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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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  • Equity Valuation
     Since the beginning of the year, we have recommended caution for stock investors, with a 8% limit upside versus 7 % downside risk.

    Cost of capital has been overpowering the large valuation discount.

    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. As opposed to every large investment organization, which bases valuation off of accounting concepts (i.e., P/E) or the Capital Asset Pricing Model ( based off of stock volatility), our cost of equity capital (the discount rate we apply to present value free cash flows) is determined through detailed fundamental cash flow and credit information.

    The table at the bottom, refreshed for all filings as of July 30, affirms the relationship between stock price valuations and cost of capital. While the free cash flow multiple is clearly important and carries significant value, and is a far superior indicator than the P/E multiple, it is change in risk that leads the equity market’s direction. Most pundits would agree, as last validated March, 2009. Keep in mind the free cash flow of the firm is the income to the investor. The same cannot be said with earnings.

    Over the past decade and a half (except for the early 2000s) leading up to 2007, as the table notes, risk remained reasonable for the S&P and free cash flows were growing. At that end point, our metrics clearly picked up the change, a long time prior to the world-wide financial and credit meltdown.

    So where do we stand now. Stocks are about 5% undervalued, but given the high cost of equity capital, we remain cautious. There are some very undervalued companies selling a low multiples of free cash flow but also have low cost of capital and high returns on invested capital. Also, given the re-liquefaction of the financial structures, it would not be unusual to see M&A activity picking up, including some hostile deals.

    For more conservative investors, we continue to recommend maximum cash positions within their target equity allocation.

    HISTORIC COST OF EQUITY, FREE CASH FLOW MULTIPLE AND S&P FAIR VALUE

    FCF MULTCOST OF EQUITYS&P APPX F.ValueYEAR
    16.99.21090Mar 2010
    16.59.11161July 30,2010
    16.59.21124May 2010
    17.08.59531995
    17.88.79821996
    18.08.811251997
    208.89892002
    20.58.711182004
    248.812232006
    279.612092007
    249.5304June, 1987


    (c) Credit Trends
















     


    Disclosure: No positions
    Jul 31 2:16 PM | Link | Comment!
  • Taxes- A Large Issue Looming

    “Last year we made $112 million before taxes….except we don’t pay no taxes”

    -from “Some Like it Hot”


    Publicly held firms try their best to replicate the Mafia’s tax rate, but normally only get there if losses are involved. As such, taxes must be carefully scrutinized for its effect on cash flow and leverge.

    CT Capital’s risk (equity cost of capital) model incorporates many tax variables, including both the effective (that reported to shareholders) rate and that based on the actual taxes paid.

    On creditttrends.com (and in my upcoming book, Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making) I have highlighted the difference and how investors will be given advance warning through examining changes to the tax accounts. We will continue to do so here.

    The firms included in the Table below could have serious tax issues ahead, based on one such metric-its deferred tax liability.  We are isolating the deferred tax liability to bring to your attention how it is created and the possibility of a large future tax bill in the event the firm is unable to grow the base from which this liability is created. For example, Verizon Corp. (VZ) has a very large deferred tax liability which would certainly force it to pay considerably higher taxes if it were to stop the growth in its capital spending. Verizon, like many companies, also took advantage of bonus depreciation resulting from The Economic Recovery Act. In Verizon’s case, however, it appears over the upcoming few years, its deferred liability will be growing, although it does bear watching.

    This liability has attracted the attention of investors, creditors, managers and accountants for a long time. At issue is the difference between the tax expense reported in the financial statements and the actual tax payment to the governmental authorities, including overseas. The two are different because of different tax treatments of items for tax and for financial reporting purposes. Some differences are permanent (i.e., they are not expected to reverse in the future) whereas others are temporary differences that are expected to reverse.

    An example of a temporary difference is accelerated depreciation related to capital equipment, although it is applicable to any item for which deprecation is allowed, including livestock. Goodwill can either be a tax deductible expense or not, depending how it is created.

    If a deferral is reversed, the financial structure (leverage ratios) are effected, including the possibility of a violation of a debt covenant. The deferred tax account can be a provider or user of cash if the tax rate were to change.

    In the Table below we compare the deferred taxes on the balance sheet, which represents the accumulated tax deferrals due to timing differences between the reporting of revenues and expenses for financial reporting and tax purposes, with shareholders equity. All the firms in the Table have a deferred tax liability at least equal to 10% of their stated net worth.

    Also shown are deferred taxes (which represents deferred income tax expense reported in the Operating Activities section) which is compared to total cash flow from operations. All the firms in the Table have seen their recent operating cash flows boosted by at least 10% due to deferred taxes; thus in our estimation such reported cash flows are overstated, given these firms have reported negative free cash flows.

    There are many firms which will see their tax bills rise due to a reversal of this liability-not just those on this small table-and so this issue must be analyzed in detail as it represents real cash going out the door. After all, this cash must come from somewhere- bank account, additional borrowing, sale of assets or stock, etc.

    I bring this issue up, as with a slowing economy, many firms will look to cut back on capital spending, which is the primary force behind the increase in the deferred tax liability.

    Also, with State budgets in havoc, corporations will find some of their tax incentives disappearing and new taxes introduced. Indeed, taxes will be a big issue for every firm over the coming years.






    For additional information, please visit credittrends.com






    Disclosure: No positions
    Tags: AWR, CRK, DNN, AXLL, HOS, T, OPOR, WWON
    Jul 19 7:55 AM | Link | Comment!
  • Impact to Free Cash Flow From Sale of Receivables

    Included in Alcoa’s (AA) press release this week was the statement its cash flows would have been even higher had it not been for the ending of its sales of accounts receivables.

    What Alcoa didn’t state is that such sales enhanced its prior quarters, with the amount of additional sales, above the prior period (adjusted for normalized growth) to be subtracted from cash flow from operations. Alcoa’s prior periods cash flows, using traditional methods have benefited from such sales. In our analysis we back out such favorable impact to arrive at a normalized free cash flow and operating cash flows.

    The sale of receivables is part of the analysis of all asset sales.

    Asset Sales

    For entities needing to raise cash, asset sales are always considered in addition to external financing. The least costly capital raise will always be considered first, especially if the financial turbulence is expected to be short-term and the cost of debt and equity are high.

    The continual sale of inventory for below market prices, or accounts receivable factoring, normally provide an  unmistakable warning that should raise a flag for students of cash flow and risk, as the realization price reflects a cost which would not normally be acceptable to a well-financed organization. Asset sales are often a de-facto partial liquidation. Continuing asset sales that take place for lower than balance sheet values are indeed  telltale signs.

    To improve operating cash flows, companies often sell operating divisions, as they rebalance their portfolio of companies in search of the highest return opportunities. Small asset sales and balance sheet management typically constitute good business practice, and add to free cash flow and reduced cost of capital. Managers committed to weeding out poorly performing business units can significantly enhance their company’s market valuation.

    Significance, in accounting parlance, relates to size and whether the failure to report an event as a separate line item would mask a change in earnings or trend. The analyst should determine if the company under analysis has indeed sold assets during any particular reporting period due to weakness in its borrowing capacity, or an attempt to bolster disappointing operation cash flow. Both Enron and Delphi Corp, prior to their bankruptcies, were selling inventory with the understanding they would be repurchased at a later period, a clever way to raise cash but a telling sign of liquidity shortfall.

    The securitization of assets for sale into a Special Purpose Entity, as was invoked by Enron, may not, by itself, represent a reason to sell a security or dismiss the purchase of one, especially in light of otherwise undervaluation by the marketplace. In fact, many companies have raised cash via the securitization of accounts receivable, redeploying those funds back into a business which resulted in high rates of growth in cash flows. When viewed under the light of other metrics, asset sales could form part of a mosaic, indicative of a financial risk urging avoidance of the particular security, or to place a higher discount rate on its free cash flow, accounting for the new, higher level of uncertainty.

    Entities which have substantial accounts receivables, like retailers, often discount these future cash receipts for immediate cash, as Macy’s did during 2006. The figure below reveals the impact on its average collection period resulting from that sale. Of course, average collection period and similar credit metrics, such as cash conversion cycle, will be distorted by the sale of receivables.

    Selling receivables boosts current period operating cash flow and thus must be normalized by the analyst in evaluating historical and prospective cash flows. To do so, one would compute the past 4 years average accounts receivable to sales and apply that to the current year, as if the financing did not occur. At that point, the analyst can evaluate the Operating and Power cash flows for that year, including the sales of receivables.

    More importantly, since the upcoming year(s) cash collections will be lower, an updated cash flow projection must reflect the new expected collections, with emphasis on the ability of the entity to retire or recast upcoming debt and other obligations coming due.  Macy’s has, according to its “Financing” footnote, $2.6 bn. in principal payments due over the coming 3 years.  Since prospective cash flows will be diminished by the present value of the change in future collections, fair value could shift, depending on how the cash from the sale is deployed.  In its statement of cash flows, seen is the drop in cash flows from operations, with management reacting to by cutting budgets company wide.

    MACY’S, INC.
    CONSOLIDATED STATEMENTS OF CASH FLOWS
    (millions)

                 
      2008  2007  2006 
    Cash flows from continuing operating activities:            
    Net income (loss) $(4,803) $893  $995 
    Adjustments to reconcile net income (loss) to net cash provided by continuing operating activities:            
    (Income) loss from discontinued operations     16   (7)
    Gains on the sale of accounts receivable        (191)
    Stock-based compensation expense  43   60   91 
    Division consolidation costs and store closing related costs  187       
    Asset impairment charges  211       
    Goodwill impairment charges  5,382       
    May integration costs     219   628 
    Depreciation and amortization  1,278   1,304   1,265 
    Amortization of financing costs and premium on acquired debt  (27)  (31)  (49)
    Gain on early debt extinguishment        (54)
    Changes in assets and liabilities:            
    Proceeds from sale of proprietary accounts receivable        1,860 
    Decrease in receivables  12   28   207 
    (Increase) decrease in merchandise inventories  291   256   (51)
    (Increase) decrease in supplies and prepaid expenses  (7)  33   (41)
    Decrease in other assets not separately identified  1   3   25 
    Decrease in merchandise accounts payable  (90)  (132)  (462)
    Decrease in accounts payable and accrued liabilities not separately identified  (227)  (396)  (410)
    Increase (decrease) in current income taxes  (146)  14   (139)
    Decrease in deferred income taxes  (291)  (2)  (18)
    Increase (decrease) in other liabilities not separately identified  65   (34)  43 
                 
    Net cash provided by continuing operating activities  1,879   2,231   3,692 
                 
    Cash flows from continuing investing activities:            
    Purchase of property and equipment  (761)  (994)  (1,317)
    Capitalized software  (136)  (111)  (75)
    Proceeds from hurricane insurance claims  68   23   17 
    Disposition of property and equipment  38   227   679 
    Proceeds from the disposition of After Hours Formalwear     66    
    Proceeds from the disposition of Lord & Taylor        1,047 
    Proceeds from the disposition of David’s Bridal and Priscilla of Boston        740 
    Repurchase of accounts receivable        (1,141)
    Proceeds from the sale of repurchased accounts receivable        1,323 
                 
    Net cash provided (used) by continuing investing activities  (791)  (789)  1,273 

    Source: Macy’s 2008 10K

    In many cases, it is less expensive to borrow funds with the creditor taking a security interest in accounts receivables and inventory. This would be a loan, not a factoring agreement where the accounts receivable are sold. In a factoring arrangement, the cost to the firm is typically higher.

    When receivables are financed through borrowings, it is shown as a finance activity, even though the actions are basically identical to its sale. Also, by factoring, the firm keeps the loan off of its balance sheet. Another issue to consider is whether the receivables being sold were done so on a non-recourse basis, so that if they are ultimately uncollectable, Macy’s has no further legal obligation. A moral obligation, may exist, however, and must be considered.

    The figure below shows Macy’s average collection and payables period for 2003-2009 fiscal years.  When Macy’s sold about $ 4.1 bn. of their in-house receivables during 2005-2006, it dropped their collection period, but of course, the company paid a price for the immediate cash. They did reduce total debt by about $ 1.5 bn. but unfortunately they also succumbed to shareholder pressure and expended $2.5 bn. on the repurchase of shares, hopeful the buyback would boost the stock price, which it did not, since their cash flows were weak.

    To Macy’s, which had substantially increased its leverage resulting from its $ 5.2 bn. purchase of May Department Stores the year earlier, the cash resulting from the sale of receivables might have ultimately staved off bankruptcy two years later when its business fell due to the recession and loss of market share to competitors, the latter not a atypical byproduct of a large business combination. For sure, management wished the $ 2.5 bn. stock buyback never took place. The $2.5 bn. outflow robbed Macy’s of needed financial flexibility by eliminating a large cushion when its business turned down.

    While the sale of receivables does indeed provide immediate cash, it is important to consider why the action was taken, especially for companies that operate on tight margins. For such entities, the sale may eliminate profits those sales initially produced. For them, if the cash is not used to pay down trade payables or other business related obligations, the analyst must question where such cash will eventually come. Because Macy’s wasted funds from the sale on share buybacks, they cut their purchases of PPE in half over the next two years. It is difficult to imagine a large sale of accounts receivable to buy back shares is ever a good idea.

    Macy’s-Days to Pay vs. Collections Period

    For additional information on this type analysis, pre-order- “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

    Disclosure: No positions

    Kenneth S. Hackel, C.F.A.
    President
    CT Capital LLC

    www.credittrends.com



    Disclosure: No positions
    Tags: M, AA
    Jul 14 3:02 PM | Link | Comment!
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