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Kenneth Hackel
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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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    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
    Why is it then, that mega-corporations, with their enormous resources, including sophisticated investment bankers and experienced Boards of Directors, investors continue to see the misapplication of  risk in financial models, as reflected in poorly constructed business combinations and similar decision -making? For the answer we need to look no further back than the worldwide credit crises, when an “others are doing it” philosophy permeated corporate culture, almost bringing down the entire financial system.
    Risk analysis, as defined by the uncertainty to the firm’s cash flows and impact to cost of capital, must meet with greater clarity and weight if errors are to be minimized.
    Unfortunately, many decisions are not grounded on the cash based return on invested capital, but rather, so called “strategic” decisions. These might include a “best practices” approach or one involved in buying market share. Once the exuberance and inertia of a proposed strategic deal takes hold, it is often difficult to contain. Its major proponents are often successful convincing even dubious fellow team members of the potential benefits, even when they lay outside the realm of the true bottom line, free cash flow in relation to cost of capital.
    By definition, the risk of a large business acquisition could result in either outsized benefits or financial distress to shareholders. Once a few successful business acquisitions have become fully integrated, I have found executives’ propensity for larger deals develops, even though follow-on acquisitions often involve considerably greater risk.
    The replacement of qualitative for quantitative reasoning is most often the genesis of a failed business decision.

    Those reviewing prospective deals, whether an M&A team or a securities analyst, must thoroughly review the spread between the cash based ROIC and cost of capital over at least a full industry and business cycle. Where one does not exist, such as in the case of a newer firm, the increase in risk must be particularly well-thought out, given the effect of the purchase price on remaining resources and flexibility. The expected benefits must be cash flow, not market share. As many Board members are not financially inclined, it is still their responsibility to direct their attention to an area in which they are not expert. They must understand the added financial risk of a substantial decision as measured by the range of potential outcomes, and the affect each has on cash flows, cost of capital and the firms’ equity and enterprise value.  
    The Board must be convinced their firm has the requisite skill sets to successfully integrate the planned acquisition. Are key employees of the target company on board? Who might be alienated?  How realistic are the assumptions to take out costs and any projected cash tax savings, whether due to stock awards or other costs allowed to be deducted for tax purposes. On the other hand, are the target firm’s commitments and conceivable contingency liabilities thought out and reflected in a scenario? Are pension and other benefits, including stock awards taken into account?

    Understanding the harmful effect a single bad deal on cash flows due to the assumption of excessive risk results in higher cost of capital, less financial flexibility and lost confidence by employees, suppliers, creditors, and stockholders.
    For the shareholder, the sole benefit to a business combination or acquisition is an increase in the free cash flow per share while maintaining a reasonable spread to cost of capital.  If it fails to meet this test, it is almost never worth doing.

    Kenneth S. Hackel, CFA
    For additional information, please visit ; 

    Disclosure: no positions
    Aug 27 3:14 PM | Link | Comment!
  • When Will Analysts Learn?


    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.

    It was just a month ago when reporters wrote of the “pop” in GE (GE) shares following that firm’s large buyback announcement.

    General Electric shares gained for a third consecutive session as investors continued to celebrate the sprawling conglomerate’s decision to increase its dividend and launch a share buyback.

                                                                     Source: Wall Street Journal, July 27, 2010

    Look at it since—GE stock is now underperforming the S&P 500 Index since the $15 billion buyback announcement:

    If I were the supervisor of that HPQ analyst I would have him prove to me why an increase in accounting ratios such as P/E or return on equity, with no commensurate rise in free cash flow or return above that currently forecasted should result in a higher share price—it never has and never will—ask the people at IBM (IBM), Macy’s (M), Home Depot (HD), or those financial institutions which bought back several hundred billion dollars worth of stock prior to the credit meltdown.

    Related Articles:

    Disclosure: No positions

    Kenneth S. Hackel, CFA
    CT Capital LLC

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    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.

    Disclosure: No position
    Tags: IBM, M, HD, GE, HPQ
    Aug 20 5:18 PM | Link | Comment!
  • HPQ and S&P Undervalued, but HPQ More So

    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.

    Cash flow from operating activities are considerably lower than would be estimated by merely taking the company's figure directly from the 10K and 10Q. Adjustments must be made for their large employee stock plans which is offset through share buybacks. Further adjustment must be made for the low (aggressive) tax rate, normal working capital adjustments and other variables explained in the book. HPQ has large operating leases we add to net debt as well as a large unfunded pension liability given their liberal assumptions. They are a large beneficiary of the commercial paper market and their financial subsidiary.

    Fair value for HPQ is $47.27

    Regarding stocks in general, I would advise an equity position in mid-range of normal allocation, up from maximum cash position.

    For our equity accounts, we are fully invested, but then again  we believe we operate at a distinct advantage relative to other investors. Our model account is again out-performing the S&P for the year.

    We again urge all of you to pre-order the text and I am sure your analytical skills will give you a big leg up relative to other professional security analysts.


    Disclosure: no positions
    Tags: HPQ
    Aug 17 7:37 AM | Link | Comment!
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