(The comment below does not constitute an opinion as to the valuation of Honeywell (HON) common stock—only its pension accounting.)
However, for investors who make buy/sell decisions on the basis of P/Es or other accounting conventions, the news out of Honeywell was certainly good. For 2011, the firm, based on information released yesterday, expects to accrue a $200MM expense on its P&L, despite an actual cash contribution into its pension plans of $1 billion. Its shift to mark-to-market helps during periods of rising asset values.
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Honeywell (HON) announced a change to its method of pension accounting whereby it will reflect changes in market value each year instead of the smoothing them, which helped show a healthier plan when market values were declining for Honeywell. Now that market values are rising, Honeywell is desirous of changing its methodology. The company then revised its earlier results in conformity with the changes.
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Taxes are an important focal point of securities analysis due to its scope, size, as well as its direct and measurable impact on cash flows. Taxes impair current and prospective operating cash flows because it is imposed on residual profits, after a series of adjustments and credits; the only question is the degree. Investment projects are always considered on an after-tax basis, considering both the income tax effect and the financing effect. Special tax incentives may also impact the hurdle rate and project return on invested capital (ROIC).
Because taxes are not imposed on its income an enterprise pays as interest to creditors, the income tax system creates a bias in favor of debt financing. This bias often results in the overuse of leverage by some firms, and a greater probability of bankruptcy.
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When Kraft (KFT) released its balance sheet and income statement when reporting its fiscal third quarter last Thursday, it did so without a corresponding statement of cash flows. In its place, including during the ensuing conference call, Chairman Rosenfeld redundantly pointed to operating earnings without a single mention of cash flow, unusual given the heavy reliance by investors on the dividend. Operating earnings do not represent distributable cash flows, among other reasons, it is reported prior to interest expense, which is hefty for Kraft.
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UPS sold $2 billion in long-term bonds to fund its pensions yesterday, raising its total debt/equity to over 100%.
Although UPS is a solid and consistent generator of both free and operating cash flows, we saw that during the credit crisis of a short couple of years ago, even UPS’s fixed income securities could be impaired.
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If equity markets represent the flawless leading economic indicator generally believed, investors should be very comfortable nowadays. After all, the S&P 500 is up almost 12% so far this year. Yet, economists remain generally concerned.
Is it not then unreasonable to ask: Are the glorious headlines trumpeting rising free cash flows portending a sustainable and durable continuation of the economic expansion or perhaps the result of severe cost cutting with a dose of imaginative accounting?
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The province of insurance is often a misunderstood and lightly inspected area of security analysis. It is, however, becoming increasingly important in cash flow and risk analysis in light of rising health care costs, growth in corporate assets, a seemingly higher incidence of natural disasters and lawsuits, and other specialized needs for which insurance is required. This has resulted in the rising use of self-insurance as a cash savings technique.
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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.
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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.
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Kenneth Hackel, president of institutional investment advisor, CT Capital LLC, submits that the lessons related to the crisis of the credit markets during 2007-2009, including effects on the economic and financial markets, have been well constructed. What he believes is not as well-known, is the equity market, as measured by the S&P 500, has lost much of its prowess as a forecaster of pending economic change, and therefore as a forecasting tool of pending recession and expansion.
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Given the rise in financial valuations the past 7 weeks without any obvious increase in economic strength also present in the “Main Street” economy, detailed security analysis is now taking on increased gravity. This is especially so with another earnings “season” upon us, and with it, an avalanche of references to cash flow and free cash flow. If only investors and financial reporters had greater clarity regarding cash flow analysis, stock volatility would be much reduced and investors’ financial results improved.
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I see the head economist at Goldman Sachs (GS) is now forecasting the US economy will either be “fairly bad” or “very bad.” If his forecast proves accurate, what does that say about equity investors in general, who have carried valuations and equity benchmarks to new yearly highs? Does it also tell you Goldman’s economists and research teams are not on speaking terms?
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During the height of the credit crises a short two years ago, the hint of a credit downgrade was sure to result in an outsized drop in the underlying stock. On the other hand, a confirmation of a rating pushed the impacted stock higher. Now, due to the considerable balance sheet re-liquefaction and built-up capital, the fear of a credit rating is not near as worrisome.
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News from MetLife (MET) After Market Close: Low Interest Rates to Impact Earnings
Expect to hear a lot more about the impact of low interest rates. Not only is it affecting the asset side of the balance sheet, but the liability side as well, as I have been pointing out almost weekly since June.
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Intel (INTC) and Research in Motion (RIMM) came onto CT Capital’s buy list over the past month after having been brow-beaten by many security analysts. Analysts believed these firms are, or soon will be, succumbing to the modern tablet era which will either make their current product line-ups obsolete or less relevant, as a new stream of products gains a foothold on their market share.
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I have written extensively on business combinations over the past six months, including “hidden” costs associated with their taking place.
The current economic environment, that of slow top line growth with a boost in year over year financial flexibility is often a recipe for happy investment bankers. But what does it mean for equities?
Here, history is crystal clear: investors would be incorrect to presume a step-up in merger activity would presage higher stock prices, which can only take place with improvements in free cash flows and reductions in the cost of capital.
While the cost of after tax debt continues to decline, the cost of equity has remained stable over the past month.
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The news of Adobe Systems (ADBE) yesterday would have not surprised the serious student of cash flow and cost of capital.
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In this article we look at evidence that strongly suggests IBM (IBM), despite being turned into a cash “machine,” has done so not through its own R&D efforts, but rather through massive cost cutting. And its strategy is errily similar to that of Hewlett-Packard (HPQ), even prior to today’s announcement of a $1.7 billion acquisition, its second large announced deal over the past week.
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IBM (IBM) CEO Sam Palmisano should measure his words prior to speaking badly of others.
In an interview with the Wall Street Journal, Palmisano said that during former CEO Mark Hurd’s five-year tenure, Hewlett-Packard (HPQ) was hurt by sharp cuts in its R&D budget, and that the company was declining in relevance.
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If one values a share of stock using the same analysis and judgment as that of owning a US Treasury bond, they would consider its worth to be the present value of its tax-adjusted free cash flows plus a terminal value; for that is how bonds are indeed valued.
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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.
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The Obama administration’s proposal to make the research and development credit permanent and to allow for a temporary 100% tax deduction for qualified capital expenditures is sure to boost cash flows. However should the IRC deduction 199 benefits be rolled back for the major oil companies, as is being currently discussed, the impact to certain firms could be harmful in out years.
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The securities analyst must be aware of and take into consideration those “added” costs and expenses which can add significantly to the cost of a transaction. It is long been shown that most mergers, while strongly defended by management, fail, in good part because they fall short in delivering the intended result—higher cash flows and lower cost of capital.
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In March 2005, shares in NCR Corp (NCR) tumbled over 17% the day it was announced Mark Hurd, its CEO, would leave the company to join Hewlett-Packard (HPQ). At NCR, Hurd had cut costs while increasing revenues, and as a result, free cash flow grew substantially. As the shares in NCR were falling on the date of announcement, stock in Hewlett-Packard rose over 10%.
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I was looking at some of this years’ winners and losers and couldn’t help but notice the discrepancy in returns of Hewlett-Packard (HPQ) versus Lexmark (LXK) going back 3 years. For this year, Lexmark is up 35% and Hewlett-Packard down 25%.
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