Mergers, Importance of Factoring Stock Based Compensation, and Are Analysts Too Top Line Oriented?
Capital deploying investments typically have a negative effect on their current period’s cash flows. If viewed as projects which safely add to ROIC above cost of capital, such investments can be expected to benefit shareholders, even if the short-term cash flows are impaired. As firms ramp up production or go through the common but expensive integration costs, investors should not lose sight of longer term benefits. Unfortunately, this is often not the case, and so, for investors who can spot and take advantage of the market’s skepticism, superior returns await.
A current example is EBay (EBAY), which over its three fiscal years ending 2009 had been active managing its asset portfolio, spending about 40% of its cash flow from operating activities on acquisitions while selling one large division which provided 21% of acquisition costs. As seen below, EBay shares have grossly underperformed the S&P during this time. With no substantive changes to its portfolio in its current fiscal year, EBay’s shares and adjusted cash flows have improved, but bear in mind one must adjust the EBay’s balance sheet changes to reflect its new businesses for normalization. With a normalized and consistent free cash flow yield of 13.2% on its invested capital (CT Capital includes purchased goodwill), and a lowly 7.5% cost of capital, I’ll take my chances while analysts debate it out. Unquestionably, EBay’s acquisition strategy was a benefit to current year’s performance.
Merger and other assimilation costs can obviously be substantial, and need to be anticipated given the current level of merger activity. The cash flow analyst must understand what identifiable intangible assets can be amortized and deducted for tax purposes, as opposed to goodwill that cannot be deducted. Those costs which provide a long term benefit may be capitalized; to the cash flow analyst, capitalization of these expenses is never permitted.
Merger related bookkeeping can be used to create earnings under GAAP through improper capitalization, such as capitalizing assets that should be expensed, improperly classifying assets that result in lower depreciation, or even overstating assets that result in the later judicious use of reserves.
Currently, the treatment of acquisition costs for GAAP purposes is to deduct as expenses in the year incurred. As a result, there could be significant book-versus-tax accounting differences for acquisition costs in both the year of acquisition and subsequent years.
Certain expenses related to acquisitions were previously capitalized as part of the purchase price, are now expensed and can hurt reported earnings, another reason why CT Capital has always preferred cash flows. Transaction debt related to debt issuance can be capitalized, which of course, we would look upon poorly. For a list of intangible assets that may be capitalized, see IRS regulations or Security Valuation and Risk Analysis.
Stock Based Compensation
Should stock based compensation be deducted from free cash flow (or EBITDA), as normally calculated? Yes, but the appropriate method is dependent on whether the firm is active repurchasing its shares.
As Synaptic’s (SYNA) shows in its 10Q, for the three months ended December, 2010, $9.5MM of stock based compensation was included in COGS ($0.4), R&D ($3.3) , and SG&A ($5.7).
For firms like Synaptic’s, share based compensation constitutes a large percentage of cash flow from operations. For the cash flow analyst, the procedure for analysis is quite clear cut. However, for those investors who tend to rely on GAAP measures, a separate set of issues arise, not the least of which are the assumptions underlying the expense. For instance, while it is well known the vesting period would influence the rate and amount of the expense, so too would the rate of forfeiture and any associated tax benefit.
In fact, during 2009, Synaptic’s needed to restate its earnings due to a change in its software used to calculate the forfeiture rate until the final vesting date, which resulted in a overstatement of earnings of $3.1 MM. To CT Capital, as we look at cash flows, for which the tax benefits are set upon vesting, the restatement was in fact immaterial. It does go to show, however, how share based compensation can influence reported earnings and commonly used analyst metrics.
Share based compensation in any particular year can influence how analysts measure margins or expense ratios. To the extent share based compensation is generous, reported margins may seem unusual relative to straight compensation. The decision of a firm to offer benefits should not be overstated, including employee benefits such as 401K plans or other stock based plans. Share based compensation also represents about 40% of Synaptic’s $36MM deferred tax asset.
Ultimately, the impact to cash flows of share based compensation must be accounted for through cash consumed from share repurchases and/or the impact on the free cash flow per share, resulting from the increased number of shares ( and tax benefit, if any) upon vesting.
For those firms which tend to offset share based compensation with share buybacks, those newly issued shares can come from treasury or newly issued shares.
Are Security Analysts Too Top Line Conscious?
While growth in revenues are the precursor of the cash collection process, and provide important clues towards product acceptance, market share and managerial pricing decisions, it is not uncommon for equity securities to also behave irrationally around an announced revenue disappointment. Firm’s market shares can “bounce” around a central tendency while “corrective” revenue propping actions are undertaken. Certainly, by the time any sales shortfall is reported to the public, the cost structure is being addressed, if not already being adjusted, thereby often placing the firm towards stabilization of the long-term free cash flows. This is especially true for firms with extended histories of stable market shares.
Market share shifts are seen throughout the business cycle as competitors jockey about, and in so doing, are willing to accept lower margins, hoping that in the long run, such pricing actions will alter customer behavior. This does not normally work to the benefit of shareholders.
Since new product launches are typically fought with pricing, market shares shift and perceptions of new industry leaders take hold. The importance of the sales and marketing teams, lead by the executive officers are important reinforcements while a firm awaits their own product introductions.
In the meantime, as margins fall and revenues disappoint investors, over-reactions occur, frequently pushing the afflicted stocks below the fair value of their free cash flows, adjusted for their cost of equity.
For over 30 years shown I have shown that firms with a long history of stable normalized growth of free cash flows and associated low cost of capital see superior stock performance, even though such performance can at times be uneven. IBM (IBM) represents a notable example, as its stock underperformed during a period of subpar revenue growth as its management adjusted its investment portfolio. Even during this period, however, the firm’s free cash flows were increasing.
Disclosure: EBAY and SYNA are long positions for CT Capital LLC clients
Kenneth S. Hackel, CFA
President
CT Capital LLC
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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” (McGraw-Hill, 2010)
