Credit Trends

Credit Trends was interviewed about BP’s pension plan by Pensions & Investments Magazine.

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The table at the bottom affirms the relationship between stock price valuations and cost of capital. While the free cash flow multiple is also 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!

During bull markets expansion in multiple valuations is commensurate with like growth in free cash flows, pushing those multiples even higher.

During bear markets, even though firms are more managed for risk, the cost of capital rises, as investors demand additional compensation for the increase in exposures. This comes even though valuation multiples are being suppressed.

As the table shows, during June, 1987 (which doesn’t seem that long ago to me) I was warning of impending risk, and finally shortly before the October crash, was quoted in the New York Times: “ The bull market is dead , it’s over.”  This quote was repeated the following day.

Several months after the crash, as many firms needlessly fell to ridiculous levels, four stocks in my clients portfolios were bought out. Because of that, I was featured in an Inside Wall Street column in Business Week titled “A Divining Rod for Deal Stocks is Striking Gold” and from that article, correctly predicted no less than 4 additional companies than were eventually bought out. It was just a matter of cash flow, risk and valuation. Nothing, as Warren Buffet would surely note, has changed in how the valuation of financial securities should be performed today. There are new instruments, to be sure, but how one goes about such valuation of risk and reward, will barely change.

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.

To see our worksheet, please pre-order “Security Valuation and Risk Analysis.” at any online bookstore.

As for where we stand now, and what investors can reasonably expect, the table, our other data and history, point to sub-par (below 8%), yet positive returns over the coming year. The cost of capital, at 9.1% is sufficiently high such that any increase in risk would surely result in a magnified effect on stocks.

True, the free cash flow multiple is in the bottom quartile of its historic range, but the cost of capital is in the top half. This combination of higher risk and lower valuation is almost always a recipe for out-sized volatility. Normally it takes years to see the type of reduction in risk necessary for a prolonged expansion. If that seems excessive, recall stocks have declined over the past decade. This, however, should not preclude investors being exposed to stocks. With 10-year Treasury’s under 3%, investments in firms with a clear spread between their cost of capital and their return on that capital should bring superior returns to their stockholders, given a below-market multiple for those assets. This has always been the case and always will, in a free society (sovereign risk is one of our cost of capital metrics).

We will attempt to bring you some of those firms in this space. We will also point out firms which are selling at inexpensive valuations, but behind the financial curtain, are really risky securities to be avoided.

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

FCF MULT	COST OF EQUITY	S&P APPX F.Value	YEAR
16.9	9.2	1090	Mar 2010
16.5	9.1	1156	July 2010
16.5	9.2	1124	May 2010
17.0	8.5	953	1995
17.8	8.7	982	1996
18.0	8.8	1125	1997
20	8.8	989	2002
20.5	8.7	1118	2004
24	8.8	1223	2006
27	9.6	1209	2007
24	9.5	304	June, 1987

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Example: At the beginning of this year Alcoa (AA) transfered $600MM in stock to a master trust, which can later be sold, but will still be outstanding.  This is stock (44.3 MM extra shares) which will reduce all financial measures-earnings per share, cash flow per share, return on invested capital…… And what’s more, Alcoa needs to place more cash into its still underfunded plans!

But Alcoa is not the only firm with such a need. There are many thousands like Alcoa, and at least 20 public firms have announced in-kind contributions over the past year, according to a search on EDGAR, the SEC database.

A couple of weeks ago there was a story of a U.K company which put whiskey futures into its pension plan to shore up funding. I would remind you this was not the first of its kind. Public firms have placed non-cash (in-kind) assets onto its plans for a long time—for instance, a number of years ago US Steel placed timberland into its plan and many firms have contributed stock of its publicly traded subsidiary companies. Years ago, some firms placed company stock into pension plans as a takeover defense. Is it possible Alcoa was doing the same?

Department of Labor approval is required for in-kind transactions in order to protect the interests of the participants.

It’s all part of cash flow analysis. Why? Because when firms understate their pension contribution, as Alcoa has been doing, they are overstating their cash flows. Stock contributions could also aid prospective free cash flows as the contribution is a tax-deductible expense and, by preserving cash, could be a value-enhancing and accretive transaction. For firms operating at a loss,  the tax-deduction, if a loss-carryover credit remains, could be entitled to an additional refund.

Stay tuned! Alcoa had negative free cash flow during its first fiscal quarter and was only able to show positive cash flow from operating activities for its last fiscal year from “working” its balance sheet.  On the positive side, they have been aggressive at reducing its corporate and downline overhead. They used derivatives and swaps, but as hedges. Also, their cost of sales was somewhat artificially bloated last year due to a halt to a tax benefit in Italy. Alcoa still has a ways to go in streamlining, which will aid free cash flow, as its growth rate in key areas is still high in relation to its growth in cash flows, as normalized and adjusted. Alcoa can easily free up several hundred million dollars in free cash flow from additional expense cutting, according to the proprietary data of our firm CT Capital LLC.

If you’d like to learn more about cash flow and risk: Pre-order “Security Valuation and Risk Analysis” McGraw-Hill, on Amazon or other online book stores.

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Sell-side analysts and investors are, as they should, scouring to find the next Apple Computer.

In order to help the process along, we ran our proprietary software, with a few popular metrics capsulized in the table below.

What is surprising from the table below is that investors had quite a few years to buy stock in Apple when it was between $50-$100 per share, for at that time the company was already showing a powerful rate of growth, and the ability to produce superior free cash flow and return on its invested capital. Over the ensuing five years, Apple has been able to reduce its risk parameters, which we measure as its cost of equity capital, and which we will delve into in additional blogs in the weeks ahead.

As the table shows, for the period 1997-2009, Apple showed a compounded rate of sales growth of 11.8% per year very similar to its growth rate in sales between 2000 and 2005.

In addition to the metrics in the table, we reviewed at least 60 other fundamental metrics, from tax rate, cost of sales, and other financial stability variables, to R&D efficiency, patents, pensions and other post-retirement, purchase agreements, commitments, litigation risk, use of cash, growth in certain metrics compared to others, etc.

We believe we have the most comprehensive fundamental database that exists!

Let me say, before I go further, I have not found the next Apple Computer, if indeed there is one out there. The closest company in all metrics was Google, but picking Google is no fun, besides being within 20% of fair valuation.

From the initial screens, firms dropped out for many reasons, some financial, some credit, many “other,”  such as pending litigation. Some firms were buying back stock, which Apple does not, and which we have long felt is a waste of shareholder cash. Share buybacks do nothing to enhance shareholder value and certainly nothing to improve return on invested capital (ROIC).

With that said, what investor would be against a double, which we believe our recommendation offers.

OPEN TEXT CORP.

Open Text (OTEX) develops and supports enterprise software specializing in Enterprise Content Management (ECM) solutions.  It has strategic alliances with SAP AG, Microsoft Corporation, and Oracle Corporation. They have the second leading market share in its field at 18%, versus IBM’s 22%. ECM is essentially software that manages everything from invoices, mail spreadsheets and any other business content important to the firm. Open Text brings forth a best practices approach, combining features of the leading software vendors such as IBM’s Office, with those of Oracle, and SAP. The partner represents 10% of OTEX license revenue as their biggest partner.

OTEX has a diversified global and customer base of leading industrial, government and financial firms. Sales are 53% North America, 39% Europe and 8% Asia and other.

The recent fall-off in OTEX shares is creating good value for investors. Its shares, having reached $50 in May, due to a  disappointing quarter from Europe and Asia, is now trading at $38. Over the past 5 years, revenues have risen by a compounded rate of 21.9% and free cash flow by 39% per year, a rate which is now obviously slowing considerably, but, whose long term growth approximates that of Apple. Recall Apple sputtered in quite a few periods itself.

OTEX is seeing bigger swings in its quarterly GAAP results due, in part, to recent acquisitions making seasonality more pronounced. Such swings are being created by governmental expenditures, a large customer of recent quarters resulting from the most recent acquisitions. Even though earnings are showing greater inconsistency, free cash flows are remaining strong. In fact, the firm has stepped-up hiring in Canada, where business remains robust.

With a market value of $2.1 billion, Open Text currently sells at 11.4 x free cash flow versus 16.5 x for the S&P Industrials; 15% of its current market value is in cash which will see a significant build, ex acquisitions, over the coming years. Over the past three years its operating cash flows adjusted for balance sheet changes are roughly similar to its operating cash flows-this signals the management has not been engineering its balance sheet to raise cash, which is what one would expect with a strong, consistent producer of free cash flows like OTEX.

Of equal importance is OTEX’s return on invested capital (ROIC) of 18.5% compared to its cost of equity capital of 9.1%, below that of the median S&P cost of capital of 9.2%. Cost of capital has risen of late due to greater volatility in its financial results. By comparison, EMC’s ROIC is 15.6%. The firm has shown a positive spread over its cost of capital in each year but one year since 2002, but still produced free cash flow in that year. The firm is very much a value creating entity, in good part from well-priced acquisitions. In this regard, management has stated it will be utilizing its upcoming free cash flows for acquisitions rather than buybacks. Acquisitions are small and thus have greater chance for success as integration and financial risk are reduced.

OTEX has benefited from a very low cash tax rate versus an effective rate, from large loss carryforwards (many from acquisitions) for which it is only allowed to utilize the credits over time. It has large foreign loss carryforwards. Of the total, $26 MM is domestic and $406 MM foreign. Expiration is not a concern.  Its most significant tax jurisdictions are Canada, the US and Germany. Cash taxes should remain low for the coming five years, at which point the economy should hopefully bring up the most recent growth rate. In just two of its past six years, has OTEX paid greater than $7MM in taxes.

Although not debt free like Apple, owing to its acquisition program, its fixed charges, including that related to pension are easily serviceable from operating cash flows, including debt reduction from free cash flows. Its discount rate related to its pension is, at 6%, is high but, as adjusted, adds little to overall liabilities. The fund is underfunded by $14.8 MM . Its annual service and interest cost is less than $1MM. OPEX  has a 7 year term loan at LIBOR plus 2.5%, expiring in 2013 which they should have no trouble, given current conditions, extending.  They are also employing a derivatives’ strategy as an interest rate collar having a $100MM notional value. Collection period and days payables outstanding reflect a healthy concern. OTEX uses a limited cash flow hedge for foreign currency.

Given normalized 10% long-term growth, and 18x multiple, which would be conservative given its consistency measures, its weighted average and equity cost of capital, and 3% inflation, fair value is estimated to be in the low $80’s, a price which we feel should be realized within the coming three years.

OTEX has risk and should not wish to be considered by certain investors-consult your investment professional.

Investors and potential investors should not rely on any information contained herein or communicated by any means to replace consultations with qualified investment professionals to meet their individual investment needs.  The materials contained herein are for general purposes only.  They do not have regard to the specific investment objectives, financial situation or risk tolerance of individual or corporate investors.  Investors should consult with a financial professional prior to making any investment decision or investing in any of the firm’s products.  CT Capital LLC, it employees, or any associated individual, is not responsible for any investment decisions the recipient of these materials may make with respect to any investment.  Data contained herein is gathered from sources believed to be correct and reliable but assume no liability for the accuracy or validity of any material whether written or verbally communicated.  Nothing in this presentation should be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security or investment by CT Capital LLC, its directors, officers, principals, employees, agent, affiliates, or any third party.

No employees or clients of CT Capital LLC  or www.credittrends.com own a position in OTEX., nor was CT Capital or credittrends paid for preparing this report.

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Most corporate managers and economists believe productivity measures lie at the top of determinants of value creation and corporate health.  For that reason, it is a recurring theme during meetings with investors and in regulatory filings, as expressed in a September, 2009 8-K filing for Kraft Foods (KFT) concurrent with their bid for Cadbury PLC: 

“A strong pipeline of cost-savings initiatives will result in higher productivity and better margins as part of its three-year plan.”

We will see that while productivity is certainly an important factor which could lead to higher cash flows, its positive bearings are primarily confined as a measure of consequence to the current or soon-to-be free cash flow producer.  For, if a firm’s products are met with insufficient demand, and the inputs under which they are produced do not generate satisfactory cash flows, it would be rare for productivity improvements to be able to turn the business around.  If the entity is a satisfactory producer of free cash flow, then productivity improvements can indeed lead to even greater free cash flow and a higher security price.  For this reason, top line growth and cash flow from operations are more important valuation and cost of capital metrics, than productivity.  In fact, productivity measures are an over-rated metric.

During periods of slow growth, or expectations of slowing growth, managers often pursue a downsizing strategy, including layoffs, efficiencies, and reduction in the number of manufacturing facilities, all in an effort to improve long-term productivity. But what can realistically be expected from such actions?

Corporate executives who are continually reviewing their internal portfolio, enhancing their products and lines of business, filling in strategic gaps where necessary to improve core competencies, while eliminating and streamlining those assets that underperform, with an eye on cash flows, typically see higher returns on invested capital than those entities which simply look to shed labor as a quick fix solution.

This is an important distinguishing factor in CT Capital’s cost of capital credit model.  While the model considers productivity boosting measures as value enhancing, it is not awarded the large weighting most investors  believe exists, and for companies which are not positive producers of cash flows, its weighting is zero.  The weaker the cash flows, the lower the importance of enhancing productivity is to cost of capital improvement.  If an entity has no prospect of ever generating free cash flow, its equity value, as a going concern, is at best zero, regardless of how many units it produces.

The workforce and productive capital and plant can be set once current and projected operating and free cash flow are reasonably estimated; it would be imprudent to match workforce and plant with units of production or revenues if the entity is not capable of generating long-term free cash flow.

Determining the optimum labor force as being a function of sales or unit output does not reflect upon an enterprise as a cash flow maximizing entity but rather as a unit producing entity.  Determining output based on profits may not leave distributable cash to the owner of equity. The corporate managers and analyst must therefore determine the level of output that places free cash flow at its highest  level , both today and prospectively.

Free cash flow is maximized at that point on the chart where labor is most efficient.  If the current level of employment cannot produce satisfactory free cash flow, management must seek a lower cost labor pool, downsize the labor force, become more productive, raise prices, reduce other expenses, or lastly, sell the asset. If, by virtue of such action(s), the entity turns into a free cash flow producer, it has value to its equity owners.

For a detailed analysis of stock prices, cash flow and productivity, see “Security Valuation and Risk Analysis“, McGraw Hill, November, 2010.

Disclosure: No positions

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

http://www.credittrends.com/blog/

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Debt covenants pertaining to the entity’s most restrictive requirements must be calculated in each reporting period and all covenants that are disclosed must be reviewed for closeness to violation. Each quarter, we determine which debt, income, working capital and other covenants might be exposed over the coming two years.

If the entity might be required to raise capital to reduce leverage to avoid violating a condition, the likelihood of such a raise must be appraised, as should the need for, and probability for success of (including cure resulting from), an asset sale. The violation of a covenant requires the assistance of investors and creditors and thus the relationship with such parties must also be assessed. Although some covenant violations are relatively easier to cure than others, such as a violation caused by a change in an accounting standard, the entity must stand ready to address remedies to any current or future violation.

The effect of, and possibility of, cross-defaults must be explored, including an examination of the entity’s holders of debt securities, should the possibility of breach exist.
Any forbearance issued would result in a large penalty to cost of capital. If the entity is unable to bring its debt payments current, foreclosure and bankruptcy are imminent. Even if the entity can satisfy its creditors, it often comes at a large cost to equity holders.

If the analyst believes it more likely than not a violation will occur and a remedy questionable, the entity’s cost of capital would be marked up at least two percentage points, with the amount dependant on the severity and likelihood of a cure. If a probable violation could result in bankruptcy, the mark up to cost of capital could be in excess of 20 percentage points. At this stage, analysis becomes one of asset and liquidation values and re-organization cost estimates.

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

www.credittrends.com

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A good question,and one that is soon to haunt many stock investors.

How?

The median S&P firm assumes their defined benefit plans will be able to return 8% on their plan assets, far short of that which appears reasonable. Even with yesterday’s 3.1% rally, stock returns have been quite negative in almost every period over the past decade.  And what about real estate? For firms that thought commercial properties would raise their long-term returns, those returns have been poor as well. No help there!

With the economy, including employment, lagging, is their any reason to believe financial assets will return to the 8% annual level? We think not.

And if firms decided to terminate their plans and place those assets in insurance annuities? Forget it, as annuities are yielding about 4.5%, depending on the contract being written and the risk the pension sponsor is willing to take back. This compares with a median discount (settlement) rate of approximately 150 basis points higher.

Aside from the exorbitant investment return assumption, sponsors are also benefiting from other liberal actuarial assumptions, such as the spread between the investment assumption and the salary assumption, the latter now 4%, on, average. The problem is that the investment assumption is a more powerful variable, as it applies to both the active and retired workforce.

For pension plans that were underfunded 2 years ago and received the benefit of last years financial market rebound, the chances are they have returned to underfunded status, probably requiring stepped-up contributions. To the extent they hold this off, they are overstating their cash flows.

It is an area worth exploring- as investors in GM learned.

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The highest percentage of net present fair value of an equity security is derived from the most immediate free cash flows. However, since BP is expected to produce slim free cash over the intermediate term, an investment may still be warranted, according to the estimates below.                  

We do not recommend an investment in BP, as higher success opportunities exist, and the probability of the much written about buyout is, as we see it, less than 10%. Additionally, BP’s pension fund requires contributions of at least $1.5 billion more per year than is currently contemplated, making even our estimates quite uncertain. However, as seen below, if the estimates were achieved, only 10% of BP’s current fair value is derived from the free cash flows of the current and next three fiscal years.

Our point is the coming three years should not be the determining factor to an investment in BP if the company can at least stay free cash flow neutral during this time.

Only if one believes BP’s free cash flows will be negative for the coming three years, and subsequently be unable to resume growth in that key metric, should an investment be avoided, and a short position established.

On the contrary, if an investor believed the added liabilities resulting from the Gulf disaster would diminish free cash flows such that BP were free cash flow neutral (or slightly negative) this year, marginally ($3 billion positive next year) and then slowly regain free cash flows such that it would surpass its past three year free cash flow average of $ 11 billion during the 2016 fiscal year, BP’s current fair value would rise to the high $30 area.

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

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With interest in stocks seemingly waning, a potential boost could be on the way-thanks to the U.S. Congress via financial regulation.

It is now a given that proprietary trading and derivatives activity are going to become a smaller part of financial firms balance sheets-effecting large investment banks and insurance companies. The benefiting outlet of such financial intermediaries  could very well be their private equity businesses.

JP Morgan, for their 2009 fiscal year, reported about $80 billion in net derivatives receivables versus just $7.3 billion in private equity.

Goldman Sachs reports private equity as part of their $146 billion in alternative investments, and is probably no greater than  10% of that asset class.

Although a minority of the private equity assets of such firms are currently in publicly traded firms, that could easily change, given today’s low multiple valuations and the extended investor time horizon assumed in private equity deals.

To the extent such large financial firms are forced to curtail current lucrative areas as a result of new regulation and oversight, the beneficiary could very well be an increase in private equity and M&A activity, the result of which would be a positive turn in investor confidence, valuation multiples, and the cost of capital.

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If valuation levels are so inexpensive, doesn’t it stand to reason merger activity and buyouts would be sprouting?

After all, ten year AA’s are yielding 4.1%, or an approximate after-tax cost of just 2.9% for the 30% cash payer.

While the cost of equity capital is substantially higher-9.2% for the median S&P Industrial, a weighted average cost of capital, assuming a 20% cash, 60% debt 20% equity deal, is approximately 3.2%, given today’s cash yield.

If free cash flow is as high as has been reported during the past earnings season, not to mention the expected growth by security analysts, one would logically assume buyouts to be flourishing. After all, if one believes the free cash flow numbers being reported as accurate, the gap between that number and the cost of capital would add significant value to shareholders. After all, wouldn’t you invest in firms with a free cash flow yield of 8% if you could borrow at 3.2%?

The reason we are not seeing more M&A activity is simple. The free cash flow, as is being defined by analysts is incorrect, that of operating cash flow minus capital expenditures. They are not making the important adjustments to cash flow from operating activities to divine the real free cash flow number, which is lower than being reported.

To learn more about this, order “Security Valuation and Risk Analysis’, McGraw-Hill.

Acquisitions are typically value-destroying undertakings for shareholders, and are considered a negative signal for shareholders and creditors. Many companies look upon acquisitions as a growth strategy without a clear plan for synergies and the creation of additional free cash flow. Most acquirers overpay. While financially flexible firms often have the capacity for acquisitions during economic downturns, when prices would be lower, they most often wait for economic expansion. The most successful business combinations are those which build upon established core competencies.

Underperforming entities which attempt to improve their performance by buying well-regarded competitors normally run into trouble, as a “best practices” approach typically succeeds when both parties to an acquisition are already successful.

There are many notable examples of large companies failing in a business combination: AT&T’s purchase of NCR, Time Warner’s purchase of AOL, Applied Material’s acquisition of Etec and Damler’s acquisition of Chrysler. In each of these cases, the entity being acquired had a cost of capital in excess of its ROIC.
When final demand in a particular industry shows signs of slowing, or firms have excess cash on their balance sheet, it is not unusual to see merger activity pick up. At this stage, most failed mergers take place.
But not all mergers are value-destroying. Acquisitions grounded on cash flow, as opposed to “filling in gaps” or shortfalls in revenues or product, have a greater probability of success. And, if the acquirer can easily reduce the cost structure, free cash flow can increase significantly, lowering cost of capital. Exxon’s purchase of Mobil resulted in points deducted from its cost of capital.
Some of the more easily cut costs are duplicative departments and cost savings in key expense areas, such as finance and treasury, advertising, technology, insurance and employee benefits. Manufacturing, including the supply chain and transportation can also results in significant savings. If the acquired entity has been mismanaged, new management can quickly turn the cash flows is a positive direction.
Successful business combinations are marked by experienced managers who have shown a history of success with such integration. When this is the case, the merged entities combine various departments and put additional pressure on vendors for cost savings. Difficulties are more easily overcome as experienced teams work together toward a common goal, pulling in employees who can solve unique problems. Vendors often feel obligated to cut their selling prices under the fear of losing the relationship. Landlords are also under pressure to hold back increases as leases come up for renewal as good, strong tenants are often difficult to replace, and also act as a draw to the property. It is thus important the analyst weigh the effect of a business combination on tertiary parties. If a supplier is weakened resulting from a business combination, the price for an important input could rise.

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There is not a single firm that measures risk as we do. As you know, we have been bearish on stocks for the good part of a year. Even when stocks were reaching new post-credit crisis highs, we did not bulge.

Why?

Because every firm measures risk using the same old, worn-out, models that base risk off of volatility or non-distributable earnings.

We measure risk using the most important factors to a business. Items including sales growth, sales volatility, cash burn, credit spreads, ability to roll over debt, foreign risk, insurance, possible loss of a patent or key executive, taxes, and over 60 other variables.

Everything we do is more intensive.

From how we define free cash flow which includes excess expenditures to invested capital which is based off of our proprietary free cash flow.

Maybe you would benefit from learning these credit and cash flow methods?

If you are interested in becoming a better securities analyst, pre-order “Security Valuation and Risk Analysis” available at all online book outlets.

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I doubt the merger talk making today’s news will lead to a buyout of BP.

There is just too much unpredictable risk involved and the size of any buyout too large ($100 billion+), to say nothing of probable earnings and cash flow dilution, for such a deal to have merit.

As for Exxon, the name most prominently mentioned, I would be shocked if they accepted the risk a buyout of BP would entail, especially given a glut of oil going into a period of a worldwide economy showing clear signs of fragility.

While we have written we expect BP to engage in at least $10 billion in asset sales, which should be part of a program to bring the cost of capital down, and which should aid the stock price,a full out buyout is quite unlikely.

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Despite a free cash flow multiple that would normally signal a rally in the equity markets, stocks are sinking.

Even we started to believe, after being negative most of  the year, we would see such a rally, given the past 25 years of data. Investors are not lengthening their time horizon, preferring to focus on an increased cost of capital, rather than potential return-unfortunately, there is no way of forecasting an end to this current valuation/risk matrix, which can, in fact, exist for many years.

Why has this been the case? The answer lies in the cost of equity capital, the true and only real measure of fundamental risk, which began the year for the S&P Industrials at 8.3%, but now stands at 9.1%. Simply put, investors are demanding a 9.1% return to invest in the average equity, or else are content to “sell” or sit on the sidelines. At CT Capital, we measure at least 60 metrics of cash flow, credit, and other variables, fundamental in nature, which measure everything from a firm’s cash flow consistency to its credit spreads-and, by and large, the cost of equity has been increasing, with minor exception, throughout the year. We believed the low valuation multiple would overcome this, but thus far has clearly not been the case. Currently, 9.1% expected returns are not readily available, and thus despite a 16.2x free cash flow multiple, compared to the average 21.5 multiple of the 1990’s, a rally is not in sight.

Equity markets are normally volatile when cost of capital and free cash flow multiples are moving in opposite directions, so that alone does not scare us.

Despite the S&P, when looking at our free cash flow/cost of equity model, showing undervaluation of 7.1%, we should not expect an equity rally until there is a sustained improvement in risk. While at market peaks, little attention is paid to risk, at current, the 7.1% undervaluation is not sufficient reward to entice investors given the risk to corporate cash flows. This risk may not be apparent with the upcoming earnings season, even though much of the free cash flows reported last quarter represented managed expense and catch-up spending, rather than add-on growth.

As such, we would move portfolios back to maximum cash until cost of capital falls back to below 8.5%.

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The company must:
1-Produce detailed pro-forma five year financial statements showing they have the capacity to make it through the period given the steps below.

2-Announce a sale of 1 billion shares, something we called for at the very beginning of the event, and has, by delaying, cost the firm at least $5 billion. The UK Government might be needed now to buy half the shares, which they will agree not to sell for at least ten years.

3-Announce asset sales of at least $5-$10 billion

4-Sell production into the futures market, thereby taking in at least $15 billion, of future revenue.

5-Announce they are eliminating the dividend for at least three years.

6-Work out a back-up contingency loan with the UK, at a very low rate, perhaps, with an equity kicker, if needed.

7-Cut back capital expenditures to no more than $ 15 billion, the level of 3 years ago.

If they announce and carry out these measures, I am confident the stock, after perhaps an initial fall, will rebound 20% from current levels, given no further setbacks in the Gulf of Mexico. They will have provided investors and current and potential creditors of the financial flexibility assuring not just their survival, but normalized growth. With the capital raise, and corporate squeeze on spending, they will have at least $75 billion currently needed to reduce their current high cost of capital.***************

*****************UPDATED FAIR VALUE TABLE IF BP DOES NOT TAKE 7 STEPS**************************

FAIR VALUE =$20.48

			Year
Discount Rate	11%	Probability	1	$       3.00
Present Value	$31.1	35%	2	$       1.00
			3	$       2.00
			4	$       3.00
Discount Rate	12%	30%	5	$       3.00
Present Value	$28.14		6	$       3.00
			7	$       4.00
Discount Rate	15%	15%	8	$       3.00
Present Value	$21.58		9	$       3.00
			10	$       4.00
			11	$       5.00
Discount Rate	18%	15%	12	$       5.00
Pres. Val	$17.22		13	$       5.00
			14	$       5.00
			15	$       5.00
Discount Rate	25%	10%	16	$       5.00
Pres. Vale	$11.39		17	$       5.00
			18	$       5.00
			19	$       5.00
Current FV		$20.48	20	$       5.00
			21	$       5.00
			22	$       5.00
			23	$       5.00
			24	$       5.00
			25	$       5.00
			26	$       5.00
			27	$       5.00
			28	$    30.00

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Even if absolute certainty existed with regard to a firm’s cash flows, earnings, sales and equity, its stock would still have risk, such as inflation, potential litigation, management change, loss of a patent, currency exposure, or any of many potential macro events.

When one introduces typical risks that confront a business daily, and I would include recent events in Greece and BP among them-an investor may believe the quantification of such risk is impossible.

I can tell you this is not the case.

We use a checklist of such events, both common and those very infrequent, and the only real risk is, I have found, to ignore their possibility. This is why I hope you order “Security Valuation and Risk Analysis” on Amazon or other online outlet. I am releasing a credit spreadsheet which will save you a lot of grief and perhaps a lot of money. It is also, of course,  intended to help you earn you superior returns by helping you point out firms which investors in general do not recognize, or have overstated their risks. The spreadsheet will help you in fundamental security analysis on a level which is not being done by any firm or analyst today-it will force you to examine and make adjustments to cash flows and risk, as measured by the cost of equity capital, which, I am sure, will place you head and shoulders above the competition.

In the meantime, please visit this site often, as I plan on releasing tidbits (but not the credit spreadsheet) which will be of help. For example, see the recent post of how to make adjustments to cash flow from operations.

If you are surprised by risk in the stocks you own, you probably didn’t do your homework.

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The firms in the following list all derive at least 10% of their sales and operating profits from the Asian region and have at least 10% of their total assets there.

Disclosure: No positions

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

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The median free cash flow multiple for the S&P Industrials fell to 16.8x and the cost of equity to 8.6%, the first time this has occurred in four months.

This is a bullish sign given the free cash flow multiple is in the bottom half of the valuation funnel. Holding the equity market back thus far in 2010 has, no doubt, been the upward re-valuation of risk. A large caveat is the cost of capital (risk), is in the top half of historic ranges, indicative of a volatile equity market with considerable risk. When the two are placed into a model, total valuation is indicative of an undervalued equity market which bears slightly more reward than risk for the patient investor.

Given the cost of capital/free cash flow valuation is in the lower half of the funnel, it would appear, baring an increase in the cost of capital, the nascent rally has a good chance for continuation over the coming year. As a whole, the S&P Industrials are undervalued by 5%

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These past several weeks saw the stock of one of the world’s largest firms plummet, with only minor, as yet, effect on cash flows. It was of course risk, or more correctly, impending risk to cash flows, that worried investors in both equity and fixed income assets of BP.

While surprises cannot be predicted, security analysts must constantly evaluate all risks, for even in BP’s historic 10Ks, we learned the extent of their insurance coverage for an event of this magnitude; and insurance adequacy is but one of the 60+ variables we look at in constituting the cost of equity, the required return shareholders expect.

We will learn more of these other risks in later blogs, any one of which could cause a seismic shift to valuation. Today, we will look at the risk to cash flow from operating activities. We will see, also during a later blog, we measure consistency of many factors, operating cash flow included.

The operating cash flow of the company in our credit spreadsheet is from the form 10K’s and 10Q’s. Cost of capital is penalized if operating cash flow (OCF) is negative. The greater the number of periods for which OCF is negative, the greater then penalty.  For some items such as postretirement benefits and other retirement obligations, we include the net cost for the period rather than actual cash outflows, in order to separate what we view as financing of these obligations from the operating cost component.

Adjustments to the operating cash flows may be made to the extent current reporting obscures the ability of the analyst to place a correct economic valuation on the enterprise. For example, the sale of accounts receivable would be picked up under operating cash flows, if reported as a financing activity. Capitalizing interest would be reclassified from investing to operating cash flow, as might interest, dividends and taxes that have been reported as investing or financing activities.

The signing of capital leases may artificially enhance operating cash flows. This is because that while the interest portion of capital leases are counted as an operating activity, the reduction in the lease, through those principal payments, are reported as a financing activity. We typically make adjustments to reported operating cash flow to remove items we consider nonrecurring and include those we consider recurring, so the historical financial ratios will be more indicative of future performance. These adjustments cover items including discontinued operations; effects of natural disasters; gains or losses on asset sales and sale/leasebacks; and one-time charges for asset write-downs, restructurings and plant shutdowns.

Other adjustments could be made to allow for better comparability among peer companies and to derive actual cash from operating activities which may be included as financing or investment activities. The nature of any adjustment is to more accurately reflect the ability of the enterprise to satisfy its obligations and enhance forecasting. When making adjustments, they must be consistently applied or comparability will be lost.

Typically, companies need to generate cash from their operations in order to survive. However, businesses may from time to time show negative operating cash flows in trough years, which should be offset by larger positive operating cash flows in good years. Similarly, a company may occasionally have, due to adverse business conditions or changes in balance sheet items, a year in which cash from operations is negative. However, an enterprise cannot sustain negative operating cash flows for long periods without obtaining additional financing, liquidating assets, or falling into bankruptcy.

If the firm’s business is contracting, the firm’s executives will attempt to extract cash through “working” the balance sheet, in which case we will see considerably stronger operating than power operating cash flows (which adjust for a normalized balance sheet)  and net income reported under GAAP. In these instances, power operating cash flow metrics would be granted greater weight than operating cash flow metrics.

For a complete discussion on this topic as well as all metrics in our credit spreadsheet, please order “Security Valuation and Risk Analysis,” Kenneth Hackel, C.F.A, at Amazon and all online bookstores.

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If the equity market were to rise less than 7% this year, the following firms would be particularly impacted. Column 3 shows some firms have expected returns of 9%, which would appear particularly optimistic, especially since all firms on the list have plans that are underfunded by at least $1bil. and have a substantial asset allocation to equities.

Disclosure: No positions

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

www.credittrends.com

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We have run our free cash flow model given an expected haircut to BP’s (BP) free cash flow (less so this year) with a very gradual build. We have also upped the cost of equity to both 10% and 11%, (although we are now using 11% in our own model).

We have also run more conservative estimates, which show a large hit to free cash flow than is being used by the average analyst. For example, in Scenario 1, we show zero free cash flow in 2012, and model minimal free cash flows in 2011and 2013-2015, with a permanently reduced impact in the years 2016-2023. The same free cash flows are used for Scenario 2 except with an 11% cost of equity (COE).

An average of the 4 scenarios, based on 15% probability for scenarios 1 and 2 and 30% probability for Scenario 3 and 40% for Scenario 4, equates to a current fair value of $36.24 a share. Of course, if one believed the bullish free cash flows of Scenarios 3 and 4 to be more likely, then fair value would be closer to $41.

We feel confident that cost of equity is at least 11%, especially given BP’s current 8.5% bond yield. This being the case, unless an investor was fairly confident BP would see the estimated free cash flows realized, there would appear to be greater value elsewhere in the financial markets than BP.

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

www.credittrends.com 
Follow me on twitter @credittrends

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A story that never received the proper publicity during the bull market of 2009-2010 was its very positive (savior) effect on pension funding status, and employer contributions. The rise in equity markets allowed many hundreds of billions of dollars to appear on the balance sheet as equity instead of having to be spent to plug the pension gap.

But most of those firms which benefited are not out of the woods, as the negative stock performance during 2010 is sure to re-introduce such large employer expenditures which could very well impair security analyst estimates.

The following is a list of firms which

• Have, for their most recent fiscal year, accrued a greater expense for their pension plans than they actually contributed;
• Have seen a decline in the value of their plan assets over the past 2 years;
• Have either maintained or increased their discount rate (assumed rate of return) over the past 2 years;
• Have seen an increase in their pension benefit obligation over the past 2 years.

Table 1[1]

Source: S&P Data Services, Company reports

Presumably, firms which have suffered a decline in their plan assets should not be forecasting an increase in their settlement rate, which is the rate their projected benefit obligation could be settled. Firms might do this to show a lower liability and to lower their plan contributions. Their auditors and actuaries should only allow this for a short time before demanding stepped-up contributions.

The following table shows, for the same firms in Table 1, last year’s pension expense as a percentage of net income, the funded status of their plans, these firm’s total debt which to which we include operating lease obligations and shareholders’ equity.

Table 2

Source: S&P Data Services, Company reports

While there might be to some, a number of surprising names on the list, keep in mind that additional large funding into the plans would most likely cause a disappointment to earnings estimates, even though the firm might have the credit capacity to fund with low cost of capital. In the game of expectations, such firms are particularly vulnerable given their funding status and have not, of late, contributed their actual expense.

Several firms on the list look particularly vulnerable. One such is Goodyear Tire (GT), whose plan (see Table 3 summary below) is very underfunded, they have not had the financial ability to catch up, and have a high cost of capital. However, as the list shows, many firms are vulnerable.

Table 3

Source: S&P Data Services, Company reports

The pension and other post-retirement benefit area should be receiving greater scrutiny that it currently receives, as time is sure to tell.

Kenneth Hackel, C.F.A.

President, CT Capital LLC
www.credittrends.com

Data Source: Research Insight, CT Capital, Company 10Ks

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[1] Pension-Funded Status Indicates the funded status of a pension plan as either overfunded or underfunded.  This item is the sum of: Pension – Long Term Asset  minus the sum of  (1) Pension – Current Liability and (2)   Pension – Long-Term Liability

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Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making

Kenneth S. Hackel, C.F.A.

Reason Book was Written: To introduce a successful and innovative approach to the valuation of equity securities.

Central Tenets: (a) Cost of capital, a principal component of valuation, should not be determined by stock volatility, as is widely practiced by enterprises, investors, consultants and security analysts, but by the entity’s cash flows and credit health; (b) Return on Invested Capital (ROIC), a principal component of valuation, should be measured as a function of the assets production of free cash flows, as it should benchmark the expected cash return for cash expended, and (c) Free cash flow should include cash the entity could easily free up, and this can be captured thru analysis of various discretionary spending areas. EBITDA, an income statement based accounting concept, is not a measure of the true economic return.

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Sell 1 billion shares at $30 per share and agree to eliminate the dividend for 3 years.

Currently, BP pays about $10 bil. a year in common dividends, so that after 3 years, if the company’s normalized free cash flows continue at the past three year rate, and the $30 bil. is dispersed, their book value will not have declined, as BP managers will be working all discretionary expenditures to generate cash.

They will then have $60 bil.+ ( with interest) to pay claims, which would be more than sufficient as cases drag through the courts and perhaps funds could be set up to pay effected parties. More than likely, given BP’s current balance sheet, they would have closer to $ 68 bil. without impairing its current financial structure.

As much as BP is making horrific headlines now, in three years, it will be a bad memory for most-the world will have gone through many crises by then.

If the price of crude rises, BP’s cash flows will be much stronger- as much as a combined $ 100 bil in operating cash flows and $40 bil. in free cash flow, with the added free cash available to pay claims, making for a total $75 bil.+ without severely impacting current financial structure.

With $75 bil.+,  BP would approach and put together various insurance syndicates with the huge pool in guaranteed funds to take over the liability.

Given the cost of the Exxon Valdex cleanup was $ 2.1 bil., with another $1 bil or so (after insurance) to settle claims, it is doubtful BP cannot satisfy claims from its financial flexibility.

After a couple of years, as it becomes apparant BP will work itself out of the disaster, and as management begins to “mop up” the additional shares from free cash flow, its stock should be at a level seen early this year. If the price of crude were to rise above  $ 95 bbl, the share price of BP could be expected to rise substantially.

As for the immediate issuance of equity, would BP be able to float the issue? Given its trading volume is averaging 300 mil shares a week on the NYSE alone, a deal that size would seem quite do-able.

The company’s first step, is to hit the equity markets for the raise. After the deal is placed, there is a good chance for a rebound in the shares.

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For most industrial entities, return on invested capital (ROIC) represents the most important measure of management ability. Projects whose ROIC exceeds its cost of capital, create value, and as value-enhancing projects continue to grow, the results are reflected in the acquirer’s share price. If the executives in charge of the firm’s assets are consistently able to invest in such projects, it represents the most management- proven technique to reward shareholders looking to build long-term value. Improvements in ROIC are seen in companies able to achieve higher margins, stronger cash flow, and low cost of capital.

For entities which operate on minimal capital, we employ a technique which is based on ROIC, but works better, since, as ROIC approaches zero, it results in extremely large, impractical returns, both positive and negative.

As Oracle Corporation, a very successful acquirer, wrote in its 2009 10K report: “We estimate the financial impact of any potential acquisition with regard to earnings, operating margin, cash flow and return on invested capital targets before deciding to move forward with an acquisition.”

When interest rates are low, corporate planners evaluate taking on projects they might not consider when interest rates are higher. The saving on cost of marginal debt might make such projects worthwhile for equity holders. However, if the cost of debt is variable (i.e., tied to LIBOR) and interest rates rise, the project might become unprofitable. For this reason, that possibility is almost always hedged, allowing the enterprise to eliminate that risk.

Return on invested capital is becoming one of the more widely used analyst metrics. It is of particular relevance however, when under competition with the entity’s cost of capital. By itself, only a vital, but often, partial picture emerges. And for entities or divisions of entities which cannot earn a greater return (on projects) on their invested capital than their cost of capital, its value will decline.

The ROIC is not a measure of security valuation. An entity can continue to accept projects which exceeds its cost of capital, but if its valuation multiple is excessive, its stock could very well decline in the short-run.

Entities which are underleveraged may be denying shareholders a higher valuation if they decline projects having a ROIC greater than the after-tax yield on the excess cash and cost of debt.

Corporate managers evaluate the firm and the business units return on invested capital versus those units cost of capital. Underperforming assets typically have a specific period to improve performance before strategic alternatives are considered. The inability to successfully divest or improve the returns on such assets in a timely manner, meaning, if the unit cannot achieve its cost of capital, could have a negative effect on the entire operations of the enterprise, including its stock price. Management attention is diverted to underperforming units in hopes of turning them around or getting them ready for sale. In addition, the process of divestitures could cause strains on the remaining business segments in need of cash to expand or retool their operations.

The theory behind return on invested capital is to present investors and creditors with an accurate measurement of the cash on cash return management has been able to earn. They need to spend cash to purchase assets in the hopes of a cash return greater than the cost to acquire them.

It is for this reason the analyst should not begin with a GAAP measurement such as net income or EBITDA, but rather free cash flow, in the computation of return on invested capital. Creditors, as with stockholders, expect a cash return, which may not be possible with accounting profits.

EBITDA INAPROPRIATE AS A VALUATION TOOL AND IN MERGER ANALYSIS

Return on invested capital, being one of the central determinants of valuation, has clear advantages over the use of EBITDA.

For example, EBITDA:

• excludes important tax payments that represents a reduction in cash available;
• does not consider capital expenditure requirements for the assets being depreciated and amortized that may have to be replaced in the future;
• does not reflect changes in, or cash requirements in working capital needs; and
• does not reflect the significant interest expense, or the cash requirements necessary to service interest or principal payments, on debt.

Even in a merger analysis, for which EBITDA was originally intended, its use is limited. In addition to the above drawbacks, it may not be useful since it:

• does not include share-based employee compensation expense, goodwill impairment charges and other charges which can impact prospective free cash flows;
• does not include restructuring, severance and relocation costs incurred to realize future cost savings and enhance the operations of the entity;
• does not include the impact of business acquisition purchase accounting adjustments;
• does not reflect company sale transaction expenses and merger related expenses, and
• may include other adjustments required in calculating debt covenant compliance such as pro forma adjusted EBITDA for companies acquired during the year.

To begin analysis of the ROIC metric, we first look at how return on invested capital is commonly defined by security analysts and enterprises, as a search on EDGAR, the SEC database reveals. Here too, as with free cash flow, definitions reported in financial statements differ for filers, making comparability often difficult to impossible. As with free cash flow, many firm’s tailor-make a ROIC definition, attempting to both place themselves in a favorable light, and adjust for peculiarities of their business.

A search through the Edgar database reveals a commonly used definition of ROIC to be:

ROIC=(EBITDA+Interest Income*(1-Tax Rate)+Goodwill Amortization)/(Total Assets-(Current Liabilities+Short Term Debt+Accumulated Depreciation))

National Semiconductor, has an even simpler definition, as spelled out in their 2009 10K: “We determine return on invested capital based on net operating income after tax divided by invested capital, which generally consists of total assets reduced by goodwill and non-interest bearing liabilities.”

Not only does beginning with EBITDA suffer from the shortfalls listed above, it is not a measure of distributable cash and is thus not a measure of real return to holders of equity securities. Excluding goodwill, like National Semiconductor, ignores a real cash outflow for which management is expected to earn free cash flows.

A SUPERIOR ROIC METHODOLGY USING FREE CASH FLOW

Using free cash flow as a base allows for comparability, uniformity, and offers what ROIC is really supposed to capture, the cash return on cash spent for capital. A more logical definition for ROIC, and one being proposed for analyst adoption to be:

 ROIC= (Free Cash Flow-Net Interest Income)/(Invested Capital (Equity+Total Interest Bearing Debt+Present Value of Leases-Cash and Marketable Securities) )

This more precise definition includes:

• Intangible assets, as those funds were used to acquire cash producing assets
• All interest bearing debt, as they too were sold to purchase productive assets
• Present value of operating leases, as this represents contractual debt in exchange for required assets needed to produce revenue, hence cash flows. To exclude operating leases would be to unfairly boost the return on invested capital and to distort the comparison between companies that buy assets or enter into capital leases and those that enter into operating leases.
• Since free cash flow is used, it includes the payment of cash taxes and the elimination of other accruals.

We do not add back, as true with EBITDA-based measures, interest income to free cash flow as we are attempting to measure the cash return on productive, not financial assets.

Investors, large and sophisticated to small and naive, with the latter often dependent on, and trusting of the former, often fail to understand the complicated relationship between valuation metrics and return on invested capital.

It is easy to want a simplified approach to investing, such as price/earnings multiple or price/book, but quite another to be able to and understand the bearings behind the numbers, and why so many entities sell for what appears to be an incredibly low valuation multiple or ratio.

In essence, entities having a low return on invested capital or dependent on large capital expenditures resulting in small amounts of distributable cash flows deserve low valuation metrics despite their higher rates of growth in GAAP related yardsticks. This is why many investors are fooled having invested in low P/E multiple companies. It is for this reason we advocate adoption of the return on invested capital metric using free cash flow as a base and, in our model portfolio only invest in entities which have shown the ability to consistently produce an average free cash flow yield in excess of the 10 year treasury yield.

Under the cash flow based definition, goodwill, intangible assets, and all other productive assets which required cash expenditure are counted in the capital base. Operating leases should also be included in the capital base, as they represent a financing decision for capital expected to return cash to the firm. We would not, however, impute an interest charge on the operating leases to deduct from free cash flow, as the entire lease payment is deducted in the computation of free cash flow, as reported under operating activities.

You will find by using the more precise and logical definition of ROIC, to be used in comparison to cost of capital, your portfolio will exhibit lower risk and higher returns.

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Insurance is most often a missing link in fundamental security analysis.

For example, despite BP’s strong credit health (was rated “A” by credit trends) to date, its lack of adequate coverage related to the spill ($1 bil. per occurrence) has caused us to raise our cost of of capital on the firm by 500 basis points. By so doing, the stock has become over-valued at these levels, despite producing over $ 18 bil. in free cash flow during 2008 and $9.7 bil during 2009. Recall our free cash flow model includes the addition of a portion of discretionary expenditures.

If however, the price of crude, a sensitivity analysis reveals, were to rise to $98/bbl, cash flow from operations over the coming two years would approximate $70 bil, when including the added efficiencies of working capital, capital spending, and other discretionary expenditures.

Insurance and Litigation
The role of insurance is an often underappreciated and under-analyzed area of security analysis, which could affect the cost of capital if it was insufficient or its cost grew greater than the rate of growth in operating cash flows.

Regarding uninsured losses, current accounting rules require a company disclose “specific quantitative and qualitative information” about loss contingencies, but does not require them to provide for the fair value impact losses would have on earnings or cash flows. Insurance adequacy is, unfortunately, rarely discussed during investor conferences.

Needing to be uncovered are:
• How is the company protected in the event of major damage to its computer system or warehouse?
• What is their coverage for product liability?
• How are they protected for worst case scenario in the event of a cyber attack, business interruption, due to strike, fire, or power outage?
• Is key man life insurance required to attract a replacement executive?
• Are they attempting to save cash and under-insuring?
• Does the firm require back-up facilities or other redundancies? Are they adequate to allow them to continue providing goods and service?

Example
Murphy Oil had large uninsured damage, impacting free cash flow, during 2006:
Uninsured damages, higher insurance premiums, settlement of the class action oil spill litigation and other hurricane-related pretax costs in the company’s North American operations were $3.0 million in 2007 and $107.3 million in 2006. The hurricane expense in 2007 was caused by a downward adjustment of expected insurance recoveries based on an updated loss limit published by the company’s primary insurer.

Security analysts are typically late in their evaluation of insurance adequacy, relegating their questioning to an event that has already occurred or is forecast, necessitating a review. Not true for the entity itself. For this reason, all large companies have dedicated employees, if not departments, whose sole purpose is to handle the insurance for the organization. If not for insurance, many companies would have filed for bankruptcy, the policies allowing them to collect cash resulting from large lawsuit awards or other catastrophic events. Many firms with facilities on the Gulf Coast of Louisiana would certainly have been out of business had it not been for property and business interruption insurance, resulting from Hurricane Katrina. If an entity not having the resources to cover potential claims exposes its productive capital by being underinsured, its cost of capital should be increased.

Companies have lost large awards resulting from non-awareness of legal liabilities pre-dating their acquisition of a business and for which they did not possess adequate insurance coverage. Other times, new scientific studies determined a company was selling a product which was later found to be unsafe. Such was the case with asbestos, which drove scores of previously financially healthy companies into bankruptcy, including Armstrong World Industries, which did not recognize the problem at its asbestos division at the time it was purchased. In fact, the US Government, at the time Armstrong acquired the company, required their buildings contain asbestos. Armstrong was a very strong and consistent producer of free cash flow, but eventually the asbestos liabilities became too great for their balance sheet and calls on capital. When the lawsuits began, Armstrong did not buy sufficient insurance, estimating they could work their way out of the problem with their strong operating cash flows.

When the price of insurance rises, entities may choose to self-insure part of the risk; the analyst must determine the soundness of self-insurance given a catastrophic event.

Example:
Self Insurance: The company utilizes a combination of insurance and self insurance for a number of risks including workers’ compensation, general liability, automobile liability and employee related health care benefits (a portion of which is paid by its employees). Liabilities associated with the risks that the company retains are estimated by considering historical claims experience, demographic factors, severity factors and other actuarial assumptions. Although the company’s claims experience has not displayed substantial volatility in the past, actual experience could materially vary from its historical experience in the future. Factors that affect these estimates include but are not limited to: inflation, the number and severity of claims and regulatory changes. In the future, if the company concludes an adjustment to self insurance accruals is required, the liability will be adjusted accordingly.
Source: Bed Bath & Beyond, 2009 10K

Example:

The marketing and sale of our products may involve product liability risks. Although we currently have product liability insurance, we may not be able to maintain our current coverage at an acceptable cost, if at all, and there is no guarantee that our insurance coverage will be adequate to meet all types of product liability claims we may encounter. In addition, our insurance may not provide adequate coverage against potential losses. If claims or losses exceed our liability insurance coverage, we may go out of business.
Source: ecoSolutions, 2009 10K

Most companies have key man whole life insurance on its top executives. Such policies are a tax deductible expense while the cash surrender value most often grows significantly over time. These policies belong to the company, and, as such, their cash surrender values are placed on the balance sheet, although the amount is often hidden with “Other Assets.” This cash can be called on by the entity at any time, if needed, but normally is used to fund key executives retirement benefits.

Not only must the current adequacy of insurance be considered, so too must the risk of litigation that, if took place, would result in a weakened financial condition. Some industries are, by their nature, more subject to lawsuit, while other industries may evolve to become of a higher risk. An increase in such risk is not to be taken lightly, as was seen by the toy industry during 2006 when lead paint was found in many of their products, resulting in free cash flow that could not be reasonably estimated. As was discussed earlier under “Contingent Liabilities,” a thorough review of such prospects (including adequacy of product liability insurance) needs to be explored.

If legal costs exceed, or are expected to exceed 5% of normalized (3 or 4-year) cash flow from operations, a penalty is assessed. If, in the opinion of the analyst, an existing lawsuit, or the threat of one for which the analyst believes has merit, which will result in a payment of greater than 5% of normalized operating cash flows, a penalty is assessed.

Potentially large payments which could emanate from manageable small lawsuits for which a payment has been made would result in a large penalty. Often, however, a firm is reluctant to discuss payment associated with a lawsuit to discourage publicity.

Insurance inadequacy will penalize cost of capital, the amount dependant on the risks involved. Firms that under-insure workers compensation are especially at risk.

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