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.
Despite this past week’s 3.4% earnings-related stock rally, as of this writing, the S&P 500 Index is just near break-even for the year.
I bring up this unfortunate news as we are about to close out another month for the calendar year 2010, now 58% done. By August end, the year will be two-thirds over, and so will vacation time.
Alcoa stock has fallen by 33% this year. Analysts of cash flow and risk could have avoided this issue (see earlier article).
Firms that, when they halt receivables sales and tell their shareholders their cash flows would have been higher (without mentioning the positive boost to prior quarters), are raising a warning flag.
Pension plans are making news-from local and state governments to large corporations. They are being cut back, eliminated or, for many, in trouble without the workforce recognizing the extent of the problem.
Most firms have been forced to prop up their plan’s health with additional cash contributions, while many other firms are simply hoping the financial markets, as they did during 2009, will bail them out.
Meanwhile, for others, the plans are so underfunded, it is just a matter of time before the inevitable takes hold-larger than expected contributions or a bailout by the Pension Benefit Guaranty Corp. Those firms have been able to make it this far due to overzealous actuarial assumptions which have moderated the true liability. However, with both stocks and hedge fund performance below zero the past three years, which firms stock prices are the most vulnerable?
The list below shows the bottom 20% of that S&P grouping, with each firm on the list underfunded to the extent such amounts to at least 5% of both their total debt (including capitalizing the operating leases, shown as a separate column), and 5% of its current stock price. Many are in much more precarious position, as is shown. In addition, each company on the list has both an expected return on plan assets and a discount rate at least equal to the market average. Of the S&P group of companies, the average investment assumption is 8% and the average discount rate 5.8%, both of which is presently too high and understates the true liability confronting firms with defined benefit plans. The firms on the list have expectations greater than that! Also shown are last fiscal year’s plan contributions, benefits paid and projected benefit obligation (PBO).
The PBO is the actuarial present value of all benefits earned by an employee as of a specified date for service rendered prior to that date plus projected benefits attributable to future salary increases. Indicated is the funded status of a pension plan as either overfunded or underfunded, however, all of these firms plans are currently underfunded as of their latest fiscal.
The underfunded status of defined as the sum of:
minus the sum of
Accumulated pension plan benefits are reflected at present value to remain on a comparable basis with plan assets. The assumed rate of return on assets is the discount rate used to arrive at the present value of plan benefits.
If the financial market does not bail these firms out, the alternative could quite well be additional significant and currently unforeseen contributions which will impair reported and expected earnings, cash flows, return on invested capital, and cost of capital.
I would strongly urge all investors in these firms to thoroughly review the actuarial soundness of their plans as this represents significant risk that can be avoided prior to the headlines.
Disclosure: No positions
Kenneth S. Hackel, C.F.A.
President
CT Capital LLC
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To learn how to analyze pension soundness and the pension soundness and the pension footnote and reporting requirements, please pre-order “Security Valuation and Risk Analysis“, out this fall from McGraw-Hill, by Kenneth Hackel, C.F.A.
Included in Alcoa’s (AA) press release this week was the statement its cash flows would have been even higher had it not been for the ending of its sales of accounts receivables.
What Alcoa didn’t state is that such sales enhanced its prior quarters, with the amount of additional sales, above the prior period (adjusted for normalized growth) to be subtracted from cash flow from operations. Alcoa’s prior periods cash flows, using traditional methods have benefited from such sales. In our analysis we back out such favorable impact to arrive at a normalized free cash flow and operating cash flows.
The sale of receivables is part of the analysis of all asset sales.
Asset Sales
For entities needing to raise cash, asset sales are always considered in addition to external financing. The least costly capital raise will always be considered first, especially if the financial turbulence is expected to be short-term and the cost of debt and equity are high.
The continual sale of inventory for below market prices, or accounts receivable factoring, normally provide an unmistakable warning that should raise a flag for students of cash flow and risk, as the realization price reflects a cost which would not normally be acceptable to a well-financed organization. Asset sales are often a de-facto partial liquidation. Continuing asset sales that take place for lower than balance sheet values are indeed telltale signs.
To improve operating cash flows, companies often sell operating divisions, as they rebalance their portfolio of companies in search of the highest return opportunities. Small asset sales and balance sheet management typically constitute good business practice, and add to free cash flow and reduced cost of capital. Managers committed to weeding out poorly performing business units can significantly enhance their company’s market valuation.
Significance, in accounting parlance, relates to size and whether the failure to report an event as a separate line item would mask a change in earnings or trend. The analyst should determine if the company under analysis has indeed sold assets during any particular reporting period due to weakness in its borrowing capacity, or an attempt to bolster disappointing operation cash flow. Both Enron and Delphi Corp, prior to their bankruptcies, were selling inventory with the understanding they would be repurchased at a later period, a clever way to raise cash but a telling sign of liquidity shortfall.
The securitization of assets for sale into a Special Purpose Entity, as was invoked by Enron, may not, by itself, represent a reason to sell a security or dismiss the purchase of one, especially in light of otherwise undervaluation by the marketplace. In fact, many companies have raised cash via the securitization of accounts receivable, redeploying those funds back into a business which resulted in high rates of growth in cash flows. When viewed under the light of other metrics, asset sales could form part of a mosaic, indicative of a financial risk urging avoidance of the particular security, or to place a higher discount rate on its free cash flow, accounting for the new, higher level of uncertainty.
Entities which have substantial accounts receivables, like retailers, often discount these future cash receipts for immediate cash, as Macy’s did during 2006. The figure below reveals the impact on its average collection period resulting from that sale. Of course, average collection period and similar credit metrics, such as cash conversion cycle, will be distorted by the sale of receivables.
Selling receivables boosts current period operating cash flow and thus must be normalized by the analyst in evaluating historical and prospective cash flows. To do so, one would compute the past 4 years average accounts receivable to sales and apply that to the current year, as if the financing did not occur. At that point, the analyst can evaluate the Operating and Power cash flows for that year, including the sales of receivables.
More importantly, since the upcoming year(s) cash collections will be lower, an updated cash flow projection must reflect the new expected collections, with emphasis on the ability of the entity to retire or recast upcoming debt and other obligations coming due. Macy’s has, according to its “Financing” footnote, $2.6 bn. in principal payments due over the coming 3 years. Since prospective cash flows will be diminished by the present value of the change in future collections, fair value could shift, depending on how the cash from the sale is deployed. In its statement of cash flows, seen is the drop in cash flows from operations, with management reacting to by cutting budgets company wide.
MACY’S, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(millions)
| 2008 | 2007 | 2006 | ||||||||||
| Cash flows from continuing operating activities: | ||||||||||||
| Net income (loss) | $ | (4,803 | ) | $ | 893 | $ | 995 | |||||
| Adjustments to reconcile net income (loss) to net cash provided by continuing operating activities: | ||||||||||||
| (Income) loss from discontinued operations | – | 16 | (7 | ) | ||||||||
| Gains on the sale of accounts receivable | – | – | (191 | ) | ||||||||
| Stock-based compensation expense | 43 | 60 | 91 | |||||||||
| Division consolidation costs and store closing related costs | 187 | – | – | |||||||||
| Asset impairment charges | 211 | – | – | |||||||||
| Goodwill impairment charges | 5,382 | – | – | |||||||||
| May integration costs | – | 219 | 628 | |||||||||
| Depreciation and amortization | 1,278 | 1,304 | 1,265 | |||||||||
| Amortization of financing costs and premium on acquired debt | (27 | ) | (31 | ) | (49 | ) | ||||||
| Gain on early debt extinguishment | – | – | (54 | ) | ||||||||
| Changes in assets and liabilities: | ||||||||||||
| Proceeds from sale of proprietary accounts receivable | – | – | 1,860 | |||||||||
| Decrease in receivables | 12 | 28 | 207 | |||||||||
| (Increase) decrease in merchandise inventories | 291 | 256 | (51 | ) | ||||||||
| (Increase) decrease in supplies and prepaid expenses | (7 | ) | 33 | (41 | ) | |||||||
| Decrease in other assets not separately identified | 1 | 3 | 25 | |||||||||
| Decrease in merchandise accounts payable | (90 | ) | (132 | ) | (462 | ) | ||||||
| Decrease in accounts payable and accrued liabilities not separately identified | (227 | ) | (396 | ) | (410 | ) | ||||||
| Increase (decrease) in current income taxes | (146 | ) | 14 | (139 | ) | |||||||
| Decrease in deferred income taxes | (291 | ) | (2 | ) | (18 | ) | ||||||
| Increase (decrease) in other liabilities not separately identified | 65 | (34 | ) | 43 | ||||||||
| Net cash provided by continuing operating activities | 1,879 | 2,231 | 3,692 | |||||||||
| Cash flows from continuing investing activities: | ||||||||||||
| Purchase of property and equipment | (761 | ) | (994 | ) | (1,317 | ) | ||||||
| Capitalized software | (136 | ) | (111 | ) | (75 | ) | ||||||
| Proceeds from hurricane insurance claims | 68 | 23 | 17 | |||||||||
| Disposition of property and equipment | 38 | 227 | 679 | |||||||||
| Proceeds from the disposition of After Hours Formalwear | – | 66 | – | |||||||||
| Proceeds from the disposition of Lord & Taylor | – | – | 1,047 | |||||||||
| Proceeds from the disposition of David’s Bridal and Priscilla of Boston | – | – | 740 | |||||||||
| Repurchase of accounts receivable | – | – | (1,141 | ) | ||||||||
| Proceeds from the sale of repurchased accounts receivable | – | – | 1,323 | |||||||||
| Net cash provided (used) by continuing investing activities | (791 | ) | (789 | ) | 1,273 | |||||||
Source: Macy’s 2008 10K
In many cases, it is less expensive to borrow funds with the creditor taking a security interest in accounts receivables and inventory. This would be a loan, not a factoring agreement where the accounts receivable are sold. In a factoring arrangement, the cost to the firm is typically higher.
When receivables are financed through borrowings, it is shown as a finance activity, even though the actions are basically identical to its sale. Also, by factoring, the firm keeps the loan off of its balance sheet. Another issue to consider is whether the receivables being sold were done so on a non-recourse basis, so that if they are ultimately uncollectable, Macy’s has no further legal obligation. A moral obligation, may exist, however, and must be considered.
The figure below shows Macy’s average collection and payables period for 2003-2009 fiscal years. When Macy’s sold about $ 4.1 bn. of their in-house receivables during 2005-2006, it dropped their collection period, but of course, the company paid a price for the immediate cash. They did reduce total debt by about $ 1.5 bn. but unfortunately they also succumbed to shareholder pressure and expended $2.5 bn. on the repurchase of shares, hopeful the buyback would boost the stock price, which it did not, since their cash flows were weak.
To Macy’s, which had substantially increased its leverage resulting from its $ 5.2 bn. purchase of May Department Stores the year earlier, the cash resulting from the sale of receivables might have ultimately staved off bankruptcy two years later when its business fell due to the recession and loss of market share to competitors, the latter not a atypical byproduct of a large business combination. For sure, management wished the $ 2.5 bn. stock buyback never took place. The $2.5 bn. outflow robbed Macy’s of needed financial flexibility by eliminating a large cushion when its business turned down.
While the sale of receivables does indeed provide immediate cash, it is important to consider why the action was taken, especially for companies that operate on tight margins. For such entities, the sale may eliminate profits those sales initially produced. For them, if the cash is not used to pay down trade payables or other business related obligations, the analyst must question where such cash will eventually come. Because Macy’s wasted funds from the sale on share buybacks, they cut their purchases of PPE in half over the next two years. It is difficult to imagine a large sale of accounts receivable to buy back shares is ever a good idea.
Macy’s-Days to Pay vs. Collections Period
For additional information on this type analysis, pre-order- “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.
Disclosure: No positions
Kenneth S. Hackel, C.F.A.
President
CT Capital LLC
Alcoa (AA) worked its assets to eke out some free cash flow during the quarter, as it has the past three years.
However, management’s statement that free cash flow would have been even higher had it not been for the ending of several accounts receivable programs doesn’t hold a lot of water.
Over the past three years, after adjusting for “working the balance sheet”, AA produced on average $1.2 billion in cash flow from operations, or 38% below that reported to stockholders under cash flow from operations. Thus, while AA still has some additional “capture” here, the bulk of the work is done. We are, however, impressed with AA’s fixation on free cash flow, although I point out this is not unusual for debt heavy firms which have been reporting tax losses, like Alcoa. For example, during FY ’09, AA’s cash tax rate was negative, while its effective rate was 38.7%
AA still has an underfunded pension, which surprisingly did not come up during analyst questioning, despite the $600MM stock contribution the company made in its first fiscal quarter. AA still has steep debt payments over the coming few years.
AA appears to be a risky stock I would avoid, although a better than a dreadful scenario, and general equity market rally will likely result in some advance in its shares.
Disclosure: No positions.
Kenneth S. Hackel, C.F.A.
President
CT Cpital LLC
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.
Included in Alcoa’s press release yesterday was the statement its cash flows would have been even higher had it not been for the ending of its sales of accounts receivables.
What Alcoa isn’t stating is that such sales enhanced its prior quarters, with the amount of additional sales, above the prior period (adjusted for normalized growth) to be subtracted from cash flow from operations. Alcoa’s prior periods cash flows, using traditional methods have benefited from such sales. In our analysis we back out such favorable impact to arrive at a normalized free cash flow and operating cash flows.
The sale of receivables is part of the analysis of all asset sales.
ASSET SALES
For entities needing to raise cash, asset sales are always considered in addition to external financing. The least costly capital raise will always be considered first, especially if the financial turbulence is expected to be short-term and the cost of debt and equity are high.
The continual sale of inventory for below market prices, or accounts receivable factoring, normally provide an unmistakable warning that should raise a flag for students of cash flow and risk, as the realization price reflects a cost which would not normally be acceptable to a well-financed organization. Asset sales are often a de-facto partial liquidation. Continuing asset sales that take place for lower than balance sheet values are indeed telltale signs.
To improve operating cash flows, companies often sell operating divisions, as they rebalance their portfolio of companies in search of the highest return opportunities. Small asset sales and balance sheet management typically constitute good business practice, and add to free cash flow and reduced cost of capital. Managers committed to weeding out poorly performing business units can significantly enhance their company’s market valuation.
Significance, in accounting parlance, relates to size and whether the failure to report an event as a separate line item would mask a change in earnings or trend. The analyst should determine if the company under analysis has indeed sold assets during any particular reporting period due to weakness in its borrowing capacity, or an attempt to bolster disappointing operation cash flow. Both Enron and Delphi Corp, prior to their bankruptcies, were selling inventory with the understanding they would be repurchased at a later period, a clever way to raise cash but a telling sign of liquidity shortfall.
The securitization of assets for sale into a Special Purpose Entity, as was invoked by Enron, may not, by itself, represent a reason to sell a security or dismiss the purchase of one, especially in light of otherwise undervaluation by the marketplace. In fact, many companies have raised cash via the securitization of accounts receivable, redeploying those funds back into a business which resulted in high rates of growth in cash flows. When viewed under the light of other metrics, asset sales could form part of a mosaic, indicative of a financial risk urging avoidance of the particular security, or to place a higher discount rate on its free cash flow, accounting for the new, higher level of uncertainty.
Entities which have substantial accounts receivables, like retailers, often discount these future cash receipts for immediate cash, as Macy’s did during 2006. Figure 3-2 reveals the impact on its average collection period resulting from that sale. Of course, average collection period and similar credit metrics, such as cash conversion cycle, will be distorted by the sale of receivables.
Selling receivables boosts current period operating cash flow and thus must be normalized by the analyst in evaluating historical and prospective cash flows. To do so, one would compute the past 4 years average accounts receivable to sales and apply that to the current year, as if the financing did not occur. At that point, the analyst can evaluate the Operating and Power cash flows for that year, including the sales of receivables.
More importantly, since the upcoming year(s) cash collections will be lower, an updated cash flow projection must reflect the new expected collections, with emphasis on the ability of the entity to retire or recast upcoming debt and other obligations coming due. Macy’s has, according to its “Financing” footnote, $2.6 bn. in principal payments due over the coming 3 years. Since prospective cash flows will be diminished by the present value of the change in future collections, fair value could shift, depending on how the cash from the sale is deployed. In its statement of cash flows, seen is the drop in cash flows from operations, with management reacting to by cutting budgets company wide.
MACY’S, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(millions)
| 2008 | 2007 | 2006 | ||||||||||
| Cash flows from continuing operating activities: | ||||||||||||
| Net income (loss) | $ | (4,803 | ) | $ | 893 | $ | 995 | |||||
| Adjustments to reconcile net income (loss) to net cash provided by continuing operating activities: | ||||||||||||
| (Income) loss from discontinued operations | – | 16 | (7 | ) | ||||||||
| Gains on the sale of accounts receivable | – | – | (191 | ) | ||||||||
| Stock-based compensation expense | 43 | 60 | 91 | |||||||||
| Division consolidation costs and store closing related costs | 187 | – | – | |||||||||
| Asset impairment charges | 211 | – | – | |||||||||
| Goodwill impairment charges | 5,382 | – | – | |||||||||
| May integration costs | – | 219 | 628 | |||||||||
| Depreciation and amortization | 1,278 | 1,304 | 1,265 | |||||||||
| Amortization of financing costs and premium on acquired debt | (27 | ) | (31 | ) | (49 | ) | ||||||
| Gain on early debt extinguishment | – | – | (54 | ) | ||||||||
| Changes in assets and liabilities: | ||||||||||||
| Proceeds from sale of proprietary accounts receivable | – | – | 1,860 | |||||||||
| Decrease in receivables | 12 | 28 | 207 | |||||||||
| (Increase) decrease in merchandise inventories | 291 | 256 | (51 | ) | ||||||||
| (Increase) decrease in supplies and prepaid expenses | (7 | ) | 33 | (41 | ) | |||||||
| Decrease in other assets not separately identified | 1 | 3 | 25 | |||||||||
| Decrease in merchandise accounts payable | (90 | ) | (132 | ) | (462 | ) | ||||||
| Decrease in accounts payable and accrued liabilities not separately identified | (227 | ) | (396 | ) | (410 | ) | ||||||
| Increase (decrease) in current income taxes | (146 | ) | 14 | (139 | ) | |||||||
| Decrease in deferred income taxes | (291 | ) | (2 | ) | (18 | ) | ||||||
| Increase (decrease) in other liabilities not separately identified | 65 | (34 | ) | 43 | ||||||||
| Net cash provided by continuing operating activities | 1,879 | 2,231 | 3,692 | |||||||||
| Cash flows from continuing investing activities: | ||||||||||||
| Purchase of property and equipment | (761 | ) | (994 | ) | (1,317 | ) | ||||||
| Capitalized software | (136 | ) | (111 | ) | (75 | ) | ||||||
| Proceeds from hurricane insurance claims | 68 | 23 | 17 | |||||||||
| Disposition of property and equipment | 38 | 227 | 679 | |||||||||
| Proceeds from the disposition of After Hours Formalwear | – | 66 | – | |||||||||
| Proceeds from the disposition of Lord & Taylor | – | – | 1,047 | |||||||||
| Proceeds from the disposition of David’s Bridal and Priscilla of Boston | – | – | 740 | |||||||||
| Repurchase of accounts receivable | – | – | (1,141 | ) | ||||||||
| Proceeds from the sale of repurchased accounts receivable | – | – | 1,323 | |||||||||
| Net cash provided (used) by continuing investing activities | (791 | ) | (789 | ) | 1,273 | |||||||
Source: Macy’s 10K
In many cases, it is less expensive to borrow funds with the creditor taking a security interest in accounts receivables and inventory. This would be a loan, not a factoring agreement where the accounts receivable are sold. In a factoring arrangement, the cost to the firm is typically higher.
When receivables are financed through borrowings, it is shown as a finance activity, even though the actions are basically identical to its sale. Also, by factoring, the firm keeps the loan off of its balance sheet. Another issue to consider is whether the receivables being sold were done so on a non-recourse basis, so that if they are ultimately uncollectable, Macy’s has no further legal obligation. A moral obligation, may exist, however, and must be considered.
The figure below shows Macy’s average collection and payables period for 2003-2009 fiscal years. When Macy’s sold about $ 4.1 bn. of their in-house receivables during 2005-2006, it dropped their collection period, but of course, the company paid a price for the immediate cash. They did reduce total debt by about $ 1.5 bn. but unfortunately they also succumbed to shareholder pressure and expended $2.5 bn. on the repurchase of shares, hopeful the buyback would boost the stock price, which it did not, since their cash flows were weak.
To Macy’s, which had substantially increased its leverage resulting from its $ 5.2 bn. purchase of May Department Stores the year earlier, the cash resulting from the sale of receivables might have ultimately staved off bankruptcy two years later when its business fell due to the recession and loss of market share to competitors, the latter not a atypical byproduct of a large business combination. For sure, management wished the $ 2.5 bn. stock buyback never took place. The $2.5 bn. outflow robbed Macy’s of needed financial flexibility by eliminating a large cushion when its business turned down.
While the sale of receivables does indeed provide immediate cash, it is important to consider why the action was taken, especially for companies that operate on tight margins. For such entities, the sale may eliminate profits those sales initially produced. For them, if the cash is not used to pay down trade payables or other business related obligations, the analyst must question where such cash will eventually come. Because Macy’s wasted funds from the sale on share buybacks, they cut their purchases of PPE in half over the next two years. It is difficult to imagine a large sale of accounts receivable to buy back shares is ever a good idea.
Macy’s-Days to Pay vs. Collections Period
Source: Research Insight, CT Capital LLC
For additional information on this type analysis, pre-order- “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.
Disclosure: No positions.
Kenneth S. Hackel, C.F.A.
President
CT Capital LLC
