Details Matter
IBM reported to shareholders some pumped-up FCF from expense cutting, stock-based compensation, working capital, leases, pensions and post-retirement and taxes (sounds small individually, but all adds up), leaving room for some disappointment. IBM’ ‘s revenue growth has been below-norm for years relative to expectations. Bottom line, IBM remains remains one I really enjoy following, although in its reporting, its uses a simple definition of FCF, and so requires a lot of adjustments. Although going through a hiccup, IBM shares are, in my belief, undervalued, although I understand what makes this stock tick.
The Details:
IBM aside, if investors and security analysts spent a few extra hours reading the financial filings, especially the less-traveled footnotes, they could undoubtedly improve their performance.
Here are just a very few general lookout points:
- Firms which announce they will no longer, or for a period of time, contribute cash to their 401K, and replace those contributions with stock. (CNBC’s Herb Greenberg featured our analysis of Alcoa’s (AA) transfer of $600 MM in stock – not cash – to its pension plan in this segment. We also analyzed its free cash flow and stock price implications in this article.)
- Firms which make consistent trips to the debt markets, which if closed or tightened, would enter distress. Same is true for firms which rely on individual bank lending programs, as we saw with Jackson-Hewitt Tax Service (JTX).
- Firms which are seeing their foreign pension plan liabilities growing, combined with higher cash benefit payments or credits, yet are contributing less (ex, IBM) to these plans. Faithful Credit Trends readers already know we feel a large number of plans are underfunded (our earlier post, Buyer Beware – These Firms Exposed to Greater Risk, identifies some surprises). The effect on debt covenants and leverage should be understood if a large catch-up payment is necessitated.
- Firms which have volatile cash tax rates- a dead giveaway for trouble. (See our article, Taxes -A Large Issue Looming, for our analysis of tax implications.)
- Not adjusting financial ratios (i.e., Return on Invested Capital (ROIC)) for the actual cash tax rate-not the rate reported to shareholders.
- Not running accurate FCF models with various sensitivity analysis and probabilities—see our earlier BP article here.
- Comparing accruals versus cash payments.
- Leases must be inspected, both for their impact to leverage ratios and for their “hidden” effect on operating and free cash flows. (Our article identifies the Risks to Cash Flow from Operating Activities).
- Not factoring in other post-retirement benefits, which unlike pension, are pay as you go, and can be very costly.
- Not factoring in working capital changes to cash flow from operating activities.
- Understanding the tax benefits of stock based- compensation, which I will be writing about here next week. Stock based compensation can greatly affect cash flows, especially as most firms buy back stock to offset the dilution. But other factors need to be taken into account as well, such as tax benefits.
- Adjusting for extraordinary items and for important items in cost of goods sold (COGS) or selling, general and administrative (SG&A), and Research, including depreciation.
As a few cents per share can be cause for a plummeting or soaring stock price, the analysis of details can be very rewarding-for the wallet and for the ego.
There are plenty more to name here, but you get the point and I won’t give the store away here. The store is available for sale however in the form of “Security Valuation and Risk Analysis.” Please pre-order and save money, which for which you won’t be charged until shipment. Remember: Credit Trends is a free site and I would like to keep it that way, whereas many newsletters charge for advice which merely repeats the obvious- and the money from the book goes to a good cause.
Disclosure: No positions
Kenneth S. Hackel, C.F.A.
President
CT Capital LLC
