annual percentage rate on consumer loan transactions (which could encompass both the Company’s consumer loan and pawn businesses), place a cap on the dollar amount of fees that may be charged for short-term loans, ban rollovers (payment of a fee to extend the term of a short-term loan), require the Company to offer an extended payment plan, allow for minimal origination fees for advances, limit refinancings and the rates to be charged for refinancings and require short-term lenders to be bonded.
Sometimes it’s better not to hire your friends, admittedly some late advice for former Bear Stearns executives. For Bill Gates, it’s definitely not to late given the superiority in Microsoft’s strength and consistency in its cash flows. However, enough time has gone by to render a verdict on the leadership ability of Steve Ballmer. For Microsoft (MSFT), the tables below are telling, as we compare some important metrics to those of Oracle (ORCL), its largest and most important competitor.
This week, IBM, one of the world’s leading producers of Free Cash Flow (FCF), saw its stock tumble, when, among other things, it failed to produce the expected top line growth. What did investors really expect from a company soon to celebrate its 100th anniversary doing business in a near-recessionary climate? We’ll see how Apple (AAPL) is doing in 2076. Meanwhile, there were small details in IBM’s reporting that signaled what was to come.
As we’ve been writing about for quite a while…………..
Boards cannot maintain a 5.9% discount rate to their liabilities when 10 year Treas. are at 2.9% and annuities aren’t much higher.
Boards cannot maintain 8% and higher investment assumptions in this era of low growth with high volatility
Boards must recognize the extent of their underfunding in financial statements.
Boards must recognize the extent their actuarial assumptions are distorting reality.
Gone must be the days of playing around with the pension to boost earnings and executive compensation and retirement benefits.
Please see articles on this site, as Boards will soon recognize the extent of the issue. Investors must recognize it now!
There have been more than a few stories making the rounds advocating share repurchases, in which the authors attempt to make the point that firms which repurchase their shares tend to outperform the general market.
What do Bear Stearns, Freddie Mac, Lehman and Station Casinos have in common? Their executives believed they were so well-funded they began very large buyback programs, even though they borrowed to do so.
We see no reason, with a 9.1% cost of equity capital, to change our current thinking.
But good values do in fact exist, and so I am not advocating an equity portfolio be 100% cash. In fact, a couple of weeks ago, I wrote stocks could conceivably rise as much as 8% this year, given the current FCF multiple, and a small fall to the cost of equity.
Equities of firms which produce strong, consistent free cash flows, and as importantly, have a return on their invested capital greater than their cost of capital, will see their stock prices rise over time. But investors must buy such firms having a current free cash flow yield in excess of 7%. These firms are priced to comfortably rise to a greater degree than bonds, money funds, or real estate.
Please see related stories, and tables throughout this site.
Sounds crazy, no?
Given corporate Boards remaining relentless in cash maximization policies, alongside reluctance to spend without a confident payback period, the obvious outlet is stepped-up acquisitions. Given a strategic free cash flow-based acquisition, firms could put themselves in a position of stepping up their return on invested capital, given the very low cost of debt that might need to be raised to fund the purchase. A well-priced and timed acquisition can significantly add to shareholder value, while of course, an ill-priced, ill-executed and poor candidate would severely destroy value.
IBM, although a very strong credit, has been shrinking equity and buying back its shares (see our earlier articles: CFOs Making the Same Mistake and The Folly of Share buybacks).
It has also been underfunding its pension. When firms look to squeeze cash, the pension is an obvious target, and more often than not, disappointment, especially relative to expectations, is on the way. A couple of weeks ago we wrote IBM is underfunding its plans.
Please see our related articles on pensions and free cash flow implications of underfunding:
Disclosure: No positions
Kenneth S. Hackel, C.F.A.
President
CT Capital LLC
Subscribe to CreditTrends.com by Email
For additional information on the implications of pension underfunding and its impact on free cash flow, cost of equity and return on invested capital, pre-order- “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.
“Last year we made $112 million before taxes….except we don’t pay no taxes”
-from “Some Like it Hot”
Publicly held firms try their best to replicate the Mafia’s tax rate, but normally only get there if losses are involved. As such, taxes must be carefully scrutinized for its effect on cash flow and leverge.
CT Capital’s risk (equity cost of capital) model incorporates many tax variables, including both the effective (that reported to shareholders) rate and that based on the actual taxes paid.
Alcoa stock has fallen by 33% this year. Analysts of cash flow and risk could have avoided this issue (see earlier article).
Firms that, when they halt receivables sales and tell their shareholders their cash flows would have been higher (without mentioning the positive boost to prior quarters), are raising a warning flag.
