If equity markets represent the flawless leading economic indicator generally believed, investors should be very comfortable nowadays. After all, the S&P 500 is up almost 12% so far this year. Yet, economists remain generally concerned.
Is it not then unreasonable to ask: Are the glorious headlines trumpeting rising free cash flows portending a sustainable and durable continuation of the economic expansion or perhaps the result of severe cost cutting with a dose of imaginative accounting?
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.
Intel (INTC) and Research in Motion (RIMM) came onto CT Capital’s buy list over the past month after having been brow-beaten by many security analysts. Analysts believed these firms are, or soon will be, succumbing to the modern tablet era which will either make their current product line-ups obsolete or less relevant, as a new stream of products gains a foothold on their market share.
At the end of last year, to avoid having to consolidate its 83% ownership investment in Globalfoundries, which, if undertaken would have harmed its financial results and balance sheet, AMD took the unusual step of renouncing its control in that large enterprise.
Adopted by FASB in June, 2009 for adoption beginning in 2010, FAS 166, Accounting for Transfers of Financial Assets, and No. 167, Amendments to FASB Interpretation No. 46(R), changes the method by which entities account for securitizations and special-purpose entities. FASB 166 relates to the consolidation of variable interest entities, and 167 amends existing guidance for when a company “derecognizes” transfers of financial assets. A variable interest entity is a business structure that allows an investor to hold a controlling interest in the entity, without that interest translating into possessing enough voting privileges to result in a majority. The new standard requires noncontrolling interests be reported as a separate component of equity and that net income or loss attributable to the parent and noncontrolling interests be separately identified in the statement of operations.
Under this recent accounting rule dealing with variable interest entities, which took effect this year, AMD would have been required to consolidate Globalfoundries its debt and income into AMD. By renouncing its control, AMD is merely required to state its investment as a single line entry, even though it may be partially or wholly on the hook for a share, or all, of its debt.
These type of actions, while having little to no impact on cash flow, can nevertheless serve as signals of impending busineess conditions. For if AMD’s position was strong, we doubt such a transaction would be considered. But that’s the result of a firm with large negative free cash flow with high cost of capital-unlike Intel.
No wonder AMD’s stock has continued to fare poorly.
Intel Corporation (INTC) will release its financial results after the US financial markets close.
We spotlight INTC due to its consistent ability to produce free cash flows and strong credit, both of which manifest in a below-market cost of equity capital. INTC is, by Credit Trends, rated “A” for both cash flow and debt, as seen below.
While the model has picked up some deterioration of its credit quality over the past year (operating cash flow adjusted for working capital changes, leases, total debt, ratio of working capital to total debt, pensions, inventory/sales, reinvestment, taxes, others), INTC remains a very strong credit, and is thus accorded our highest rated class.
The table below shows INTC could free up additional free cash flows by reducing its selling, general and administrative expense more in line with its rate of growth. Interestingly, INTC has done this with its R&D even though R&D as a percentage of both sales and cost of sales has declined. This was due to the absolute expense reduction in nominal dollars during its past fiscal year of approximately $100MM. This was quite close to the $91 MM we calculated as corporate “fat” we called for a year ago.
INTC is a low tax rate payer by any measure, but in a higher rate (on a cash basis) and more importantly, a more consistent rate than AMD or TXN. In “Security Valuation and Risk Analysis” we show how taxes should be analyzed for areas of weakness and strength, including its role as a leading indicator. In its last fiscal year, INTC was in a 16.5% cash rate versus the 23.4% rate reported to shareholders. By contrast, AMD was in a 3.4% cash rate and TXN a 16.4% rate. Over the past 6 years INTC’s cash tax rate has averaged 6 percentage points higher than TXN.
As for fair value, given its estimated 7% rise in long-term free cash flows and low cost of capital, INTC is currently about 13% undervalued.
INTC 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, its 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 credittrends own a position in INTC, nor was CT Capital or credittrends paid for preparing this report.
