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Kenneth Hackel, CFA
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Kenneth S. Hackel C.F.A., Biography Kenneth S. Hackel is founder and President of CT Capital LLC, an institutional investment advisory firm specializing in the analysis of corporate cash flow and cost of capital in investment decision making. Until 1996, he was President of Systematic Financial... More
My company:
CT Capital LLC
My blog:
Credit Trends
My book:
Security Valuation and Risk Analysis
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  • Your Portfolio: "... at least, do no harm."
     “… to help, or at least do no harm.”

                              Hippocrates

    Investors, without recognizing the implications of their decisions, often sway from the fundamental concept of doing their portfolio no harm.

    And during bull market runs this credo further fades beyond the horizon as the money grab for yield and capital gains is the investor’s new best friend with risk becoming another 4 letter word.

    This won’t happen again, right? We’re smarter now.

    As any Las Vegas (or local) bookmaker knows, risk is often not what it appears. It is sub-surface. A great athlete may be facing marital or court issues, a nagging injury, didn’t sleep well, stomach cramps, girlfriend problems, or contract issues. Even the great Lebron James played awful during last season’s NBA basketball playoffs as his thoughts turned to playing for another team.

    This analogy is clear-cut when it comes to investing. Certain risks are obvious, others not so. Some are clearly spelled out, such as patent protection and existing lawsuits in a company’s Form 10-K. Other risks are not so obvious, such as a reporting firm’s use of the standard, but incorrect definition of free cash flow of operating cash flow minus capital expenditures. I guess the management at such companies believes moral and legal obligations such as preferred dividends, purchase agreements and other liabilities that need to be settled with cash, such as derivative contracts, workers compensation claims or lawsuit judgments, don’t matter. 

    The great macro risks-those that impact all securities and firms practically worldwide-often appear to come out of the blue, but history suggests this is not the case.
     

    Federal Reserve Inflation Crackdown 1980
    S&L Junk Bond Crises 1990
    US Subprime Mortgage Crisis 2007
    Mexican Debt Crisis 1982
    Asia (Thailand) Debt Crisis 1997
    Russia Default 1998
    Argentina Economic Crisis 1999
    Mortgage/Debt Crisis 2007-2009
    Greek/Eurozone Crisis 2009

     

    On the individual security level, the uncovering of risk goes beyond that found in the revenue line, where most security analysts spend their time. Sure, I look at revenue growth and stability of revenues as a metric in our cost of capital model. However, over time, you will find it is management’s ability to most efficiently utilize the firm’s resources that creates value.

    The value-altering risks which impact individual firm’s worth are practically always apparent, and it is here where security analysts and investors should spend the bulk of their time. This is the area where the big winners and losers emanate. Both Apple (AAPL) and Google (GOOG) flashed greatness years ago with their strong and consistent free cash flows alongside low cost of capital, especially relative to peers. On the other hand, firms with high cost of capital, revealing unacceptable risk, was particularly noticeably for many firms whose stocks have fallen over the past years, such as Tenet Healthcare (THC) or DR Horton (DHI), which has been financing its operations primarily via asset sales and income tax refunds.

    If a firm cannot increase its free cash flows, it does not create value for shareholders, given a fixed level of invested capital. It is for this reason, free cash flow based ROIC is a metric that CT Capital focuses on. Any risk must be explored regardless of the cause, and a sensitivity analysis prepared showing a range of potential outcomes. Investors need to work off a checklist, as we do at CT Capital—see Security Valuation and Risk Analysis for such a checklist-and evaluate any potential source or risk to the uncertainly of cash flows and financial structure.

    While events overseas have always effected the financial market here in the U.S., I cannot recall a time period when there are so many hotspots of concern as there exists today—the Greek financial crises simmers down and the Irish crisis begins; now there are additional concerns in Portugal, Spain, and even Russia where sovereign debt has a higher yield than its best corporate obligations.

    While all investors can do is hope today’s international issues are resolved, as they inevitably become, a more hands-on approach is required when it comes to the analysis and ownership of individual stocks. By carefully evaluating any and all risks to the firm’s cash flow, invested capital and cost of capital, the investor is not only helping himself, but at the same time, doing no harm. Given the recent stock rally, I would say such stepped-up analysis is quite important.

    For additional information, including a complete discussion related to the analysis of credit quality and risk see Security Valuation and Risk Analysis, McGraw-Hill, 2010.

    Related articles:

    Disclosure: No positions

    Kenneth S. Hackel, CFA
    President
    CT Capital LLC

    Contact CT Capital

    Subscribe to CreditTrends.com by Email

     

    If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” (McGraw-Hill, 2010).



    Disclosure: No positions.
    Tags: GOOG, AAPL, THC, DHI, DIA, SPY
    Nov 22 1:17 PM | Link | Comment!
  • Death, Taxes, and Health Care Costs

    Ken Hackel, president of institutional equity manager, CT Capital, and author of Security Valuation and Risk Analysis (McGraw-Hill, 2010), warned about six months ago, of the impending pension liability. Now, as expected, firms with large defined benefit plans are fessing up to the power of the discount rate on the ultimate liability, which is now resulting in stepped-up contributions. Hackel estimates that for many firms, with 10-year Treasury bonds at 2.5%, a further 1% reduction in current yields could very well have the same impact as a 20% reduction in the estimated long-term investment return assumption. When Kenneth first started writing of the liability, a 1% reduction was roughly equivalent to a 15% decline.

    But now, Kenneth addresses health care costs, the liability for which may rival or exceed that of pensions for many firms.

    Ultimately, the rise in health care spending affects cash flow and market values for all companies.  While some firms are cutting back on their exposure by eliminating health care benefits for retired employees who may purchase private plans, the bill for the active workforce remains a large, often unpredictable expense, unlike that of pensions having a defined contribution plan.

    A firm is required to disclose information about the terms of the plans, the participants, the assumed rates (including health care cost trend rate), the affects of a one-percentage-point increase in the assumed health care cost trend rates, and the types of assets held to discharge postretirement obligations, if any.

    Each year, under generally accepted accounting principles (GAAP), firms must estimate the current and five-year health care cost trend rate.  Consulting firms make similar forecasts, for example Hewitt Associates estimates costs will rise by 8.8% this year. Aon Consulting is predicting a rise of over 10% as is Segal in its most recent survey. Since consultant forecasts are running higher than most company estimates the difference represents potential hits to analysts and internal cash flow and leverage ratio estimates.

    Over the coming five years, medical inflation and the rising cost of health care could well absorb greater amounts of cash flow from operations.

     Example:

    SG&A expenses, as a percent of net sales, improved ten basis points compared to 2009. If the effect of gasoline price inflation on net sales in 2010 is excluded, these expenses increased three basis points compared to 2009. Warehouse operating costs, excluding the effect of gasoline price inflation, increased seven basis points, primarily due to higher employee benefit costs, particularly employee healthcare and workers’ compensation.

            Source: Costco Wholesale Corp (COST) 2010 10K.

     

    Example:

    An increase of 100 basis points in the initial healthcare cost trend rate would have increased our post-retirement benefit expense by $4 million and increased our projected benefit obligations by $73 million.

               Source: Qwest Communication (Q) 2010 10K

    Unless corporations can successfully shift additional burden onto their employees-now about 22%-Kenneth expects to see an impact on market valuations. At CT Capital, we account for this liability into our cost of equity capital model. It will be interesting to see if corporate Boards recognize the evidence and raise trend rates if their firm’s expectations are not set in reality.

    Under the Patient Protection and Affordable Care Act, insurers must justify their increases to state regulators.  But even for states, the impact is huge. New York State, for example, has estimated a liability for future health care approaching $ 205 billion. The problem of states ultimately impacts the valuations of publicly held firms if state taxes need to be raised, employees cut, or a federal bailout required.

    The new federal law, which requires employers to provide health care or face penalties, does not take effect until 2014, although some provisions take immediate effect, such as coverage up until age 26 (from 19 or student graduation) for children who are dependants.

    In CT Capital’s model, the penalty to cost of equity capital is dependent on the size of the expense, its actual rate, consultant forecasts, and its (the expense) relation to operating and free cash flows. When firms do not release their healthcare expense it must be crudely estimated, if material, based on their number of employees and the difference between their estimated trend rate and industry forecasts. This must include any Federal or State subsidies or other tax credits which reduce periodic cost.

    In December 2003, the U.S. Congress enacted the Medicare Prescription Drug, Improvement and Modernization Act of 2003 for employers sponsoring postretirement health care plans that provide prescription drug benefits. The Act introduced prescription drug benefits under Medicare as well as a federal subsidy to sponsors of retiree health care benefit plans. Under the Act, the Medicare subsidy amount is received directly by the plan sponsor and not the related plan. Further, the plan sponsor is not required to use the subsidy amount to fund postretirement benefits and may use the subsidy for any valid business purpose. Under the Obama health care legislation, this subsidy is to be taxed, which forced many firms to lower their deferred tax asset, which, at the time, was a non-cash charge. It could have later impaired cash flows.

    Unlike pension plans, postretirement plans are largely unfunded and typically highly underfunded. Disclosure requirements for funded plans are similar to those of pensions. For example, a firm is required to disclose the amount of the net periodic postretirement cost, showing separately the service cost component, the interest cost component, the actual return on plan assets for the period, amortization of the transition amount, and other amortizations and deferrals. A firm is also required to provide information about assets and liabilities: the fair value of plan assets; the actuarial present value of the accumulated benefit obligation (identifying separately the portion attributable to retirees, other fully eligible employees, and other active plan participants); unrecognized prior service cost; unrecognized net gain or loss; unrecognized transition amount; and the amount included on the balance sheet (whether an asset or a liability).

    What are the implications for the analyst? The direct effects of the accounting standards regarding other postretirement benefits on cash flows are likely to be minimal, although the impact on the balance sheet resulting from the increased liability could prove sizable, as seen for some reporting companies. As with pensions, a high ratio of retirees to active workers will raise the liability. To the extent that the liability interferes with financial flexibility and cash flows, the impact could force cash to be allocated among operating companies in a different manner, especially if particular subsidiaries have younger workforces allowing for lower contributions.

    Example:

    When General Motors adapted SFAS 106, analysts considered it to be another accounting rule providing little information of value because GM’s shareholders’ equity was about $28 billion at the time. When the rule was adopted, GM took a $24 billion hit to earnings to set up the reserve for postretirement health benefits.

    Unlike fixed debt obligations, the sponsor could amend plan benefits to reduce the liability but might require employee or union acceptance. If the company is successful in reducing health care costs, as stated, operating cash flows will improve.

    Regarding the financial structure: if the health care cost trend rate is inappropriately low, the potential liability would be greater than portrayed by the company and future operating cash flows lower than expected. This would include any tax subsidies received by the entity that are used to offset health care costs.

    A decrease in the discount rate would result in an increase in the real benefit obligation and a decline in the funded status, whereas an increase in the discount rate would result in a decrease in the benefit status obligation and an improvement in the funded status. But because there is no legal requirement to fund these plans, the company could continue to fund current costs without addressing the liability, unlike pension obligations. To the extent that such benefits are implied, the analyst should consider the effect the postretirement liability might have on leverage and working capital ratios and debt covenants.

    For additional information, including a complete discussion related to the analysis of pension and other post-retirement benefits see Security Valuation and Risk Analysis, McGraw-Hill, 2010.

    Related articles:

    Disclosure: No positions

    Kenneth S. Hackel, CFA
    President
    CT Capital LLC

    Contact CT Capital

    Subscribe to CreditTrends.com by Email

    If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis,” McGraw-Hill, 2010.



    Disclosure: No Positions.
    Tags: DIA, SPY, QQQ, CTL, COST, HNZ, IBM
    Oct 25 3:44 PM | Link | Comment!
  • It's Here!-After All, It Only Took 40 Years

                Security Valuation and Risk Analysis, McGraw-Hill, 2010
                                      Available at all online bookstores

     
     
    Tell us what your new book is about?
     
    Rarely does a does a book on finance and investments “break important new ground.” I believe Security Valuation and Risk Analysis, encompassing my four decades covering about every facet of security analysis and corporate finance, does so.
     
    In it I show that:
     
     (a)Cost of equity capital, a principal component of stock value, should not be determined by security volatility, as is widely practiced by public enterprises, investors, consultants and security analysts, but by the certainty related to the entity’s cash flows and credit health. A one percentage point change in cost of equity often results in a 25% or greater change to fair value and very often precedes turns in the underlying stock movements; (b) Return on Invested Capital (NASDAQ:ROIC), a principal component of valuation, should be measured as a function of the assets ability to produce free cash flows, as it should benchmark the expected cash return for cash expended (invested capital, as adjusted). It should not be based on Earnings before depreciation, taxes and depreciation (EBITDA). EBITDA, an income statement based accounting concept, is not a measure of the true economic return; (c) Free cash flow should include cash the entity could easily free up, but to be correctly computed, must be adjusted for the many misclassifications and extraordinary items frequently found in reported financial statements. Such adjustment procedures are explained.



    Why is the new valuation methodology you outline in the book revolutionary?

     
    This book gets to the heart of how value should really be construed by the value investor. Popular fair value measurement tools often provide inaccurate assessments. An ongoing concern derives its value from its free cash flows and its ability to add (or destroy) value resulting in shifts to those cash flows. Existing tools do not provide for such measurement as they have been conceived by academics and accountants, often under the strong urging of large and persuasive corporations.
     
    The book’s comprehensive cost of capital worksheet with detailed explanations of each metric provide a unique and common-sense solution to the measurement of the discount rate from which free cash flows are discounted and fair value established. It is one based on credit, and compasses over 60+ such metrics, from sales stability to tax rate-from cash burn rate to insurance adequacy, yield spreads, sovereign risk,-and everything in between.
     
    How can it be applied to today’s investing climate?
     
    In today’s or tomorrows investing climate, the need to accurately access the firm’s normalized and current cash flows, along with the capital (and its cost) necessary for their production are paramount to the valuation process.
    Because credit analysis is so important in the determination of risk and value, the book details a thorough analysis of the roles debt, equity and hybrid securities play in the capital structure including possible calls on capital such as commitments, contingencies, guarantees, convertible securities, exposure to lawsuits and other cash requirements, such as sinking funds. Also explored are contingent capital, debt covenants, adjusted debt, goodwill, special purpose entities, contingent liabilities, and the importance of sensitivity analysis in evaluating financial structure.

     
    What are 3 reasons why financial planners and investment managers should buy your book?
     
    1- As the book’s advances become applied, early readers will be given a real advantage over other investors.
     
    2- Readers will come to understand stock movements they currently have trouble explaining, since significant movements are almost always led by changes in cost of equity capital and the perceived risk to the credit (cash flows). The text explains why entities having a low cash-defined ROIC resulting in small amounts of distributable cash flows are accorded lower valuations despite having higher rates of growth in revenues and/or earnings.
     
    3- The text is replete with examples to illuminate each topic. 

    Disclosure: No Positions
    Oct 22 2:27 PM | Link | Comment!
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