German conglomerate Siemens AG (SI) is a global titan in the industrial, energy and healthcare sectors. Although SI competes with many smaller capitalized firms within the business units they operate, US based General Electric (GE) is the conglomerate of similar size and variety of businesses.
Our dual cash-flow and accrual analysis for the five quarters through Q3 2012 is indicating that Siemens share price may be significantly overvalued at current levels.
Cash-Flow: Our dual cash-flow ratio signals are flashing "Recent Bearish" and "Confirmed Bearish". This suggests that operating cash-flow (OCF) as a percentage of sales have declined over multiple periods and in the most recent quarter. Also, "cash" generated from the balance sheet (BSCF) may be rising at a faster rate than OCF relative to sales.
Declining OCF and rising BSCF trends are one indication of weakening earnings quality. It also tells us that reported earnings are increasingly being supported with balance sheet maneuvering rather than cash from actual operations.
Accruals: It is not unusual for diversified businesses to employ accrual accounting. Adjustments to cash generated by and used for operations, investment and financing are often variable relative to the timing of a transaction and the effect on net income.
For example, accrued interest and service costs related to underfunded pension obligations were significant for SI in the latest quarter (see page 6). As of June 30, 2012, the estimated underfunding of SI obligations was approximately €8.0 billion as compared to € 6.5 billion in the prior second quarter.
The pension issue highlights one reason that assumptions and input variables used in traditional discount-cash-flow models can be challenging to determine accurate future intrinsic value of a stock price.
For example, if you compare future rate of return with that of so-called "risk-free" return of a US Treasury, one might argue shares of SI look cheap. On the other hand even a conservative assumption of 6% (forward discount rate) might be flawed as longer term Treasury rates (10 year) are currently anomalous to historical interest rate trends.
A 25 basis point change in either assumption (discount rate or "risk-free") could potentially skew forward annual EPS estimates for SI by an estimated $2-3 per share (assuming a 10% annual EPS growth rate). This would likely also impact a discounted cash-flow model further as future expected earnings growth rates might be clouded by terminal value and/or weighted average cost of capital (WACC) judgments.
Our dual cash-flow and accrual model is not a guarantee of future intrinsic value either. Instead, we use recent and past history to identify and detect changes within the financial statement relationships. By observing adjustments and reconciliations presented in reported data, we can spot trends which provide valuable clues to future potential directional price movements of a security.
In the case of SI, the use of accruals shows a modest but incremental increase during the previous five periods of our study. For the 2012 3rd quarter ending June 30, the accrual ratio for SI was +5.11 versus an average of +3.96 in the prior five quarters. A reading of +5 or greater is considered bearish and another indication of potential weakness in the earnings quality.
Capital Productivity and Revenue Metrics: We are also seeing some modest declines in ROA and returns on capital employed. Offsetting declines in the recent period was a slight improvement in the cost of capacity (as compared to each €dollar of sales).
Other headwinds: A surge in the Euro currency in recent weeks might be counter productive to forward earnings and order development for SI. While the company did benefit from currency tailwinds this past year, corporate treasury activities may find it difficult to bolster non-operating returns on a comparable basis going forward.
Third quarter revenues for the three months ending June 30, 2012 rose 10% y-o-y, to €19.54 billion. Five percentage points of that came from favorable currency translation effects (see page 3). Management also cited substantially lower volume from large orders, particularly in infrastructure and energy. Profit margins have been falling compared to peers.
Fair-Value Estimates: We have an estimated fair-value of $84 on Siemens shares presently. SI currently trades for $102.33 a share, almost 21% above our FV estimate.
We expect cost cutting to be at top of management's agenda going forward. Yet, an expected slowing of revenue in the fourth quarter will also be a sign that euro zone woes may be reflecting weakness in demand for German goods.
The financial statements are suggesting to us that the quality of earnings being reported by Siemens in recent quarters may be weakening. This can be seen in declining cash-flows generated by actual operations, bearish accrual trends and deteriorating capital productivity / revenue metrics.
Investors should be careful not to misinterpret SI's bright long-term growth prospects with complacency of near-term downside risks. Siemens is a well run organization with leading market share in many of the industries it serves. Our concern is a valuation issue not liquidity.
The stock has enjoyed a stellar run these past few months and outperformed the broader S&P 500 handily during that time. Yet, shares look to be priced for perfection at current levels.
Traders might consider opportunities in the $95-100 area. Investors with a longer horizon might wait for a pull-back to $90 to initiate partial positions. Full positions could be considered in the mid-$80s or under.