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If equity markets represent the flawless leading economic indicator generally believed, investors should be very comfortable nowadays. After all, the S&P 500 is up almost 12% so far this year. Yet economists remain generally concerned.

Is it not then unreasonable to ask: Are the glorious headlines trumpeting rising free cash flows portending a sustainable and durable continuation of the economic expansion or perhaps the result of severe cost cutting with a dose of imaginative accounting?

I believe it is the former, as free cash flow multiples remain in the lower half of historic ranges and cost of capital, although in its upper half boundary, has been trending modestly lower for the past three quarters.

Aiding valuations have been cost reductions, which, according to CT Capital’s models, still have a ways to go, unlike many contrary pronouncements I have read in the press. This is especially so for firms which, as a means to value-enhancement, enter into business acquisitions that of necessity include employee consolidation and labor movement to lower cost geographies. Also part of the trend is the restraint in domestic capital spending, consolidation and elimination of product lines (SKUs), and wages.

An industry cross-section sampling of 50 companies that have reported over the past month (ex. banks and airlines), present sufficient data to conclude approximately 22% of the improvement to cash flow from operating activities has resulted from such cost cutting in addition to more effective asset utilization, including supply chain improvements.

Analysts, as is often the case, tend to belittle operating improvements, and point to their possessing a one-time impact. That latter point is not true. A firm which can maintain efficiencies, resulting in permanent improvements to free cash flow, significantly enhances its value.

Like Heinz (HNZ), which was selling its receivables to help fund its pension liability to avoid strategic operating cutbacks. Or how about a firm growing its self insurance captive to save on premiums (as was done by Republic Services (RSG), which stresses cash flow generation in its press releases). Or the better known improvements to working capital, all forms of financial engineering that can accrue to the benefit of shareholders?

Financial engineering has a poor connotation since it does not reflect improvements to the revenue line. But it helps firms maintain financial flexibility and credit status while allowing for improvement to cash flows, including shareholder distributions.

The ability of a firm to take advantage of transfer pricing, including the manufacture of goods in low cost jurisdictions or to borrow in a low cost jurisdiction and pay taxes in a high jurisdiction can be an important event in lowering the tax bill and enhancing share value. By retaining profits in those low labor-cost countries, firms escape those tollgate taxes by holding their cash investments there. At the same time, their financing and higher tax-deductible interest expenses take place in the higher-tax rate jurisdictions in which they operate, lowering their tax bills.

Input Prices

Many firms are being confronted by rising input costs which they are not totally able to pass on. We saw this in a recent announcement by 3M (MMM). Hedges put in place to guard against input inflation can be costly and not always successful, especially since greater input volatility is associated with higher hedging costs. Also, if the price of the hedged input were to fall, the firm would find itself at a competitive disadvantage. For these reasons, many firms only partially hedge.

Security Valuation and Risk Analysis provides many examples of derivative instruments used for a variety of purposes, including that for Berkshire Hathaway (BRK.A), which reported this past Friday. Berkshire continues to be active in the derivative markets and was so again during the recent quarter. It took in almost $2 billion [for this], despite reporting a loss on existing contracts. The analyst should lower Berkshire’s reported cash flow by $1.7 billion.

If input prices continue to rise, some of the recent gains in cost-cutting and financial engineering will undoubtedly be reversed in the upcoming quarters, should revenues not pick-up. However, the affected firms' credit would have deteriorated further had those transactions not been put into place.

Service and manufacturing sector firms have shown remarkable cash savings from supply chain improvements. For example, improvements in supply chain management saved hundreds of millions of dollars for some companies. Transportation accounts for about 50% of supply chain costs, and through better asset utilization, routes and modal mix, significant cash savings have been achieved.

Stock-Based Compensation

Stock-based compensation currently represents an important area for the cash flow analyst to explore. Although most stock awards do not result in cash being exchanged upon grant, future cash flows are clearly affected, especially if share buybacks to offset dilution take place. Companies would gain flexibility to the extent stock-based grants provide an alternative to cash compensation and their creditors should be better off, while their shareholders will be diluted.

Because stock-based compensation is reported as an operating activity and stocks buybacks as a financing activity, the two should often be considered hand in hand. Firms like Oracle Corp. (ORCL) and thousands of other firms take significant portions of their cash flow from operations to offset dilution.

McAfee (MFE), soon to be part of Intel (INTC), filed its 10-Q last week. The company receives a significant portion of its operating cash flows from stock based-compensation, thereby inflating the most common definition of free cash flow (operating cash flow minus capital spending) used by firms and analysts. For the nine months ended September 30, 2010, stock-based compensation amounted to 30% of cash from operating activities versus 36% a year prior at McAfee.

At CT Capital LLC, we examine the history of such actions, and where appropriate, penalize the firm for the real cost of share-based compensation.

Pensions—A Small Sigh of Relief

The now 11.7% rise this year for the S&P is sure to help pension obligations. However, for the year, underfunding in general continued, owing to the 2.5% 10-year Treasury yield with commensurately low annuity rates. I therefore expect to see a continuation of stepped up contributions for the balance of the year and into the 10-K season.

Heinz (HNZ) financed its cash contribution, in part, by hard-working of the balance sheet, without which cash flow from operating activities would have been considerably below the prior year. Also, HNZ set up a receivable securitization facility from which it received $84 MM and brought in an additional $48 MM from a total return swap.

If long-term yields rise without a retrenchment in stocks, I am very confident we will see a surge in pension close-outs.

If this were to take place, even if accompanied by large one-time charges, cost of capital will decline and stock valuations will rise for those impacted firms. This is because we are currently penalizing reported cash flow from operating activities resulting from current pension contribution levels which reflect actuarial assumptions not in line with reality. The primary culprits remain the discount rate, and to a lesser extent, the long-term investment assumption. Despite the over-achievement of stocks, the returns on commercial real estate, hedge funds and equities, have been far below the 8% generally assumed over the past 3, 5 and 10 years.

Lastly, regarding the new Congress, health care and tax rates need careful watching, as they are sure to impact cash flows going forward. Firms file tax returns in every jurisdiction they do business, and cash flows are impacted by the decisions made or legislated.

CT Capital’s models are carefully constructed such that shifts in factors expected to alter cash flow, including its stability and certainty, will be properly reflected in its portfolios.

Disclosure: No positions

Source: Rising Cash Flows: Economic Expansion or Cost Cutting / Financial Engineering?