During the height of the credit crises a short two years ago, the hint of a credit downgrade was sure to result in an outsized drop in the underlying stock. On the other hand, a confirmation of a rating pushed the impacted stock higher. Now, due to the considerable balance sheet re-liquefaction and built-up capital, the fear of a credit rating is not near as worrisome.
News from MetLife (MET) After Market Close: Low Interest Rates to Impact Earnings
Expect to hear a lot more about the impact of low interest rates. Not only is it affecting the asset side of the balance sheet, but the liability side as well, as I have been pointing out almost weekly since June.
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Intel (INTC) and Research in Motion (RIMM) came onto CT Capital’s buy list over the past month after having been brow-beaten by many security analysts. Analysts believed these firms are, or soon will be, succumbing to the modern tablet era which will either make their current product line-ups obsolete or less relevant, as a new stream of products gains a foothold on their market share.
I have written extensively on business combinations over the past six months, including “hidden” costs associated with their taking place.
The current economic environment, that of slow top line growth with a boost in year over year financial flexibility is often a recipe for happy investment bankers. But what does it mean for equities?
Here, history is crystal clear: investors would be incorrect to presume a step-up in merger activity would presage higher stock prices, which can only take place with improvements in free cash flows and reductions in the cost of capital.
While the cost of after tax debt continues to decline, the cost of equity has remained stable over the past month.
The news of Adobe Systems (ADBE) yesterday would have not surprised the serious student of cash flow and cost of capital.
In this article we look at evidence that strongly suggests IBM (IBM), despite being turned into a cash “machine,” has done so not through its own R&D efforts, but rather through massive cost cutting. And its strategy is errily similar to that of Hewlett-Packard (HPQ), even prior to today’s announcement of a $1.7 billion acquisition, its second large announced deal over the past week.
IBM (IBM) CEO Sam Palmisano should measure his words prior to speaking badly of others.
In an interview with the Wall Street Journal, Palmisano said that during former CEO Mark Hurd’s five-year tenure, Hewlett-Packard (HPQ) was hurt by sharp cuts in its R&D budget, and that the company was declining in relevance.
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If one values a share of stock using the same analysis and judgment as that of owning a US Treasury bond, they would consider its worth to be the present value of its tax-adjusted free cash flows plus a terminal value; for that is how bonds are indeed valued.
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Our cash flow/cost of capital model is the most comprehensive that exists, and, as readers know, has proved quite accurate. It was bearish going into the credit crisis and signaled significant under-valuation March 2009, to the extent we put out a special email.
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The Obama administration’s proposal to make the research and development credit permanent and to allow for a temporary 100% tax deduction for qualified capital expenditures is sure to boost cash flows. However should the IRC deduction 199 benefits be rolled back for the major oil companies, as is being currently discussed, the impact to certain firms could be harmful in out years.
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The securities analyst must be aware of and take into consideration those “added” costs and expenses which can add significantly to the cost of a transaction. It is long been shown that most mergers, while strongly defended by management, fail, in good part because they fall short in delivering the intended result—higher cash flows and lower cost of capital.
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In March 2005, shares in NCR Corp (NCR) tumbled over 17% the day it was announced Mark Hurd, its CEO, would leave the company to join Hewlett-Packard (HPQ). At NCR, Hurd had cut costs while increasing revenues, and as a result, free cash flow grew substantially. As the shares in NCR were falling on the date of announcement, stock in Hewlett-Packard rose over 10%.
Despite today’s large equity rally, the S&P is still down over 2% for the year, in sharp contrast to a median S&P 8% pension actuarial investment assumption, while 10-year bonds yield 2.64%, a long way from the needed 5.8% median discount rate assumption.
The current fair value of Hewlett-Packard has been reduced to $43.52, based on our current free cash flow estimates, which includes various adjustments to cash flow from operating activities.
If you wonder why HPQ is now trading, despite the huge buyback announcement, which, when combined with its remainning $4.1 authorization, totals 16% of its outstanding shares, back to where it was on Friday, you need the book to your right: Security Valuation and Risk Analysis:
Last week, on credittrends.com , I wrote:
Whether HPQ is successful or not in its bid, one would expect the Board to increase the $4.4 billion remaining authorization in its share repurchase program, both in an attempt to appease analysts and investors who have been critical of the firm as well as present a united and undaunted front to investors and customers of a Board having strength and conviction while potential new CEOs are being interviewed.
I do not agree with today’s announced additional $10 billion share repurchase as it does not add value to existing shareholders.
The proper measurement of risk and reward is what distinguishes the mediocre from the superior executive. While perhaps the easy way out is to forgo investment opportunities altogether, historically noteworthy investors have shown the assumption of risk can bring on large returns. On the other hand, as we clearly see in the case of HPQ, the inappropriate assumption of risk can destroy value.
When BP (BP) was in the heat of the Gulf explosion crisis, we presented our free cash flow sensitivity analysis (here) and forecast, showing the stock was fairly valued in the mid- to perhaps upper- $30s range. When the stock reached $40, we reported that investors were “getting giddy” over its prospects (see article here)—that were not warranted given its free cash flows, and increased cost of equity related to the uncertainly of its free cash flows and updated capital structure.
Here we do the same now for Hewlett-Packard (HPQ): which results in a fair valuation of $47.27.
While the bidding for 3PAR (PAR) is reminiscent of two drunks at a horse auction, whereby the winner is the loser, the 2 point decline in HPQ (HPQ) shares seems excessive. By taking $4.6 billion off its market value relative to the $1.6 billion (at last count) acquisition, investors appear to be ignoring the enterprise’s 8% free cash flow yield. The executives at HPQ have done an admirable job wringing costs out of the firm, from supply chain to benefits.
The fact that HPQ (HPQ) and DELL (DELL) have recently grossly underperformed the technology index is tacit recognition their pursuit of 3PAR (PAR) is a value destroying acquisition. Investor response is therefore appropriate in light of the minimum $1.6 billion cash outflow, in return for an asset that is barely free cash flow positive, and brings to light the seriousness in which business acquisitions must be analyzed. In fact, I estimate, 3PAR would need to add over $ 40 million in free cash flow for the deal to make sense, a scenario not foreseen for at least 3 years.
A quick reading of 3PAR’s (PAR) financial statements reveals the $1.6+ billion deal is not value-adding for HPQ shareholders.
In itsAugust 18th S1 filing, GM (GM) stated its US defined benefits plans were underfunded by $17.1 billion and its non-US plans by $10.3 billion. The Company states its discount rate should be approximately 75 basis points lower, given current rates.
ALBANY — State Comptroller Thomas DiNapoli revealed plans yesterday to slash the state pension fund’s growth forecast for the first time in a decade amid growing concerns about exploding retirement costs.
